SponsorNews - June 2016
Jay Czarapata, Senior Wealth Advisor Representative, Bronfman E.L. Rothschild
John Richards, Investment Research Manager, Bronfman E.L. Rothschild
Target Date Funds Defined
Target date funds are mutual funds that invest in a mix of stocks, bonds, and cash equivalents with a portfolio that automatically resets or rebalances according to a selected time frame that is appropriate for a particular investor. Target date funds automatically rebalance to become more conservative (invested more heavily in bonds and cash equivalents vs. stocks) as an individual gets closer to the target date or retirement age.
While the concept of target date funds is simple to grasp, plan sponsors need to be aware that there are many types of target date funds offered in the marketplace with differing investment strategies, glide paths, actively managed vs. passively managed approaches, fees, and fee structures. It is important that plan sponsors, as fiduciaries, understand these differences when selecting target date funds as investment options in their plan.
Benefits of Target Date Funds
Target date funds offer plan sponsors and their participants a number of benefits.
• Eases retirement investment decision making by offering a one-stop investment selection
• Simplifies saving for those who would like to put their investments on autopilot
• Offers professional management, built in asset allocation and ongoing rebalancing of their retirement portfolio
• For automatic enrollment plans, target date funds are a QDIA easing fiduciary liability
• Allows the plan sponsor to provide employees with an easy and simple investment choice
• Gives plan sponsors peace of mind that they are making an appropriate investment selection that will help employees save for retirement
Shortcomings of Target Date Funds
One of the major drawbacks of target date funds is that, while they may be a simplified choice, their one-size-fits-all approach does not take into account an investor’s risk tolerance. In our opinion the biggest shortfall of target date funds is that they assume everyone has the same risk tolerance level. To counter this shortfall, we encourage plan sponsors to include core options, risk-based model portfolios and target date funds in their investment line up. When we meet with a plan’s participants, we then administer a risk tolerance quiz. We consider risk-based model portfolios to be an optimum choice for those participants that understand their risk tolerance level. Target date funds are a nice alternative for those participants that aren’t focused on risk, do not want to bother with understanding their risk tolerance or just want a simple “do it for me” solution. We offer plan sponsors not only a solid investment line up, but we help their employees understand the investment options and engage in the process.
Plan Sponsor Must Follow Fiduciary Principles When Choosing Target Date Funds
When we work with plan sponsors to select the appropriate target date funds for their retirement plan, we follow this process:
1. Create an investment selection process and document it
We work with plan sponsors to create and document an investment selection process that would include:
• Creation and administration of an Investment Policy Statement which would act as the framework for the process
• Gather, evaluate, and compare information about target date funds
The criteria for evaluation would include examining:
• investment strategy
• portfolio management team
• portfolio style (active vs. passive)
• glide paths (see definition below)
• designation of the funds as “to” or “through” retirement (see definition below)
• performance returns
• fees and expenses.
The selection process needs to be documented and reviewed on an ongoing basis. Investment committee members need to be part of the selection process and understand how it was undertaken.
2. Engage in periodic review of your investments, including target date funds
On a regular basis, plan sponsors should review all the investments in their lineup, including target date funds. Plan sponsors should assess if the target date funds are still appropriate investment options for their plan, if the specific funds chosen have had any performance issues, if they have adhered to their investment strategy, or if they have had any turnover in management, among other things. We would also recommend that the investment policy statement be used as a guide during the regular review process. We also advocate for quarterly monitoring of all investment performance.
3. Effectively communicate the target date funds to the employee population
A plan sponsor must understand their participant population, specifically the factors that may make target date funds an appropriate selection for their employees. For many, the inclusion of automatic features will make target date funds an appropriate choice. Plan sponsors need to help employees understand and engage in the investment options in their retirement plan, including the target date funds. How well employees understanding and engage is a sign of their overall financial wellness.
Target Date Funds: The Bottom Line
Target date funds make saving easier for plan participants. It is incumbent on the plan sponsor as a fiduciary to oversee the selection, implementation, and monitoring of target date funds.
The Employee Retirement Income Security Act (ERISA) has existed since 1974. It governs the operations of qualified retirement plans and plan fiduciary governance. Increased awareness of ERISA has risen due to new laws and regulations plus increased enforcement by the Department of Labor (DOL).
The plan sponsor and those making discretionary decisions for the plan are considered plan fiduciaries. The responsibilites of a fiduciary are very broad. If you lack the knowledge or expertise to fulfill those fiduciary and ministerial responsibilities, you are to hire and/or delegate some of those responsibilities to experts. As a plan fiduciary, you must always conduct regular due diligence on service providers and monitor the results they deliver. That responsibility NEVER goes away.
There are many ERISA section numbers to decode. Be careful of statements made by service providers and advisors regarding how they can absolve you of fiduciary liability. Some are more comprehensive than others but most provide limited coverage.
402(a) – Named Fiduciary – this is the full scope fiduciary. All aspects of the plan management and operation start here. This is the plan sponsor decision-makers, including the Board of Directors. The Named Fiduciary delegates various fiduciary, non-fiduciary and ministerial functions and activities to others. This includes Trustees, custodians, Third Party Administrators, auditors, investment firms and professionals, 3(21) Investment Advisors, 3(38) Investment Managers, and 3(16) service providers. This delegation of authority allows the Named Fiduciary to mitigate or share some of the risk in fulfilling those duties. However, they still must monitor the results.
3(21) – The authority to act on behalf of the plan and the participants comes from ERISA Section 3(21). That section defines the fiduciary roles that involve discretionary authority or control with respect to the management of the plan or assets. If someone says they are a 3(21) fiduciary, have them clearly define what kind and to what degree of responsibility.
3(21) Investment Fiduciary – This is a subset of 3(21). The focus is the plan investments. They provide advice and guidance to plan fiduciaries on plan investments and custodians, conduct investment due diligence, prepare and implement investment policies and processes, review participant education, plan design and service providers. The plan fiduciary and 3(21) Investment Fiduciary meet regularly and make joint decisions.
3(38) Investment Fiduciary – This fiduciary’s focus is making discretionary plan investment decisions in accordance with the plan’s investment policy statement. Decisions are made without input from the 3(21) or 402(a) fiduciary. While the delegation of authority on investment related matters is greater than a 3(21) Investment Fiduciary and the liability to the plan fiduciary reduced, it is not eliminated. Results of the 3(38) must still be measured and monitored. If results are not achieved, the plan fiduciary has a duty to remove them.
3(16) Plan Administrator – This is a full scope fiduciary and not to be confused with a Third Party Administrator. The 3(16) is appoointed by the Named Fiduciary or designated in the plan document. They manage and operate the plan. The areas under the authority of the 3(16) include Plan Qualification and Operations; Reporting and Disclosure; Plan Coverage and Testing; Contributions, Withdrawals and Distributions; and Plan Asset Management. This role includes filing the Form 5500, providing disclosures, communications with plan participants and any party dealing with the plan, providing complete and accurate census, eligibility determination, hiring service providers and other plan operational functions. Some of these responsibilities are fiduciary and some are ministerial in nature. Third Party Administrators (TPA) are often hired to support the 3(16). A duty to monitor the results of the service provider still remains.
3(16) Plan Administrator – Service Provider – This is a limited scope fiduciary. The service provider in a 3(16) role will only assume fiduciary responsibility and liability for services in which they have adequate control over the information, but many functions will be covered. These can include many of the items described above, such as signing and filing the Form 5500, approving distributions and loans, and can act as the service of legal process for the plan in case of a lawsuit. Not all service providers will assume this liability and the scope of services may be different.
In employing any service provider, ask the tough questions regarding their expertise, experience, systems, processes, resources and ability to effectively communicate with you.
Oct 31, 2014 --- Retirement plan advisers and third-party administrators (TPAs) are likely to find information gaps when performing assessments of retirement plan census data or client ownership data, according to Natalie Wyatt at Innovest. ---
In addition to plan sponsor oversights and lack of knowledge, information gaps can happen when there has been an acquisition, sale, or divesting of a plan sponsor’s business, says Wyatt, senior sales representative with Innovest, which provides technology services to trust, wealth management and retirement professionals. Information integrity can also be compromised during a change in officers or ownership of the business, or during a partial plan termination.
Wyatt addressed the topic during a session at the 2014 American Society of Pension Professionals and Actuaries (ASPPA) Annual Conference. She reminded attendees that recent changes to the Defense of Marriage Act (DOMA) require plan sponsors to revisit employee data.
Plan advisers may be responsible for coordinating the submission of employee census data to retirement plan advisers. Common errors to watch for include:
• Date of hire – Was the employee hired for a part-time or full-time position? Is the employee a rehire with prior dates of service?
• Date of termination – Did the employee go from full-time to part-time, transfer to another division, or really terminate?
• Contract labor – The Department of Labor (DOL) keeps an eye out for employees that are misclassified as contractors.
• Hours worked – Does the plan sponsor know how to properly calculate hours worked for eligibility and participation?
• Compensation – Is the plan sponsor submitting the correct compensation per the definition in the plan? There could be a different definition of compensation in the plan for different things, such as allocating contributions or forfeitures and key employee or highly compensated employee for top heavy and nondiscrimination testing purposes.
Wyatt suggested plan advisers establish a checklist for information they need and errors to look out for, and have a process in place for all staff to use when coordinating data from plan sponsors to plan providers.
One of the best ways to motivate plan sponsors to ensure data is correct is the fear factor, she says. “Let them know what happens if regulators find an error due to incorrect information.”
To get correct information, advisers and TPAs will need to communicate with each other; the human resources staff at the plan sponsor; the plan sponsor’s payroll provider, certified public accountant (CPA) or attorney; and the plan sponsors themselves.
Wyatt noted that if plan sponsors outsource the HR or payroll functions, it can be a challenge to get correct census information because outsourced providers typically provide a standard set of information and only provide gross income for participants. It could cause extra work for advisers and TPAs, and this should be documented in service agreements.
When working with payroll departments or providers, advisers and TPAs can help set up processes to make sure they will get correct information. In addition, Wyatt said, there are software providers that offer online solutions to help plan sponsors gather census data.
In addition, setting up a calendar of reminders to send plan sponsors can help, such as a reminder at the beginning of December about what the plan definition of compensation is, or asking plan sponsors in January whether they had any rehires in the past year.
A conference attendee from Unified Trust said the company spends a good amount of time onboarding clients, determining the proper definition of compensation, looking at what the payroll vendor is providing in its files, making sure plan sponsors check and update information with each payroll file.
Wyatt suggested plan advisers and TPAs get employers to sign a statement that data they provided is accurate. In addition, she said advisers and TPAs may sometimes need to harass non-responsive employers to provide data. If clients continue to be non-responsive, it may be time to discontinue the relationship, she added.
With acronyms like ADP, ACP, NHCEs, and HCEs, the technicality of 401(k) plan nondiscrimination testing may seem overwhelming.
Even though nondiscrimination testing is likely performed by a plan’s recordkeeper or third-party administrator, plan sponsors need to
understand the basics of the tests, including the types of contributions that are tested, the methods used and the consequences of failing.
The Employee Retirement Income Security Act (ERISA) requires several tests each year to prove 401(k) plans do not discriminate in favor of employees with higher incomes.
For some of the tests employees are divided between non-highly compensated employees (NHCEs) and highly compensated employees (HCEs). The Internal Revenue Service (IRS) defines highly compensated employee as an individual who:
• Owned more than 5% of the interest in the business at any time during the year or the preceding year, regardless of how much compensation that person earned or received, or
• For the preceding year, received compensation from the business of more than $115,000 (if the preceding year is 2013 or 2014; $120,000 if the preceding year is 2015), and, if the employer so chooses, was in the top 20% of employees when ranked by compensation.
The compensation used for determining whether an employee is an HCE is indexed each year.
Robert Richter, vice president with SunGard’s Wealth and Retirement unit, breaks the nondiscrimination rules into three parts. First, he explains, there are rules to ensure there is broad coverage of employees, which is tested by the 410(b) coverage test.
Next, once you have a sufficient number of NHCEs covered, you look at the benefits, rights, and features of the plan to ensure they are nondiscriminatory. This is tested by the ADP and ACP tests.
ADP stands for actual deferral percentage, explains Robert Kaplan, national retirement consultant for Voya Retirement Solutions. This test compares the average of salary deferral percentages for HCEs to the average of salary deferral percentages for NHCEs. The ADP test applies to pre-tax and Roth elective deferrals. Kaplan states the purpose of this test is to ensure all participants, both HCEs and NHCEs, are benefitting from the plan.
The ACP, or actual contribution percentage test, compares the average of the percentage of matching contributions and after-tax employee contributions for HCEs verses NHCEs. Matching contributions and voluntary employee after-tax contributions (different from Roth elective deferrals) are included in this test. The purpose of this test is to ensure that the actual usage of the plan feature is widespread and not only used by the HCEs. “Plans subject to testing only work if employees across the entire income spectrum participate,” Kaplan adds.
Finally, there is a test to ensure the 401(k) plan is not top-heavy which looks at overall benefits that have been accumulated by key employees. Generally, if more than 60% of the overall assets in the plan are attributable to key employees (different from HCEs) then the plan is top-heavy and certain minimum benefits may need to be provided to the non-key employees. Defined by the IRS, a key employee is any former or deceased employee who at any time during the plan year was an officer making more than $170,000 (this is indexed each year); an owner of more than 5% of the business; or an owner of more than 1% of the business and making more than $150,000 for the plan year.
“So the first two, coverage and nondiscrimination of benefits, are annual tests looking only at contributions for a specific year, whereas the top-heavy rules are a test based on total accumulated benefits,” Richter explains.
Repercussions of Failing
If the 410(b) coverage test is failed, plan sponsors must bring the plan into retroactive compliance by the end of the plan year, either by extending coverage to a broader group of NHCEs or by modifying contribution allocations or benefit accruals. Alternatively, HCEs will have to report their vested accrued benefit as income on their income tax returns.
For the ADP and ACP tests, Kaplan says, “If the plan fails either test the employer must take corrective action in the 12-month period following the close of the plan year in which the oversight occurred.”
The IRS explains two methods for correcting a failed ADP or ACP test:
• Determine the amount necessary to raise the ADP or ACP of the NHCEs to the percentage needed to pass the tests, and make a qualified non-elective contribution (QNEC) to all eligible NHCEs in that amount.
• Distribute excess contributions, adjusted for earnings, to the HCEs. If any excess matching contributions are not 100% vested for the participant, the applicable percentage must be forfeited. Kaplan notes that for calendar year plans, distributions must be done by March 15 (2 ½ months following the plan year) to avoid excise taxes.
If a plan is found to be top-heavy in a plan year, the plan sponsor must make a QNEC, that includes lost earnings, to the non-key employees. The contribution is generally 3% of compensation.
“Congress prefers increased benefits for NHCEs or non-key employees. That is why there are provisions in the law to give employers an exemption from the ADP and ACP tests and the top heavy rules,” Richter adds. “Specifically, safe harbor 401(k) plans can be designed to avoid these tests. That is the carrot. The cost is that safe harbor plans require certain minimum contributions for NHCEs.”