Close Close

Portfolio > Portfolio Construction

The ERISA Mystery Part II: Model Portfolios in Participant-Directed Plans

Your article was successfully shared with the contacts you provided.

The Department of Labor is charged with enforcing retirement plan participant disclosure rules, commonly known as the 404(a)(5) rules. Under these rules, it is ultimately the plan administrator’s job to disclose these fees and expenses. However, under the 408(b)(2) regulations, covered service providers, such as investment managers who manage all or a portion of assets in an individual account (“designated investment managers”), are also required to provide certain information to the plan administrator. Specifically, the DIM must provide the administrator with performance data for the available investment options, including the one-, five- and 10-year performance, as well as the performance since inception.

This remains true whether the manager is managing those funds pursuant to a model or on a separate account basis. The rules do not impose any limitations on the investment alternatives that a designated investment manager may offer to plan participants or implement in a participant’s portfolio. However, a plan sponsor may impose limitations by its terms or in its agreement with the DIM. A fairly common limitation imposed by plan sponsors is that the DIM may only invest in a plan’s designated investment alternatives. This is important for many reasons, but only one that is relevant to this article.

The DOL released “Field Assistance Bulletin 2012-02R” in July 2012, which clarified how the 404(a)(5) regulations would apply to model portfolios. When a plan offers a regular menu of designated investment alternatives (DIAs) to its participants and also offers a model portfolio that uses the same DIAs as underlying investments, the model portfolio itself is not viewed as a DIA for 404(a)(5) regulations. In other words, performance information for the model portfolio does not need to be included in the annual performance chart provided to participants. However, the plan sponsor may elect to do so.

Although a model portfolio would not be viewed as a DIA for purposes of the 404(a)(5) regs, any related fee charged to a participant who elects to invest in the model portfolio would be viewed as an individual expense under the 404(a)(5) regs. An explanation of a participant’s individual expenses must be provided annually, and the actual dollar amounts charged to a participant’s account must be disclosed on a quarterly basis. Thus, in the case of a participant charged for investing in a model portfolio, the amount deducted from the participant’s account would need to be disclosed on the participant’s quarterly statements and an explanation of these charges would need to be provided annually.

However, if a model portfolio contains non-DIA positions, the model is considered a DIA. This requires the firm to report the model’s performance like any other equity fund (i.e., one-, five- and 10-year, and since inception). Participants must also receive a quarterly statement of all administrative and individual expenses actually charged to or deducted from their specific account, and a description of the services for which these charges or deductions were made. These specific disclosures may be included in quarterly benefit statements required under section 105 of ERISA.

There is no formal guidance on whether the advisor can use a representative or composite account to report performance to the administrator. It would be extremely difficult for the advisor to regularly calculate actual performance for all participants electing the model. The DOL has not yet opined on whether or not a representative account can be used to report performance. However, the data provided must not be false or misleading.

The DOL’s field assistance bulletin did favorably cite the Securities and Exchange Commission’s 1986 no-action letter regarding Clover Capital Management Inc., so Stark & Stark does have some comfort in believing that the DOL is accepting of this approach. However, as of the date of this article, the DOL’s regulatory and compliance office has not returned our telephone calls to discuss this matter.