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So What is the Risk? Diversification Requirements for Defined Contribution Plans

Posted in Plan Administration, Retirement Plans

This might sound like the start of a bad joke, but I had the opportunity to speak with a room full of accountants last week about fiduciary liability.  It was not as boring as it sounds because of some really good questions raised about what constitutes sufficient diversification in defined contribution plans.  Specifically, they asked me what a fiduciary is required to offer that would satisfy the obligation to diversify.

First, bear in mind that ERISA Section 404(a)(1)(c) requires that a fiduciary diversify the investments of the plan so as to minimize the risk of large losses.  Fair enough, but how do we do that?  So then we look to the regulations.  29 CFR 2550.404(c)-1(b)(3)(i)(B) tells us that a plan has to offer the opportunity to "choose from at least three investment alternatives:

  1. Each of which is diversified;
  2. Each of which has materially different risk and return characteristics;
  3. Which in the aggregate enable the participant or beneficiary by choosing among them to achieve a portfolio with aggregate risk and return characteristics at any point within the range normally appropriate for the participant or beneficiary; and
  4. Each of which when combined with investments in the other alternatives tends to minimize through diversification the overall risk of a participant’s or beneficiary’s portfolio.

Notice that items 2, 3 and 4 consider "risk"  This is because in a defined contribution plan, the "risk" is born by the participant, not the plan sponsors.  So we offer diversity, but we have to offer diversity in consideration with the risk, not necessarily the type of investments.  It is not enough to just offer a stock fund, a bond fund and a treasury securities fund.  You have to consider the risk of each investment option and provide a meaningful way for participants to balance the risk amongst the investment options.

It is not a matter of just choosing 3 different options, or 10 or 100.  We have to show that we made a meaningful and prudent determination of the risk of each investment option offered and allowed for a diversification of risk within the participant’s portfolio through a diversity of options with varying degrees of risk.  We don’t have to make them avoid risk, but we have to give them alternatives with varying degrees of risk so they can diversify (if they want to).  So when deciding how many investment options to offer in a defined contribution plan, fiduciaries have to consider risk not just types of investments and offer diversity.  Otherwise, the lack of risk diversity will violate ERISA rules.