USA – DISTRICT OF COLUMBIA Trends and Developments Contributed by: Sanford Heisler Sharp McKnight, Sanford Heisler Sharp McKnight
aries build adequate guardrails to deal with extreme volatility, participants exposed to that risk could find themselves on the wrong end of market swings. This obligation will likely require many fiduciary com - mittees to engage deeply with conflict-free investment professionals with specialised expertise when evalu - ating non-traditional products. Ultimately, though, the DOL makes clear that fiduciaries cannot disregard red flags in performance simply because a strategy is marketed as innovative or diversified. Fee Analysis “The fiduciary must consider a reasonable number of similar alternatives and determine that the fees and expenses of the designated investment alternative are appropriate, taking into account its risk-adjusted expected returns, and any other value the alternative brings to furthering the purposes of the plan. For this purpose, ‘value’ includes any benefits, features, or services other than risk-adjusted returns net of fees.” The DOL’s proposed safe harbour reiterates that fidu - ciaries must consider the fees and expenses of invest - ments in the plan line-up. While not obligated to select the cheapest available investment, fiduciaries must be able to articulate and justify what additional “value proposition” the higher-cost investment alternative provides. For example, if an actively managed strategy charges more than a passive alternative, the committee must evaluate what extra benefits warrant the extra costs. This may require investigating issues such as: • whether historical alpha generation is sustainable; • whether diversification characteristics improve participant outcomes; • whether the manager’s process has remained con - sistent; and • whether historic performance is actual or the result of hypothetical modelling. Similarly, the proposal’s discussion of share classes underscores that fiduciaries cannot get so in the weeds that they overlook common sense. The DOL is clear that selecting a more expensive share class
when an identical lower-cost option exists “demon - strates imprudence”. Most alternative investment products charge two types of fees: an investment advisory fee as a per - centage of a fund’s net assets and a performance fee based on a percentage of the fund’s profits. This structure is typically referred to as “2 and 20”, a 2% investment advisory fee and a 20% performance fee. Historically, performance fees could only be assessed against investors with substantial assets. Most partici - pants would not qualify. Fiduciaries will need to embrace a new set of issues that performance fees pose. Will participants under - stand how performance fees work? How are they calculated? Is the fee based on all gains or just gains above a threshold/benchmark? Is there a high water - mark – ie, must the fund recoup past losses before it can begin calculating performance fees? Participants may not understand these concepts or how they work. Disclosure that the average person can understand will be critical to addressing these issues. The proposal ultimately increases , not decreases, expectations regarding the process that fiduciaries use to evaluate fees and the rationale used to jus - tify any additional expenses. Fiduciaries who cannot clearly explain the basis for an investment’s total eco - nomic cost structure should not feel “safe” within the proposed “safe harbour” framework. Liquidity Analysis “The fiduciary must appropriately consider and deter - mine that the designated investment alternative will have sufficient liquidity to meet the plan’s anticipated needs at both the plan and individual levels.” Liquidity may emerge as one of the most operation - ally challenging aspects of the proposed rule. Many alternative investment funds own non-public invest - ments that cannot be readily disposed of like a stock traded on an exchange. Such funds hold an abun - dance of cash on hand, and therefore lack the liquidity that many plan participants have come to expect with publicly traded mutual funds.
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