Is Your 401(k) Default Fund on Target? New DOL and SEC Guidance on Target Date Funds. Topics to Cover

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1 BEIJING BRUSSELS CHICAGO DALLAS FRANKFURT GENEVA HONG KONG LONDON LOS ANGELES NEW YORK SAN FRANCISCO SHANGHAI SINGAPORE SYDNEY TOKYO WASHINGTON, D.C. Is Your 401(k) Default Fund on Target? New DOL and SEC Guidance on Target Date Funds Beth J. Dickstein Sidley Austin LLP Copyright Topics to Cover Best practices for plan fiduciaries in choosing and monitoring target date funds Understanding a target date fund s glide path Evaluating the fees of target date funds Advice to participants on how target date funds operate Increased disclosure when a target date fund is the plan s qualified default investment alternative DOL Guidance SEC proposed regulation relating to advertising of target date funds Proposed effective date of SEC rules to marketing and other sales literature relating to target date funds

2 Basics Definition: funds that provide varying degrees of longterm appreciation and capital preservation through a mix of equity and fixed income exposures based on the participant s age, target retirement date (such as normal retirement age under the plan) or life expectancy. Intended to be an investment solution. Each target date fund generally is intended for participants with a target retirement year within a narrow band of years (such as a five year period). Glide Path the investment strategy for shifting investments to a more conservative portfolio. Can be a fund of funds, which invests in other funds or a stand alone product, which invests directly in a diversified portfolio of assets. Glide Path Higher risk investments at early age. Eventually reaches a landing point at which time the asset allocation becomes static. Glide path may flatten at the target retirement date. Alternatively, glide path may flatten near end of life expectancy. Different views on when equity investments should be significantly reduced.

3 Allocations Used in Glide Paths of Different Funds 2008 returns for 2010 target date funds ranged from -3.6% to -41%. Due to wide variation in asset allocations. Vanguard - 90% equity at age 40 and younger, declining to 50% at age 65 and 30% by age 72. Fidelity 50% equity at the target date, declining to 20% about 15 years after the target date. Bernstein equity/bond allocation of 60%/40% at age 65. Fund of Funds Products Mutual fund target date funds exempt from the fiduciary duty and self dealing prohibited transaction restrictions of ERISA. Plan asset target date funds (e.g., bank collective investment funds) subject to the fiduciary duty and prohibited transaction provisions of ERISA. Conflicts of interest? Layering of fees?

4 Benchmarks Lack of accepted industry benchmarks. Benchmarks have been established by Morningstar, Dow Jones, Target Date Analytics, and Standard and Poor s. Benchmarks of Morningstar Dow Jones and Target Date Analytics are based on each entity s hypothetical optimal glide-path. S&P s benchmarks are based on the average allocations of target date funds. Difficult to evaluate performance without accepted benchmark. Summary of Developments Designation as a Qualified Default Investment Alternative by DOL Regulations (12/07). ERISA Advisory Council hearing and report (2008). Senate Committee Hearing (2/09). Joint Hearing by the DOL and Securities and Exchange Commission ( SEC ) (6/09). DOL Guidance SEC Proposed Rule Amendments

5 404(c)(5) Regulations Target Date Funds as a QDIA Effective December 24, Named target date funds as a QDIA. Growth in assets invested in target date funds. Growth in the number of target date funds available ERISA Advisory Council Hearing Working group requested testimony on various issues including the following: What retirement and participant assumptions should be used when selecting and monitoring target date funds? How does a plan fiduciary evaluate and monitor target date funds when there is no standardized benchmarking methodology? What investment education and communication is required for participants to enable them to invest in target date funds or to assess whether they should actively manage their own investment? What are the different types of target date funds?

6 2008 ERISA Advisory Council Hearing The working group described plan participants general need for investment education. The working group believes that target date funds could provide a solution to participants general lack of knowledge/interest in plan investing. Working Group Recommendations: The DOL should reinforce ERISA requirements relative to plan investments in target date funds. The DOL should develop participant education materials and illustrations to enhance awareness of the value and the risks associated with target date funds. Senate Committee Hearing February, 2009 Hearing by U.S. Senate Special Committee on Aging. Concern over retirement security. Focus on target date funds. Senator Herb Kohl, Chairman, sent letters to the Secretary of Labor and the Chairwoman of the SEC urging review of target date funds.

7 Joint Hearing by the DOL and SEC In response to Senator Kohl s letter, the DOL and SEC held a joint hearing in June, DOL and SEC expressed concerns regarding: Differences in the glide paths; Variance in investment returns between funds with the same target retirement date; Participant disclosure and understanding; and Whether regulatory change or other reform is needed. Joint Hearing by the DOL and SEC Testimony focused on certain topics, including: Importance of target date funds as a simple alternative. Reasons for differences in glide paths. Need for equity investments after retirement. Whether target date funds should be customized.

8 Joint Hearing by the DOL and SEC Whether participant disclosure is adequate. Considerations for plan fiduciaries in selecting target date funds. Suggestions for additional regulation. Should the Glide Path be Regulated? The Certified Financial Planner Board argues that acceptable allocation ranges should be established. Help align risks with participants expectations. ICI and Profit Sharing Council of America do not believe that either the SEC or the DOL should regulate the ranges of asset allocations. Regulation generally would be unprecedented - except for investments in employer securities and real property, ERISA does not limit types of acceptable investments.

9 Joint DOL/SEC Guidance DOL intends to issue 3 pieces of guidance: 1. Initial joint DOL/SEC guidance titled Investor Bulletin: Target Date Retirement Funds, issued 5/6/2010; 2. Best practices checklist; and 3. Amendment to the QDIA regulation as it relates to target date funds. Joint DOL/SEC Guidance Investor Bulletin (Issued May, 2010) Discusses basics of target date funds: Target date funds are designed to be long-term investments for individuals with particular retirement dates in mind. No guarantee that participant will have sufficient retirement income at the target date. Fund disclosure describes the types of investments and how the investment mix will shift over the life of the fund. Can change so monitor fund s investments over time.

10 Joint DOL/SEC Guidance Investor Bulletin (Issued May, 2010) Evaluating a Target Date Fund: Review the fund s asset allocation over the entire life of the fund. Review the fund s asset allocation at its most conservative investment mix. Review the fund s risk level. Joint DOL/SEC Guidance Investor Bulletin (Issued May, 2010) Evaluating a Target Date Fund: Review the fund s performance. o Should participants reference a particular benchmark? Review the fund s fees. o What should a participant review?

11 SEC Proposed Amendments Proposed amendments to rule 482 under the Securities Act. Proposed amendments to rule 34b-1 under the Investment Company Act. Proposed amendments to rule 156 under the Securities Act. Background Rule 482 Rule 482 under the Securities Act permits investment companies to advertise information prior to delivery of a statutory prospectus. Such advertisements are prospectuses under Section 10(b) of the Securities Act. Proposed amendment applies to advertisements and supplemental sales literature that place a more than insubstantial focus on one or more target date funds. Amendments apply whether or not the target date fund is a QDIA.

12 Background Rule 34b-1 Rule 34b-1 under the Investment Company Act sets forth the requirements for supplemental sales literature. Under Rule 34b-1, a communication sent after the effective date of a fund s registration statement is not deemed a prospectus if a statutory prospectus was sent to a person prior to or at the same time the applicable communication was sent to such person. Proposed Amendments to Rule 482 and Rule 34b-1 Disclose in print advertising: Investor should consider age or retirement date, as well as other factors, including the investor s risk tolerance, personal circumstances, and complete financial situation. Investment is not guaranteed and could loss money. Circumstances under which allocations can be modified without a shareholder vote. If the fund uses a year in its name, describe the intended allocation as of that year and the allocation as of the last quarter and specify that those allocations are as of such times.

13 Proposed Amendments to Rule 482 and Rule 34b-1 Disclose in print advertising for more than one fund: A prominent table, chart, or graph that clearly depicts the asset allocations over the entire life of the funds: at identified periodic intervals (no longer than 5 years) at the inception of the funds at the target dates at the landing points (date of static asset allocation) at the most recent quarter end Radio or TV ads must state the landing point, explain that the asset allocation becomes fixed at the landing point, and describe the intended allocations at the landing point. Background Rule 156 Rule 156 under the Securities Act contains guidance on the types of information in investment company sales literature that could be misleading. It applies to all sales literature, whether or not delivered with the fund s prospectus. Under rule 156, whether a statement is misleading depends on the context in which the statement is made. Rule 156 outlines certain situations in which a statement could be misleading.

14 Proposed Amendments to Rule 156 Proposing to amend rule 156 to address certain statements suggesting that securities of an investment company are an appropriate investment. Will apply to all types of investment companies. Such a statement could be misleading because of the emphasis it places on a single factor, such as an investor s age or tax bracket, as the basis for determining that an investment is appropriate. Such statement could be misleading because of representations, whether express or implied, that investing in the securities is a simple investment or that it requires little or no monitoring by the investor. Effective Date of SEC Amendments Changes to Rule 482 will apply to target date fund advertisements and supplemental sales literature that are used 90 days or more after the effective date of the amendments. Rule 156 changes will be effective immediately upon adoption.

15 SEC Comments Requested SEC requests comments on: Does the proposed definition of target date fund cover the types of funds that should be subject to the proposal? Is it appropriate to limit application of the amendments to marketing materials that place a more than insubstantial focus on one or more target date funds? Should the SEC prescribe specific asset classes to be used in disclosing the asset allocation or the methodology for calculating the percentage allocations? Are there additional amendments that would effectively address the concerns relating to target date fund names? Should the prospectus requirements provide specific disclosure requirements for target date funds? SEC Comments Requested SEC requests comments on: Should specific materials be exempted from the rule? Should the SEC prescribe the specific format for the asset allocation disclosure? Do investors need other information along with allocation percentages in order to understand the significance of those percentages (such as risks, and volatility of different asset classes)? Should there be disclosure whether the glide path extends to the target date or through the life expectancy of the investor? Should the prospectus specify a manager s discretion to change the glide path?

16 SEC Comments Requested SEC requests comments on: Will the disclosure of a target date fund s asset allocation be an effective way to reduce investor misunderstanding? Will the disclosure cause investors to prioritize investment risk at a particular moment in time over longevity risk, inflation risk, or other risks? Should the proposal be modified to address any impact that it may have on investor or manager behavior? Are there other means to enhance comparability among target date and current asset allocations? Are the proposed effective dates appropriate? Comments due August 23, 2010 Possible Legislative Actions Possible legislation that will require target date fund managers to take on a fiduciary responsibility in order for such funds to be eligible for the designation of QDIA. Response to Avatar testimony in Senate hearings and DOL advisory opinion. DOL issued advisory opinion to Avatar stating that manager of a target date mutual fund does not become a fiduciary under ERISA merely because the target date fund invests in affiliated funds.

17 Is More Regulation Needed? Wide differences of opinion. Those advocating for additional regulation want: More regulation of disclosures and naming conventions; Specified ranges of asset allocations; and Limitation of mutual fund exception from regulation under ERISA. Is More Regulation Needed? Those against more regulation state: Existing disclosure rules are sufficient; Regulation of disclosure would not make participants read the disclosure; and Having the DOL and SEC prescribe acceptable asset allocation ranges would be unprecedented and likely unsuccessful.