QUALIFIED DEFAULT INVESTMENT ALTERNATIVES (QDIA) WHITE PAPER … DECEMBER 2010Scott Cameron, CFAPRINCIPALIn 2006, the Pension Protection Act (PPA) was signed into law with the objective of encouraging ERISA-defined contribution plans to adopt automatic enrollment features that would force plan participants to “opt-out”,rather than “opt-in”, to their company’s retirement plan. One component of PPA required the Department ofLabor (DOL) to draft regulation that would assist employers in selecting default investment options forparticipants that do not make an active investment election in their plan.On October 24, 2007 the Employee Benefits Security Administration (EBSA) of the DOL issued finalregulations governing default investment options. The final regulations provided safe harbor relief from fiduciaryliability for participant outcomes, if the plan sponsor selected a qualified default investment alternative (QDIA)and met all of the other requirements for disclosure and participant flexibility. It is important to note that the finalregulations did not require plans to comply with the rules, but instead created a safe harbor protection for thoseplans that elected to comply.Up until the creation of the QDIA rules, most plan sponsors had selected their plan’s stable value, generalaccount product, or money market fund as the default investment option if participants failed to make aninvestment election for their assets in the plan. These types of investments were generally considered the“safest” option within the plan, because they were designed to minimize market volatility and loss of principal.While these types of investment might have provided short term safety, they offered minimal opportunity forlong-term gains sufficient to provide a participant with a comfortable nest egg at retirement. By selecting thesetypes of investments as the default option, many plan sponsors were overweighting market risk (the loss ofprincipal) versus the other risk types facing retirement investors (i.e. inflation risk and longevity risk).The final regulations released by the EBSA outlined which options qualified as QDIAs. According to the EBSA,the objective of the final regulations was “…to ensure that an investment qualifying as a QDIA is appropriate asa single investment capable of meeting a worker’s long-term retirement savings needs.” The final regulationsdid not specify individual products that qualified, instead it outlined four categories of products that would meetthe objectives and qualify as QDIAs. The EBSA provided the following description for the four types of QDIAs: • A product with a mix of investments that takes into account the individual’s age or retirement date (an example of such a product could be a life-cycle or targeted-retirement-date fund);
QDIA … 2 • An investment service that allocates contributions among existing plan options to provide an asset mix that takes into account the individual’s age or retirement date (an example of such a service could be a professionally-managed account); • A product with a mix of investments that takes into account the characteristics of the group of employees as a whole, rather than each individual (an example of such a product could be a balanced fund); and • A capital preservation product for only the first 120 days of participation (an option for plan sponsors wishing to simplify administration if workers opt-out of participation before incurring an additional tax). 1Of the four types of investment products that qualified, three are viable options for most plan sponsors. Thefourth option, a capital preservation product that could be used for a limited time only, is not feasible for mostplan sponsors because it would require them to track the 120 day deadline and re-default a participant intoanother option if they failed to make an election in the 120 day window. The 3 workable options created a notedbreak from the past, in that they are options that would consist of a blended mix of stocks and bonds, ratherthan the more conservative, cash-like options that were so popular up until that point.Many plan sponsors see managed accounts as an inadequate default option because they are most effectivewhen a participant is actively engaged with the solution and is willing to provide detailed information on theirspecific situation so that the solution can be tailored to the individual’s specific needs. Most default participantsbecome default because they are unwilling to make even simple decisions, let alone provide the financialbackground necessary for a managed account solution. And finding a single balanced fund (or model portfolio)that is suitable for all, or at least the vast majority, of the sponsor’s participant population is difficult because ofvarying circumstances. Plan sponsors risk being too conservative or too aggressive for some portion of theiremployee population depending on what they ultimately select as the balanced fund.Of the three options, target date funds are, by a large margin, the most heavily adopted type of QDIAinvestment option. They offer a large advantage over the other two options in that they are easy to use andeasy to communicate. Compared to a professionally-managed account solution, they are less expensive andrequire less front-end input of information from the plan participant. Target date funds are also more attractivethan the balanced fund solution, because they allow for some difference in asset allocation and risk profilebased on an individual’s age.Please refer to our white paper, Evaluating Target Date Fund Structure, for more information regardingconsiderations in selecting a target date product.Multnomah Group, Inc.Phone: (888) 559-0159Fax: (800) 997-3010www.multnomahgroup.com1 Employee Benefits Security Administration “Regulation Relating to Qualified Investment Alternatives in Participant-Directed Individual Account Plans”,April 2008.