White Paper: A Plan Sponsor's Guide to Retirement Plan Investments

PLAN SPONSOR’S GUIDE TO
RETIREMENT PLAN INVESTMENTS

PLAN SPONSOR’S GUIDE TO RETIREMENT PLAN INVESTMENTS | PAGE 1
As the sponsor of a retirement plan, you, or someone you
appoint, will be responsible for making important decisions
involving plan assets. Understanding the different terms, risks
and attributes of plan investments is vital regardless of the
role you play in determining how the plan’s assets are invested.
Investments may range from exchange-traded instruments, the
terms of which are typically clear and transparent, to private
company equity securities, which can be difficult to value. Plan
assets may also include more complex instruments such as
derivative financial instruments and insurance products such
as annuities. In many plans, more complex and structured
instruments may be used to manage the overall risk that may
exist in a portfolio.
Each instrument’s terms and the conditions, particularly those
that pertain to underlying risk exposure, redemption features
and terms that impact investment liquidity, should be closely
considered. By understanding the terms and conditions
for all investments in a plan’s portfolio, you may avoid
unwanted surprises during an audit of your retirement plan
by your auditors, the regulators or upon liquidation of these
investments.
Reporting Requirements
Reporting requirements for ERISA-qualified retirement
plans generally include the Form 5500 as well as audited
financial statements prepared in accordance with U.S.
generally accepted accounting principles (GAAP). Included
in these requirements is the accurate reporting of the plan
investments. Different terminologies are used for the reporting
of investments, including carrying value, fair value, fair
market value and contract value. It is critical you understand
these terms and how they impact reporting so that you stay
in compliance with regulations. Through various laws and
regulations, the Department of Labor (DOL) holds the plan
sponsor accountable for the accuracy and completeness of the
Form 5500.
For 5500 reporting purposes, plans are classified as “small” or
“large” depending on the number of participants1
they have on
the first day of each plan year. In general, large plans, defined
as plans with more than 100 participants, require audited
financial statements to be included with the Form 5500. Small
plans are generally exempt from the requirement for audited
financial statements unless the plan holds significant amounts
of non-readily marketable investments.2
Through various laws and regulations, the
Department of Labor (DOL) holds the plan
sponsor accountable for the accuracy and
completeness of the Form 5500.

Plan investments are required to be reported at current value
on Form 5500. However, when you submit audited GAAP
financial statements with your Form 5500, those financial
statements are required to report plan investments at fair
value. Generally, current value and fair value will be the same.
The determination of fair value for reporting under GAAP includes
several considerations that are detailed in FASB ASC 820. Fair
value for an exchange-traded instrument is relatively straight
forward, as market observable information is available. However,
for instruments that are not exchange-traded, such as private
company equity securities, fixed-income debt securities, stable
value funds, guaranteed investment contracts (GICs) and other
investment contracts, consideration of the requirements of ASC
820 are necessary. As a general rule, ASC 820 requires the use
of market observable data when available, which means the
determination of fair value includes a process for determining if
market observable data exists, and the extent to which it should
be used. In order to evaluate and apply the requirements of ASC
820, plan sponsors and administrators need to understand the
terms and conditions of each investment held by the plan and
how those terms impact fair value.
It is recommended plan sponsors document the process to
determine and verify the reported values of the plan’s assets
and related disclosures as regulators and auditors typically
examine those calculations during an audit.
Retirement Plan Investment Types
The types of investments are as diverse as the investment
strategies and the goals of the plans themselves. Fixed-
interest funds provide a guaranteed rate of return; self-directed
brokerage accounts allow participants to choose the types of
investments held in their individual account; mutual funds in-
clude a diverse portfolio of assets offered at a lower price than
could be created by an individual and exchange-traded funds
are pooled investment fund vehicles that trade like stocks.
Investments not listed on national exchanges or over-the-
counter markets are more difficult to value and often referred
to as “alternative” investments. Defined benefit retirement
plan investments tend to rely more on alternative investments
due to their investment goals and strategies for matching
benefits and liquidity with expected benefit payments.
TYPES OF INVESTMENTS
Common retirement plan investments include the following:
n Exchange-traded equity securities (common stocks and
exchange-traded funds, ETFs)
n Mutual funds
n Fixed-income debt securities (highly rated and speculative)
n Common/collective trust funds and pooled separate
accounts
n Stable value investments, GICs, insurance contracts, annuities
n Investment and hedge funds
n Derivative instruments (options, swaps, credit wrappers, etc.)

Alternative investments are the most difficult to value as
market observable information is generally not available.
Each investment may also have very specific terms
and conditions. The terms and conditions are critical
to understanding the plan’s liquidity options. In certain
instances, pooled investment vehicles may be reported
at the Net Asset Value (NAV) as a practical expedient to
fair value. NAV equals the total fair value of the pooled
investment vehicle’s assets divided by the total number of
units outstanding for the fund. Though the fair value for such
investments may often differ from the NAV due to restrictions
on redemption or other liquidity features, GAAP allows the
NAV to be used as fair value for qualifying investments.
Common types of alternative investments include:
Common/Collective Trust Funds and Pooled Separate
Accounts: Though they look and function much like
a mutual fund, pooled separate accounts (PSAs) and
common/collective trusts (CCTs) are not registered with
the Securities and Exchange Commission (SEC). PSAs
and CCTs may invest in various securities and alternative
investments such as mutual funds and marketable
securities as well as hedge funds and private equity
funds. They often hold cash as well because the funds’
fees are deducted from the fund value versus charged
to the other investors, and cash needs to be available to
provide liquidity for redemptions. The fair value for these
investments is generally determined using the NAV as
a practical expedient, however, if the plan anticipates
disposal of the investment at an amount other than the
NAV, the fair value must be determined using traditional
methods, which would consider the plan’s anticipated
proceeds from the disposal of the investment. Plan
sponsors and administrators should ensure a process
is developed to monitor the NAV of such investments,
including understanding how the NAV is developed and
obtaining audited financial statements from the pooled
investment fund.

Stable Value Investments: These types of investments
primarily include GICs, synthetic GICs and PSAs and
CCTs that invest in a GIC. The unit of account for these
investments is the investment contract itself, thus, the
fair value must consider all of the contractual terms
and conditions. A traditional GIC typically consists of
a contract between the plan and the issuer in which
the plan holds an interest in the general assets of the
issuer. However, the investment return of the contract
may be indexed to a certain set of specific assets or a
fixed rate of return. Repayment of the principal and the
guaranteed interest rate are from the issuer’s general
assets, thus, the creditworthiness of the issuer can be
a significant input to the fair value of the contract. The
fair value is also impacted by the liquidity features of
the contract as well as how the crediting interest rate
compares to market rates for similar investments. If the
issuer is a highly rated insurance company, the fair value
generally consists of a discounted cash flow model using
market observable inputs.
In a synthetic GIC, the return is based on the return of
a pool of assets that is owned by the plan. The contract
also includes a third-party “wrapper,” which is a derivative
instrument designed to provide a guarantee of that
contract’s stated interest rate and principal (i.e. if the
underlying assets underperform, the counterparty to the
wrapper will make the plan whole). The fair value of a
synthetic GIC includes the sum of the fair value of the
underlying plan investments plus the fair value of the
contract with the third-party service provider, which is
typically an insurance company. Obtaining the information
to determine the fair value of the components of a
synthetic GIC can often be difficult.
Private Equity Funds: Generally organized as partnerships,
private equity funds raise capital from qualified investors
such as high net-worth individuals, pension funds and
financial institutions. Private equity funds tend to include
debt securities and various other private securities.
Investments in private equity funds usually have a written
investment contract or prospectus that details the
withdrawal restrictions and other information pertaining
to the investment. The NAV may be used as a practical
expedient in valuing the investments. Investment values
may also reflect a valuation specialist’s report.

Hedge Funds: Using a more aggressive approach than
mutual funds, hedge funds employ leverage (e.g.,
options, futures, swaps and short selling) as part of their
investment strategy and offer limited liquidity. They are
exempt from the rules and regulations that govern mutual
funds.
Real Estate Funds: As the name suggests, these
investments exist largely in the real estate market and
typically involve the direct purchase of real estate property.
If the fund does not qualify for use of the NAV as a practical
expedient, the fair value of the underlying assets held
in real estate funds can be determined by third-party
appraisals, cash flow projections or insurance valuation.
Funds of Funds: When investment companies invest in
other investment companies the result is a funds of funds
investment structure. Funds of funds can include many
tiers of investments and involve offshore structures. If
the investments are publicly traded, they can be valued at
their fair market prices.
The fair value of these pooled investment vehicles
generally will qualify for use of the NAV as a practical
expedient to reporting fair value. Determining the fair
value disclosures under ASC 820 requires a thorough
understanding of the terms and conditions of the
investment contract, including the liquidity features.
Additionally, plan sponsors and administrators should
ensure a process is in place to evaluate the quality and
reliability of the NAV provided by the fund. If the NAV is not
a reliable source, the plan sponsor may need to design
procedures for testing the fair value of the underlying
assets held by the fund.
Securities Lending: In exchange for cash or other
collateral, the plan may lend securities within its
portfolio to a broker to make up the difference from
short sales or fail transactions. The collateral received
remains a plan investment. Values of securities lending
instruments require a close consideration of the fair
market values of the assets involved, as the collateral
received often depends on the fair market value of the
investment’s assets.
TYPE FAIR VALUE DETERMINATION
CCTs and PSAs These investments qualify for use of the
NAV (practical expedient) unless the plan
anticipates a disposal at an amount other
than the NAV.
Stable Value
Investments
These types of investments primarily
include GICs, synthetic GICs and PSAs
and CCTs that invest in a GIC. Fair value
must consider investment contract terms
and conditions. For synthetic GICs, the fair
value is the sum of the fair value of the
underlying investments plus the fair value
of the contract with the third-party service
provider.
Private Equity
Funds
Investments in private equity funds qualify
for use of the NAV (practical expedient)
and may also use information compiled in
a valuation specialist’s report.
Hedge Funds If the investments do not qualify for the
use of the NAV (practical expedient), the
fair value should consider all attributes
that would be used to price the interest by
independent market participants.
Real Estate
Funds
The fair value of the underlying assets can
be determined by third-party appraisals,
cash flow projections or insurance
valuations if they do not qualify for use of
the NAV (practical expedient).
Funds of Funds Publicly traded investments rely on fair
market value for fair value. Typically, the
investments qualify for use of the NAV
(practical expedient).
Securities
Lending
The fair value includes the fair market
value of the assets involved.
Derivative
Financial
Instruments
Certain derivative instruments may
be exchange-traded or valued using
observable market data. For complex
derivative instruments that do not have
market observable data, a valuation
specialist is often necessary to determine
fair value.

Derivative Financial Instruments: Many plans hold
derivative financial instruments, which is a contract
whose price is derived from one or more underlyings (e.g.,
stocks, bonds, commodities, currencies, interest rates,
etc.). Such instruments may include forward contracts,
futures, options and/or swaps which must be valued and
reported in the plan’s financial statements at fair value.
The valuation of these instruments is as diverse as the
instruments themselves and may range from exchange-
traded instruments to complex options without market
observable evidence. Generally, a valuation specialist is
required for complex derivative instruments that do not
have market observable evidence.
Valuing the Investments
The typical services provided by custodians and trustees to
retirement plans include providing values that are based on the
best information available at the time of the report. If a plan is
invested solely in assets with readily determinable fair values,
such as mutual funds or marketable securities, the trustee or
custodian typically obtains fair values from nationally recognized
pricing services such as Interactive Data Corporation (IDC) or
Bloomberg. However, in cases where the plan invests in assets
without readily determinable fair values, the reported values may
be based on the best information available to the trustee and
custodian at the time of the report, which may or may not be
fair value. Many times the custodian may obtain a value directly
from the issues of the investment. To obtain the fair value for
alternative investments, a process should be developed to
determine the reliability of the evidence obtained and when the
use of specialists is needed.
Acceptable valuation techniques used to determine the fair
value of an investment include: the market approach, the cost
approach and the income approach.
Most retirement plan investments use a market approach,
which draws on values from observable transactions and
exchanges. The income approach works best for investments
that produce cash flows or for which market observable
information is not available. This approach uses a valuation
model that converts expected cash flows into present amounts
(such as a discounted cash flow model). The cost approach is
used infrequently as it does not often provide a useful valuation
for investments; however, it may be used for certain types of
private equity securities. In the case of a start-up, for example,
historical cost may be the best value available.

FASB ASC 820 Fair Value Hierarchy
To determine fair value in accordance with GAAP, you
must prioritize the inputs used by the various valuation
techniques. FASB ASC 820 breaks down valuation methods
into three levels based on the availability of market
observable evidence used. These inputs and the valuation
methodologies used to estimate fair value also represent
disclosure requirements required by GAAP, which differ with
each level of the fair value measurement hierarchy.
The purpose of this hierarchy is to provide useful information
regarding the degree of estimation used to determine the
fair value of the various plan investments. It is also used
as a disclosure model for financial statements prepared in
accordance with GAAP. Following the hierarchy serves as a
useful guide for determining which inputs and assumptions are
significant to determining the fair value of an investment.
Level 1: Level 1 fair value measurements rely on market
observable evidence for the exact security being valued.
Determining fair value using Level 1 inputs requires using
the current fair market value of the security. Examples of
Level 1 fair value measurements include exchange-traded
instruments such as common stocks, exchange-traded
funds (ETFs) and listed derivatives. Mutual funds that are
traded regularly in significant volumes are also generally
Level 1 fair value measurements.
Level 2: Similar to Level 1 measurements, Level 2
measurements use observable inputs and rely on data such
as the fair market value of similar assets traded on an active
market. Also included are investments listed on exchanges
that do not trade frequently and assets that rely on pricing
models with significant observable inputs (such as interest
rates that may be observed for the entirety of the investment
life). Examples of Level 2 investments may include GICs,
corporate bonds and government bonds.
Investments in which the fair value is reported using the
NAV as a practical expedient, such as CCTs, group trusts
(103-12 investment entities), PSAs and stable value funds
are generally Level 2 fair value measurements unless the
redemption or other liquidity features prevent liquidation in
less than a 90-day period.

Level 3: Level 3 measurements use significant inputs that
are not observable, therefore preparers have to rely on
estimates and assumptions to derive significant inputs into
a valuation model (for example, expected cash flows for a
non-traded instrument). The fair value model should reflect
how a typical investor would determine the value of the
investment, including risk assessment and pricing models.
Level 3 measurements typically include: GICs, private
company securities and complex derivative instruments.
Investment funds in which redemption is restricted for
a period greater than 90 days are classified as Level 3
fair value measurements as well, regardless of the use
of the NAV as a practical expedient. Among the required
disclosures for Level 3 measurements are purchases and
sales, earnings, terms, restrictions, valuation methods and
inputs and quantitative disclosures of the unobservable
inputs. Additional disclosures apply to plans that are
considered to be public entities, such as sensitivity analysis
related to the significant unobservable inputs.
Again, in most instances, the fair value of the plan’s
investments is reported by the plan’s qualified custodian.
Most qualified custodians obtain fair value information through
third party sources such as IDC or Bloomberg. However, the
responsibility to report the fair value of the investments lies
with the plan administrator, thus, each plan should have an
individual or committee with processes in place to ensure the
fair values reported by the qualified custodian are accurate and
can be relied upon. This is particularly significant for plans that
hold investments that require fair value measurements using
significant unobservable inputs (i.e. Level 3 measurements),
but it is also necessary for all plan investments.
The Audit Process
During a full scope audit engagement, audit procedures
include the review and validation of the valuation methods
used to determine the fair value of the plan investments.
This requires a strong understanding of the valuation models
used for each type of instrument, as well as all significant
inputs used to determine the fair value. An audit validates the
models and the significant inputs used. With Level 3 fair value
measurements, as the degree of estimation is significant for
certain inputs, the audit team may need to use a valuation
specialist to assist with the review of the models and inputs.
Depending on the complexity and degree of estimation involved
in developing the inputs, auditing the fair value of Level 3 fair
value measurements can increase audit effort significantly.
The responsibility to report the
fair value of the investments lies
with the plan administrator.
FAIR VALUE
HIERARCHY
INVESTMENT
TYPE
VALUATION
METHOD
Level 1 ETFs and mutual
funds
Current market
value (closing
market price)
Level 2 Some GICs and
debt securities,
CCTs, PSAs and
stable value
funds
Use of observable
market data such
as current market
value and interest
rates.
Level 3 Private company
securities
and complex
derivatives
Rely on non-
observable inputs
and often require
risk assessments
and pricing
models

Typically, financial statement audits are performed without any
client-imposed scope limitation or other restriction. ERISA is
unique in that when certain criteria are met3
, it permits plan
management to instruct the auditor to limit the scope of testing
of investments. This limited scope election must be supported
by a certification to both the accuracy and completeness
of the plan’s investment information from a qualified entity.
Such audits are referred to as “limited scope” audits. Plan
management is responsible for determining that the conditions
of the limited scope audit exemption have been met.
Plan sponsors should carefully consider each option before
selecting an engagement type.
If your plan elects a limited-scope approach to the audit,
you should review the contracted level of service of the
plan trustee or custodian (i.e., process and procedures for
determining the fair value the investments) and assess
whether investment values are properly reported based on
current or fair value as of the plan’s reporting period. While
the qualified custodian may certify that the information on the
statement is complete and accurate, the certification does not
necessarily mean the values represent current or fair value as
required by ERISA and GAAP.
In a limited scope audit, the auditor has no responsibility
to test the accuracy or completeness of the investment
information certified, including the reported fair values.
However, plan sponsors’ responsibilities do not change, and
they should still be able to identify how the fair value for each
investment is determined, the source of the information used
in the fair value measurement and related disclosures required
by GAAP. As mentioned above, the models and processes
used to determine fair value represent required disclosures
in the financial statements that must be included regardless
of whether the auditor has been engaged to perform a limited
scope or a full scope audit.

Should the plan auditor become aware that the investment
information certified is incorrect, the auditor may be required
to take certain steps, such as requesting the trustee or
custodian to recertify or amend the certification to reflect
proper investment values and investment income. The
trustee or custodian may have to exclude (“carve out”) such
investments and investment income from the certification,
which would require full scope audit procedures to be
performed for the excluded investment(s). Whether you
undergo a full or limited scope audit, your plan sponsor, and in
some cases, your investment manager, should meet with the
audit team to discuss the terms of the various investments
included in the plan’s portfolio.
Your Responsibilities
Ultimately, a plan sponsor is responsible for complete and
accurate financial reporting of all plan investments which
requires the sponsor to:
n Establish processes for understanding plan investments
and the determination of fair value measurements and
disclosures
n Select appropriate valuation methods
n Identify and adequately support any significant assumptions
used in preparing a valuation
n Ensure that the presentation and disclosure of the fair value
measurements are in accordance with Form 5500 reporting
requirements and GAAP.
Endnotes
1
Employees become includable as “participants” on the date the employee becomes eligible to participate—regardless of whether the employee elects to participate.
The participant count must include (1) actively participating employees, (2) retired, deceased, or separated employees who still have assets in the plan and (3) all
eligible employees who have yet to enroll or have elected not to enter the plan. A special ruling (80/120 Rule) allows plans with between 80 and 120 participants,
as of the first day of the plan year, to file the Form 5500 in the same category (“large plan” or “small plan”) as indicated on the prior year’s Form 5500 filing.
2
Small plans are exempt from the audit requirement to the extent that at least 95 percent of their assets are qualifying plan assets. Plans not satisfying this test may
still avoid the audit requirement if the total amount of non-qualifying plan assets are covered by an ERISA Section 412 fidelity bond. Small plans seeking to avoid the
audit requirement must also make certain required disclosures to plan participants.
Qualifying plan assets have been defined to include all assets held by either a bank or other similar financial institution, an insurance company, a registered broker-
dealer or any other trustee qualified under section 408 and also includes participant loans and qualifying employer securities under section 408(b)(1).
3
Certification requirements of 29 C.F.R. § 2520.103-5 define the scope of an accountant’s examination and report under ERISA section 103(a)(3)(A) and (C) and 29
C.F.R. § 2520.103-8.

Glossary of Terms and Acronyms
CCTs: Common/collective trusts resemble mutual funds but
are not registered with the SEC and are typically issued by
financial institutions.
Current Value: (ERISA) section 3(26) defines the term
current value as: “fair market value where available and
otherwise the fair value as determined in good faith by a
trustee or a named fiduciary pursuant to the terms of the
plan and in accordance with regulations of the Secretary [of
Labor], assuming an orderly liquidation at the time of such
determination.” Generally current value and fair value under
GAAP are the same.
DOL: Department of Labor
ERISA: Employee Retirement Income Security Act of 1974
includes rules and regulations for employee benefit plans.
ETFs: Exchange-Traded Funds or exchange-traded equity
securities.
Fair Value: FASB ASC 820 defines fair value as: “the price
that would be received to sell an asset or the price paid to
transfer a liability in an orderly transaction between market
participants at the measurement date.”
Form 5500: The DOL, the IRS, and the Pension Benefit Guar-
anty Corporation jointly developed the Form 5500 in order
for employee benefit plans to satisfy annual reporting re-
quirements under Title I and Title IV of ERISA and under the
Internal Revenue Code, thus, the Form 5500 serves as both
a regulatory form as well as a tax filing.
GAAP: U.S. Generally Accepted Accounting Principles
GIC: A Guaranteed Investment Contract consists of a
contract with the issuer in which the plan holds an interest
in the general assets of the issuer, however, the investment
return of the contract may be indexed to a certain set of
specific assets or a fixed rate of return.
IDC: Interactive Data Corporation is a nationally recognized
pricing service that can help plan custodians determine fair
value for various securities.
PSAs: Pooled Separate Accounts resemble mutual funds but
are not registered with the SEC and are issued by insurance
companies.
NAV: Net Asset Value equals the total fair value of the
pooled investment vehicle’s assets divided by the total
number of units or interests outstanding for the fund.
GAAP allows the NAV to be used as fair value for qualifying
investments.
Synthetic GIC: A synthetic Guaranteed Investment Contract
in which the return is based on the return of a pool of assets
that is owned by the plan. The contract also includes a third-
party wrapper that guarantees the contract’s stated interest
rate and principal.
Wrapper: A derivative instrument designed to provide a
guarantee of a contract’s stated interest rate and principal
(i.e. if the underlying assets underperform, the counterparty
to the wrapper will make the plan whole).
www.mhmcpa.com
© Copyright 2014. Mayer Hoffman McCann P.C. All rights reserved.

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White Paper: A Plan Sponsor's Guide to Retirement Plan Investments