Council Examining Practices for Outsourcing Plan Services

The Department of Labor’s (DOL) ERISA Advisory Council is examining practices for outsourcing employee benefit plan services.

In an issue statement, the council notes that certain functions by their nature must be outsourced to a third party, while others are outsourced for practical reasons, but there is an emerging trend toward also outsourcing functions that have traditionally been exercised by plan sponsors or other employer fiduciaries, including functions such as investment fund selection, discretionary plan administration and investment strategy. In addition, the council says, there’s an emerging trend towards using multiple employer plan structures as a mechanism to “outsource” the provision of retirement plan benefits particularly in the small company market.

According to the council, outsourcing plan services presents questions about the allocation of legal responsibilities and risk for activities of service providers on behalf of plans, including responsibilities imposed by the Employee Retirement Income Security Act (ERISA) and responsibilities allocated and risks assumed service contracts. The council contends the allocation of responsibilities and risk is not always well understood by plan sponsors and other employer fiduciaries and they may misunderstand what their legal responsibilities continue to be when services are outsourced.

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“While the Department of Labor (DOL) has issued guidance in several areas regarding both plan sponsor and service provider responsibilities, there is no uniform analytical framework for understanding outsourcing, particularly in the context of fiduciary services,” the council says in its issue statement. The council intends to draft recommendations to the Secretary of Labor for consideration.

It says its examination will focus on:

  • Identifying current industry practices and trends regarding the types of services being outsourced (both fiduciary and non-fiduciary) and the market for delivery of those services, including differences in outsourcing practices by type of provider, plan size or plan type;
  • Clarifying the legal framework under ERISA for retaining outsourced service providers, including both plan sponsor and service provider responsibilities, and suggest areas where further DOL guidance might be helpful;
  • Making recommendations to DOL about current best practices in selecting and monitoring outsourced service providers, including identification of performance standards, benchmarking of costs and mitigating conflicts of interest;
  • For fiduciary services, exploring the differences between status as a fiduciary under ERISA section 3(16), 3(21) and ERISA section 3(38) and the scope of co-fiduciary liability in the outsourcing context;
  • Identifying current contracting practices with respect to outsourced services, including provisions such as termination rights, indemnification, liability caps, service level agreements, etc. that might assist plan sponsors and other fiduciaries in negotiating service agreements; and
  • Examining insurance coverage and ERISA bonding practices of outsourced service providers to assist in understanding the extent to which risks are shifted from plan sponsors and other fiduciaries to service providers.

The American Benefits Council (ABC) urged the ERISA Advisory Council to avoid adding an additional layer of complexity for retirement plan sponsors.

“We respectfully request that the DOL take caution to not add another layer of complexity related to plan sponsors’ decisionmaking as it pertains to the procurement of plan-related services from suppliers and vendors who reside outside the company,” Allison R. Klausner, assistant general counsel for benefits, Honeywell International Inc., said in testimony before the council, speaking on behalf of ABC.

“The Council would support DOL initiatives with regard to outsourcing work relating to the delivery of employee benefits, but only so long as it is not one that limits the freedoms of the plan sponsor to make corporate decisions that fit its corporate culture and the personality and needs of its workforce,” she added.

Klausner told the council about the process Honeywell uses to select outsourcing providers, but noted while the system works well for her firm, every company is different. “Any government initiative in this area should permit continued flexibility for American companies as they provide benefits to their workers and retirees in an effort to support their collective health and financial well-being,” she said.

Unbundled TDFs Attract Sponsor Attention

Retirement plan advisers can deliver significant value by helping sponsor clients address the shortcomings of prepackaged TDF solutions, says Tara Mashack-Behney of Conrad Siegel Investment Advisors.

Mashack-Behney is partner and president at Conrad Siegel. She says there is something of a contradiction at the heart of many prepackaged target-date fund (TDF) solutions. Prepackaged TDFs are often added to retirement plan menus as the qualified default investment alternative (QDIA)—as one of the prudent safe harbor investment options mentioned specifically in the Pension Protection Act of 2006. The products tend to have well-designed asset-allocation glide paths and are overseen by skilled portfolio managers benefiting from economies of scale and powerful analytics, Mashack-Behney explains, giving sponsors a sense of protection and paternalism behind the TDF.

While the advantages of prepackaged TDFs are generally understood by sponsors, most overlook an important potential drag on proprietary TDF performance, she says. The drag is this: Fund companies often install mandates limiting what underlying funds their TDF managers are allowed to purchase as part of the proprietary TDF portfolio. In many cases the managers are only permitted to invest in their own firm’s fund offerings, Mashack-Behney says, even when those funds consistently underperform similar offerings on the market.

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“From the beginning of our work in target dates we started recognizing that pattern,” she tells PLANADVISER. “When you look at fund company X’s 2020 fund, for example, all of the underlying investments across the asset categories are likely to come from company X, regardless of whether the company offers a strong fund in a given category.”

Mashack-Behney says that more plan sponsor clients seem to be growing aware of this potential prudence problem. They still like the name recognition, strong governance and customer support behind the big proprietary products, she says, but sponsors are also becoming concerned about the implications of placing proprietary mandates on underlying TDF holdings. It’s not hard to see how the proprietary mandate could harm the fund manager’s ability to truly pursue the best risk-adjusted returns at the right expense, she says.

One answer to the proprietary mandate problem, Mashack-Behney says, is to build an “unbundled TDF” from the plan’s core menu. This will likely require collaboration with a skilled fee-only investment adviser who has the ability to create and adjust advanced model portfolios created from core menu options, she says, but the payoff can be substantial.

Some clients are also concerned about the idea of offering two different sets of funds to employees—one set on the core menu and another set for participants joining the plan under the QDIA provisions, who in effect are limited to funds offered by the TDF provider.

“We realized that we were putting all this consulting work into developing a sensible mix of 10 or 12 funds to offer as the core menu to the few people who wanted to build their own asset-allocation mixes,” Mashack-Behney explains. “But the participants being defaulted into the plan under fund company A’s TDF were basically not given any access to these funds and had to settle for company X’s lineup, some of which may be underperforming the options on the core menu. This is a problem.”

Jake Gilliam, a managing director and senior portfolio manager at Charles Schwab Investment Management, makes a similar argument.

“We commonly see target-date funds that are using underlying holdings in basically untested or underperforming proprietary funds, funds that wouldn’t pass muster to be included on the core investment menu as a stand-alone fund,” Gilliam tells PLANADVISER. The matter probably isn’t at the top of an auditor’s to-do list, but investment committees could be opening themselves up to liability if they do not take care to ensure the underlying funds in a TDF meet the standards of the investment policy statement (IPS).

“When we present this idea to sponsors the first thing we do is look at their core menu and optimize that,” she explains. “We ensure that there is a fund in all the prudent asset classes for the average participant and that the offering in each class is the best available for that particular plan and its demographics.”

Then her firm takes the core menu offerings and builds model portfolios—either as a series of TDFs with automatic glide paths or as a series of risk-based portfolios ranging from conservative to aggressive.

“Once we conduct risk assessments and figure out which model the participant fits in, those models are managed by us,” she says. “We select the underlying mixes and we do the automatic quarterly rebalances for the participants in the risk funds. So for the participant it’s very much a do-it-for me arrangement, like the proprietary TDFs.

“The big advantage over these types of funds is that we could both be set to retire in the same year, but you can afford to take more risk than I can because you have a lot of outside funds. Our models can account for this, but many proprietary TDFs cannot,” Mashack-Behney says. “And another appealing feature of the custom risk fund series is that we can set up triggers to automatically move the participant down through the lower risk levels as they age, so the custom risk funds can also function like the TDF, but with a little more control. We call this our Automatic Risk Reduction Program.”

Participants are given a lot of disclosure in this model, she adds, and because the unbundled TDF is built from the relatively small core menu it is often easier for sponsors and participants to understand.

“Especially with the help of an adviser, you can really control and understand the mixes underneath the TDFs and the risk-based funds,” Mashack-Behney says. “It gives the sponsor more flexibility. We’re used to developing new asset mixes and we know how to build these portfolios from the defined benefit world, so what we’re doing is applying the thinking for our defined contribution clients.”

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