Administration February 8, 2018

Morningstar Paper Lays Out Method to Determine the Best QDIA

“The world is moving toward big data, and thus far as an industry we haven’t been able to use big data in a meaningful way. We are now in the midst of a paradigm shift that will allow plan sponsors to make data-driven decisions in an entirely new way,” says Thomas Idzorek, with Morningstar Investment Management.

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Recent technological advancements, along with increased data availability and quality, enable plan sponsors to stop guessing and move beyond heuristics to use detailed data on individual participants to make a robust, data-driven selection of an appropriate qualified default investment alternative (QDIA). Morningstar Investment Management staff detail this in their new paper, “Stop Guessing: Using Participant Data to Select the Optimal QDIA.”

Thomas Idzorek, CFA, chief investment officer – Retirement at Morningstar Investment Management LLC in Chicago, and lead author of the paper, tells PLANPSONSOR, “Our managed account engine will consider age, plan account balance, salary, contribution, state of residence—different states have different tax rates—employer tiered match, employer contribution, plan loans, brokerage account holdings, retirement age, gender and pension as well as other outside assets to determine the recommended allocation to equities for each participant.” Much of this information the plan recordkeeper would have, he notes.

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The paper shows how knowing this information can help defined contribution (DC) plan sponsors determine the QDIA that best fits their participant base.

To demonstrate the framework, Idzorek explains, the team first ran a hypothetical plan of 10 participants of different ages through Morningstar’s managed account engine to come up with a recommended allocation to equities. They first plotted each individual’s recommended allocation to equities on a chart, alongside the equity glide path for a balanced fund. When measuring the difference in equities between the glide path and the individual recommendations, they found the balanced fund was off by an average of 20 equity percentage points. They then plotted each individual’s recommended equity allocation alongside the equity glide path of the Morningstar Lifetime Allocation Index – Conservative and found it was off by only 12 equity percentage points.

“If both cost the same, the plan sponsor should choose the one that fits its demographic better,” Idzorek says. He notes that this same comparison can be done with funds offered by any provider or any QDIA a plan sponsor wants to evaluate.

The report authors did the same comparison to the Morningstar Lifetime Allocation Index – Moderate, as well as a custom glide path. “A custom glide path may cost more, but it could improve fit even more,” Idzorek points out. He adds that for some plans that have participants with diverse financial situations, the recommended equity allocation “may be all over the place, and in that case, a managed account may be the best fit.”

Where does cost come into the decision? If the plan sponsor could improve the average fit for its demographic, what should it pay for that? Idzorek says when calculating the cost of moving to a better average fit, plan sponsors should be willing to pay a reasonable amount for an improvement. “If a plan sponsor can move to a QDIA that on average fits their plan population better by 15 equity percentage points, they should be willing to pay approximately 20 basis points for that type of improvement,” he says. “A cost greater than that would not justify a move.” Idzorek notes that there are a number of other benefits to managed accounts that aren’t considered specifically by this analysis, such as savings rate advice.

The same comparison of recommended equity allocation can also be used to evaluate a hybrid QDIA vehicle—one for which a target-date fund (TDF) is used for the younger demographic then participants would move to a managed account at a certain age. Idzorek says, “There’s not necessarily a right or wrong way to determine at what age the change to a managed account would occur, but if everyone younger than 35 is shown to be well-served by the glide path of the TDF and there is more dispersion above that age, then 35 would be the age for the transition to managed accounts.” He adds that the demographics of different plans could result in a different age. The key is that this new framework allows a plan sponsor to evaluate the options that are available to them, the costs, and given the plan’s unique demographics make a defendable, data-driven decision.

The comparison may also be used in more complicated scenarios. For example, Idzorek explains that if a plan sponsor offers a defined benefit (DB) plan, is considering freezing the DB plan, and changing their DC match, they may be wondering if their current target-date fund family is still appropriate for their plan given the potential changes. “Plan sponsors can incorporate information such as this to come up with specific equity recommendations for individuals under a variety of potential scenarios and use that information to inform their decision making,” he says.

“We have established a framework for quantifying the cost/benefit of a better-fit QDIA. As a result, plan sponsors can stop guessing and use participant demographic data to inform which … QDIA option … fits the plan best; the participant age or other factors that should be used to structure a hybrid QDIA; which glide path fits the plan best; and, whether a custom target-date glide path is necessary,” the paper says.

It notes that there is no agreed-upon definition of “best” when determining fit. The ideal implied glide paths for different plans can and should differ significantly. For some plans, a conservative glide path will be most appropriate, while for others an aggressive glide path will be most appropriate. 

“We believe the techniques described in this paper will empower plan sponsors and their advisers to stop guessing and use an easy-to-implement, yet rigorous QDIA selection process,” the paper says. Idzorek adds, “The world is moving toward big data, and we haven’t been able to use big data in useful way until now. This new paradigm will enable plan sponsors to stop guessing and to meet their fiduciary obligations in a much more robust and defendable manner.”
Compliance February 8, 2018

5th Circuit Affirms Dismissal of RadioShack Stock Drop Suit

The court found participant claims did not meet standards set forth in Fifth Third Bank v. Dudenhoeffer.

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The 5th U.S. Circuit Court of Appeals has affirmed a district court’s dismissal of a case alleging Radio Shack continued to offer company stock as an investment option in its 401(k) plan when it was no longer prudent to do so.

The case was first introduced years ago, and the U.S. District Court for the Northern District of Texas used the presumption of prudence then used by courts to dismiss the suit. However, the lawsuit was refiled after the Supreme Court in Fifth Third Bank v. Dudenhoeffer clarified that fiduciaries of employee stock ownership plans (ESOPs) are not entitled to any special presumption of prudence under the Employee Retirement Income Security Act (ERISA).

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The three named plaintiffs in the class action filed suit against the members of the plan’s retirement committee, RadioShack’s board of directors and the plan trustees. They also sued the plan administrative committee and trustees of the RadioShack Puerto Rico 1165(e) Plan. The plaintiffs settled with the trustees.

The appellate court noted in its opinion that Dudenhoeffer establishes different standards for duty-of-prudence claims based on public information and insider information, respectively.

The plaintiffs contend that the committee defendants breached the duty of prudence by failing to respond to publicly available information that warned of RadioShack’s decline and suggested that RadioShack stock was too risky for a retirement plan. They argue that Dudenhoeffer does not apply to public-information claims that a stock was excessively risky, and that even if it applies, RadioShack’s declining economic condition gave rise to special circumstances that entitle them to relief.

But, the 5th Circuit concluded these claims fail under the standard announced in Dudenhoeffer and that no special circumstances warrant relief. According to the opinion, Dudenhoeffer establishes that for publicly-traded stocks, “allegations that a fiduciary should have recognized from publicly available information alone that the market was over- or under-valuing the stock are implausible as a general rule, at least in the absence of special circumstances.”

The appellate court also found that under the Dudenhoeffer standard, the plan fiduciaries did not breach the duty of prudence by relying on market price as a fair indicator of the value of RadioShack stock. “Although the complaint references scores of news articles and analyst reports detailing RadioShack’s demise, the complaint provides no plausible reason that the negative commentary from these sources was not incorporated into the RadioShack stock price. The same is true of the complaint’s discussion of debt, financial statements, and downgrades to RadioShack’s stock, bond, and credit ratings,” the court’s opinion says. “On the contrary, the overall decline in the price of RadioShack stock during the class period shows that the market accounted for this negative information.”

According to the opinion, the retirement plan committee held an ad-hoc meeting on July 11, 2014, to consider the propriety of RadioShack stock as a plan investment option given a recent rating downgrade. The committee considered freezing or capping future contributions, removing the stock from the plan, and aggressively educating participants about the importance of diversification and risks of investing in a single stock. The committee decided to freeze future plan participant investment in RadioShack stock “as soon as administratively feasible,” September 15, 2014. The committee declined to divest the stock, reasoning that it would force participants to sell their shares at an all-time low and would send a negative message about the company’s prospects.

The appellate court said the plaintiffs fail to plausibly allege that a press release in which a RadioShack executive said he believed the stock may be worth nothing made the market price of RadioShack stock unreliable at the time the committee froze plan purchases of the stock months earlier or at the time the release was made.

The plaintiffs did not plausibly plead that any defendant had information not available to the public, the 5th Circuit said. It found that even if assuming the defendants had insider information, the plaintiffs’ non-public information claims would not satisfy Dudenhoeffer. To state a duty of prudence claim based on nonpublic information, “a plaintiff must plausibly allege an alternative action that the defendant could have taken that would have been consistent with the securities laws and that a prudent fiduciary in the same circumstances would not have viewed as more likely to harm the fund than to help it.”

The complaint alleges the committee defendants should have frozen plan contributions to the fund earlier, disclosed inside information to the market to deflate the stock price, or liquidated the plan’s holdings of RadioShack stock after disclosing the alleged inside information. “Because a prudent fiduciary could conclude that each of these actions would have done more to harm the plan than to help it, the district court properly dismissed the plaintiffs’ duty of prudence claims based on insider information,” the appellate court’s opinion states.

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