The DOL’s proposed regulation on selecting investments, including alternative assets, 2026-06178.pdf, identifies six factors that need to be considered in the process of selecting any investments for participant-directed plans, such as 401(k) plans and private sector 403(b) plans. The six factors are: Performance, Fees, Liquidity, Valuation, Performance Benchmark, and Complexity. The proposal describes each of the six factors and then provides examples to illustrate their application.
In my last post in this series– Alternative Assets (6), I discussed the first of those six factors—Performance, and the DOL’s description of the process for evaluating performance (or, more accurately, expected future returns). While not entirely clear, the description of the process could be viewed as one approach to satisfying the evaluation of the particular factor or it could be viewed as being the only way to satisfy the factor. If the latter, it would require major changes to the processes of most plan sponsors and advisers. Hopefully the final regulation will clarify the DOL’s intentions.
This article discusses the first of the two examples about evaluating the Performance factor. (It is also not clear if the examples are just illustrations of one approach to fiduciary prudence or whether the DOL contemplates that they will be the only way to evaluate the examples’ facts and circumstances.)
The first example is:
- Example. Return—
(i) Facts. The named fiduciary of a plan (e.g., the plan sponsor or plan investment committee), working with a third-party investment advice fiduciary within the meaning of section 3(21)(A)(ii) of ERISA, considers three target date fund series. The investment advice fiduciary presents various risk measures for the named fiduciary to consider, including the Sharpe Ratio, a commonly used measure to assess risk-adjusted performance, and a risk-adjusted return measure that subtracts a risk penalty from returns. The investment advice fiduciary explains these concepts and their implications to the named fiduciary that then relies on this advice to select a target date fund series that has lower expected returns but lower expected risk, as measured by volatility. The named fiduciary makes this selection after considering the risk capacity of the plan’s participants. The lower risk strategy that the named fiduciary selects has achieved higher risk-adjusted returns by including alternative assets with low correlations to stocks and bonds in its investment portfolio, thereby reducing the volatility of returns.
(ii) Analysis. Plan fiduciaries, with the benefit of third-party investment advice when appropriate, need not select an investment with the highest returns, nor aim to achieve the highest possible returns. It is often prudent to select a lower-risk investment strategy with a lower expected return. Plan fiduciaries may wish to consider selecting investments that hold alternative assets with low correlations to stock and bonds in their portfolios for exactly this purpose of improving riskadjusted returns.
(iii) Conclusion. A plan fiduciary selecting a designated investment alternative should consider various risk metrics when evaluating investments. The plan fiduciary should seek to maximize returns, net of fees, for a given level of appropriate risk, consistent with the participants’ likely needs over the course of the anticipated investment. By doing so, including by engaging and relying on third-party investment advice, as appropriate, to analyze and explain how to evaluate risk, the plan fiduciary shall be deemed to have satisfied the requirements of paragraph (g) of this section.
Comment: Many of the examples in the proposal (including this one) include, as relevant considerations, the use of non-discretionary 3(21) advisors and/or discretionary 3(38) investment managers. In totality, that suggests that the DOL views the use of qualified advisors as indicative of a prudent process. That is consistent with the holdings of some courts.
As mentioned in earlier posts in this series, the DOL expects fiduciaries to consider a reasonable range of alternatives for each type of investment to be included in the lineup for participant direction. While this example uses three alternatives to represent a reasonable number, other examples use five options. We are left to think that somewhere in the range of 3 to 5 options would be considered to satisfy the “reasonable number” requirement. Shifting from legal to practical, it is not my experience that small and mid-sized plans engage in a process that includes an “objective, thorough, and analytical” evaluation of at least three target date fund series. Apparently the DOL intends to change the common practices of plan fiduciaries and advisors. If so, and if this approach is retained in the final regulation, it could have the beneficial effect of causing the fiduciaries of small and mid-sized plans to more carefully evaluate target date funds in light of the needs and circumstances of the covered participants.
As a final comment on this example, I find it interesting that the DOL used “risk capacity” of the covered participants as a factor for evaluating target date funds. I don’t see that being regularly used by fiduciaries and participants. And, where risk is used, my (somewhat limited) experience is that “risk tolerance” is used by fiduciaries and advisors, rather than “risk capacity”. (For what it’s worth, I do think that risk capacity is the better measure when evaluating a target date suite…and particularly the risk capacity of the older participants and the TDFs that are designed for older participants.)
Regardless of whether it is “tolerance” or “capacity”, it suggests that fiduciaries should consider participant risk levels when selecting target date funds. It may be a good idea, but it is different than what is commonly done in the small and mid-sized plan market.
In any event, the DOL is making the point that plan sponsors and fiduciaries are entitled to consider—and should consider–the covered participants in making investment decisions, which is, in my view, the correct conclusion.
The preamble discusses the example, but adds little to the provision in the proposed rule:
5.2. Performance Examples
Proposed paragraph (g)(1) provides an example illustrating a fiduciary’s consideration of returns. The example describes a named fiduciary that, after considering the risks of the potential investments and the risk capacity of the plan’s participants, selects a target date fund series that has lower expected returns, but lower expected risk, as compared to the similar, alternative target date series considered. The lower risk strategy in the example included alternative assets with low correlations to stocks and bonds, which reduced the volatility of returns. In making the selection, the named fiduciary relied on advice from a third-party investment advice fiduciary within the meaning of ERISA section 3(21)(A)(ii). The example in paragraph (g)(1) illustrates the principle that plan fiduciaries need not select an investment strategy with the highest returns nor aim to achieve the highest possible returns but rather should seek to maximize returns for a given level of appropriate risk, consistent with the participants’ likely needs over the course of the anticipated investment.
Concluding Thoughts
Obviously, potential investments should be vetted with anticipated future performance being a key metric. And obviously, to me at least, the needs and circumstances of the covered participants should be considered in selecting the investments—and that is particularly true for the target date funds that will be available for participant selection and that will be used as the default option.
However, I’m worried about the use of “risk capacity” as a consideration for that. On the one hand, it seems appropriate. However, I have two countervailing thoughts. First, I don’t think it is commonly done by the fiduciaries of small and mid-sized employers (but I don’t know about the very large companies with billion-dollar plans). Second, while some employers may have a dominant group with a single risk capacity, I think that many plans cover a wide range of employees with dissimilar risk capacities. While TDFs may manage that issue—at least to a degree—by becoming more conservative as participants approach the target dates, that is not the case for other types of investments, and this proposed rule applies to those investment options as well. What are fiduciaries to do if risk capacity is a material factor when selecting all investment options to be offered for participant direction?
