Default Investments – Target Date Funds

1. Default Investments – Target Date Funds Marcia Wagner, Esq. Tess J. Ferrera, Esq. The Wagner Law Group Schiff Hardin, LLP 99 Summer Street, 13th Floor 901 K Street, N.W., 700 Boston, MA 02110 Washington, D.C. 2001 marcia@wagnerlawgroup.com tferrera@schiffhardin.com 617.357.5200 202.778.6435

2. Target-Date Funds -- Background • Popularity exploded after Pension Protection Act (“PPA”) of 2006. • PPA added ERISA § 404(c)(5) • Encouraged employers to include automatic enrollment as a feature of their plan. • Created Qualified Default Investment Alternatives (“QDIA”) to provide plan fiduciaries a safe harbor default investment option in the event the default option experienced loses. • Provides investment solution to participants that did not manage their account.

3. Background on Target Date Funds • Typically, formed as open-end investment companies registered under the Inv. Co. Act. • Defining characteristic – “glide path” which determines the overall asset mix of the fund. • Performance issues in 2008 raise concerns, especially for near-term TDFs. • Based on SEC analysis, the average loss for TDFs with a 2010 target date was -25%. • Individual TDF losses as high as -41%.

4. Target-Date Funds -- Background • What was learned when the market crashed in 2008? • Some TDFs designed for 2010 retirement date lost a lot of value. • Many participants were unaware of the risks associated with TDFs and that large losses possible so close to retirement. • TDFs with same target date exhibited wide variation.

5. Target-Date Funds -- Background • Did the 2008 losses demonstrate that plan fiduciaries breached their duty of prudence and/or loyalty to participants?

6. Target-Date Funds – Fiduciary Rules • Overview of Fiduciary Obligations: • ERISA § 404 – Prudence, Loyalty, Diversification and Adherence to Plan documents • ERISA § 406 – Prohibited Transactions

7. Target-Date Funds – Fiduciary Rules • Pension Protection Act of 2007 added a new Section 404(c)(5) to ERISA. • Safe Harbor for default investments when participant fails to make investment selection. • Automatic Enrollment. • General failure to make election. • Historically, defaults were very conservative vehicles. • Applies anytime participant fails to make selection, not only in the automatic enrollment context.

8. Target-Date Funds – Fiduciary Rules • A plan fiduciary that complies with the regulations will not be liable for any loss resulting from the investment. • Not intended to be the exclusive method by which a fiduciary can discharge his or her obligations absent an affirmative participant election.

9. Target-Date Funds – Fiduciary Rules • To comply with the regulations, a fiduciary must: • Invest the assets in a Qualified Default Investment Alternative (“QDIA”); • Participants and beneficiaries must have been given the opportunity to direct investments, but failed to do so; and • Comply with notice requirements.

10. Target-Date Funds – Fiduciary Rules • First notice must be provided at least 30 days in advance of eligibility, or the date of any first investment in a QDIA; or • On or before the date of plan eligibility, provided that the participant has the opportunity to make a permissible withdrawal under IRC Section 414(w); and • Second notice – within a reasonable period of time at least 30 days in advance of each subsequent plan year.

11. Target-Date Funds – Fiduciary Rules • A fiduciary provides to a participant materials relating to the QDIA, i.e., • Account statements • Prospectuses • Voting rules • List of assets comprising the portfolio

12. Target-Date Funds – Fiduciary Rules • Participants must be given the opportunity to transfer their assets, in whole or in part, out of the QDIA at least as frequently as any other participant that affirmatively made an investment decision, but in no event less frequently than every three months.

13. Target-Date Funds – Fiduciary Rules • During the first 90-days, a participant that withdraws or transfers their account from the QDIA shall not be subject to any restrictions, fees or expenses, including surrender charges, liquidation or exchange fees or other similar charges. • Normal operating expenses are permissible, i.e., investment management fees, legal and accounting, distribution fees, 12b-1 fees, etc.

14. Target-Date Funds – Fiduciary Rules • The notices must be written in a manner calculated to be reasonably understood and contain the following: • The circumstances under which assets may be invested in the QDIA and a statement notifying of the right to withdraw or change the percentage of the election; • An explanation that participants have the right to direct their accounts;

15. Target-Date Funds – Fiduciary Rules • A description of the investment characteristics of the QDIA, including investment objectives, risk and return, and related fees and expenses; and • An explanation that participants have the right to redirect their investments and information about how they go about making changes.

16. Target-Date Funds – Fiduciary Rules • If a fiduciary complied with the regulations, was the fiduciary protected by the safe harbor 404(c)(5) regulations when the market crashed in 2008?

17. Target-Date Funds – Fiduciary Rules • Under the 404(c) regulations, DOL takes the position that those regulations do not protect the fiduciary for the fiduciary selection of the investment menu in the 401(k) line-up. • Same is likely true in the QDIA context under 404(c)(5).

18. Target-Date Funds – Fiduciary Challenges • Problems for a fiduciary in the selection of the a TDF: • TDFs are relatively new and lack long-term track records – difficult to find benchmarks. • Variance in glide paths make it difficult to find the right benchmark. • Variance in underlying asset classes cause a similar problem

19. Government Reaction to TDF 2008 Performance • DOL and SEC at Senate Special Committee on Aging hearing on TDFs (Oct. 28, 2009). • Investor Bulletin jointly released by DOL and SEC. • DOL’s fiduciary checklist on TDFs is pending. • SEC proposal for TDF advertising materials. • If name has target date, “tag line” disclosure needed. • Advertising must include glide path information. • On Nov. 30, 2010, DOL proposed rules on TDF disclosures for participants, amending: • Participant-level fee disclosure reg’s that were finalized on Oct. 20, 2010. DOL TDF regulations not yet final.

20. DOL’s Proposed Changes to QDIA Reg’s • DOL proposes change to QDIA notice for TDFs. • Explanation and illustration of TDF’s glide path. • Relevance of target date (e.g., 2030) in TDF name. • Disclaimer that TDF may lose money after retirement. • DOL also proposes general changes to QDIA notice (even if not a TDF).

21. DOL’s Changes to Participant-Level Fee Disclosure Reg’s • Background (recap) • New rules will require disclosure of plan-related fees and annual comparative chart for plan’s investments. • DOL proposes change to annual comparative chart for TDFs (even if not a QDIA). • Must include appendix with additional TDF info. • Same info as required for QDIA notice. • Informal follow-up guidance from DOL • TDF prospectus is unlikely to satisfy QDIA notice and annual comparative chart requirements, as proposed. • DOL will not provide “model” target date disclosures.

22. Congressional Proposal for TDFs • Senator Kohl announced his intent to introduce new legislation (Dec. 2009). • Concerns over high fees, low performance or excessive risk in many TDFs. • Would impose ERISA fiduciary status on TDF managers when TDF used as QDIA in 401(k) plans.

23. Avatar Advisory Opinon • Conflicts arise when a “fund of funds” invests in affiliated underlying funds. • Conflicts are permitted because fund managers are carved out from ERISA’s fiduciary requirements. • Are fund managers ever subject to ERISA? • Firm requested clarification on scope of carve-out. • In Adv. Op. 2009-04A (Avatar Associates), DOL declined to rule that the TDF managers are fiduciaries. • Implications of DOL guidance • Plan sponsors are alone in their fiduciary obligation. • Must ensure TDFs (and underlying funds) are appropriate plan investments.

24. Target-Date Funds – Fiduciary Rules • Fiduciary selection process: • Consider retaining an expert if plan sponsor lacks internal expertise to assist with selection. • Define investment goals and objectives before choosing a TDF. • Understand participant population.

25. Target-Date Funds – Fiduciary Rules • Issues to evaluate: • Actively managed vs. passive management • Underlying investments – how risky – look under the hood. • Glide paths • Fees

26. Default Investments – TDFs Practical Implications • Provide meaningful TDF disclosures to participants as a “best practice” right now. • Provide key information about TDF’s glide path, landing point and potential volatility. • Also facilitate sponsor’s prudent review of the plan’s TDF series. • Assist in the fiduciary review of the “fund of funds” structure, glide path, underlying funds and risk. • Special review of TDFs for participants in or nearing retirement (e.g., 2015 TDF).