Thursday, October 21, 2010

Just Out of Reish - Too Safe Is Too Bad

Safe investments may not be safe…for fiduciaries
…For fiduciaries, safe means that they are protected from lawsuits either because they complied with the law or because they have a legal safe harbor. Safe—for most participants—means an investment that has very little, if any, volatility. In the investment world, volatility measures how much the value of an investment fluctuates. For example, stable value or money market accounts are intended to have a fixed principal that does not fluctuate in value.
Another important definition is time frame. When the market is highly volatile, …people tend to measure their investment results in weeks or months. However, that is inconsistent with ERISA’s approach, which would measure investment results over years, or decades, or working careers.
With that in mind, how can safe be risky for 401(k) fiduciaries, and vice versa, particularly for default investments?
Risky can be safe for 401(k) fiduciaries when selecting qualified default investment alternatives, or QDIAs. …QDIAs are the investments that can be used for participants who …fail to direct their investments, as a fiduciary safe harbor under ERISA section 404(c)(5). While there are three categories of QDIAs, this column discusses only target-date funds, or TDFs.
By legal definition—and common application—QDIAs, and therefore target-date funds that qualify as QDIAs, must have a material allocation to publicly traded stocks and, therefore, are volatile when compared with, for example, stable value investments.
The first step of our analysis is that risky or volatile investments in equities are safe for fiduciaries when used in QDIAs even though they seem less safe—or more volatile—to participants.
Seal of the United States Department of the Tr...Image via WikipediaHowever, what about the use of safe investments, such as stable value and money markets, as default investments? In that case, what feels safe for participants is risky for fiduciaries. …Succinctly stated, the DoL viewed the riskiness of inadequate benefits at the end of a working career as being more important than the riskiness of stock and bond market volatility in the short term.
If you accept the DoL’s view on this issue, or if you want the fiduciary safe harbor protections for QDIAs, the prudent course of action is to invest default money for the long term. Based on conventional investment thinking, that means that fiduciaries should place defaulting participants in diversified portfolios consisting of, at the least, stocks, bonds, and cash.
In some recent papers, researchers argue that ...Image via WikipediaYet, what if an employer wants to avoid possible employee criticism for investment losses? Isn’t that permissible?
It may be permissible based on the demographics of a particular work force, but only after the fiduciary has engaged in a prudent process and reached an informed and reasoned decision that a long-term investment in stable value or money market vehicles is likely to produce equivalent or superior retirement benefits. However, in that case, the fiduciaries have lost the safe harbor and, as a practical matter, the burden will be on the fiduciaries to prove their case—that is, to overcome the common belief that is expressed in the DoL language.
Even there, is it possible that there could be a lawsuit where participants have small gains, but no losses?
Yes, it is. In 1986, the DoL filed a lawsuit against a union pension trust and subsequently entered into a settlement of that lawsuit. In the press release regarding the settlement, the DoL stated, “The department has charged that the trustees caused the plan to sustain financial losses by investing virtually all of its assets in ordinary savings accounts during the period of time covered in the suit.” To help you understand the quote, ERISA considers insufficient gains to be losses. So, there you are. Risky is safe and safe is risky.

Fred Reish is Managing Director and Partner of the Los Angeles-based law firm of Reish & Reicher. A nationally recognized expert in employee benefits law, he has written four books and many articles on ERISA, IRS and DoL audits, and pension plan disputes. Fred has been awarded the Institutional Investor Lifetime Achievement Award and the PLANSPONSOR Lifetime Achievement Award. He is also one of the 15 individuals named by PLANSPONSOR magazine as “Legends of the Retirement Industry.”
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