Fees and Higher Cost Asset Classes in Retirement Plans

Earlier this week, I wrote about Bell v Anthem and the rampant litigation over fees in defined contribution plans. I thought I'd take this one step farther today and discuss a few related topics.

Since this post in particular is highly legal in nature and deals with a number of investment topics, I am going to reiterate that I am not an attorney and do not provide legal advice nor am I a CFA, CFP, or RIA, and I do not provide investment advice. Any of either that you glean from this piece is at your own risk and is not intended.

For the most part, the fee-related class action suits have been about failure of the plan sponsor and its committee to properly follow its own Investment Policy and to fail to use the least expensive funds available when it does. Suppose the retirement plan in question along with its committee believe that it's in the best interest of plan participants to have a truly diversified set of investment options available to them in the plan. And, by truly diversified, they have included a set of alternative investments and hedge funds. Many plans do not.

Alternative investments as a group tend to be expensive. One might argue that it takes a more unique skill set to manage them and that simple supply and demand justifies the higher fee structure. Whether that argument holds water or not is not the purpose here, but in any event, you just don't see inexpensive alternative investment funds. Hedge funds tend to be among the most expensive of all. Seen as the ultimate in risk and reward, fees are usually extraordinarily high when compared to other asset classes.

Now, we return to the ERISA requirements that a fiduciary act in the best interests of plan participants and that expenses not be more than reasonable (as an aside, I don't think the word reasonable should ever be in the statute because your idea of reasonable may incorrectly differ with my correct idea of reasonable ... just kidding).

What makes an expense reasonable? In the case of an S&P 500 index fund, we would expect the returns before subtracting out expenses to be virtually identical for two funds, and therefore would hope that the funds with expenses toward the lower end of the spectrum available for the plan would be considered reasonable. Two international real property funds, on the other hand, will not have the same returns. And, each probably only has one share class (in other words, there is not a retail and wholesale or institutional). If Fund A has been returning (over the last 10 years) 14% per year before subtracting expenses and Fund B only 11% per year before subtracting expenses, does Fund A justify a higher level of expenses?

I don't know.

Could you get sued if you offer Fund A in your plan with expenses at 3.5% rather than Fund B with expenses at 2%? Yes, you could. Would you win that suit? I don't know.

The whole concept raises an interesting question that I touched on the other day. With all of these 401(k) lawsuits, is it prudent to offer a 401(k) plan? Is it prudent to be on the Investment Committee of a 401(k) plan? Is it prudent to offer a fund lineup in a 401(k) plan over which you could get sued, but on which you have absolutely no idea on which merits or lack thereof the case would be judged?

I don't know the answer to any of those questions, but I think they are food for thought.

Three decades ago, the defined benefit plan was king and defined contribution plans were far more often thought as a supplemental means of saving. This concept makes more sense to me.

Is it time for a return? Is it time for a return if you have all of the characteristics of that 401(k) plan without the attendant litigation risk? I think maybe it is.

If We Only Knew What 401(k) Participants Really Want

I read an article this morning called "What Participants Really Want From Their Bond Fund." It was written by a gentleman named Chip Castille. Mr. Castille is the head of the BlackRock US Retirement Group. As such, Mr. Castille is likely a participant in a 401(k) plan, although to be truthful, I don't even know if BlackRock offers a 401(k) plan to its employees.

More to the point, the article tells us what participants really want in a 401(k) plan and specifically in a bond fund in such a plan. While I could not find where the author cited any survey data, either he has some on which he is basing his conclusions or he is divining the answers because he seems to really know better from my read of the article (more on that later).

The author implies that participants are looking for safety, return or retirement income. That is a pretty broad spectrum. But, he doesn't dig into it enough for us to know how a plan sponsor or an investment professional would decide. What he does do is point out that an investment manager in a bond fund looks at how closely his fund is tracking a benchmark while participants look at whether the fund has gained or lost money or it will produce sufficient income.

I don't mean to demean what any professional says. But, here I beg to differ with the author. Participants get a lot of junk in the mail these days (not that these days are really any different from any other days in that regard). If the participants to whom he is referring are anything like the ones that I know, they don't look at individual fund performance very often. In fact, in the case of most that I know, "not very often" is spelled N-E-V-E-R. That's right; they don't look at individual fund performance. They look to see how their total account is doing. They judge (that's spelled G-U-E-S-S) whether it's a good day to be in equities or a good day to be in fixed income and periodically move their money around because they think they know.

Typically, participants don't like losses in their accounts. In fact, I would say that if you were to rank account balance events in order of importance, my guess would be that far more participants would say that they would like to avoid meaningful losses perhaps at the expense of a few big gains than the number who would say they would like to go for big gains at the potential expense of taking some very large losses.

But, I'm just guessing. I don't really know. And, frankly, the author of the article doesn't know any of this either. Face it, he hangs around with investment professionals. Investment professionals are not representative of your average garden variety 401(k) participants.

I happen to be an equal opportunity dumper, however. While I cannot find data that the author is using to draw his conclusions from, I will also take this opportunity to dump on many authors who do use data, usually from surveys.

Let me show you why with an example. Suppose a survey question is worded like this:

What do you want from your 401(k) bond fund?

1. Safety
2. Return
3. Retirement income
4. Guacamole
5. Health care

I've never posed this question this way, so I get to guess at hypothetical results. Some number of people will answer with 4 or 5. Among those who don't, that is, they answer with 1, 2, or 3, or they just skip the question entirely, do they know what I mean by each of 1, 2, and 3? My guess is that they don't. Safety has lots of meanings in life. To an investment professional, it means one thing. To a plan participant, it might mean NEVER losing money. You and I know that is essentially impossible in a bond fund, but the average participant may not.

Some firm out there that wants to prove their own point will have a survey question like this one. They will ask about 1,000 random selected people to answer the questions and some smart people in the proverbial back room will analyze the answers so that the author of the next great white paper will have the definitive solution. 

Suppose the potential answers were flip-flopped (that is, health care was at the top followed by guacamole with safety last), would that change the results? What does a participant do if they wanted to answer none of the above? Or, suppose they don't understand one of the answers. Or, perhaps, in their mind, it's a tie between two answers. Or, maybe last week they would have answered return, but after they got their most recent statement and saw a 10% decline in their account balance, they suddenly place significant value on safety.

Let's face it, none of us know what the average participant wants in a 401(k) bond fund. We don't even know what an average participant is. 

Remember the two words that I capitalized -- NEVER and GUESS. That should tell you something.

Pension Miseducation

Like many benefits and compensation professionals, I receive daily my fair share of e-mail blasts from consolidators -- those services that scour the web for tidbits to provide to their readers. Because they have tens of thousands of free subscribers, they are able to sell advertising. That's their business model, as I understand it.

This morning, I opened one of those e-mails and found this article that looked like it was worth a read. In fact, there was some interesting material in there. And then there was this:

That aphorism also suits one frustration of today's pension plan sponsors. Somehow, they have to attain lofty actuarial return goals of 7% to 8%, but the expected returns they have to draw from, for both equities and fixed income, are stuck at ground level.

Hold on a second. Lofty actuarial return goals, you say? This implies somehow that the actuaries set the target and that based on that, plan sponsors and their associated investment committees then struggle to meet that target.

This is backwards. The selection of actuarial assumptions is different for accounting and for funding. In either case, however, the actuary does not just willy-nilly pick a target return on assets assumption. For ERISA funding purposes, the law mandates the selection. For FASB (ASC) purposes, the plan sponsor selects the return on assets assumption with the advice of experts including the actuary and investment adviser for approval by auditors. To the extent that the actuary finds the assumption to fail to meet Actuarial Standards of Practice (ASOPs), the actuary is to disclose such and to provide calculations representing what the amounts would have been had the assumption met the ASOPs.

Those who do not seem to understand this take a different position. The typical process for those sponsors looks like this:

• Look at the expected return on assets assumption.
• Go to the investment adviser and tell them that they need an investment portfolio that will meet or exceed that expected return on assets assumption.

But, the sponsor owns that assumption (if it is for accounting purposes). If it's for government plan funding, usually (state and local laws differ) the sponsoring government has input into the assumption. 

If an actuary has some (or all) purview over the return on assets assumption and (s)he is doing his or her job properly, the actuary will look at the investment lineup together with a capital market model and develop a return on assets assumption commensurate with that lineup. It is not the other way around. If plan sponsors do not think that their investment lineup can return 7% to 8%, then they should lower their assumption for expected return on plan assets. Yes, this will increase their financial accounting costs (and their funding costs for governmental plans). Ultimately, the cost of a plan is what it is. The cost of paying $1 per month for the rest of an individual's life is the same, no matter the actuary.

In my personal experience, for years, many plan sponsors pressured their actuaries to use more aggressive actuarial assumptions in an effort to influence P&L and, back in the days when it mattered for funding costs, to keep required contributions down. Some actuaries agreed to do that, some did not. 

But, when a plan sponsor, including a state or local government, chooses a high expected return on assets assumption, usually to manage short-term costs, that they are unable to find a suite of investments to generate that expected return is not the actuary's fault. Place blame where it belongs.

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.

Another Knife Stabs COLI

Most of us have heard of it -- corporate owned life insurance (COLI). In the 80s and part of the 90s, it was one of the ultimate gimmicks. It had great tax treatment and great accounting treatment, and yes, it often performed well. But, over time, COLI began to get a bad name. Battling for tops among the reasons were two: brokers of COLI products were making what were viewed by many as unconscionably large profits selling the product; and many companies were buying what was known in the pejorative as janitor's insurance. That is, they were buying life insurance policies on everyone down to the janitor to fund perquisites and benefits for top executives.

Well, over time, these benefits of COLI have eroded. Someone could write a book on just that, but that discussion is for a different day here. But, in the latest blow to COLI, the IRS has released Revenue Ruling 2011-9 . What, you may ask is this, and what does it do? It adds particular teeth to [Internal Revenue] Code Section 264(f). So? What in the world is Code Section 264(f) and why do you care? Be patient, dear reader.

Section 264 is entitled Certain Amounts Paid in Connection with Insurance Contracts. Subsection (f) deals with expensing certain related interest costs on a pro rata basis.

Here is why this matters.


As COLI laws have been tightened, companies that purchase COLI have become more and more concerned about having an insurable interest in the individuals on whom they purchase insurance. So, for example, if Microsoft purchases life insurance on Bill Gates, even the most cynical among us would probably argue that Microsoft does, in fact, have an insurable interest in his life. But, suppose instead, Microsoft purchased insurance on the life of Horatio Hornblower [Note: to the best of my knowledge, they have neither done this nor considered it]. Even the most fervent COLI supporters among us would likely argue that there is no insurable interest there.

Where this turns grayer is with regard to policies held on past employees, or when a policy on a past employee is exchanged for one on a current employee. I digress. Code Section 1035 generally allows a policyholder to exchange one bona fide policy for another without creating a taxable event. So, as the insurable interest rules have tightened, many companies have routinely exchanged policies on employees who have recently terminated for policies on employees who have recently joined. That sounds innocent enough, doesn't it?

Now, let's look at Section 264(f). It says that, in general, a portion of a taxpayer's interest deduction based on the ratio of the sum of the unborrowed cash values on life and annuity contracts it owns to the adjusted basis of all of the taxpayer's assets is disallowed. Notably, Section 264(f)(1) provides an exception for officers, directors, employees, and 20% owners at the time of policy issuance. So, if all of your COLI is held on the exempted group, you get your full interest deduction. Right?

Not so fast. There is a good chance that some of the policies that you hold on the exempted group were not originally held on the exempted group. In other words, some of these policies were acquired through the use of Section 1035 Exchanges. And, the exchanges were likely (a euphemism here for perhaps 100% certain) done after the original insureds were no longer in the exempted group.

According to this ruling, both new and old policies that were acquired through a 1035 exchange after the original insured was no longer in the exempted group are not exempted. This would say that an employer needs to contemplate the termination of an employee and perform the exchange prior to that employee's termination. I think most would say that this is not practical.

From a reality standpoint, here's what this does. When COLI no longer has its most favorable tax treatment, it becomes what is sometimes referred to as an underperforming asset.. According to the revenue ruling, if an exchange is not done on a timely basis, either the interest deduction goes away because of the untimely exchange or the company now holds a policy on an individual who is no longer exempted. What did Joseph Heller call his book: "Catch-22"?

What should companies do about this? Companies that hold COLI need to check all of their policies to see which ones no longer get them the presumed deduction. Then, they need to make decisions with regard to those policies to see if they should somehow unwind them and use the assets for other purposes. Worse yet, the stated proposal of the current administration is to take away the exemption in Code Section 264(f)(1).

We can help you wade through this mess.

But, as always, neither this author nor his employer provide tax, legal, or accounting advice. This can only be obtained from someone licensed to provide such counsel.