Monday, February 27, 2012

Winning the Race to Retirement

You can see it on TV all the time. This investment management firm or that one will help you to get to a prosperous retirement. There is nothing wrong with that. In a 401(k)-only world, you may need all the help you can get. So, with regard to those firms, while I am not Mark Antony and they are not Caesar -- friends, readers and others, I come to praise those firms, not to bury them.

Suppose you are a participant in a 401(k) plan. You probably are if you are reading this. Then, it wouldn't be surprising if your plan's recordkeeper (by the way, they may also hold the majority of the funds in the plan) gives you online access to some sort of retirement modeling tool. This is a good thing.

OK, so why is this idiot blogger wasting your time? There is a little problem here. On any of these sites, either the site makes assumptions for you, or, sometimes within a set of constraints, you get to choose assumptions for yourself. This can be dangerous.


Consider your best friend. Is he or she a smart person, financially savvy? Let's assume the answer is yes. And, you, of course, are financially savvy? Would you trust that best friend of yours to be able to pick your annual return on your 401(k) balance? Would your best friend trust you with guessing a return on their balance. Probably, the answer is no, so why would you think you can guess your own rate of return. And, even if you can, is that an average return, or a constant return. And, if it's an average return, what does that mean?

Oh, come on, idiot blogger, everyone knows what an average is.

Not so fast, there may be more than meets the eye.

I'm going to consider four scenarios as follows:

  • In the first, I am going to assume to assume that you have 10 years to save, that you are currently earning $50,000 per year, that 5% of that will go into a defined contribution (DC) plan every year (on the first day of the year), that you will get a 3% pay raise every year, and that those funds will earn a constant 5% rate of return.
  • In the second, you still have 10 years to save and you are still currently earning $50,000 per year. You are still going to get a 3% pay raise every year and you are still going to put 5% of your pay into your DC plan. And, on average (arithmetic mean), you are still going to get a 5.5% annual rate of return on your money, but I am going to throw some volatility into the mix. I am going to give your annual investment return a normally distributed standard deviation of 11%. In simple terms, this means that about 69% of the time, your actual annual return will be between -5.5% and 16.5%. Further, about 95% of the time, your actual annual returns will be between -16.5% and 27.5%.
  • In the third, I will keep all of these assumptions the same, except that your average annual return will be 6% and your standard deviation will be 18%.
  • Finally, in the fourth scenario, your average annual return will be 6.5% and your standard deviation will be 26%, with all other assumptions kept the same.
Before I give you the results of this analysis, I need to explain a few more of the details here. In scenario 1, since there is no variability, I need not perform more than one simulation. In the other scenarios, however, I have normalized the annual returns so that the arithmetic mean return over the 10-year period is, in fact, the intended arithmetic mean. Additionally, I have done this simulation 10 times each and then taken the average (arithmetic mean) of the 10 account balances after 10 years.

What do you expect the relationship between the four ending account balances to be? What do you expect will be the range of results in each scenario after 10 years? 

Scenario 1:

      Average account balance after 10 years:  37,403
      Highest account balance after 10 years:   37,403
      Lowest account balance after 10 years:   36,403

Scenario 2:

      Average account balance after 10 years:  36,387
      Highest account balance after 10 years:   42,024
      Lowest account balance after 10 years:   29,106

Scenario 3:

      Average account balance after 10 years:  38,641
      Highest account balance after 10 years:   48,640
      Lowest account balance after 10 years:   28,022

Scenario 4:

      Average account balance after 10 years:  38,662
      Highest account balance after 10 years:   57,439
      Lowest account balance after 10 years:   26,411


The volatility is essentially offsetting the improved investment returns. So, when you go to your recordkeeper's website and use their modeling tool, what rate of return are you going to assume? Do they give you a place to input assumed volatility? I'll bet they don't.

I'm sure your recordkeeper means well. They don't want to confuse you. But, are they really helping you to win the race to retirement? Or, does slow and steady win the race?

It's your retirement. You make the call.

Tuesday, February 14, 2012

Good News -- IRS Floods Us With Guidance on Lifetime Income Options

When it rains, it pours. And, unlike in days of future past (for you, Moody Blues fans, with a slight spelling change), when the IRS decides to provide guidance on a topic, we get a package. In this case, the package is related to distribution options, primarily from qualified defined contribution (DC) plans, but also with implications for defined benefit (DB) plans and individual retirement accounts (IRAs).

So, here's what we got:

So, what's in them? Since it's American Idol season, dim the lights, here we go. 

Partial Annuity Options

For participants, this is good news. For plan sponsors and especially for plan administrators, this could be a nightmare, because participants may actually elect split options. Under these regulations, participants could take a split distribution option from a defined benefit plan. For example, a participant could elect a partial lump sum and a partial annuity. 

The proposed regulations specify that [Code Section] 417(e)(3) assumptions would be used to calculate the lump sum amount, but that plan assumptions (plan's definition of actuarial equivalence) would be used to calculate the amount of the annuity. This makes things way simpler than the existing rules which would require use of 417(e)(3) assumptions for the entire calculation.

Let's consider an example. Suppose a participant was entitled to an immediate single life annuity of $1000 per month or a lump sum of $140,000, among other options. Further, suppose that the plan conversion factor for this participant and this participant's spouse for a 50% Joint and Survivor Annuity payable immediately is 0.95 (if you don't like my factors, you may write your own blog, but they seemed simple and convenient for my purposes). Now, suppose that the participant elects a split option: 60% as a lump sum and 40% as a 50% Joint and Survivor. The math gets simple. The lump sum would be 0.60*140,000 = $84,000. The monthly annuity would be 0.40*0.95*1000 = $380 per month.

Hmm, maybe this is more of a pleasant daydream than it is a nightmare for plan administrators, but computer-based administration will require a lot of re-programming.

Longevity Annuities

This is great news for plan participants. I repeat, this is great news for plan participants. When a participant uses their DC or IRA account to purchase a longevity annuity (sometimes referred to as longevity insurance), the longevity annuity piece will be disregarded for purposes of the minimum distribution rules under Code Section 401(a)(9).

Here is how it works. Sometime before a participant turns 70, he elects to allocate some portion of his account to a Qualified Longevity Annuity Contract (QLAC). In order to be a QLAC, the single premium for the annuity must not exceed the smaller of 25% of the account balance or $100,000 (indexed for inflation). A participant may make multiple QLAC allocations, but in that case, the total QLAC premium is similarly limited. The QLAC must specify the deferral date for the deferred annuity and that date cannot be later than age 85. 

In the event that participant makes such an allocation, the QLAC allocation will not be subject to the required minimum distribution rules. 

And, in a piece of bad news, money in a Roth account will not be considered a QLAC.

DC Spousal Consent Rules

This one is very simple. It clarifies that when a participant invests part of his DC account balance in a deferred annuity, that part of the account is not subject to the Qualified Preretirement Survivor Annnuity (QPSA) requirement until the participant makes an affirmative election to begin annuity distribution immediately.

DC --> DB Rollovers

This is another piece of good news. Suppose you are a participant in both a DC plan and a DB plan. Revenue Ruling 2012-4 allows a DB plan to be amended to accept rollovers from a DB plan. And, when you do so in order to get an  annuity, you get the DB plan's definition of actuarial equivalence rather than having to subsidize the profits of an insurance company.

Monday, February 13, 2012

DOL Finalizes Fee Disclosure Regulations.

It's been nearly two weeks since the Department of Labor (DOL) finalized its regulations under
Section 408(b)(2) of ERISA. For those of you who are more words people than numbers people, those are the fee disclosure regulations that require service providers (vendors) to inform plan fiduciaries just how and how much those vendors are getting paid for their services.

It's been interesting hearing some of the observations to the finalizing of this regulation. One experienced retirement practitioner noted to me that this regulation was the result of a recent law change. Hmm, ERISA, recent, Gerald Ford signed it into law and he died in 2006. He last signed a piece of federal legislation in 1977, not exactly recent in the benefits industry. Another experienced benefits practitioner remarked that these regulations were the result of a new government agency established under the Obama Administration. Well, for those of you who are not fans of our current president, there are many things that you could probably choose to blame him for, but I can assure you that President Obama did not create the Department of Labor.

On to the actual guidance ... I'm going to assume that if you are reading this that you have at least some knowledge of the history of this regulation. If not, you can certainly look in this blog under the label "Fees" or in thousands of other places on the internet. Or, you can read my take here or here.

Effective Date

The effective date is now July 1, 2012, postponed from April 1, 2012. Since an earlier DOL pronouncement synced the timing of the effective date of this regulation with the participant-level disclosures under ERISA Section 404(a)(5), the initial disclosures for calendar-year plans under those regulations will be due on or before August 30, 2012.

Electronic Delivery

The body of the regulation is silent. However, nerdy people like me who read a lot of regulations from the DOL and IRS know that in recent years, the preamble to regulations is often (read that as almost always) far more useful and informative than the regulation itself. The preamble, in this case, tells us that there is nothing in the regulation that would limit the ability of service providers to furnish fee disclosures electronically including making that information available on a website so long as participants are notified how they may access those disclosures. [Tell me, why doesn't the government do what a normal person would do and specify in the regulation what vendors can do to fulfill their requirements?] In any event, the regulation indicates the DOL's expectation that 50% of disclosures will be provided electronically. I expect that the DOL's margin of error in making that statement is not more than 50%.

The Disclosure Goesintas

For the uninformed, goesintas is an old term (I think it comes from 298th century BCE (we used to call that BC) Aramaic) for what goes in to something. The analogue for the really curious is the comesoutas. For the most part, this has not changed from earlier proposals. However, at some point in the future, the DOL may require service providers to give fiduciaries a guide to understanding the disclosures. For the time being, there is a sample guide in an appendix to the regulation. And, there is a placeholder in the regulations for such a guide.

For the curious, the sample has two columns. The first column lists services [to be] provided. The second column shows where in the service agreement (if you don't have a service agreement, you can't use this) that service can be found or where information related to investment fees and expenses can be found online.

Enhancing the Technical Details

Service providers will be required to provide to plan fiduciaries sufficient information to assess the reasonableness of both direct and indirect compensation. While the interim regulation required the service provider to at least estimate the amount of indirect compensation it expects to receive, the services for which that compensation is to be received, and from whom that compensation is to be received, the final regulations require that the relationship between the service provider and the payer be disclosed. So, for example, under the final regulations, the service provider might identify a payer as a subcontractor, an affiliate, or a subsidiary.

Certain investment products are often referred to as look through investments. In 401(k) plans, for example, perhaps the most common of these are collective investment trusts (CITs). Under the interim rule, the disclosures were required to contain:

  1. compensation charged directly for acquisitions, sales, transfers, or withdrawals
  2. annual operating expenses or expense ratio unless the product's return is fixed
  3. ongoing expenses
Under the final regulations, a designated investment product (DIA) need not disclose numbers 2 and 3. Instead, it must disclose total annual operating expenses which in turn must be disclosed to participants under the disclosure regulations that apply to them.

What Brokers and Recordkeepers Have to Tell Fiduciaries

The change from the interim rules appears to be fairly subtle in this regard. For most organizations, I think it will be. Under the interim rules, recordkeepers with DIAs on their platforms were required to provide certain DIA information on their platforms. They could satisfy that requirement by passing through information from the issuer, typically a prospectus, but the materials had to be regulated by a governmental agency. The new rules change the government oversight. No longer do the materials need to be regulated, but instead, the issuer of the pass-through materials needs to be regulated. Further, the issuer may not be affiliated with the recordkeeper in order to use the pass-through rule, but the regulations indicate that the requirement can be met by replicating materials.

... time out for a rant ... what is the significance of copying and pasting as compared to just passing through? I don't think I am overly stupid, but this seems like burden for the sake of burden.

... now we return to our regularly scheduled programming ...

Information Requests

The interim rules required service providers to respond to requests (for Form 5500, for example) for additional information from fiduciaries within 30 days. The final regulation changes that to "reasonably in advance" of the governmental filing deadline.


In keeping with the interim rule, the final rule says that corrections to disclosures must be provided within 30 days. The final rule, however, adds that such corrections must include errors and omissions, not just corrections.


Where there is an explicit fee agreement (e.g., contract) in place, this information must be disclosed. Where there is not, the final regulation specifies that reasonable estimates must be made and that any assumptions used to make those assumptions must be disclosed. Further, the final rule indicates that ranges may be used as a reasonable method of disclosure of compensation. However, the final rule states that where more precise information is available, it is to be disclosed.

So, that's about it. The remainder is generally unchanged. Since this is a final rule, and we haven't heard people screaming yet, it looks like disclosures will begin being provided by mid-year. That's not bad. ERISA was signed into law on September 2, 1974 (Labor Day). We get required disclosures in less than 38 years.

Saturday, February 11, 2012

In Case You Were Wondering

No, I have not fallen off the face of the earth. And, no, I am not discontinuing this blog. But, sometimes a week of far less than desirable health gets in the way of blogging. Expect a return real soon.