How does your 401k choose investments?

In spite of only two law classes at university, I must admit to an enjoyment of legal cases. In this particular instance, I spent part of my evening reading "In re Quest Diagnostics ERISA Litigation". What a fascinating case and one that emphasizes diligence and a prudent process in selecting/ monitoring/ replacing 401k investments.

Earlier this year, I had the pleasure of attending a presentation by a former Department of Labor (DOL) 401k auditor. He asked the audience if anyone knew one of the rules for picking plan investments. He hardly finished asking the question when I happily shouted out with enthusiasm, "A defendable and repeatable prudent process!". To say that he was caught off-guard by my enthusiasm would be an understatement. But yes, he agreed, that is one of the key rules.

Stretching back to ERISA in 1974, the DOL has never asked plans to offer the cheapest investments or the best performing. If that were the case, plans would be changing investments every quarter. Not only is that an administrative nightmare but the employee experience would be less than desirable (a steady stream of thirty-day fund change notices?!).

Instead, the DOL asks plans and their advisors to have a defendable and repeatable prudent process by which funds are selected. I employ such a process with the 100 plans I oversee across the US. This screening process is used in selecting, monitoring, and replacing investments.

It is defendable because it is based in Modern Portfolio Theory (MPT). I do chuckle as MPT was first introduced in 1952 which does not make it very modern today. Still, the name has stuck and MPT is what it is called.

My process is repeatable because I perform a quarterly analysis on all of my funds. My analysis goes beyond running a report. The firm's junior advisor actively digs into funds that are not performing to ascertain why. Investment Committee meetings are held annually and more frequently in some of my larger plans.

My process is prudent. For example, I select the lowest fee version of my investments and I change that if the investment company comes out with an even lower fee version. I do not include exotic or esoteric investments in my fund line-up. In other words, I do what a Prudent Person would do.

This then brings us to the Quest case. As of December 2020, the plan had 57,000+ participants with assets totaling approximately $5 billion. This is certainly not a small plan. The lswdsuit alleges (among other things) that there was a failure to monitor the plan investments.

The case was dismissed with the judge granting Quest's motion for summary judgement. The judge found that the plan's investment advisor had evaluated the plan investments over the proper periods of time, placed funds on a "Watch list" as appropriate, and analyzed the market, economy, relevant legislative activities, and regulatory updates. In addition, the plan's Investment Committee met quarterly with written signed minutes produced at the end of each meeting.

The Court looked at the fiduciary's process rather than the results in keeping with DOL mandates. The Court found that the Investment Committee was proactive in its analysis, took prompt follow-up action, and showed a prudent process. In fact, the preponderance of evidence showed that Investment Committee acted properly.

Why then was this case even brought forwards in the first place given how quickly it was dismissed in the proceedings? I can't help but wonder if the plan size made it an attractive target. That may be but it shows the importance of having a defendable/ repeatable/ prudent process with documentation. Given how quickly it was dismissed, one might also reflect on the adage, "Measure twice. Cut once". Perhaps time and money could have been saved if the Investment Committee's process had been seen as an example of what the DOL is looking for.

As you look at your own retirement plan, ask your Investment Committee and plan advisor what process they are using to review plan investments and how they are documenting all decisions.