First Quarter Focus: Investment Due Diligence in 401k Plans

Heading into our first quarter client reviews, it makes sense to delve into the topic du jour which is Investment Due Diligence. While we produce fund monitoring due diligence reports each calendar quarter, once a year we take a look at the big picture in how we design and evaluate each plan’s investment lineup.

Let’s dive into three topics we consider critical based on Department of Labor Guidance on retirement plan investments: selecting and monitoring your plan’s default options, cash alternatives, and socially responsible (ESG) options if included in your plan.

1. Monitoring Your Options: Qualified Default Investment Alternatives (QDIA). One of the key features of today’s 401k and 403b plans is that employees are responsible for selecting their own investments. Previously, if a plan participant did not actively select their investments, they would be defaulted into a money market fund. While this was a low risk choice from a market standpoint, it carried big risk for individuals who did not realize they were invested in a money market fund and stayed there, missing out on years of investment returns, which did properly prepare them for retirement.

The Department of Labor issued new regulations in 2007 to address this issue. The new regulations were added to Section 404(c)(5) of ERISA that already provided additional fiduciary protections to employers for offering an appropriate number of funds and information needed to properly diversify. The new QDIA rules established that employers should default employees who do not take action to select their own investments into a default option that is appropriate for their age and time horizon. As would be expected, there are caveats and rules that need to be followed by employers to meet these requirements.

How do we help our clients meet these guidelines?

Annually, we conduct a QDIA Selection Process with each of our plan sponsors. We review the checklist to determine the appropriate type of QDIA for the plan demographic and, once it's determined to be appropriate, we review their QDIA option to evaluate it against proper benchmarks and the plan’s investment policy statement, utilizing research from Zuna’s investment committee and the fund manager.

If you are curious about our process, or have questions, please feel free to reach out.

2. Cash Alternatives: Stable Value, Guaranteed Options, Money Market Funds. A cash equivalent is one of the options (along with equities and bonds) that must be included in a plan to meet the basic 404(c)(5) requirements. While the term “cash” seems simple enough, in the retirement plan world, it is not a simple asset class.

While many plans have money market funds, many also have guaranteed and stable value options that are provided by the plan’s investment platform (recordkeeper). A large percentage of plans that come to us with these options are receiving fee discounts on recordkeeping for utilizing the investment manager’s proprietary fund. While this can be a good fiduciary decision, it does require additional oversight to make sure that the investment is benchmarking appropriately to other non-proprietary investments and that the plan sponsor is also evaluating other key metrics, including the financial health of the issuer.

Another challenge is that stable value and guaranteed options are not always portable which means that if the plan changes recordkeepers, moving can involve losses in the form of market value adjustments, and or, the employer may be required to pay the investment manager to avoid the plan participants losing account value in a market value adjustment. 

Cash alternatives should be evaluated in depth prior to selection and annually thereafter.

3. ESG (Environment, Social, Governance) Investing. We continue to see increasing interest in ESG (investing in funds that follow certain social or environmental standards) from our clients. Selecting and monitoring these options has been tricky at times given a long history of inconsistent guidance from the Department of Labor in how these options can be utilized in qualified retirement plans, much of it politically influenced.

The most recent guidance is the Biden administration DOL guidance that became final in January 2023 and was quickly challenged by Congressional resolution to block the rule which was subsequently vetoed by President Biden. Two lawsuits were filed to block ESG investing around the same time, one by 26 state attorney generals, in which a District court in Texas sided with the DOL, and one is still outstanding, while continued congressional threats linger.

As it stands, the current rules allow but don’t require ESG considerations in retirement plans. Most importantly, a plan sponsor’s number one priority is the financial benefit to their plan participants. This has not changed. ESG factors cannot override financial factors but they can be viewed and considered side by side.

For clients who choose to include ESG investments, we support that decision, and pay special attention to applying appropriate due diligence to these investments upon selection and ongoing. We discourage utilizing them as a default choice and document the decision making process on ESG funds annually. 

We look forward to continuing our rich investments discussions with our clients this year. If you have questions about our processes or feel they could benefit your plan, please reach out and I am happy to discuss in more detail.