Dear Prudence: DOL Proposes Safe Harbor for Defined Contribution Plans

The U.S. Department of Labor (DOL) recently issued proposed regulations providing defined contribution (DC) plan fiduciaries with a prudence-focused safe harbor for any DC plan "designated investment alternatives," including alternative assets such as private equity. This advisory reviews the proposed regulations and the safe harbor's six requirements for DC plans, which includes 401(k) or 403(b) plans.

The proposed regulations implement President Trump's Executive Order 14330 (Order) on alternative assets (discussed in our previous advisory) that directed the DOL to review its guidance regarding fiduciary duties under the Employee Retirement Income Security Act (ERISA). In particular, the Order required the DOL to address the fiduciary duties associated with investing in alternative assets, clarify its position on alternative assets, and propose rules to govern a fiduciary's duties when deciding whether to include alternative assets, including safe harbor protections for plan fiduciaries. The DOL has now completed its homework by issuing the proposed regulations.

ERISA holds plan fiduciaries to high standards and requires them to comply with a number of duties. One of those is the duty of prudence under ERISA section 404(a)(1)(B), which requires a plan fiduciary to discharge their duties using a prudent process with the care, skill, prudence, and diligence under the prevailing circumstances that a prudent person would use under similar facts and circumstances. The proposed regulations reiterate that: (i) selecting a designated investment alternative is a fiduciary act; (ii) fiduciaries have maximum discretion to select investments; (iii) ERISA does not require or restrict any specific type of investment (unless it is illegal); and (iv) DC plan fiduciaries must act prudently in establishing a diversified menu of investments. Further, to satisfy the duty of prudence, plan fiduciaries must follow a prudent process, giving proper consideration to the relevant facts and circumstances. Although the Order focused on alternative assets, the guidance in the proposed regulations applies to any DC plan investment, which means all DC plan fiduciaries must understand the proposed regulations (even if they never intend to include any alternative assets in the plan's investment menu).

To satisfy the prudence safe harbor, when selecting investments, plan fiduciaries must objectively, thoroughly, and analytically consider and determine six nonexhaustive factors for each investment in the line-up: performance, fees, liquidity, valuation, performance benchmarks, and complexity. If these six factors are met with respect to a particular investment option, that investment will be presumed to be prudent and the fiduciary's investment decision will be entitled to significant deference.

1. Performance: Any investment must enable participants to maximize their risk-adjusted returns over an appropriate time-horizon, net of fees. Plan fiduciaries meet this standard by appropriately considering a reasonable number of similar alternatives.

   The proposed regulations give an example where plan a fiduciary reviews three target-date funds (TDF) with guidance from the plan's third-party ERISA section 3(21) fiduciary who considers various risk measures, including the Sharpe ratio and a risk-adjusted measure with a risk penalty. After considering the risk tolerance of participants, the plan fiduciary relies on the advice to select a TDF with lower expected returns and lower expected volatility risk, but also higher risk-adjusted returns by including alternative assets with low correlations to stocks and bonds. In a second example, a fiduciary for a plan with a predominantly younger workforce relies on the plan's third-party ERISA section 3(21) fiduciary's recommendation to rely most heavily on the 10-year data (rather than 1-, 3-, or 5-year periods). The performance factor is met in both examples.

2. Fees: Fees and expenses must be appropriate, which plan fiduciaries can demonstrate by considering a reasonable number of similar alternatives, accounting for risk-adjusted expected returns and other "value." "Value" includes any benefits, features, or services other than risk-adjusted returns.

   The proposed regulations confirm that fiduciary prudence does not require the lowest fees and expenses, but choosing a more expensive option must be supported by value. For example, in comparing five funds with similar historical risk-adjusted returns and liquidity, a plan fiduciary choosing the fund with the highest fees, but also the highest rating for customer service and communication, may meet the fees test. In contrast, a plan fiduciary that fails to consider varying fees for different share classes would not be prudent. A lifetime income feature may justify higher fees, but the plan fiduciary should analyze and document how that feature provides additional value.

   Alternative assets are most likely to make their way into DC plans via TDFs and another example in the proposed regulations reviews a TDF that is changing strategy for risk mitigation to include hedge funds and private equity funds, while reducing publicly traded stocks and bonds. Even though under certain market conditions the TDF may underperform compared to the existing strategy, the change provides downside protection by decreasing volatility. A plan fiduciary analyzing the changed strategy with the assistance of the plan's 3(21) fiduciary who considers a reasonable number of similar modified alternatives and predicts an improvement in risk-adjusted returns, decreased volatility, but higher expense ratio, would be acting prudently.

3. Liquidity: The plan's liquidity needs must be met, both at the plan and individual level.

   Mutual funds registered as open-end management investment companies under the Investment Company Act of 1940 (40 Act) are deemed liquid. Other investments will be deemed liquid only if they meet three conditions: (i) The plan fiduciary receives written representation from the manager that the investment has adopted and implemented a liquidity risk management program substantially similar to the 40 Act requirements; (ii) plan fiduciaries read, critically review, and understand the representation and consult with a qualified professional; and (iii) the plan fiduciary does not know, or have reason to know, any information that calls into question the representation.

   For plans with deferred annuity contracts, the value of guaranteed monthly payments (which manage investment and longevity risk) may justify restrictions on liquidity, and a pooled investment vehicle with holdings in private assets could meet liquidity requirements where the plan fiduciary determines redemption structures are appropriate based on representations from the fund manager.

4. Valuation: There must be adequate measures to ensure the investment can be timely and accurately valued.

   Plan fiduciaries may rely on asset valuations from a national securities exchange or a similar public exchange where the investment trades daily. Where there is no generally recognized market, plan fiduciaries must require, read, and understand a written representation from the manager that the securities are valued through a conflict-free, independent process no less frequently than quarterly, per procedures satisfying FASB Accounting Standards Codification 820 (Fair Value Measurement), and must not have any contrary information.

   For an open-end mutual fund registered under the 40 Act that holds some securities for which there is not a generally recognized market, fiduciaries can rely on publicly available financial statements, valuation related disclosures, and the fund's Form N-1A prospectus disclosures to confirm the majority of the fund's board is independent. The DOL concludes that the valuation factor is met because the fiduciary read the asset valuations, performed appropriate due diligence on the valuation process, consulted a qualified professional, and does not have any information to the contrary.

5. Performance Benchmarks: There must be meaningful benchmarks for each investment, and plan fiduciaries must compare risk-adjusted expected returns of an investment to that benchmark.

   A "meaningful benchmark" is an investment, strategy, index, or other comparator with similar mandates, strategies, objectives, and risks, and the plan sponsor should compare risk-adjusted expected returns, net of fees, to the benchmark. No single benchmark is a meaningful benchmark for all investments, and there is no presumption or preference against new or innovative investment designs, but plan sponsors must identify the best comparators and scrutinize the value proposition.

   For example, a TDF cannot rely on a benchmark tracking returns of large cap U.S. equities where other benchmarks with more similarities are readily available.

   The benchmark for a fund registered under the 40 Act with publicly traded stocks/bonds and a private equity sleeve could be a composite, blending performance of broad-based securities market indices reflective of and in proportion to the stock/bond holdings, plus methodologies commonly used by investment professionals for the private equity sleeve, including the internal rate of return and public market equivalent method.

6. Complexity: Plan fiduciaries must determine whether they have the skills, knowledge, experience, and capacity to comprehend and evaluate an investment or whether they need assistance from a qualified investment fiduciary, manager, or other individual.

   This factor will not be met if the fiduciary fails to comprehend the features, values, and fees of an investment. For example, a failure would exist where a plan fiduciary adopts a managed account service as the plan's qualified default investment alternative with a customized portfolio tailored to each participant's unique financial circumstances for a higher fee compared to a TDF, but the fiduciary does not understand the design and does not provide sufficient information to participants to evaluate the managed account service.

The preamble provides that the overarching goal of the proposed regulation is to alleviate regulatory burdens and litigation risk. A presumption of prudence would certainly mitigate the litigation risk. However, whether courts will accept such a presumption remains in doubt. Under the Supreme Court's decision in Loper Bright Enterprises v. Raimondo (discussed in our previous advisory) the DOL's guidance is not entitled to automatic deference by the courts. In addition, in an analogous context, the Supreme Court held in Fifth Third Bancorp v. Dudenhoeffer that there is no presumption of prudence for ESOP fiduciaries. Finally, the Supreme Court's pending review of Anderson v. Intel Corp. Investment Committee may influence what courts will require a plaintiff to establish to move a case forward. Unless there is Congressional action to shift the burden of proof, the effect of this regulation on litigation will remain in doubt (discussed in our previous advisory). Yet, because prudence is about following a prudent process, employers and committees that follow the approach proposed by the regulations should ultimately prevail at trial. For that reason, we recommend that investment policy statements and investment advisor reviews closely follow the guidance set out by the DOL's proposed regulations. When the regulations are finalized, plan fiduciaries should be prepared to document the six factors for each investment alternative in meeting minutes.

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Dipa Sudra, Richard Birmingham, and Stuart Harris are partners in the employment, benefits & immigration group in the Seattle and Portland offices of DWT. For any questions or more information, please reach out to the authors or another member of our employment, benefits & immigration team and sign up for our alerts.