1. Marcia S. Wagner, Esq. Custom Solutions: Legal, Compliance and Disclosure

2. 2 Introduction Target-Date and Target-Risk Funds ◦ Popular default investments for DC plans. ◦ Many are “prepackaged” funds. ◦ One size fits all. Next Phase of Evolution - Custom Solutions ◦ Tailored to advisors’ investment strategies. ◦ Greater investment flexibility. ◦ Eliminate potential conflicts. ◦ Access to lower costs.

3. 3 Model Portfolios Discretionary Model Portfolios ◦ Model portfolio applied to participant’s account. ◦ Similar to managed accounts. ◦ Plan’s regular menu is used to create model portfolio with target-date, target-risk strategy. ◦ Example: Target-Date Model Portfolio ◦ Customary for advisor to serve as “investment manager” under ERISA 3(38).

4. 4 Model Portfolios (cont’d) Plan sponsor may manage Model Portfolios. ◦ Financial advisor serves as co-fiduciary. ◦ Plan sponsor makes ultimate investment decisions. ◦ Arrangement preferred by institutional plans. Investment Manager for Model Portfolios ◦ Plan Sponsor must select advisor prudently. ◦ But is not responsible for advisor’s individual actions. ◦ Arrangement utilized by plans of all sizes.

5. 5 Bank Collective Investment Funds Collective Investment Funds (CIFs) ◦ Maintained by bank trustee. ◦ Pooled vehicle for plan investors. Regulatory Framework ◦ IRS rules for “group trust” ◦ DOL fiduciary requirements ◦ Bank regulations (such as OCC Reg. 9.18) ◦ Exemption from SEC registration

6. 6 CIFs and Third-Party Advisors CIF’s bank trustee may partner with third party advisors (e.g., RIA firm). ◦ For example, RIA advises plan clients on their DIAs. ◦ CIF is created, using same DIAs as custom solution. ◦ RIA advises bank trustee on CIF’s underlying portfolio. SEC Exemption ◦ Requirements under ICA Section 3(c)(11) and Securities Act Section 3(a)(2). ◦ Requires bank trustee to exercise “substantial investment responsibility.” ◦ Bank trustee must have final authority over following RIA’s advice.

7. 7 Model Portfolios vs. CIFs Model Portfolios ◦ Plan sponsor must have internal resources to coordinate investment management services. ◦ May manage Model Portfolios with assistance from advisor, or appoint advisor to manage them. CIFs ◦ Convenience of an investment product. ◦ Bank trustee can assist with implementation, operational issues and participant disclosures.

8. 8 Purpose of QDIA Rules Impact of QDIA Rules on Default Investments ◦ For auto-enrolled participants whose contributions are transferred to default investment. ◦ Pension Protection Act of 2006 created “safe harbor” fiduciary protection for Plan’s default investment. ◦ Default investment must qualify as QDIA. ◦ If safe harbor applies, defaulted participants alone are responsible for their passive investment decisions.

9. 9 QDIA Definition QDIA Conditions (for Non-mutual Funds) ◦ Target-date or balanced strategy ◦ Must be managed by “3(38)” investment manager, or bank trustee meeting requirements of ERISA 3(38). ◦ Plan sponsor can also manage QDIA. ERISA Section 3(38) Definition ◦ Must have investment power. ◦ Must be a bank, insurance company or RIA. ◦ Must acknowledge fiduciary status in writing.

10. 10 Custom Solutions and QDIA Definition QDIA definition impacts structure of custom solutions. ◦ QDIA rules require target-date or balanced strategy. ◦ Must be managed by RIA or bank trustee. Custom solutions satisfy QDIA definition. ◦ CIFs are managed by bank trustee. ◦ Model Portfolios are managed by investment manager, or plan sponsor with advisor’s assistance. ◦ Non-discretionary model portfolios do not meet QDIA requirements.

11. 11 Other QDIA Considerations Target-Date Investment Strategy ◦ Asset mix must be consistent with age, retirement or life expectancy. ◦ Must become more conservative over time. Balanced, Target-Risk Strategy ◦ Asset mix must be consistent with target risk for plan. General Investment Requirements ◦ Generally accepted investment theories. ◦ Long-term appreciation and capital preservation. ◦ Diversified to minimize risk of large losses.

12. 12 General Fiduciary Standard Under ERISA QDIA safe harbor does not relieve all fiduciary responsibilities. ◦ QDIA must be prudent default investment. ◦ Fiduciary Duties of Prudence and Loyalty Prudence Standard ◦ Fiduciary must act with “the care, skill, prudence, and diligence under the circumstances…” ◦ “…that a prudent man acting in a like capacity and familiar with such matters would use…”

13. 13 Unique Fiduciary Considerations Independent Investigation of Target-Date, Target-Risk Strategies ◦ “All in One” Investment ◦ For Less Sophisticated Participants ◦ Selection of Underlying Funds ◦ Target Asset Allocations (such as TDF glide path)

14. 14 Fulfilling the Duty of Prudence Application to General Investments ◦ Procedural in nature. ◦ Requires independent investigation of merits of investment. ◦ Fiduciary must give “appropriate consideration” to relevant facts and circumstances. ◦ Investment must be reasonably designed to further plan purposes. Application to Target-Date, Target-Risk Strategies

15. 15 Potential Conflicts Relating to Underlying Funds Asset allocation solutions may be susceptible to conflicts of interest. ◦ Conflicts may arise due to manager’s incentive to invest in proprietary funds. ◦ Proprietary funds may have poor performance or excessive fees. ◦ May create bias in target allocations, affecting level of risk for participants.

16. 16 Permissible Conflicts in Mutual Funds Mutual funds permitted to invest in prepackaged set of proprietary funds. ◦ Mutual fund’s manager is exempt from ERISA. ◦ But plan’s selection of mutual fund itself is subject to ERISA prudence standard. ◦ One or more bad underlying funds could potentially taint mutual fund. Custom strategies are designed to avoid conflicts. ◦ Custom strategy’s manager is subject to ERISA. ◦ Must not invest in any proprietary funds.

17. 17 Fiduciary Advantages of Custom Strategies Providers of custom strategies typically do not sponsor proprietary funds. ◦ No conflict of interest. ◦ Ability to select “best in breed” underlying funds. ◦ Ability to replace underlying funds as necessary. ◦ No conflicts in selection of underlying funds or in determining target allocations.

18. 18 Using Plan’s Menu of DIAs as Underlying Funds Custom strategy can use Plan’s existing DIAs. ◦ Advantage for both Model Portfolios and CIFs. ◦ CIFs may also include investments not in plan menu. Fiduciary oversight may be streamlined. ◦ For plans where 3(21) or 3(38) fiduciary provides plan menu advice. ◦ Can leverage fiduciary findings for Plan’s DIAs when considering custom strategy. ◦ Consider using existing DIAs as “starting point” for Plan’s custom solution.

19. 19 Duty to Consider Custom Solutions DOL Guidance on TDFs (Feb ‘13) ◦ Target Date Funds – Tips for ERISA Plan Fiduciaries ◦ Mostly covered core fiduciary concepts. ◦ Also advised plan fiduciaries to inquire about “custom and non-proprietary” solutions. ◦ In sum, plan sponsors and advisors should inquire about availability of Model Portfolios and CIFs.

20. 20 Flexibility in Investment Strategies Advisors can develop custom asset allocation solutions for their plan clients. ◦ Plan clients can turn to advisors for non-proprietary alternatives. Glide path is critical aspect of any target-date strategy. ◦ May be customized to reflect advisor’s investment philosophy. ◦ Advisor can determine if strategy should glide “to” or “through” a participant’s retirement date.

21. 21 Cost Advantage of Custom Solutions Model Portfolios and CIFs do not have “retail” cost structure. ◦ No 12b-1 fees. ◦ Participants can enjoy “institutional” pricing. ◦ No proprietary funds with excessive fees. ◦ Passively-managed underlying funds may be used to reduce costs further. ◦ Small- and mid-sized plans can enjoy cost savings.

22. 22 Fee Considerations Fee-related Duties Under ERISA ◦ Fees must be reasonable in light of services. ◦ Excessive fees will result in fiduciary breach and violation of ERISA’s prohibited transaction rules. Fee for Model Portfolios ◦ Fees are payable to third party fiduciary. ◦ May be paid by plan sponsor or charged to plan.

23. 23 Fee Considerations (cont’d) Fee for CIFs ◦ Cost structure is part of investment product. ◦ Fees customarily reflected in “unit” value of ownership interests in CIF. ◦ Bank trustee may share its compensation with investment firm (e.g., RIA firm). ◦ No amount deducted at participant-account level.

24. 24 Fee Disclosures for Plan Sponsor 408(b)(2) Fee Disclosures for Custom Strategy ◦ Third party fiduciary must provide disclosures “reasonably in advance” of commencing services. ◦ For Model Portfolios, 408(b)(2) disclosures are included in service agreement. ◦ For CIFs, 408(b)(2) disclosures typically included in participation agreement and disclosure statement.

25. 25 Lessons from 401(k) Fee Litigation Participant Claims Relating to Excessive Fees ◦ Alleged that fiduciaries failed to protect participants. ◦ Also alleged that retail mutual funds were used, when cheaper institutional funds were available. Potential Future Allegations ◦ May allege that retail TDFs were used, when custom solutions with cheaper pricing were available. ◦ For liability protection, plan fiduciaries should investigate availability of custom solutions.

26. 26 Overview of Participant-Level Fee Disclosures 404a-5 Regulations ◦ Plan sponsor must provide quarterly and annual disclosures to participants. ◦ Plan’s DIAs must be included in comparative chart. ◦ Quarterly performance updates and other data for DIAs must be posted on website. ◦ Other information must be provided upon request.

27. 27 Participant-Level Disclosures for Model Portfolios Field Assistance Bulletin 2012-02R ◦ Model portfolio is not a DIA for purposes of 404a-5 Regulations. ◦ May be included in comparative chart on voluntary basis, but not required. ◦ Participant’s “individual expense” must be explained annually and disclosed in quarterly statements.

28. 28 Participant-Level Disclosures for CIFs Required Disclosures ◦ CIFs are viewed as DIAs under 404a-5 Regulations. ◦ Must be included in comparative chart. Selection of Bank Trustee ◦ Consider trustee’s expertise and experience in delivering participant-level disclosures. ◦ Advisors should only partner with a qualified bank trustee.

29. 29 QDIA Disclosures QDIA Regulations ◦ Separate set of disclosures required for participants. ◦ Rules cover both Model Portfolios and CIFs. ◦ Initial notice must be provided 30 days in advance, and annually thereafter. Required Content for QDIA Notice ◦ Default investment arrangement. ◦ Participant’s right to direct investments. ◦ QDIA. ◦ Participant’s right to transfer out of QDIA. ◦ Obtaining information about Plan’s other DIAs.

30. 30 Concluding Thoughts Custom solutions may include Model Portfolios or CIFs. ◦ Model Portfolios are a type of investment service. ◦ Model Portfolios are managed by investment manager, or plan sponsor with assistance of advisor. ◦ CIFs offer convenience of investment product. ◦ Advisors can partner with bank trustee to develop custom CIFs for plan clients. ◦ Safe harbor protection available under QDIA rules.

31. 31 Concluding Thoughts (cont’d) Plan fiduciary has duty to select default investment prudently. ◦ Must conduct independent investigation of QDIA, and give appropriate consideration to relevant factors. ◦ “Best in breed” funds can be used in custom strategy, eliminating potential conflicts of interest. ◦ Cheaper institutional pricing is available. ◦ Plan sponsors should inquire about availability of custom solutions to ensure compliance with ERISA.

32. 32 Important Information This presentation is intended for sponsors of 401(k) plans and other types of defined contribution retirement plans with participant-directed investments that are subject to the Employee Retirement Income Security Act of 1974, as amended (ERISA), as well as the service providers that work with such plans. This information is intended for general informational purposes only, and it does not constitute legal, tax or investment advice on the part of The Wagner Law Group or its affiliates.

33. Marcia S. Wagner, Esq. q. 99 Summer Street, 13th Floor Boston, MA 02110 Tel: (617) 357-5200 Fax: (617) 357-5250 Website: www.wagnerlawgroup.com marcia@wagnerlawgroup.com A0104060 Custom Solutions: Legal, Compliance and Disclosure