Tuesday, January 17, 2006

Default “Ed”

Whether it’s a function of the growing infatuation with automatic enrollment features, a consequence of the growing popularity of lifestyle/lifecycle offerings, or the guiding influence of financial advisors, a growing number of plan sponsors appear to be taking a fresh look at their plans’ default options – the investment choices made for participants who fail to make one. This is a prerequisite for automatic enrollment designs, of course, but plans also have long provided for an interim instruction for that participant who fills out the enrollment form but, for some reason, forgets to make an investment fund selection.

Traditionally, these default choices have been “conservative,” generally some flavor of stable value/money market fund, chosen primarily to serve as a temporary repository for the money until the participant gets around to filling out the proper form. However, the growing application of automatic enrollment features, as well as emerging statistical evidence regarding defaulted participant behaviors, has drawn into question this “common wisdom” as falling short of the standard a prudent fiduciary should apply.

The rationale for that wisdom is simple – analogous to the Biblical parable, where the master leaves his servants with “talents” pending his return. The “bad” servant basically just sticks the ones with which he is entrusted in the ground – literally keeping them safe until the master’s return. However, the “good” servants deploy those talents constructively, and in the process double the investment. Now, these days that kind of “initiative” would probably entitle the servant to jail time – certainly if, instead of doubling the investment, their actions served to wipe it out. Nonetheless, if you ever heard the story in church, there is little question that the “wicked, lazy” servant messed up – big time.

In similar fashion, current “wisdom” says that the traditional default fund choice – some flavor of stable value/money market fund – falls short of the standard a prudent fiduciary should apply. ERISA’s prudent expert is expected to do more than just keep it safe, after all.

The decision to rely on a less volatile investment isn’t exactly unfounded, however. Plan sponsors are aware – as was the “wicked, lazy” servant – that they are dealing with people who, with the advantage of 20/20 hindsight, might not take well to having their money invested “for” them in fund(s) that then lose money.

The problem with that kind of approach is that we know that defaulted participants frequently remain exactly where they were defaulted, changing neither the rate of deferral nor the fund(s) in which those deferrals were invested. We also know that, at least in the eyes of the Department of Labor, “The only circumstances in which ERISA relieves the fiduciary of responsibility for a participant-directed investment is when the plan qualifies as a 404(c) plan.” (see Divining Line).

What that means, of course, is that the plan sponsor is responsible for the prudence of ANY participant-directed investment outside the protections of ERISA 404(c) (we should also note anecdotally how few plans likely are in full compliance with this section). And what all that, taken together, means is that plan sponsors have to ask themselves “Do I think that this default is prudent for the likely term of its investment in this plan?”

That does not, IMHO, mean that a stable value/money market fund cannot be prudently used as a default option. It just means that the plan sponsor/fiduciary has to remember that they own that investment decision - - up till and including the moment at which the participant affirmatively acts to retake that responsibility (and, at least according to the DOL, does so under the full auspices of ERISA 404(c)).

- Nevin Adams

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