The Quandaries of Being A Retirement Plan Fiduciary

Last week, the Department of Labor issued its final rule on what it means to be a fiduciary and on conflicts of interest. Virtually everyone in the retirement plan industry has been scurrying about to determine what the effect of the rule is. Some, including the US Chamber of Commerce, say it will lead to unnecessary litigation. Others say it will drive unknowledgeable advisers out of the retirement plan business.

If you're interested in the details of that regulation, every large consulting firm, law firm, and recordkeeper either has or will be publishing their take on it. Here, however, I want to address a different issue.

If you sit on the committee that oversees a retirement plan whether its called the Benefits Committee, the Investment Committee, or the Committee for All Things Good Not Evil, by virtue of that role, it is probable that you are a fiduciary. That means that both individually and as a member of that committee, when making decisions related to the plan (not your own account in the plan, but the plan generally), you have a requirement to act in a fiduciary manner and in the best interest of plan participants.

That's not a low bar.

Instead of bringing up situations that arise from the new final regulations (the other articles will present you with all of those that you need), let's instead consider an age old problem. Suppose your company sponsors a defined benefit plan and you are on the committee that oversees the plan. Let's complicate the situation a bit by adding in the following fact pattern:

• The plan is covered by the PBGC (Title IV of ERISA)
• The plan is frozen and the committee's minutes show that the intent of the committee is to terminate the plan whenever it becomes well enough funded
• Your company is subject to US GAAP; in other words, you account for the plan under ASC 715 (previously FAS 87).
• Your own personal incentive compensation is affected by corporate financial performance measured under US GAAP
• Over time, you have received a material amount of equity compensation from your employer meaning that you now hold a combination of shares of stock, stock options, and restricted stock in your employer

Your actuary comes to a meeting with your committee and informs you that you have three options related to a funding strategy:

• Option #1 will keep the ASC 715 pension expense down and will not result in a settlement (that would be a loss currently), but will result in the plan being less well funded
• Option #2 will produce a settlement loss, but will get the plan closer to termination and leave it currently better funded for remaining plan participants
• Option #3 will reduce ASC 715 pension expense and get the plan better funded and therefore closer to termination, but will have a material effect on the corporate balance sheet and could cause the company to violate certain loan covenants

You do have a quandary, don't you? Only Option #1 will help you to maximize your incentive pay. In my personal experience, in days gone by, for that particular reason, Option #1 would have gotten some votes. If you vote for Option #1, are you fulfilling your responsibilities as a fiduciary?

I'm not an attorney, so I'm not going to answer that question, but I'm sure you can find many who would be happy to weigh in.

Option #2 looks like it could be better for plan participants. Of course, that depends a little bit on what better means in this context. But, if the committee goes with Option #2, you know that your incentive payout could be smaller. If you vote against Option #2 (another question for the attorneys), are you fulfilling your fiduciary requirements?

And, then there's Option #3. How far do you have to go to fulfill your fiduciary requirements? Do you have to make decisions that are clearly not in the best interest of the company, but that may be in the best interests of plan participants? 

It's tricky, isn't it?

Now, let's consider a different situation that may not affect your personal compensation. Using Strategy #1, your company will pay PBGC premiums equal to about 10% of its free cash flow. Using Strategy #2, those same premiums will be reduced to about 3% of free cash flow. But, your actuary isn't familiar with Strategy #2. And, you do have a really good relationship with him. But, the people who brought you Strategy #2 say you can only implement it by using them.

What should you do? What must you do?

DOL Weighs in Again on Top-Hat Plans

ERISA contemplated so-called top-hat plans. In fact, it spelled out exactly what was contemplated in providing this opportunity for nonqualified deferred compensation so clearly that the legislative intent could never be misconstrued.

No, it didn't.

As is often the case when bills go from staffer to staffer and then to the floors of the houses of Congress, the bills tend to emerge with run-on sentences often punctuated by a myriad of commas making Congressional intent something upon which otherwise knowing people cannot agree.

Perhaps, some day they will learn.

No they won't, not in my lifetime anyway.

In any event, in a case (Bond v Marriott) concerning top-hat plans in front of the 4th Circuit Court of Appeals, the Department of Labor (DOL) wrote an amicus brief providing its opinion on the statutory wording around top-hat plans.

So, I know that those not familiar are just itching to find out. What does the statute say?

Congress gave us an exception to certain provisions of ERISA for a "[p]lan which is unfunded and is maintained by an employer primarily for the purpose of providing deferred compensation for a select group of management or highly compensated employees."

What is the primary purpose of a top-hat plan? Is it to be primarily for providing deferred compensation to a select group that is composed of management or highly compensated employees? Or, is it to be for providing deferred compensation to select group that is composed primarily of management or highly compensated employees?

It's one of those great questions that has confounded us through the ages. No, actually, it's a question that has confounded a select group of us since the passage of ERISA in 1974. To add to that confounding just a bit, everyone who practices in this field knows what a highly compensated employee is. The term is well defined in Code Section 414(q). But wait, Section 414(q), as written, has only been around since 1986 (added by Tax Reform) meaning that perhaps for these purposes, we don't even know what a highly compensated employee really is.

In its amicus brief, the DOL gives us its opinion, one that it claims to have held at least since 1985 and perhaps longer. The DOL tells the court that the primary purpose should be the provision of deferred compensation [for this select group] and that other purposes might include retaining top talent, allowing highly compensated individuals to defer taxation to years with lower marginal tax rates, or avoiding certain limitations applicable to qualified plans in the Internal Revenue Code. DOL further tells us that it does not mean that the select group may be composed primarily [emphasis added] of management or highly compensated employees or that the plan may have some other secondary purpose which is not consistent with its primary purpose.

The brief goes on to give us the judicial history around the provision and of course informs us which case law got it right and which did not. But, the DOL is clear in its claims and steadfastly denies that exceptions should be allowed.

I may be missing something here regarding the DOL. I think that the DOL has regulatory purview over ERISA. While the DOL has ceded that purview most of the time to the IRS where the Internal Revenue Code has a conforming section, that does not seem to be the case here. Could the DOL not have written regulations in 1975 or 1985 or 1995, or 2005 clarifying who, in fact, is eligible for participation in a top-hat plan? Or did they think it so clear that it was not worth their effort, despite being befuddled by decision after decision handed down by federal courts?

I know that when I got into this business, coincidentally in 1985, the more experienced people who taught me instructed that top-hat plans were to be for a group that was primarily management or highly compensated. In fact, it is difficult, in my experience to find practitioners who learned otherwise.

Perhaps that's wishful thinking. Perhaps, on the other hand, it's wishful thinking on the DOL's part. Perhaps the case will go to the US Supreme Court eventually so that nine wise jurists can put their own spin on it and settle this argument once and for all.

Until then, ...

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.

DOL Provides Guidance on TDFs

In February 2013, the Department of Labor (DOL) issued a paper entitled “Target Date Retirement Funds – Tips for ERISA Plan Fiduciaries.” Clearly, this is a signal from DOL that this is an issue for plan sponsors and their plan committees to watch. But, there are other fiduciaries as well and some have a vested interest in a plan sponsor’s choice of target date funds (TDFs). In this article, we’ll examine the DOL paper and some of its implications, but first we provide some background for those who don’t live in this world on a daily basis.

In 1993, Barclay’s Global Investors introduced the first TDF. While there had been some dabbling in risk-based funds, this was the initial plunge into developing a fund targeted at an individual’s intended retirement date. The evolution of TDFs moved along fairly slowly for the next ten years or so, but in 2006, Congress passed and President Bush signed into law the Pension Protection Act (PPA) starting a veritable explosion in TDF usage in 401(k) and other defined contribution (DC) plans.

The impetus was a provision in PPA establishing the qualified default investment alternative (QDIA), the investment that a plan sponsor uses as a default for moneys in participants’ accounts not otherwise designated for investment. The law and its guidance established that QDIAs should be one of these:

•  A fund that takes the participant’s age or retirement date into account
•   An investment service (managed account) that takes the participant’s age or retirement date into account
• A balanced fund
• A money market fund, but this can only be used for the first 120 days

According to the 2012 Janus/Plan Sponsor survey, approximately 75% of all defined contribution plans have chosen target date funds as their QDIAs.

Today, there exist a wealth of TDFs of many shapes and sizes. Virtually all of them have in their name a year (multiple of five) that is intended to represent a participant’s expected retirement age. Often, that is where the similarities end. There are “to” funds and “through” funds so named because they are either intended to take a participant to retirement (the participant is expected to take a distribution when he or she retires) or through retirement (the participant is expected to keep his or her money in the plan and draw it down gradually through retirement). There are proprietary funds (those which are essentially a fund of funds run by the asset management institution that manages the TDF) and there are open-architecture (often custom) TDFs composed of those funds that the asset manager thinks are most appropriate for the fund regardless of the manager of the constituent funds. There are TDFs that are composed largely of actively managed funds (these usually have higher underlying expenses) and TDFs that are composed primarily of passively managed funds (usually having lower underlying expenses).

The DOL paper suggests factors that a plan sponsor should consider in its fiduciary decision to choose a family of target date funds, often as the QDIA. Specifically, the paper points out investment strategies, glide paths (this is the move from a more aggressive equity-heavy strategy far from retirement to a more conservative strategy closer to retirement), and investment-related fees.

Plan sponsors should consider this DOL guidance carefully. While there is nothing in the paper that suggests that a plan sponsor must follow the DOL’s suggested steps, one would certainly think that plan sponsors that do so may relatively well shield themselves from costly losses in litigation. No strategy is foolproof, but if I were on a jury or if I were a judge and I heard that a plan sponsor did exactly what the Department of Labor suggested, such evidence would often compel me.

The paper spells out these eight steps:

• ·         Establish a process to compare and select TDFs
• ·         Establish a process for periodic review
• ·         Understand the fund’s investments and how they will change over time
• ·         Review the fund’s fees and investment expenses
• ·         Ask about the availability and appropriateness of non-proprietary TDFs
• ·         Communicate with your employees
• ·         Use all available sources of information in evaluating and selecting your TDFs
• ·         Document the process

I am going to add two more items to this list. First, a number of defined contribution recordkeepers are affiliated with or owned by asset management firms. Some of them will only take on a new client if their own proprietary TDFs are used as the plan’s QDIA. It may be acceptable to begin by using these proprietary TDFs as the plan’s QDIA, but when you use recordkeepers of this sort, you will certainly have a contract for services for several years. The contract will offer you financial disincentives to change TDFs to those provided by another vendor. It aligns well with the DOL’s advice to not engage in such a contract. Doing so could put you in a poorly-performing family of funds that you cannot switch out of without incurring significant fees (usually passed on to the participants) or in a very expensive family of funds that are subsidizing hidden fees or both.

Second, the DOL’s final piece of advice (of the eight) is to document the process. Documentation of processes is an excellent idea. It’s especially an excellent idea if you follow your own processes. However, a number of companies (see for example, Tussey v ABB) have lost or settled litigation when they did not follow their own documented processes. Not having a documented process is bad, but documenting what you should and will be doing and then doing something else is probably much worse.

Several points that the DOL makes are particularly noteworthy. Consider, for example, a proprietary family of TDFs composed of high-expense actively-managed proprietary funds. While not all TDFs are set up this way, the following is a possible scenario:

• ·         Family of TDFs is composed of high-expense, actively-managed proprietary funds
• ·         The TDFs come with an underlying investment expense
• ·         Each of the underlying funds in the TDF provide a return net of expenses

In this case, the TDF is essentially double-charging the plan participants. Each of the underlying funds has a significant investment expense and, at the same time, the overall fund comes with an additional investment expense. The DOL paper points out how an account balance of $25,000 compounded at 7% per year for 35 years will accumulate to approximately 40% more than the same account balance compounded for 35 years at 6% per year. Put into more practical terms, for a younger employee, the 40% implicit cost of much higher investment fees may be insurmountable.

Finally, the paper points out the importance of defined benefit (DB) plans in selection of TDFs. While it is true that far fewer employees are covered by DB plans than were 25 years ago, a significant number still are. While the paper doesn’t use these words, it makes clear that plan sponsors that also provide broad-based DB plans might consider those defined benefit amounts as a fixed income investment for participants. In such cases, using a more aggressive TDF is likely appropriate.

The DOL paper is not formal guidance. It’s not part of a regulation on fiduciaries. Following the DOL’s advice in this case is not, per se, required. But, a word to the wise: other such pieces of informal guidance have been considered safe harbors by courts. Plan sponsors and their consultants might wish to consider this publication that way as well.

Multiple Employer Plans are for Related Multiple Employers

Last Friday, the Department of Labor (DOL) released Advisory Opinion 2012-04A. I found it interesting because it related to some conversations that I had several months ago. It seems that for the last number of months, one of the very hot topics among retirement plan advisers for smaller plans has been multiple employer plans.

Someone had found a gimmick. You see, a multiple employer retirement plan is a single plan for employees of multiple employers. As a single plan, it needs one Form 5500, one plan audit, one plan document, etc. Each of those elements costs money. Split among lots of employers, that's a lot of savings.

Several of those advisers asked me about this approach. I didn't have statute or regulations in front of me, but remarked that I didn't think it passed the smell test and that government agencies would find a way to kill this idea. The downside of being a part of it if it was found to be non-compliant far exceeded the upside of the cost savings.

Guess what? The DOL Advisory Opinion found more than just failure to pass the smell test. ERISA tells us that a plan must be maintained by an employer or employee organization or both. Employer further includes a group or association of employers acting for an employer.

To break this down into lay terms, organizations in one multiple employer plan need to bear some relation to each other. The DOL found that in the instant plan, many employers bore no relationship to each other.

Bottom line, while the Advisory Opinion only carries limited weight and does not specifically affect qualification under Sections 401 and 501 of the Internal Revenue Code, be assured that Labor and Treasury read each other's pronouncements related to retirement plans.

The downside may have exceeded the upside.

New DOL Target Date Fund Rules

In today's Federal Register, the DOL published new rules for target date funds in qualified defined contribution plans. Briefly, target date funds (TDFs) are pre-mixed funds of funds usually put together by mutual fund providers. They allow a participant to select an estimated or targeted retirement date (usually in 5-year increments) and put their money in a fund that uses a glide path (investment allocation policy) that becomes more conservative as a participant approaches their targeted retirement date. TDFs became exceedingly popular as the Qualified Default Investment Alternative (QDIA) of choice after passage of the Pension Protection Act of 2006.

You can find the DOL guidance here: http://www.ofr.gov/OFRUpload/OFRData/2010-29509_PI.pdf

Key guidance in the rule includes the following:

• Fiduciaries are relieved from certain fiduciary responsibilities in defined contribution plans if they follow the rules.
• Plan administrators must furnish participants and beneficiaries with certain information related to each available investment under the plan.
• That information must include:
• A narrative explanation of the glide path and a description of the point at which the TDF will reach its most conservative investment allocation. This is key in understanding whether the purpose of the particular TDF is to get participants to retirement or through retirement.
• A graphical illustration of the TDF's glide path.
• An explanation of the relevance of the TDF date; e.g., for a 2030 fund, what does the "2030" mean?

Again, this is probably a step in the right direction for TDFs in reaction to the precipitous fall in the value of TDFs in late 2008 and early 2009. But, the reasoning is wrong. Of course, TDFs can lose money. All investments can. The point is that retirement plan participants need to understand the decisions that they must make. This is good information, but if they don't understand that this is an investment that is designed to increase in value, but that could decrease in value, then we have gotten nowhere. 

Americans need to be more financially educated. Savvy is a good goal, but educated is a necessity. It's nice that we learn about the explorers in school (Columbus, Magellan, etc.), but wouldn't it be nice if we educated our students in financial topics as well? It's never too early to start, but for many workers, it's far too late. For them, perhaps the best they can do is to follow the sage (or not so sage if you prefer) advice of Ron Popeil (he of infomercial fame): "Set it and forget it." Unfortunately, there is his follow-up line: "Wait, there's more."

DOL Proposes Sponsor to Participant Disclosure Regulations

Here's an article http://tinyurl.com/2eubs8w that I wrote on the new regulations that the DOL wrote on ERISA Section 404(a). As I said in the article:

Probably the key takeaway is that sponsors (and their service providers) will have a lot of work to do to bring their plan disclosures into compliance with this new rule. Establishment of websites for non-public funds, developing and formatting participant communications, making sure that necessary information is captured, and the redesign of systems to accomplish all of this, will for many sponsors and service providers involve significant expenditure of management time and expense. The larger issue to consider may be how much of the cost associated with these changes will be passed along to plan sponsors and/or participants by those service providers.

No good checklists currently exist to assist sponsors in ensuring that each requirement is covered. Additionally, in some cases, service providers may not be willing or able to assist plan sponsors in complying with requirements. Perhaps this will be an appropriate time for sponsors to use outside experts who can do this effectively rather than having someone struggle to learn the rules once and rarely, if ever,apply them again.

The compliance burden aside, the information actually provided to participants may or may not be helpful. The DOL has done a lot of work – including focus group testing – to come up with a disclosure scheme that will improve participant choices. Whether, in practice, the new rules have their intended effect only time and experience will tell.