the case for the vast majority of U.S. workers. We know that the percentage of income replacement will vary broadly based on the income level and personal circumstances of workers. Whatever the percentage, most DC plans share a common goal: to help workers retire at their desired age and with sufficient income to maintain their lifestyle throughout retirement. For organizations that also provide a DB plan, the DC income replacement target may be only 30 percent. What’s important is to consider the objective for your plan and set a reasonable target.
In December 2014, we interviewed Philip S. L. Chao, Principal and Chief Investment Officer of Chao & Company Ltd., a retirement plan and fiduciary consulting firm, about their approaches to DC investment design. He shared the followed comments:
We begin with a basic question: “What is the objective for this plan?” It is rare for us to set up a new plan; rather, we’re typically asked to advise on an existing plan. With that said, it may be surprising how much time we spend on the plan’s objective. We ask the plan sponsor to forget about how the plan is designed today; they are encouraged to step back and identify what they are trying to accomplish. This often leads to a refreshing discussion of the DC plan as a benefit program and the outcome they seek for their participants. Yet, plan sponsors are rarely specific about the desired outcome. Instead, we often initially hear they simply want a competitive plan, or they may tell us how a DC plan is the only retirement savings vehicle employees have. We then work with the plan sponsors to articulate and document the objective for the plan. Once the objective is set, then we work on crafting the investment structure to help meet this objective.
Chao goes on to tell us more about setting an income replacement target, saying:
We consider the organization’s workforce (i.e., thinking in sole interest of the participants) and the retirement income sources for the typical employee. A law firm’s demographics, income distribution and other factors may differ greatly from a retail chain store. The law firm may have higher-paid workers and lower turnover. These are important considerations as we think about the median worker profile. Median is not perfect either, but it’s a start. We consider Social Security, likelihood of the existence of other retirement plans, housing wealth, and other retirement income sources.
In general, plans consider a 75 % to 80 % income replacement as the default target, including Social Security. About half of that need can be covered by Social Security and other income sources. This leaves DC plans to fill in the remaining 35 % to 40 % of income for the median worker over the course of a working career. This isn’t exact and won’t fit all workers, but a general target helps us as we consider the plan design. We ask ourselves whether the median participant is likely to meet their income needs. We want the plan sponsor to understand the probability of failure and whether the plan is likely to meet the set objective. This goes beyond investment return and pulls in the average deferral rate, employer contribution amount and other assumptions. Assessing the likelihood of meeting the plan’s objective can help plan sponsors evaluate target-date funds and other QDIAs [Qualified Default Investment Alternatives] as well as test the balance in and portfolio construction adequacy of their core lineup.
While DC plans need to focus on meeting participant needs and consultants tell us that the number one driver of plan sponsor decisions is to “meet participant retirement goals,” they also note that the second driver is to “manage litigation risk” (PIMCO’s 2016 Defined Contribution Consulting Support and Trends Survey). Sound plan governance and plan oversight are central to both of these. Before delving deeply into meeting a retirement objective, let’s take a look at litigation and fiduciary duties.
REDUCING DC LITIGATION RISK: PROCESS AND OVERSIGHT
In 2014, we sat with James O. Fleckner, Partner and Employee Retirement Income Security Act of 1974 (ERISA) Litigation Practice Leader at Goodwin Procter LLP, to talk about how plan sponsors can reduce the risk of litigation. Fleckner first provided some background on the Employee Retirement Income Security Act, a 1974 federal law that is intended to “help protect the interests of employee benefit plan participants and their beneficiaries by establishing fiduciary duties of care, plan disclosure requirements and more. This federal statute governs most private employee benefit plans, including defined contribution plans.”
To protect themselves against lawsuits, “Plan sponsors should understand and fulfill their fiduciary duties,” Fleckner comments. These include the duties of loyalty, prudence, diversification, and fidelity to plan documents. Loyalty focuses plan sponsors on doing what is in the best interest of participants, rather than on what may be of value to themselves or their company. “We’ve seen this duty raised in cases that have alleged that the plan fiduciaries cared more about saving money for the company than they did about doing what was right for the participants,” he notes.
Prudence, in contrast, focuses on the process for making fiduciary decisions; for those lacking expertise to make decisions such as about investments, the government suggests they hire experts. Fleckner also discussed the duty of diversification, which is intended to help reduce the risk of losses. Plan sponsors are guided by the provisions of ERISA section 404(c) in offering at least three diversified investment choices within the plan. And, finally, there is the duty to follow plan documents.
ERISA litigation may arise when it is alleged that a plan sponsor has failed to meet any of these fiduciary duties, or to challenge technical violations of ERISA’s prohibited transaction rules. Unlike in DB plans, where the company bears the cost in the event of an error or misjudgment, in DC plans the participants bear both the upside and downside risk – hence Fleckner commented that “we see few DB lawsuits and many DC cases. Also, since many of these fiduciary duties are left open to interpretation or to the particular facts and circumstances of a given case, this area exposes plan sponsors to litigation risk.”
In the end, says Fleckner, fiduciaries need to demonstrate that they care about their participants: “In defending against any litigation involving those choices, it is most helpful to have a written record of the consideration that the fiduciaries gave in arriving at their decision. That way, we can show the judge that, in fact, the fiduciaries were evaluating options and landed on the ones that they felt were most appropriate for their participants.”
WHO’S A FIDUCIARY?
ERISA requires that a DC plan have at least one fiduciary – that is, a person or entity either named in the written plan, or through a process described in the plan, as having control over the plan’s operation. The Employee Benefits Security Administration (EBSA) explains: “The named fiduciary can be identified by office or by name. For some plans, it may be an administrative committee or a company’s board of directors. A plan’s fiduciaries will ordinarily include the trustee, investment advisers, all individuals exercising discretion in the administration of the plan, all members of a plan’s administrative committee (if it has such a committee), and those who select committee officials. Attorneys, accountants, and actuaries generally are not fiduciaries when acting solely in their professional capacities. The key to determining whether an individual or an entity is a fiduciary is whether they are exercising discretion or control over the plan.”
For plan sponsors who lack expertise in a specific area such as investment oversight, they may want to engage an investment consultant or other experts to help them fulfill their fiduciary responsibility. In 2011, we spoke at length to David Levine of Groom Law Group regarding fiduciary rules played by plan sponsors and outside advisors, including how to understand primary ERISA fiduciary categories, and what responsibilities fit with each.
In the U.S. system, the core concept of fiduciary, Levine told us, is contained within a single category – an ERISA “3(21) fiduciary.” Beyond this basic definition are various additional roles, such as the concept of the named fiduciary, which generally is a fiduciary named either in a plan document or by a plan sponsor. A named fiduciary is the default plan fiduciary. Others, including advisors, can also be 3(21) fiduciaries. Further, a person can be a 3(16) plan administrator responsible for certain core administrative duties under ERISA. The determination of when a person is a fiduciary or not depends on their exact duties, on whether the duties are discretionary in nature, and on the financial relationship of the person to the plan. The bottom line, Levine says, is that “It’s important to carefully