Key Takeaways
Target date funds (TDFs) simplify retirement investing for participants but can also present some legal challenges for plan sponsors.
One of the most effective ways sponsors can help shield the plan from participant litigation is by thoroughly documenting the TDF evaluation and selection process.
Best practices include establishing a formal review committee, using objective criteria for evaluation, consulting with experts and regularly reviewing the selection rationale.
The rise of TDFs and associated legal concerns
Target date funds are designed to simplify retirement planning by automatically adjusting asset allocation as the participant nears retirement. They have become a staple in many employer-sponsored plans, particularly as qualified default investment alternatives.
Despite their benefits, TDFs can also be a source of legal challenges for plan sponsors. Litigation related to investment underperformance and fiduciary imprudence has increased in the last several years.1 For example, one law firm has filed about a dozen lawsuits on behalf of participants that involve the underperformance of a particular passive TDF suite relative to the five largest TDF suites on the market. Although federal courts have widely and consistently rejected attempts to impose Employee Retirement Income Security Act (ERISA) fiduciary liability based solely on fund underperformance, these lawsuits highlight that simply selecting passive target date funds does not offer protection to plan sponsors.
Documentation: A shield against participant litigation
One of the most effective strategies to help mitigate the risk of litigation is to thoroughly document the TDF selection and monitoring process. Documentation serves multiple critical functions:
Demonstrates fiduciary prudence
By keeping detailed records, sponsors can demonstrate that they have acted prudently and in accordance with ERISA guidelines. This includes documenting why particular TDFs were chosen, the criteria used for their selection, and how they align with participant demographics and retirement goals.
Facilitates regular reviews
Sponsors should regularly review the performance and management of TDFs. Documentation of these reviews can show ongoing diligence and adjustments made in response to changing conditions or underperformance.
Supports communication with participants
Clear documentation can help sponsors craft participant communications, explaining their choices and the benefits of the selected TDFs. This transparency can reduce misunderstandings and dissatisfaction among participants.
Assists in providing legal defense
In the event of litigation, well-organized and comprehensive documentation can be pivotal in defending the sponsor’s decisions. Courts often look favorably on sponsors who can support their decision-making process with clear, logical and participant-focused reasoning.
TDF evaluation and selection: Best practices for sponsors
Before starting the TDF evaluation and selection process, sponsors should have a thorough understanding of the objectives of the plan, including:
- whether the plan is a primary or supplemental retirement savings vehicle for participants
- the plan’s philosophy on active versus passive management, single-manager versus multi-manager approaches, and asset class diversification
- the plan’s goal with respect to participant assets at retirement (retain them versus encourage rollovers or distributions)
Participant population is also an essential consideration, including participants’:
- risk tolerances and behaviors
- contribution rates
- expected salary growth rates
- engagement levels with the plan
- investment expertise
To effectively document the TDF selection and evaluation process, we suggest that sponsors consider the following best practices.2
While the fear of litigation is a genuine concern for plan sponsors, a well-documented selection and evaluation process for TDFs can help mitigate these risks. By demonstrating prudence, engaging in regular reviews and maintaining clear communication with participants, plan sponsors can also enhance the overall effectiveness of their retirement plan offerings. This proactive approach aids in ensuring that the interests of participants are continuously prioritized, aligning legal defense with the fundamental goals of retirement planning.
A note about risk There is no guarantee that any investment option will achieve its stated objective. Principal value fluctuates and there is no guarantee of value at any time, including the target date. The “target date” is the approximate date when an investor plans to start withdrawing their money. When their target date is reached, they may have more or less than the original amount invested. For each target date portfolio, until the day prior to its target date, the portfolio will seek to provide total returns consistent with an asset allocation targeted for an investor who is retiring in approximately each portfolio’s designated target year. On the target date, the portfolio will seek to provide a combination of total return and stability of principal. Stocks are more volatile than bonds, and portfolios with a higher concentration of stocks are more likely to experience greater fluctuations in value than portfolios with a higher concentration in bonds. Foreign stocks and small- and mid-cap stocks may be more volatile than large-cap stocks. Investing in bonds also entails credit risk and interest rate risk. Generally, investors with longer timeframes can consider assuming more risk in their investment portfolios |