Reprinted with permission from Employee Benefit Review - October 2014
Most professionals who work in the 401(k) arena would agree that managed accounts are, on balance, a favorable development for 401(k) plan participants. However, such accounts are, in many ways, still in their infancy, relatively speaking. A report issued by the United States Government Accountability Office (the “GAO”) in June titled “401(k) Plans – Improvements Can Be Made to Better Protect Participants in Managed Accounts” (the “Report”) provided a helpful discussion on the current status and likely future for the rules governing managed accounts.
In 2007, the Department of Labor issued regulations that favored certain managed accounts which could be used as qualified default investment alternatives (“QDIAs”) in 401(k) and other participant-directed defined contribution plans. The GAO report estimates that such plans now hold over $100 billion in managed accounts.
According to the GAO, “managed accounts” are broadly defined as an investment service pursuant to which investment decisions are made for specific participants to allocate assets, among a mix of investments determined to be appropriate for the participants based on their own personal information. By contrast, target date (or life cycle) funds are defined by the GAO as investment products that determine an asset allocation for a participant based on factors such as age or expected retirement date, and that adjust the asset allocation as the target date approaches and, for some funds, is passed. Finally, the GAO defines balanced funds as investment products that generally invest in a fixed mix of assets (such as 60 percent equity and 40 percent fixed income) that, perhaps, is adjusted to reflect a participant’s personal situation.
In other words, the GAO views target date funds and balanced funds as one of a plan’s investment options, just like any mutual fund or similar investment choice that may be available under the plan. A managed account, however, is viewed as the service whereby a (typically) external provider makes the investment allocation decisions for the plan participants amongst the various investment option otherwise available under the plan. The GAO acknowledges the existence of custom target date funds, which have attributes similar to managed accounts in that the provider allocates a participant’s investments among existing plan options to create the mix of assets deemed appropriate for the participant’s age and objectives.
The GAO reviewed the offerings of eight providers of these types of investment management services and estimated that those providers represent over 95% of the managed account industry in defined contribution plan (as measured by assets under management in 2013). They identified these broad areas of concern, which are discussed in more detail below, along with my key take-aways for plan sponsors.
1. Providers structure managed accounts differently, which can harm participants.
The GAO observed that the eight providers used different investment options, different investment strategies, and different approaches to the use of participant information, and rebalanced at different intervals. As a result, “participants with similar characteristics in different plans may have differing experiences.” (Report p. 14). Most plan sponsors would probably not be surprised to learn that different providers have different approaches which will lead to different results. The real issue for the appropriate plan fiduciary is to determine which providers and which approaches are prudent for their plan participants. Some of the challenges to making those determinations are discussed later in the GAO report (and this article).
Next, the GAO pointed out that while most managed account advisors serve as ERISA Section 3(38) investment manager fiduciaries, some do not. Instead they may be a mere ERISA Section 3(21) investment advisor fiduciary. The GAO, quoting DOL officials, noted that when a fiduciary properly appoints (and monitors) a 3(38) investment manager it is generally relieved from responsibility for poor investment decisions made by the investment manager. This is not the case where a 3(21) investment advisor fiduciary is appointed – in that case the appointing fiduciary can be held responsible for poor investment decisions. Plan sponsors should keep this important distinction in mind when hiring a managed account provider.
Finally, the GAO highlighted the fact that when a managed account is offered as a QDIA, the QDIA regulations generally require that the provider be a 3(38) investment manager, but no similar rule applies where managed accounts are provided on an opt-in basis. It is not clear whether the DOL could even change the rules for opt-in accounts, but this is an issue that may be worth following. Another area that the GAO asked the DOL to consider is whether managed account providers may have a disincentive or conflict of interest to advise participants of out of plan options such as rollovers, because it could reduce the amount of assets they manage within the plan.
2. Managed accounts offer advantages for some participants but fees and lack of standardized reporting requirements from DOL can offset these advantages.
Among the advantages cited by the GAO are increased diversification of retirement assets by participants using managed accounts, as well as a correlation with larger contributions (though this may have more to do with automatic enrollment and automatic selection features that are likely more prevalent in plans using managed accounts), and improved access to retirement planning information.
The primary disadvantage cited by the GAO is the additional fee that a participant must pay for managed account services. It is unclear whether the “value” of the services received for the fee should be based on a comparison to the return, net of fees, that the average participant would have obtained it if such participant self-directed his or her 401(k) plan investments, or if a better comparison is to the fees charged by other professionally managed investment accounts. However, given the high visibility paid to plan fees, particularly by the plaintiff’s bar, plan sponsors may want to consider subsidizing (or fully paying) the managed account fees charged to plan participants. In any event, plan sponsors should consider working with an outside consultant to do a full review of all fees related to or associated with the managed account services charged by the record keeper or managed account provider.
The other disadvantage is that the DOL guidance generally does not require most managed accounts to satisfy the disclosure rules that apply to “designated investment alternatives” (such as mutual funds). The GAO concludes that “Because DOL does not require plan sponsors to provide participants information on the performance of their managed accounts or to compare performance against a set of standard benchmarks, it is potentially difficult for participants to evaluate whether the additional fees for managed accounts are worth paying, considering the effect of fees on returns and retirement account balances. As a result, participants may be unable to effectively assess the overall value of the service and to compare performance against a set of standard benchmarks.” (Report p. 45). As discussed in the next section, this is a problem for plan sponsors as well as plan participants. At a minimum, sponsors should work with their outside investment consultant to make sure they understand the fees being charged and are able to come up with some benchmark or other measurement to assess the performance of any managed accounts, and should consider the pros and cons of passing this information along to plan participants even if not legally required to do so.
3. Absent guidance, sponsors face challenges in selecting and overseeing managed account providers.
The GAO indicated concerns regarding plan sponsor access to managed account provider options. This is a big challenge for plan sponsors when working with their record keepers because frequently the only option is a proprietary offering or a third-party who has been pre-selected by the record keeper. Plan sponsors (and their consultants) need to explore the marketplace and engage their record keeper about being able to use a third-party provider of the plan sponsor’s choice.
The GAO points out that it is difficult for plan sponsors to select and monitor managed account providers because there are no widely accepted industry benchmarks or other tools for comparing providers. Although similar issues apply for target date funds, the DOL has issued guidance on such funds for plan sponsors (Department of Labor, Employee Benefits Security Administration, Target Date Retirement Funds – Tips for ERISA Plan Fiduciaries (Washington, D.C.: February 2013). However, it has not issued similar guidance for managed accounts. Until more guidance and better benchmarking becomes available, plan sponsors should work closely with their outside investment consultant so that they can demonstrate that they have acted prudently in selecting (and monitoring) their managed account providers.
The GAO recommended that the DOL: