In my last post in this series– Alternative Assets (5), I discussed the provision in the DOL’s proposed regulation on the Selection of Designated Investment Alternatives for participant-directed plans (2026-06178.pdf) that provides a fiduciary safe harbor for each of the 6 identified factors if fiduciaries “inform” themselves properly. (While labeled a “safe harbor”, it is more accurately a presumption that a prudent decision was made…if a prudent process was followed to become informed about the particular investment.)

One effect will be that fiduciaries are better protected for their decisions since plaintiffs will have to overcome the “significant deference” presumption that the decision was prudent. However, an offsetting consideration is that it will be more difficult for participants to hold fiduciaries accountable for losses due to imprudent decisions.

In the proposal, the DOL identifies six factors that it views as relevant to almost all investment decisions.  The six factors are: Performance, Fees, Liquidity, Valuation, Performance Benchmark, and Complexity. The application of the factors is described by examples—20 examples in total. The specified factors are defined in the proposal. This article begins a series that discusses each of the factors and their examples.  We start with the Performance factor.

The proposal describes the Performance factor as:

(g) Performance. The plan fiduciary must appropriately consider a reasonable number of similar alternatives and determine that the risk-adjusted expected returns, over an appropriate time-horizon, of the designated investment alternative, net of anticipated fees and expenses, further the purposes of the plan by enabling participants and beneficiaries to maximize risk-adjusted returns on investment net of fees and expenses. [The bolding is mine]

Comment: Let’s look at each of the bolded statements.

A reasonable number of similar alternatives. In other words, in making a decision about the selection of a particular investment type (e.g., a large cap blend fund), fiduciaries must consider and compare a “reasonable number” of competing investments of the same type.  Sounds pretty simple, right?  Not so fast.  First, how many does it take to be reasonable?  The regulation doesn’t say, but examples in the proposal variously use 3 or 5 as a reasonable number.  Let’s say it’s four.  How often do plan fiduciaries consider four competing target date fund suites before making a decision on the one to include in the plan?  What about stable value funds?  How many are typically considered in the comparison that would be required if this rule becomes final?  How many TDF suites or stable value funds are included on the recordkeeper’s platform?  Will this raise compliance issues for mid-market and small plans? I think so.

But what about other types of investments, for example, large cap growth funds?  My experience is that advisors typically use services that have databases of information about many funds, software to make the comparisons, and possibly rating systems to help with the analysis.  In those cases, scores of funds could be initially evaluated if you consider all the funds of a particular type in the database.  That may produce a single recommendation or a number of funds to be considered in determining which one is right for the particular plan.  In either case, the process is inconsistent with the idea of looking at just 3 to 5 funds.  In fact, one of the problems with just looking at a limited number of funds is that they may not be representative of the universe of funds that are available to the plan.

The risk-adjusted expected returns. I’m not an investment adviser, so I’m not experienced in this area. But when I ‘ve sat in on committee meetings, the discussions have been about total return and not risk-adjusted returns.  This language suggests that it would be imprudent to look at total returns, and not risk-adjusted returns.  I have two problems with that.  First, one possible interpretation of the proposal is that the DOL is taking a principle’s-based standard (i.e., the prudent person standard) and turning it into a rules-based approach (e.g., fiduciaries must use risk-adjusted returns).  If that interpretation is correct, then I think the DOL is out of line.  The proper methods of vetting investments should be left to the private sector and investment experts and should not be proscribed by the government. Second—and this is based on my lack of relevant experience, I wonder how  future (or “expected”) risk-adjusted returns could be calculated.  Do past risk-adjusted returns necessarily determine future risk-adjusted returns? Is that a reasonable assumption?

I also worry that the approach described in the proposal is inconsistent with the practices of fiduciaries of small and mid-sized plans that are prudently managed even though it is not in the manner described by the DOL.

A simple solution would be for the DOL to clarify that the examples are just that, and that they should not be read as requirements or as the only way to prudently select investments.

Appropriate time horizons. This is problematic.  The obvious question is, does this apply to the time horizon of the plan…which could be decades?  Or to the appropriate horizon of the median participant….which I recently read is relatively short….a matter of 4 or 5 years? Or is based on the average—is it mean, mode or median–ages of the participants in the plan? Or something else? The DOL discusses that in the preamble.  That is discussed later in this article.

The preamble provides a little more information about the DOL’s intentions:

5. Performance

 5.1. The Standard

Proposed paragraph (g) identifies performance as a factor for fiduciary consideration in selecting a designated investment alternative. The paragraph provides that the fiduciary must appropriately consider a reasonable number of similar investment alternatives and then must determine that the risk-adjusted expected returns of the designated investment alternative, over an appropriate time horizon and net of anticipated fees and expenses, furthers the purposes of the plan by enabling participants and beneficiaries to maximize risk-adjusted return on investment, net of those fees and expenses.

As further illustrated by the examples in paragraphs (g)(1) and (g)(2), discussed below, proposed paragraph (g) makes clear that a fiduciary’s consideration of an investment alternative’s performance should not focus solely on expected returns. When evaluating performance fiduciaries must take into account the risks that investors are exposed to with respect to the designated investment alternative (including, among other risks, economic, market, sector, and investment-specific risks and counterparty risks), as well as the risk capacity of the plan’s participants.

Comment: My sense is that fiduciaries do not take all of these factors into account, although some may be.  For example, are “economic, market, sector, and investment-specific risks” taken into account when selecting an S&P 500 index fund?  I don’t think that is typical.  In fact, I think that the prevailing approach is to select a broad range of investments, some more volatile and some less so, and then allow the participants to match their individual risk profiles by appropriately combining those investment alternatives in their accounts. And, once again, I am concerned that the DOL is writing rules-based standards and should be taking a more principles-based approach.

Proposed paragraph (g) also references an appropriate time horizon. Plan fiduciaries must consider the time horizon of the plan’s participants when evaluating performance. Depending on the age of the workforce, retirement savings can often involve a long time horizon. Evaluation of an investment alternative’s performance should take into account the participants’ likely needs over the course of the anticipated investment.

Comment: I disagree.  In my view, fiduciaries should offer a broad range of investment alternatives that allow participants to match their risk profiles in the individual accounts.  Some participants will be more conservative while others will be more aggressive.  A plan should provide opportunities for both, as opposed to having a monolithic lineup that favors one group over another, e.g., that favors more conservative participants over those that are willing to take more risk or that favors those that are younger to the detriment of those that are older.

Finally, paragraph (g) provides that the consideration of an investment alternative’s performance also should occur net of anticipated fees and expenses. This presents the fiduciary with the most accurate information about the investment’s performance.

In all these areas, plan fiduciaries may wish to work with an investment advice fiduciary (within the meaning of ERISA section 3(21)(A)(ii)) to understand and evaluate the performance of the investment.

Comment: Both of these statements make sense and are consistent with common practices of plans of all sizes.

Concluding Thoughts

I am worried that, in its pursuit of a fiduciary safe harbor, the DOL is making the following mistakes:

• Applying the standards of very large companies, with their substantial resources, to the small and mid-market plan sponsors and their fiduciaries;
• Giving examples that appear to be imposing mandatory rules, which is inconsistent with a principles-based standard—the prudent person standard of ERISA.

Having said that, I do think the DOL is earnest and trying to develop a reasonable approach to fiduciary compliance and safety.

But I think that the process needs to be restarted through an extension of the comment period and the issuance of an RFI—request for information—about the prudent practices of small and mid-sized plan sponsors.

Time will tell.  However, I am concerned.