Asset Classes in DC Plans -- Should They be the Same as in DB?

I read several summaries of a BNY Mellon white paper entitled "Retirement Reset: Using Non-Traditional Investment Solution in DC Plans." Honestly, I would have read the whole white paper, but after searching for it on the BNY Mellon website using the exact name of the paper and having no related hits come up, I decided that I would have to stick with the summaries.

In any case, the paper attributes the limited range of investment options available in DC plans as the primary reason that participants' accounts in DC plans do not have the same performance as do DB assets. According to the author, Robert Capone, if DC plans were constructed more similarly to DB plans, participants would allocate about 20% of their assets to non-traditional strategies including real assets, total emerging markets, and liquid alternatives.

Reality check time, people!

The bulk of my readers are pretty savvy people. Would all of you choose to invest your own 401(k) money in these asset classes? Would you invest in a fund of liquid alternatives just because it was a fund of liquid alternatives?

There are a myriad of reason why participants in DC plans, on average, do not get the returns on investments that DB plan sponsors do. Here are some:

• In theory, DB plans, have an infinitely long investment time horizon. That is, open DB plans generally do not have an accumulation phase and a decumulation phase. Sound sponsors can withstand blips.
• In a DB plan, sponsors fight to keep asset-related fees low. They know that every dollar that they pay out in fees is a dollar that they will have to contribute. And, in fact, since PPA, it is generally a dollar that they will have to contribute immediately. In DC plans, usually, the investment management fees come right off of participants' top lines. It is human nature that plan sponsors will be seeking to get a good deal for participants, but not be as concerned as they are on the DC side.
• DC plan participants, even if they choose to invest in non-traditional strategies, do not usually have the knowledge or the tools to develop an investment portfolio that sits on an efficient frontier.
• DB plans don't have leakage. Whereas participants in DC plans may take plan loans or hardship withdrawals and have periods during which they are either unemployed or choose to not defer, DB plans have large pools of assets and liabilities.
• DB plans spread those asset pools over a group of participants. The group has a liability profile and the group is diverse. In a DC plan, a participant is one unique person. That person is of a given age, and in an ideal world, one year later, that person will be exactly one year older. As the participant ages, if he follows prevailing wisdom, his portfolio should get more conservative. Are we really espousing that a 55-year old such as me should have 20% of his plan assets in non-traditional strategies? If so, should my bias be toward liquid alternatives? According to research that I did on a number of investment websites, this class has among the highest risk of all asset classes. Isn't it a little bit late in my working lifetime for me to be taking those kinds of risks?

In summary, I suspect that the BNY Mellon white paper is well-founded and well-written. But, it seems to me highly theoretical and perhaps not particularly practical advice. I have my own reasons why DC returns are not as good as those in DB plans.

• Market timing -- many DC participants see that the markets are going up or down and move into equities after a rise or move out of them after a fall. Being behind the trend is not the way to increase investment performance. A set it and forget it strategy is generally better.
• Target-date funds -- Target-date funds or TDFs are often the best way for participants in DC plans to have a properly diversified portfolio. However, when plan sponsors choose the family of TDFs for a plan for their employees, they typically do not do research to seek the best TDF. What happens more frequently is that they use the TDFs of their recordkeeper. As I have written many times, most TDFs are not funds of the best of the best. Instead, they are funds of proprietary funds. So, to pick on two of the largest players, a Fidelity TDF probably does not contain any Vanguard funds, and conversely, a Vanguard TDF probably does not contain any Fidelity funds. Custom TDFs are becoming more popular, but in practice, they are largely restricted to plans of large plan sponsors.
• Lack of professional asset allocation -- A large DB plan will typically have an Investment Committee that controls its investments. That committee often has several people on it with professional training in investments. They engage outside advisers to monitor funds. They engage outside advisers to assist with asset allocation. They often pay large sums of money to see the results of asset-liability modeling. Such modeling often starts with goal-setting. On the DC side, even to the extent that a similar process is followed, it is done en masse. I'll bet that your plan's Investment Committee never asked you about your risks and your goals in developing an asset lineup for the plan in which you are fortunate enough to participate.

There are lots of reasons that DC plan returns, on average, are not as good as those in DB plans. I'm sorry to have to say it, but in my humble opinion, the lack of availability of real assets (are these different from fake assets), total emerging markets (as compared to partially hidden markets) and liquid alternatives (is this red versus white or Red Bull versus Monster) is not the answer.

I apologize for being so cheeky on a Monday morning, but I'm afraid that my parentheticals are not far from the average participant's comprehension of those asset classes.

DOL Suggests Rules on Lifetime Income Illustrations

Earlier this week, the Employee Benefit Security Administration (EBSA) of the Department of Labor (DOL) released three items related lifetime income illustrations for benefit statements for defined contribution plan participants. I know, that's a mouthful. Here's what we got from them:

• An advance notice of proposed rulemaking (ANPR) under Section 105 of ERISA that gives us an idea of what future regulations might look like and to seek comments
• A "fact sheet" discussing briefly what they have done
• A lifetime income calculator using the methodology expressed as a safe harbor in the notice

For background, the Pension Protection Act of 2006 (PPA) established a requirement for annual benefit statements from qualified retirement plans. All these years later, we don't know how to do the required lifetime income illustrations.

The ANPR tells us that any set up of assumptions that we use that employ generally accepted investment theory will probably be considered reasonable. EBSA also gave us safe harbor assumptions. When push comes to shove, we expect that most sponsors (or their vendors), once the regulations become effective, will opt for simplicity and use the DOL's safe harbor assumptions.

What are they, you ask?

• Contributions continue to normal retirement age at the current (dollar amount), increased by 3% per year
• Investments return 7% per year
• Discount rate of 3%
• To convert account balances to annuities, use the interest rate on Constant Maturity 10-year T-bills
• Use a 417(e)(3) mortality assumption (for those who don't keep their noses mired in the Internal Revenue Code, this means that the mortality assumption is to be the one currently used for most pension purposes under the law)
• If you're married, you and your spouse were born on the same day ... even if you weren't
• For purposes of converting the current account balance to a lifetime income stream, payments begin immediately and you are assumed to be your current age or normal retirement age, whichever is older

To me, some of these assumptions are not bad and some are ... well, they're not not bad. Let's start at the top. For people who stay in the workforce continuously until retirement, the 3% annual increase in contributions is probably as reasonable as anything else. But, very few people stay in the workforce continuously anymore. There are all of maternity leave, paternity leave, layoffs, reductions-in-force, and then there are the companies that freeze pay or cut benefits making the 3% annual increase assumption a bit lofty.

How about investment returns of 7% per year combined with a 3% discount rate? That's a 4% real rate of return, net of expenses. Did anyone watch the Frontline special on PBS telling you how your account balances are eroded by expenses? If you did, I bet you don't think a 4% real rate of return is reasonable.

What a participant is to receive in his or her statement are four numbers:

• Current account balance on the effective date of the statement
• Projected account balance on the later of the effective date of the statement or normal retirement date
• The amount of lifetime income that could be received on the current account balance over the lifetime of the participant or joint lifetime of the participant and spouse if married
• The amount of lifetime income that could be received on the projected account balance over the lifetime of the participant or joint lifetime of the participant and spouse if married

I see several outcomes from this exercise.

• Participants will have an overly rosy view of their defined contribution plans
• Despite that, they will suddenly think that their 401(k)-only retirement program isn't very good
• Most participants will not achieve the lifetime income projections that the illustrations suggest

So, what happens?

• Just as they do with Summary Annual Reports, participants find the nearest trash can or recycling bin and insert these statements, or
• Participants read the statements and ask their generally unknowledgeable friends what they mean
• Participants go to HR and ask HR what it means
• When participants start to understand, they learn that a 401(k)-only retirement program is generally not very lucrative unless they defer far more than they are currently which they probably don't they can afford

Some will complain. Some will jump ship.

What can an employer do? An employer can say that this result is fine and move on as if nothing happened. Or, an employer can decide paternalistically that it has some responsibility here and revisit retirement design. Perhaps the answer is that old dinosaur, defined benefit. Perhaps the answer is another old dinosaur, profit sharing. Either way, both have far more flexibility in design than do 401(k) plans.

The DOL needs intelligent comments on this one. I hope it gets them.

Where Bad Law Comes From -- Anatomy of a Bad Proposal

I'm not sure who writes the Administration's budget proposals. I know who is responsible, but the question is who actually writes them.

I ask because of the revenue-raising proposal to limit tax-favored retirement savings. What has been reported is that tax-favored savings will be limited to $3 million. That's a pretty good amount of money. But, the rumor that is circulating among some people in the know is a bit different.

Here is what it seems to be. For an individual, you take all of their tax-favored savings. That would appear to include Roth 401(k) as well as traditional and Roth IRAs, SIMPLE accounts, Keoghs, qualified defined contribution and qualified defined benefits. Then, you express them all as an annuity as Social Security Normal Retirement Age and the sum cannot exceed the 415(b) limit (currently $205,000 per year).

Do I think that is a bad concept? Well, in theory, limiting what people can save for retirement on a tax-favored basis is already done. The old 415(e) combined limit used to do something like this. But, that was from a single employer.

Suppose we start out simply. Adam (I picked Adam because it starts with an A) has only worked for one employer. He is about to reach his Social Security Normal Retirement Age (SSNRA) and he has the following:

• An accrued benefit in his DB plan of $100,000 per year
• A 401(k) account balance of $1,000,000
• An IRA with an account balance of $1,250,000

Whose responsibility is it to calculate the total limit? Is Adam required to tell his employer about his IRA? How are the conversions done? In this simple situation, it's not easy.

Beth, on the other hand, has jumped around from employer to employer. She is 45 years old and has accrued benefits in two DB plans, account balances in three 401(k) plans and an ESOP. She also has an IRA. One of her DB plans gives her an automatic cost of living adjustment (COLA). Who has to administer this? How? Who is responsible for telling whom what? Suppose Beth works two jobs that both provide benefits and she exceeds the limit, which one gets cut back.

Wouldn't you just love to be the people at Treasury and IRS who have to figure out how to regulate this?

The proposal may not be bad in theory, but as I understand the way it is being proposed, it is a disaster.

Stay tuned ...

New Pay Limit for Covered Health Insurance Providers and Maybe a Way Around It

Perhaps you like the Patient Protection and Affordable Care Act (PPACA, ACA, or ObamaCare). Perhaps you don't. You are entitled to your opinion. I think we can all agree that it has its good provisions and it has those that perhaps could have been better thought through. One that falls into the latter category is the [relatively] new Code Section 162(m)(6) dealing with the limit on compensation for Covered Health Insurance Providers (I'll refer to them as CHIPs because it's much easier for me to type). In a nutshell, the section and its new proposed regulations limit the deduction for compensation that can be taken by a CHIP to $500,000 annually with respect to any person.

If you want to read the regulation like I did, you can find it here. If you want a good technical overview with the requisite cynicism, I direct you to Mike Melbinger's blog.

If you would like a solution, read on.

In a nutshell, you are a CHIP if 2% of the gross revenues received by your controlled group are from health insurance premiums. Yes, that means that if you happen to be part of a controlled group that contains a health insurer, you are likely a CHIP. Congratulations!

Most of Code Section 162(m) deals with deduction of compensation (as a reasonable business expense). The parts that limit it generally limit it to $1 million, except for CHIPs. And, for CHIPs, and only for CHIPs, the determination of whether an individual's compensation exceeds $500,000 includes deferred compensation earned, nonqualified plan benefits earned, equity compensation awarded, and severance benefits paid. The calculation is not easy, but this post is not about that. If you'd like to know more about the calculation, contact me and I'll be happy to charm you with its details.

I said I have a solution, and for many companies, I think I do. What was left out? Did you notice that qualified plan contributions and accruals were left out? And, for qualified plans, we have an objective set of nondiscrimination rules.

The solution involves a technique often referred to as a QSERP. What this technique does is to take nonqualified deferred compensation amounts and moves them from a nonqualified plan to a qualified plan. In this case, it has lots of advantages:

• Frequently immediate tax deductibility
• Tax-favored buildup
• More security
• Pooling with significant other obligations in a large trust

Most often, QSERPs are utilized in a defined benefit context. But, realizing that many companies no longer have defined benefit plans providing for current accruals, QSERPs can be utilized in a defined contribution context as well. 

Again, the explanation is long and has been covered elsewhere, so I'm not going to bore my readers here, but if you'd like a detailed explanation, contact me directly.

I know the cynics among you will say that this deduction limitation is the right thing to do. For you, I will say that you should have asked Congress to craft the law in a way that doesn't leave creative minds the opportunity to find loopholes.

If you're reading this today (it's a Friday) or even if you're not, have a great weekend whenever that may come for you.

Does 401(k) Auto-Enrollment Work?

It was hailed as one of the great ideas to come from the Pension Protection Act of 2006 (PPA). Auto-enrollment, technically known as an Automatic Contribution Arrangement (ACA), was supposed to be a revolutionary change to 401(k) plans that would allow participants in this generally non-defined benefit world to someday retire comfortably.

The IRS submitted a Compliance Questionnaire to 1200 401(k) plans that had filed Form 5500. If you are interested, you can read their report for yourself. To me, one of their key findings was around plans that use ACAs. Of participants eligible for ACAs, here is the actual data:

• 43% defer at the default rate
• 29% elect a rate higher than the default rate
• 7% elect a rate lower than the default rate
• 21% opt out of participation entirely

In my experience, the most common auto-enrollment rate is 3% of pay. If that is truly representative of US companies at large, then 71% of participants are deferring 3% of their annual compensation or less. 

That's not good. Even for participants who defer for quite a long time, annual deferrals of 3% of pay, even with employer matching contributions added to them will not get anyone to a comfortable retirement.

One of the types of ACAs available to plan sponsors is a qualified automatic contribution arrangement (QACA). QACAs generally provide for auto-escalation in default deferrals. Oversimplifying somewhat, a QACA must have a default deferral percentage of at least 6% of pay in the third year following the initial period and cannot increase to a rate above 10% of pay. QACAs are exempt from ADP and ACP testing.

Participants in QACAs who do not opt out of the defaults will often have enough savings to retire comfortably. That's the good news. The other side of the coin is that IRS data shows that only about 5% of all 401(k) plans have ACAs and of those, fewer than 1/4 are QACAs. That means that roughly 1% of all 401(k) plans are QACAs. Many of the rest will have very few participants who will have prepared themselves through saving with sufficient money to retire.

That's not good. 401(k) auto-enrollment is not working as it should.

409A Bares Its Teeth ... And Bites

Anyone who reads this blog knows what I think of Code Section 409A. Like many other sections added to the Internal Revenue Code in a politically charged environment, it was an overreaction to a financial meltdown. This one was added to the American Jobs Creation Act of 2004 in response to Enron, WorldCom and other failures of that era.

The gist of the section makes sense. Essentially, Congress  (I hope I'm not attributing more logic to them than they deserve) wanted to ensure that participants in nonqualified deferred compensation plans (NQDC) couldn't get treatment preferable to that of the rank and file in qualified retirement plans. For example, there are generally restrictions on when an individual can receive on an unpenalized basis a distribution from a qualified plan. Section 409A seeks to ensure that the deal is no better in the NQDC world.

The tax penalties for failure to comply with 409A are severe. I've discussed them many times. Essentially, a failure is subject to 20% additional income tax (a marginal tax rate of 39.6% becomes 59.6% on that money) plus interest on underpaid taxes at the federal underpayment rate plus 1%. That's pretty severe.

Despite the IRS having announced that they had started an executive compensation audit program, more than a few companies have been cavalier in their efforts to comply with 409A.

They should perhaps reconsider.

I say this in response to a Federal Court ruling in Sutardja v US. Often, I provide my readers with a link to these cases so that they can experience all the excitement in reading the decision that I have, but this time I am refraining. There just wasn't enough excitement. However, here is a synopsis.

• Dr. Sutardja is the CEO of Marvell Technology Group Limited
• On 12/10/2003 (note that 409A became law in late 2004), the Board of Marvell approved a grant of not more than 2 million stock options to Dr. Sutardja. The closing stock price that day was $36.19.
• On 12/16/2003, the Compensation Committee of the Board approved a grant of 1.5 million shares  to Dr. Sutardja at an exercise price of $36.50, the stock price on that day.
• Said grant was ratified on 1/16/04 when the stock price was $43.64 (Alert: alarm bells go off ... discounted stock option alert).
• In January 2006, Dr. Sutardja exercised some of his options. He paid an additional amount to make up for the perhaps incorrect grant price.
• The IRS hit Dr. Sutardja and his wife with a tax bill for a 409A penalty for more than $5 million.
• After the Court went through a whole lot of technical mumbo jumbo, it ruled in favor of the IRS.

So, what's the point?

Marvell could have handled this more cleanly. 409A wasn't a glimmer in anyone's eyes when they authorized or granted the options. While they didn't use an approved method, Dr. Sutardja and Marvell tried to use what they viewed as good faith to fix the issue. Dr. Sutardja and his wife lost.

The real point is that Congress intended that 409A be a revenue raiser for the United States. The IRS is trying to live up to that intent. Now, there are procedures in place to fix 409A problems. Most companies don't have the expertise to do that internally. Depending on the NQDC plan in question, review of the plan including its administration may appropriately be done by some combination of attorneys, tax experts, compensation experts and retirement plan experts. Often, it should include people from more than one of these categories. 

If you engage such people to conduct a review, one of three things can happen and two may be better than the alternative:

• They will find no problems because there are no problems.
• They will find problems and you can use approved correction procedures before the IRS finds the problems.
• They will not find any problems, but the IRS will (this is the one bad one, but I think it's unlikely if your experts are really experts).

Consider conducting such a review.

SEAL Act Would Help DC Leakage Problems

In 2011, Senators Herb Kohl (D-WI) and Mike Enzi (R-WY) introduced their version of the SEAL Act. Now, two years later, Enzi and Bill Nelson (D-FL) have introduced a nearly identical bill, the Shrinking Emergency Account Losses Act (SEAL Act) into the Senate Health Education Labor and Pensions (HELP) Committee.

Essentially, the bill would accomplish two key purposes:

• Participants who elect to take hardship withdrawals will not have their rights to defer to a 401(k) plan suspended.
• Participants who terminate employment while having an outstanding loan balance in a qualified plan will have additional time to repay that loan before having a deemed distribution.

These are both positive steps that would help more participants to be prepared for retirement.

Philosophically, I have an issue with the first provision, however. A participant who has recently taken a hardship withdrawal has bigger issues than saving for retirement. Typically, that person would not be in a position to be taking money out of income for purposes other than keeping up currently.

The second provision makes sense. Currently, many administrative systems would not be equipped to handle such a provision, but certainly this could be fixed.

We'll see if the 2013 SEAL Act fares any better than its namesake did in the last Congress.