Fitting a Square Retirement Peg Into a Round Hole

I just don't get it. We knew what they were and honestly, they may have been well defined before then, but in 1974, Congress saw fit to codify defined benefit plans (DB) and defined contribution plans (DC) in ERISA. At the time, there was no Section 401(k) in the Internal Revenue Code.

It was also pretty clear back then. Pension plans were required to offer annuity options. Plans that were not pension plans (mostly profit sharing plans) were not required to offer annuity options. And ERISA said it was good.

In a profit sharing plan, a participant's accrued benefit was his or her account balance, generally. In a pension plan, generally, a participant's accrued benefit was the amount of his or her annuity. And ERISA said it was good.

But, time went by and despite ERISA saying things were good, Congress decided to tinker. And, as a group, Congress has few tools in its bag of tricks that exceed its ability to tinker. It usually works like this. Representative A introduces a bill and she has just enough votes locked up that she can almost get it through the House. And, Representative B comes to her with an idea and says that if you'll just add this one [stupid] provision, I'll vote with you and I can drag C, D, E, F, G, and H along.

That's how the sausage is made in the tinkering factory.

So, once upon a time, we had this round retirement hole (the structure that ERISA gave us) and it was good. It worked pretty well. The evidence of that is that people who spent a good part of their careers under the structure developed in ERISA have generally retired and if they planned at all well, their retirements are not at all bad compared to their working lifetimes.

But, as Congress saw fit to tinker with the rules, it found ways, among others, through bills known as Pension Protection Act[s] to convince employers to get rid of pensions. That's right, Pension Protection Acts killed pensions.

Irony.

So, through Pension Protection Acts, workers were suddenly left with nothing but account balances and through improved awareness of health risks and better medical care, they were also left with longer life spans. Those account balances that were perfectly sufficient to get them to the age 75 or so that was their life expectancy at birth had no chance of getting them to their new life expectancy that was closer to 85.

Now what?

The hue and cry was for annuities. And, thus Congress began to tinker again. How could they possibly fit this square account balance peg into the round annuity hole. So, Congress explored ideas for annuities in DC plans.

But, you see that if you offer actuarially equivalent annuities from a DC plan, then you have gains and losses and that would essentially be a DB plan. If you offer insurance company provided annuities (and recall that insurance companies are in business to make money), then you have too small of an annuity.

Oh the ignominy of the square peg.

We had a perfectly good system. It came with perfectly good benefits and for most plans, perfectly good actuarial assumptions and methods.

And Congress broke it. And after all these years, despite taking file and rasp and hammer to the square peg, the round hole remains empty.

Congress, there are smart people who do not sit in your chambers. Give us your objectives and let us find you a solution. We'll make that peg round and Americans will be able to look forward to their golden years again.

ERISA will once again say it is good.

How Big Does Your ROI Have to Be? You Can Get It Here

Let's make believe it's 2018. Let's further make believe that the Tax Cuts and Jobs Act (TCJA) or whatever it's long-winded name turned out to be was signed into law late last year. And, let's finally make believe that you hold a corporate position where you get to weigh in on corporate investments and deployment of capital.

Just how big of a return on investment do you need to be able to project in order to pull the trigger?

8%? 10%? 12%? 15%?

For most of you, I'm guessing that I've finally surpassed or at least hit your target. You'll definitely want to read on. For those that need a bigger number, give me a chance. But, I didn't want to scare away those people who think that really big numbers are only found in Fantasyland.

For those of you that really want to get into the technical details, I'm going to refer you to an excellent piece written by my Partner, Brian Donohue. Some of you may not want to get into that level of gory detail and you just want the big picture and a summary to convince you, you've come to the right place.

First off, you need to sponsor a defined benefit (DB) pension plan. It's fine if it's of the cash balance or some other hybrid variety. So, let's suppose that you do because if you don't and you have no plans to, unless you just really love my writing or just have a strange desire to find out what you are missing out on, you can probably stop reading now.

I don't want to put this in terms of dollars because if I talk about billions and you are a $100 million company, you may not think this is for you. And, conversely, if I talk about millions and you think millions go away in rounding, you won't think it's for you. So, let's talk about units.

Suppose your DB plan is fully funded on a Schedule SB basis. In other words, your funding target and your actuarial value of assets both equal 1000. Then your minimum required contribution, generally speaking, is equal to your target normal cost, probably not a big number compared to what we are talking about here.

Despite not having to, contribute 200 units. Go ahead. Do it. Trust me. I wouldn't sell you snake oil.

Here are your benefits from having done so before September 15, 2018 (assuming calendar year plan year and tax year):

• The 200 units are tax-deductible under Code Section 404 for 2017 when your corporate marginal tax rate was likely 35% (yes, there are unusual circumstances where they may not be or where the deductions may not be of value to you, but for most sponsors, this is the case) as compared to 21% beginning in 2018. Savings of 14% of 200=28 units.
• Your PBGC variable rate premiums may come down by as much as 8 units, But that could be as much as 8 units per year for multiple years (let's call it 5 years for sake of argument). Savings of 8 units times 5 years=40 units.

That's 68 units of savings on a 200 unit deployment of cash. That's 34%.

Now, I'm not going to claim that your ROI here is actually 34%. Yes, you will contribute these amounts more than likely in future years and when you do, you will take a tax deduction. But, you'll take it in the future (you remember time value of money) and you'll only get a 21% deduction when you do. And, yes, you may not get those full PBGC savings and some of them will be in the future, but your savings are likely to be significant.

And, then there is the other really key benefit -- your plan will now have a surplus on a funding basis meaning that you almost certainly don't have to contribute and deal with volatility of minimum required contributions in the near future.

I'd be doing you a disservice, of course, if I didn't give fair consideration to the downsides and perceived downsides of this strategy. So, I'm going to shoot straight with you.

Yes, you will have 200 units of cash tied up with no immediate means of accessing it. However, it's getting you a pretty good and rapid ROI, so in most cases, I think you'll get over that one.

Pension surplus is considered to be a bad thing. In fact, prevailing wisdom is that pension surplus is worth only pennies on the dollar. Well, sometimes prevailing wisdom shouldn't prevail.

If your DB plan is ongoing, this is just advance funding, plain and simple. It's money that you would have to contribute and the future when you could take your deductions at a 21% marginal tax rate.

If your DB plan is frozen, the argument is a little trickier. But, for most sponsors, if you do have a frozen plan, the cost to terminate is likely going to exceed your funding target. In fact, it's likely to exceed your funding target by a fair amount. So, those 200 units will be put to use.

But, let's take the extreme scenario where your investments do well, interest rates rise, and those 200 units really start to look like trapped surplus. 

Do you sponsor a defined contribution (DC) plan? It may not fit your current DC strategy, but generally speaking, your DB surplus upon termination can be used to fund a "qualified replacement plan" (think profit sharing or non-elective contributions) for up to seven years. So, in that case, you would be getting an advance deduction for future DC contributions.

Convinced this is worth looking into?

Yes, I've simplified things and there are potential tax and legal issues here, so I leave you with this:

Nothing in here should be construed as tax or legal advice which can only be obtained from a qualified tax or legal professional. If you need tax or legal advice, you should consult such a professional. And as with any strategy of this sort, your mileage may vary.

Instead of Making Defined Contribution Look More Like Defined Benefit, ...

I don't think I've ever ended the title of a blog post with an ellipsis before. But, surely, there's a first time for everything.

Lately, the benefits press has written an awful lot about what must be the latest trend in employer-provided retirement benefits -- making the defined contribution (DC) plan look more like the defined benefit (DB) plan. Perhaps I am missing something, but it appears that this "major" initiative has two components to it (that's right, just two):

• Communication of an estimate of the amount of annuity a participant's account balance can buy
• The option to take a distribution from the plan as either a series of installments or as an annuity

Let's consider what's going on here.

Annuity Estimate

Yes, there is a huge push from the government and from some employers to communicate the annual benefit that can be "bought" with the participant's account balance. Most commonly, this is framed as a single life annuity beginning at age 65 using a dreamworld set of actuarial assumptions. For example, it might assume a discount rate in the range of 5 to 7 percent because that's the rate of return that the recordkeeper or other decision maker thinks or wants the participant to think the participant can get.

I have a challenge for those people. Go to the open annuity market. Find me some annuities from safe providers that have an underlying discount rate of 5 to 7 percent. You did say that you wanted a challenge, didn't you?

I'm taking a wild (perhaps not so wild) guess that in late 2016, you couldn't find those annuities. In fact, an insurer in business to make money (that is why they're in business, isn't it) would be crazy today to offer annuities with an implicit discount rate in that range.

But, annuity estimates often continue to use discount rates like that.

Distribution Options

Many DC plans offer distribution in a series of installments. Participants rarely take them, however, For most participants, the default behaviors are either 1) taking a lump sum distribution and rolling it over, or 2) taking a lump sum distribution and buying a proverbial (or not so proverbial) bass boat.

Why is this? I think it's a behavioral question. But, when retiring participants look at the amount that they can draw down from their account balances, it's just not as much as they had hoped. In fact, there is a tendency to suddenly wonder how they can possibly live on such a small amount. So, they might take a lump sum and spend it as needed and then hope something good will happen eventually.

Similarly, if they have the option of getting an annuity from the plan, they are typically amazed at how small that annuity payout is. And, even with the uptick in the number of DC plans offering annuity options, the take rate remains inconsequentially small.

A Better Way?

Isn't there a better way? 

Part of the switch from DB plans to DC plans was predicated on the concept of employees get it. They understand an account balance, but they can't get their arms around a deferred annuity. So, let's give them an account balance.

Part of the switch from DB to DC plans was to be able to capture the potential investment returns. Of course, with that upside potential comes downside risk. Let's give them most of that upside potential and let's take away the worst of that downside risk. That sounds great, doesn't it.

Once these participants got into their DC plans, they wanted investment options. I recall back in the late 80s and early 90s that a plan with as many as 8 investment options was viewed as having too many. Now, many plans have 25 or more such options. For what? The average participant isn't a knowledgeable investor. And, even the miraculous invention commonly known as robo-advice isn't going to make them one. Suppose we give them that upside potential with professionally managed assets that they don't have to choose.

Oh, that's available in many DC plans. They call them managed accounts. According to a Forbes article, management fees of 15 to 70 basis points on top of the fund fees are common. That can be a lot of expense. Suppose your account was part of a managed account with hundreds of millions or billions of dollars in it, therefore making it eligible for deeply discounted pricing.

There is a Better Way

You can give your participants all of this. It seems hard to believe, but it's been a little more than 10 years since Congress passed and President George W Bush signed the Pension Protection Act (PPA) of 2006. PPA was lauded for various changes made to 401(k) structures. These changes were going to make retirement plans great again. But, for most, they didn't.

Also buried in that bill was a not new, but previously legally uncertain concept now known as a market-return cash balance plan (MRCB). 

Remember all those concepts that I asked for in the last section, the MRCB has them all. Remember the annuity option that participants wanted, but didn't like because insurance company profits made the benefits too low. Well, the MRCB doesn't need to turn a profit. And, for the participants who prefer a lump sum, it would be an exceptionally rare (I am not aware of any) MRCB that doesn't have a lump sum option.

Plan Sponsor Financial Implications

Plan sponsors wanted out of the DB business largely because their costs were unpredictable. But, in an MRCB, properly designed, costs should be easy to budget for and within very tight margins. In fact, I might expect an MRCB to stay closer to budget than a 401(k) with a match (remember that the amount of the match is dependent upon participant behavior). And, in a DB world, if a company happens to be cash rich and in need of a tax deduction, there will almost always be the opportunity to advance fund, thereby accelerating those deductions.

Win-Win

It is a win-win. Why make your DC plan look like a DB when there is already a plan that gives you the best of both worlds.

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.

Will Fee Litigation Kill the 401(k)?

401(k) litigation is going mad. In two of the most publicized cases, Tibble v Edison and Hecker v Deere, there may have been something legitimate for plaintiffs to complain about. In the latest case, however, this one fashioned as Bell v Anthem, the litigation makes this blogger wonder why a company would offer a 401(k) plan at all.

Essentially, all of this litigation stems from ERISA Section 404(c) which among other things establishes that a retirement committee and its members individually are to act in a fiduciary manner in the best interests of plan participants with respect to the plan. For years, issues under 404(c) were not litigated, and in fact, most of us weren't entirely sure how to apply 404(c).

As plans have gotten bigger and the number of investment options has grown significantly, some attorneys have found this to be particularly fertile ground for litigation. In some cases, the issues have been judged by the courts to be clear.

As an example, suppose that XYZ Investment Company offers a large cap equity fund. Not only does XYZ offer that fund, but it has two share classes -- a retail class to which it charges accounts a fee of 80 basis points and a wholesale or institutional class to which it charges a fee of 40 basis points. This is a large difference and to the extent that a plan sponsor and committee have the leverage to have the institutional class as compared to the retail class in its fund lineup, they should.

You can do the math if you choose. Using something as simple as the Rule of 72 (you can google it if you are not familiar to estimate the results), Ms. W's account balance will double approximately every 15.6 years while Mr. R's will double about every 17.1 years. Or said, differently, at the end of 35 years, Ms. W will have roughly 3 years of excess returns over Mr. R, at least on her initial deferral. Her more recent deferrals will have smaller amounts of excess returns.

Is this material? I don't know; you tell me. Is it significant enough that the plan committee should be held liable if they opted for retail class instead of institutional? That's up to the courts.

Now, we return to Bell v Anthem. The plan in question is large. Its assets total roughly $5 billion. A plan of that size certainly has the leverage to get the least expensive share classes available for its participants, regardless of whose funds they are placing in the plan. Even the big players drool over the prospects of picking up a large mandate in a plan that big.

In the particular case, all but two of the funds offered were Vanguard funds. Vanguard has a reputation, supported by data, in the industry as having one of the lowest fee structures of anyone out there.

Of the funds that were not Vanguard, one was the Touchstone Sands Capital Select Growth Fund (Institutional Class) with a 1.31% expense ratio according to Touchstone's website. The other was the Artisan Midcap Value Fund (Institutional Class) with an expense ratio in the vicinity of 1.15% according to Artisan's website.

None of the Vanguard funds had expense ratios exceeding 0.5%. The Vanguard Target Date Funds had expense ratios of less than 0.2%. Index funds in the plan had expense ratios ranging from 24 basis points down to 4 basis points. Very few knowledgeable observers would consider those expenses to be high, and in fact, most plan advisers that I know would consider them low.

Plaintiffs, however, allege that the 4 basis point fee is too high, as there was an asset class available for the same fund that only charged 2 basis points. I saw that and wondered how material that is.

Going back again to the rule of 72, I compared the two different expense ratios. With an expense ratio of 2 basis points, an initial investment would double with a 5% gross investment return about every 14.46 years. With the 4 basis point expense ratio, it would double about every 14.52 years. That's a difference of less than one month.

Could Anthem have had the less expensive fund? Probably. Are there any complications associated with it? I haven't looked into that? Was the committee and its members guilty of some sort of fiduciary malfeasance by offering the higher cost (4 basis point) fund to its participants? The courts will have to decide that.

The issues in the suit continue. It contends that because of the size of the plan that even the Institutional Class Fund is not good enough. Instead, the suit contends, Anthem could have negotiated separate Anthem accounts at an even lower cost.

Is this practical? I don't know. Does ERISA hold fiduciaries to that standard? I don't know. If it does, would I want to be on a defined contribution plan's investment committee? Absolutely not.

My reading of ERISA suggests to me that a fiduciary is to take reasonable care in acting in the best interests of plan participants. It strikes me that reasonable care includes making good decisions. It does not strike me that reasonable care requires each committee and committee member to spend enough time to make the best decision possible.

Perhaps I am wrong though. It wouldn't be the first time.

But, let's return to the separate accounts. How long would it have taken Anthem to negotiate those separate accounts? How good a deal would they get? Since that negotiation would be on behalf of plan participants, could they charge their time back to those participants? I don't know.

Either way, if this sort of suit becomes the norm, it's time to get rid of employer-sponsored individual account plans. Businesses are in business to provide products and services. When their 401(k) plans change the way they do business, it's time to stop.

Where Did We Go Awry With the 401(k)?

Section 401(k) was added to the Internal Revenue Code by the Revenue Act of 1978. It was such a significant part of that act that when I went to www.congress.gov to read the act summary, there was no mention of this new deferral opportunity. It was tossed into the legislation with little fanfare.

Why was that?

401(k) plans were never intended to be the primary retirement vehicle for the masses. In 1978, after the passage of the relatively new landmark law known as ERISA, defined benefit plans (DB) were all the rage and those companies that had chosen not to take the DB route frequently offered profit sharing plans, money purchase plans, or ESOPs, or because of the special tax treatment that they were given at the time, tax credit ESOPs, known back then as TRASOPs (bonus points for anyone who recalled TRASOPs before reading this).

Those were core retirement plans. Combined with Social Security, they were designed to be two legs of the so-called three-legged stool needed for retirement. The third leg was personal savings and the 401(k) plan was supposed to give people a more tax-efficient way to grow that third leg. Read that again; 401(k) plans were designed as savings plans, not as [core] retirement plans.

Somewhere, things went awry. I have written about this many times and blamed virtually everyone who had a voice. As our government and regulators made it more and more cumbersome to sponsor traditional retirement plans and the US economy took several turns for the worse, companies became less comfortable as sponsors of traditional retirement plans. They often placed the blame anywhere that they could. In fact, they placed it everywhere except where it belonged:

• Employees didn't appreciate the other plans (it turned out that the people who didn't have them sure thought their friends who had them had a good deal)
• They could be more competitive without them (don't you get higher productivity and better products and services from happy employees)
• The 401(k) would be enough (of course many of those same companies retained their executive retirement plans)

Now, in a workforce fraught with high turnover, low morale, and lots of part-time jobs, many of us expect employees to save for their own retirement. Projections done by proponents of those plans show that those who do will have a wonderful retirement. Those projections tend to leave out all of these complications:

• You can't defer when you are laid off and most of us seem to face one or more layoffs in our careers these days
• You will have periods in your career when you go through one hardship or another and can't afford to make the deferral you would like
• If you do have a hardship and have to pull money out, those penalties are severe
• You absolutely will not get the 7%-9% annual return on investment, net of expenses, that many of those projections would "promise"

But, companies persist in the belief that the 401(k) is the retirement plan of choice. Potential employees ask about the company's "401 plan." In the meantime, some people retire very early and many will be retiring well after the traditional retirement zone of ages 62 through 65 has passed them by. 

Isn't it time to bring back retirement plans and have more than just savings plans? Any of them can be designed today with the proper administration to show employees their account balance as of that day any day that they choose to look.

You can be an employer of choice.

A Less Expensive Way to Provide Better Retirement Benefits -- DB

I've been pushing defined benefit (DB) plans hard lately. I still believe in them. The problem as I have noted is that regulators don't. They have done everything they can to kill them. Many are gone, many remain.

Yesterday, I happened upon a brief from Boston College's Center for Retirement Research. If you want, you can get the full brief here. In the brief, based on 23 years of data, Alicia Munnell, Jean-Pierre Aubry, and Caroline Crawford -- all from the CCRC -- demonstrate that returns on assets in DB plans actually are better than those in defined contribution (DC) plans.

When you combine this with the inability of many to defer enough to their 401(k) plans to get the full company match, you can see why many will never be able to retire well with a 401(k) as their core retirement plan.

For years, though, the cry has been that people understand 401(k) plans, but don't understand DB. But, suppose I gave you a DB plan that looked like a DC plan, provided returns for participants like a particularly well-invested DC plan, provided better downside investment return protection than a DC plan, and cost the employer less than a DC plan. What would you think?

In the Pension Protection Act of 2006 (yes, that was more than 9 years ago), Congress sanctioned what are now known as market return cash balance plans. What they are are DB plans that look like DC plans to participants, provide more and better opportunities for participants to elect annuity forms of distribution if they like, and provide the opportunity for plan sponsors to control costs and create almost a perfect investment hedge if they choose.

Suppose you had such a plan. Suppose to participants looking at their retirement website, the plan just looked like another account any day they chose to look. Suppose the costs were stable. Suppose the plan provided you as a sponsor more flexibility.

That would be nirvana in Xanadu, or something like that, wouldn't it?

Another Argument for Defined Benefit

I know, defined benefit (DB) plans are dead. Actually, while there aren't as many as there used to be, I'm going to give you one more argument why they make more sense as a retirement vehicle.

Yesterday, I wrote about managing the risk in active pension liabilities. Way back in 2010, I wrote about generally managing risks and noted that plan sponsors tend not to manage defined contribution plan risks. Most of those risks that I have considered have been financial risk. Today, I am going to focus on the intersection of financial risk and compliance risk and make a case to have a DB plan as your primary retirement vehicle rather than a 401(k) plan.

In the world of 2015, we see consolidation in many industries. We also see companies, often private, being gobbled up by private equity firms. Either of these actions will usually create a larger controlled group. And, people who focus on retirement plan compliance know that most retirement plan compliance testing must be done on a controlled group basis.

Before working to point out a solution, let me give you an example to help focus on the problem.

BPE is a big private equity firm. Their general approach to retirement plans (and other benefits) has been to ignore them and let each company do what it wants. But, as BPE get bigger, its controlled group gets more complex. Having multiple industries represented in its portfolio, BPE is ultimately the sponsor of all kinds of 401(k) plans. Their engineering company (EC) has an extremely generous 401(k) plan that matches 150% on the first 8% of pay that an employee defers. Their pork rinds company (PRC) has a 401(k) plan that matches 10 cents on the dollar on the first 2% of pay that an employee defers.

BPE never saw this as a problem. But, then one day, an inquisitive Principal (IP) at BPE was reading my blog (of all things) and came across this. He saw that BPE might have a compliance problem in its controlled group because of the disparate nature of its 401(k) plans.

Ring ring ring -- that's my phone as IP calls me. He wants to know how to fix the problem. He says that surely this problem can't be real. After an hour on the phone, we have inventoried all the plans at BPE and found that they have failed to satisfy various compliance tests (coverage under Code Section 410(b), for example) for several years.

IP has a solution though. He tells me that BPE will force some of its companies to retroactively cut the employer match in some of these more generous plans.

Bzzz!

You can't do that. In fact, if BPE were to choose to fall on its sword and approach the IRS for a negotiated retroactive solution, we would suspect that the IRS would only be receptive to increasing benefits for nonhighly compensated employees (NHCEs) in the less generous plans.

IP is not happy about this. PRC runs on very low margins, but because they make more pork rinds than any company in the world, they do throw off a lot of cash. However, increasing benefits would eliminate most of that free cash that is being generated. There is stunned silence on the other end of my phone.

While the story is fictitious, the gist of the scenario is not. I've seen this happen. By being a serial acquirer, companies run into compliance problems and with 401(k) plans not being the easiest to prove nondiscriminatory, either costs escalate or they get cut at the portfolio companies that tend to employ more higher paid individuals.

What sort of plan tests better? A few weeks ago, I wrote about some. Suppose BPE had a defined contribution looking cash balance plan. One of the nice things about these plans is that they test well. Designed properly, and proper design truly is a key, financial risk is manageable. And, with that as their primary plan, the secondary 401(k)s can be managed so that compliance there will no longer be an issue.

Unfortunately, the benefits world has been resistant to this whole concept. But, you have an open mind, don't you?

We need to talk.

Get Your 401(k) Design Right

I happened to read a few things today about 401(k) matching contributions. One in particular talked about stretching the match. Apparently that means that if you are willing to spend 3% of pay on your workforce, consider making your match 50 cents on the dollar on the first 6% of pay deferred instead of dollar for dollar on the first 3% of pay deferred. This will encourage employees to save more.

That might be a really good idea ... for some companies. For other companies, it might not be.

First and foremost a 401(k) plan is, and should be, an employee benefit plan. Taken quite literally, that means that it should be for the benefit of employees.

Plan sponsors may look at the plan and say that they get a tax deduction. That's true, but they also get a tax deduction for reasonable compensation. And, there is probably less of a compliance burden with paying cash than there is with maintaining a 401(k) plan.

Where does the typical 401(k) design come from? Usually, it's the brainchild, or lack thereof, of someone internal to the plan sponsor or of an external adviser. Either way, that could be a good thing or a bad thing. Most plan sponsors have plenty of smart and thoughtful employees and many external advisers are really good.

On the other hand, when it comes to designing a 401(k) plan, some people just don't ask the right questions. And, just as important, they don't answer the right questions. We often see this in marketing pieces or other similar propaganda that talk about designing the best plan. We might see that the best plan has all of these features:

• Safe harbor design (to avoid ADP and ACP testing)
• Auto-enrollment (to get higher participation rates)
• Auto-escalation (so that people will save more)
• Target date fund as a QDIA (because virtually every recordkeeper wants you in their target date funds)

All of these could be great features for your 401(k) plan, but on the other hand, they might not be. Let's consider why.

Safe harbor designs are really nice. They eliminate the need for ADP and ACP nondiscrimination testing. They also provide for immediate vesting of matching contributions. Suppose your goal, as plan sponsor, is to use your 401(k) plan at least in part as a retention device. Suppose further that every year, you pass your ADP and ACP tests with ease. Then, one would wonder why you are adopting a plan with immediate vesting whose sole benefit is the elimination of ADP and ACP testing. Perhaps someone told you that safe harbor plans were the best and you listened. Perhaps nobody bothered to find out why you were sponsoring a 401(k) plan and what you expected to gain from having that plan.

Auto-enrollment is another feature that is considered a best practice. (Oh I despise that term and would prefer to call it something other than best, but best practice is a consulting buzzword.) Most surveys that I have read indicate that where auto-enrollment is in place, the most common auto-enrollment level is 3% of pay. Your adviser who just knows that he has to tell you about auto-enrollment tells you that it is a best practice. Perhaps he didn't consider that prior to auto-enrollment, you had 93% participation and that 87% of those 93% already deferred more than 3% of pay. Since he heard it was the thing to do, he advised you to re-enroll everyone and now, you are up to 95% participation, but only 45% of them defer more than 3% of pay. Perhaps nobody bothered to ask you how your current plan was doing.

In the words of a generation younger than me, this is an epic fail.

I could go on and on about other highly recommended features, but the moral of the story is largely the same. Your plan design should fit with your company, your employees, your recruiting and retention needs, and your budget. That your largest competitor has a safe harbor plan doesn't make it right for you. It may not even be right for them. That the company whose headquarters are across the hall from yours has auto-escalation doesn't make it right for you. It may not be right for them either.

If you are designing or redesigning a plan for your company, ask some basic questions before you go there.

• What do you want to accomplish with the plan?
• Enough wealth accumulation so that your employees can retire based solely on that plan?
• Enough so that the plan is competitive?
• Something else?
• Will eliminating nondiscrimination testing be important?
• What is your budget? Will it change from year to year? As a dollar amount? As a percentage of payroll?
• What do you want your employees to think of the plan?
• It's a primary retirement vehicle.
• My employer has a 401(k) plan; that's all I need to know.
• My employer has a great 401(k) plan.
• My 401(k) is a great place to save, but I need additional savings as well.
• Will any complexity that I add to the plan help my company to meet its goals or my employees to meet their goals? If not, why did I add that complexity?

These are the types of questions that your adviser asked you when you designed or last redesigned your plan, aren't they?

They're not?

Perhaps it's time to rethink your plan.

On Successful RFPs and Circuit Breakers

This morning, I read an article that appears in the June issue of Plan Sponsor magazine. What attracted me to it was a blurb in the email blast "NewsDash" that magically appears in my inbox every weekday morning (actually, I highly recommend NewsDash for benefits professionals).

What I found strange about the article is that it is largely a compendium of quotes from a few defined contribution recordkeeper search consultants. But, it never quite brings them together to inform the plan sponsor on what makes for a successful RFP. Instead, it is somewhat akin to listening to a roundtable discussion, but only hearing about 1 comment in 20 and that without any context.

Since this article left me somewhat cold (and that on a day when our heat index is supposed to exceed 105), I decided to think about this myself. I've been involved in RFPs (not necessarily defined contribution or even benefits) in what I view are all of the possible contexts:

• A bidder
• A search consultant
• A proposal evaluator
• An end user (the client)

Ultimately, in my opinion, the client is looking for the best value, however they define value. Some place a very high value on the relationship with the provider. Some consider it most important for participants to have a great user experience. Others focus on employee education. Still others think that price is the winner.

Each of those may be a reasonable position to take. But, it is also important to understand that there are more than just the issues of value. 

A typical proposal scoring process assigns a weighting or point value to a number of categories. Finally, the bidder with the highest weighted score is usually the winner. 

I'd like to make some changes to this. In doing so, I am going to steal some terminology from other areas.

We all know that having a relationship manager who doesn't care about you makes the relationship untenable. It's a turn-off and it should kill the deal with that particular provider. Similarly, if you are going to be the point person (on the client side) for the relationship and you just really dislike the relationship manager, that relationship won't work either.

I refer to this and other similar deal killers as circuit breakers. That is, if the breaker is turned off, the circuit doesn't connect and the deal cannot happen.

The client should establish circuit breakers. You might also think of them as minimum standards. Here are a few to consider (with a DC recordkeeping bias):

• Unacceptable relationship manager (if you really like the potential vendor other than that, you might be able to force a relationship manager of your choosing)
• Fees above a certain pre-set level
• Poor participant experience
• No projection tool on the vendor website
• Requirement to use a particular percentage of proprietary funds

I think this is fairly clear, but suppose it's not. Consider that Vendor A has the best scoring proposal. That is, Vendor A, using the pre-determined scoring mechanism gets a score of 185 out of a possible 200. Neither of the other two potential vendors scores above 160. But, you have heard from a friend at another company that the assigned relationship manager does not usually return phone calls in the same week that they are received. You view this as unacceptable. If Vendor A will not give you a different relationship manager, then they have triggered a circuit breaker and they are out of the running.

Triggering a circuit breaker outweighs a great score. Think about it. It makes sense.

Despite the Best Efforts of the Government ...

Despite the best efforts of the federal government and of governmental agencies, most Americans in the workforce today really have no idea how they are going to retire or if they are going to be able to retire. Disclosures are much more comprehensive than they were in earlier years. Opportunities for tax-favored savings have grown. Plan designs that truly encourage savings have become common.

So, where did things go wrong?

To consider this, let's look at a brief history of retirement plans -- very brief in this case.

In the beginning (Genesis in this case is known as ERISA), most American workers who were fortunate enough to have company-provided retirement plans were in defined benefit plans. In fact, Section 401(k) had not yet been added to the Internal Revenue Code. So, while some industries tended to favor thrift plans (after-tax savings plans that often also provided for an employer match), university systems and certain other tax-exempt organizations tended to have 403(b)s, and professional corporations often had money purchase and profit sharing combinations, lots of workers had DB plans as their backbones.

And, the workforce model fit with DB plans. Likely, the company that you worked for at age 30 would be the one you would retire from. As a retention device, there were lots of goodies that came with staying with that company until at least age (usually) 55. Another wonderful device known as subsidized early retirement, sometimes combined with early retirement windows, allowed companies to manage their workforces without the need for layoffs. In DB plans, there is no such thing as leakage if you stay with the same company.

So, a worker really didn't have to know all that much. What they did know is that when they retired, they would have a combination of their pension and their Social Security and that between them, that felt like enough to live on.

As the Old Testament evolved, so did the landscape change. Gradually, DB plans were replaced by 401(k) plans until we were faced with the New (world) Testament where the bulk of American workers were no longer accruing defined benefits. And, in a 401(k) plan, as we all know, it's really difficult for a participant to figure out exactly what he can buy for the rest of his life with an account balance.

And then there were disclosures.

Now, we get disclosures about the level of fees being charged against our accounts in a plan. I'm in this business. I can't read them. While the wording is not bad, those disclosures are so boring that even if I try, I am unlikely to make it through the first paragraph.

And, there are proposals that will require my employer (through a TPA) to tell me just what my 401(k) may grow to and how much per year that will be worth in my retirement. But, those all use assumptions.

I can understand those assumptions. If you are reading this, it's likely that you can as well. But, how about the poor participant who doesn't know if 6% annual investment return is reasonable? How about the poor participant who doesn't know whether retiring two years later is worth very much in terms of leading to a more comfortable retirement?

Savings plans are a good supplement, but with the current level of communications, to me, they are not the answer. Computer-based models might help, but even then, they would be dependent upon the assumptions underlying the modeling. If plan sponsors choose them, those assumptions might be reasonable in the aggregate, but very rarely for any given individual. If participants choose them, then they need more education than they can ever expect to get on those selections.

From where I sit, there is no easy answer.

Perhaps it's time to return to Genesis. When plans were funded responsibly, costs were controllable and participants who retired under a DB system with some amount of voluntary savings are generally doing pretty well in retirement.

But, will you?

Employer Retirement Plan Priorities -- Cut Risks and Costs Says Survey

This morning, I opened up my daily NewsDash email from Plan Sponsor and found an article telling me that employers that sponsor retirement plans (almost all employers of more than a few people do) are looking to curb risks and cut costs. While it's nice to know that a survey confirms prevailing opinion, this is not exactly a revelation.

As disclosures have become more comprehensive, two elements of retirement plans that have gotten particular scrutiny from outside observers are unnecessary risks and unnecessary costs. Interestingly, if a company chooses to make a generous retirement program part of its overall broad-based rewards program, outside observers generally have no problem with this.

Risk in this case is usually measured in terms of volatility. However, just plain old volatility should not be a concern. What should be a concern is volatility in plan costs as it relates to some useful metric or metrics.

Consider a hypothetical company (HC) with free cash flow of $100 million. Suppose the volatility that they are looking at is in pension contributions and that HC is expecting (baseline deterministic scenario) to have to make a contribution in 2015 of $500,000. In looking at forecasts provided by its actuary, HC notices that the 95th percentile of required pension contributions is $2 million. While that is a big increase in relative terms, it may not be enough to have any meaningful effects on the way HC runs its business (it may, depending on circumstances, but in this hypothetical situation, it does not). Depending upon HC's tolerance for risk, this may be a situation where no action needs to be taken.

On the other hand, Failing Business (FB) has a legacy frozen pension plan with expected 2016 required pension contributions of $50 million. FB has significant debt and if it contributes the full $50 million, it will just barely be able to run its operations and service its debt. If that number hits $52 million, FB will default on its largest loan.

What should FB do?

There are several schools of thought here. One is to mitigate pension contribution risk to the extent possible thereby ensuring that the ominous $52 million pension contribution number will not be reached. But, is that really a good strategy? Or is it just part of a spiral to a lingering death? The other school of thought says that FB is an ideal candidate to take on risk for potential reward. If the risk turns out to produce bad results, FB may go out of business, but it looks like whether that happens or not is only a matter of time. On the other hand, if taking the risk generates a big upside, FB will be in a much better position to revive its business.

FB is purely hypothetical and we don't know all the facts here. But, my point is that just because the trend says to do something doesn't mean its right for your company.

On the defined contribution (DC) side, the analysis is a bit different. Today, most companies (I don't have a percentage for you) offer 401(k) plans with some level of employer matching contributions. In this scenario, many companies have thought about the costs, but few have thought about the financial risks.

What are the costs that companies are thinking about? Here are a few:

• The cost of plan administration (recordkeeper, custodial, legal, accounting)
• The fund management fees
• Institutional class versus retail class
• Passive versus active management
• Open architecture versus proprietary

Generally, these are costs that a plan sponsor can control by careful selection of vendors and evaluation of options. Take a look. It may be that your current providers have let their fees to you creep up while their service to you has gone down.

Then, there's the risk. 

One of the other concerns in the DC industry is that employees are not saving enough money. So, many employers are taking steps to encourage their employees to defer more. However, if they defer more, the cost of matching contributions will increase. In my experience, almost no companies actually consider this risk, but I have seen a few CFOs who have been really upset when those matching contributions got big enough that they affected the company's financials.

There are plan designs that can help to control this. Perhaps you should consider one.

Click this link if you want to ask me how.

Custom Design Your Target Date Funds

Target date funds or TDFs have been around for a while. They've carried a bunch of different names, but at their most basic level, they are intended to allow a defined contribution (DC) participant, usually in a 401(k) plan, to have their assets properly invested based upon the participant's approximate assumed retirement date (for example, a person who is 50 today and plans to retire at age 65 would likely be instructed to invest in a 2030 fund).

TDFs became really popular after the passage of the Pension Protection Act of 2006 (PPA). PPA introduced the concept of the Qualified Default Investment Alternative (QDIA), the fund into which a participant's assets default if the participant does not make an election otherwise. Regulations issued by the Department of Labor (DOL) specifically sanctioned TDFs as QDIAs and they took off.

So, what's the problem? TDFs are professionally managed, the glide path (asset mix that changes and becomes more conservative over time) is developed by people expected to have expertise (specifically refusing to designate them experts), and the asset mix is rebalanced periodically (often quarterly) to ensure that a participant's asset mix stays near to the targets established in the glide path.

That's all good stuff.

I will tell you where it breaks down, but first we digress for a break for some lexicon. In the TDF marketplace, there are generally two types of funds, "to funds" and "through funds" -- to funds assume that a participant will take his money out at retirement while through funds assume that a participant will leave her money in through retirement only gradually drawing it down. Salespeople for the larger recordkeeper/money managers will tell you the benefits of their philosophies of to or through which ultimately have a significant effect on your glide path.

Just as TDFs are to or through, the underlying funds used to help effect the glide path are either actively managed or passively managed (often index funds). Actively managed funds charge more for their investment services. Salespeople will tell you how their managers absolutely obliterate their benchmarks. Most of those managers don't.

Finally, wouldn't you expect a really good TDF to be composed of the best funds in each asset class? They're usually not. Usually, they are composed of proprietary funds of the TDF asset manager. And, it's not unusual that they use proprietary funds that are not even the best of their own for that asset class.

Said differently, TDFs are huge moneymakers for the recordkeepers/money managers. They may not be moneymakers for the participants and, in fact, they are likely not even designed for the participants.

In a better world, participants could build their own TDFs. I wrote about this to some extent way back in 2011. And, now that I have flogged the existing proprietary TDFs into oblivion, it's time to discuss them again.

In 2015, we have tools, lots of tools. We have them on our computers, on our phones, on our tablets and phablets, and some of us even have them in our watches and glasses. The fact is that technology changes virtually daily and almost all of us have access.

Suppose we had a tool into which participants could enter their own data and build their own TDF structure based on that data. The tool would ask about things such as your savings outside of that DC plan, the age at which you actually expect to retire, whether you have any defined benefit (DB) annuities coming your way (they are, in effect, fixed income investments), how long you expect to live based on what you know about your health and your family history, major expenses that are coming up, the large inheritance that you expect, and other similar relevant data. From that and some additional questions, our handy dandy tool (I think I'll call it HAL since that name worked for a computer way back in 1968 (think movies if you are confused)) will develop glide path and portfolio specifically designed for you.

In fact, HAL will even rebalance to keep you on your glide path, and HAL will be smart enough to take risk for you if you are falling short of your targets and diminish risk for you if you are ahead of your goals. But, HAL cannot exist for a proprietary TDF. HAL does not like to fill up his TDFs with proprietary funds of the recordkeeper who sells you its TDFs.

HAL says, "Go custom!"

Let us know, we can help.

Frightening Data on DC Plan Ownership

According to an article in this morning's News Dash from Plan Sponsor, fewer families had an individual account retirement plan (defined contribution or IRA) in 2013 than in 2010. However, on the bright side, average account balances have increased over the same period.

What do we learn from this? It's difficult to know for sure, but as is my wont on my blog, I'm going to take a shot at working it out.

Why are average account balances up? Well, the equity markets have performed pretty well over the last few years. Combine that with the fact that there has been time for additional contributions to those accounts and this makes sense. When we combine this, however, with my rationale for the prevalence of accounts decreasing, it may look troubling.

That the number of families with individual account retirement plans is decreasing suggests underlying issues with the economy. What I suspect is that many long-term unemployed or under-employed have had to liquidate accounts that they had a few years ago in order to survive. People laid off from jobs have taken distributions rather than rollovers to live on. I suspect that more often than not, these have been total distributions from smaller accounts. By eliminating some of the smaller account balances, the average and median accounts have grown in size.

That only about 50% of families have individual retirement accounts and only about 65% have any retirement plan at all is not good news for our future economy. How will the remaining 35% live? Moreover, among those 65%, will they have enough to survive in retirement?

The way it looks to me is that for people who are able to fully utilize their 401(k) or other retirement program for their entire working lifetimes, retirement may be comfortable. But this data suggests that this will be a substantial minority. For the rest, the retirement system is failing us.

30 years ago, defined benefit (DB) plans were the bulwark of the corporate retirement system. After years of Congressional meddling, many employers consider DB plans to be impractical. At the same time with further emphasis on individual responsibility, the burden of providing a retirement benefit has been shifted largely to employees.

If you are good at Googling or Binging, you can easily find projections from lots of smart people showing that a good 401(k) plan will be sufficient for responsible employees to retire on. In my opinion, most of these projections are deficient. You just don't see projections that consider leakage including:

• Unemployment for a meaningful period of time
• The necessity to take a job for a short or long time that does not have a savings plan
• Increased cost-shifting of all benefits to the employee which may reduce an employee's ability to save
• High-deductible health plans which force employees in many cases to pay significant amounts out-of-pocket for health care

This data is frightening. The retirement system is severely broken. Too many times, the public policy behind the retirement system has been abused by tax policy. We are left with retirement plans being a toy for Congress to make bills seemingly budget neutral. 

The ability to retire is part of the 21st century American Dream. This data suggests that the retirement part of the dream may be just that -- a dream.

Not pretty ...

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.

401(k) Plans Without Matching Contributions Will Not Allow the Masses to Retire

I read an article this morning entitled "Encouraging Savings Without a Match." The article was informative enough and it did discuss the importance of getting workers to save. It discussed how auto features (auto-enrollment and auto-escalation) will have positive effects in allowing workers to accumulate balances large enough to retire someday.

The author and her sources are correct. Auto features will help, but they are not enough.

Why not?

Suppose I am a participant in a 401(k) plan and you are my employer. Suppose that in that plan, you provide me with a fairly measly (by today's standards) match of 25 cents on the dollar for the first 4% of pay that I contribute. That's not much; you're only contributing as much as 1% of my pay, but you are motivating (note the lack of use of the non-word incentivize) me to defer at least 4% of my pay. That means that 5% of my pay will go into my account. It's also a first-year return on my investment of 25% before I have even a bit of positive investment performance.

If instead, you provide me with a more generous match of 50 cents on the dollar for my first 6% of pay, the motivation for me to defer at least that 6% is even greater. And, of course, if you provide me with one of the nice safe harbor matches that are even more generous, I am motivated still further.

Auto-enrollment provides no such motivation. Without that motivation, when I hit a financial crunch (perhaps my new-fangled high-deductible health plan is not providing me with the risk management tools that I really need), the first place I may look to for an extra source of weekly or monthly cash is those 401(k) deferrals. Perhaps stopping them allows me to pay my rent or mortgage on time. Perhaps it allows me to make my car payments. Because I don't have an additional incentive beyond the holy grail of retirement to continue saving, ceasing my 401(k) deferrals sure feels like a good idea. And, once I stop, I probably won't start again.

From where I sit, most people today seem to live at or above their means where their means are characterized by their take-home pay. The old defined benefit-based system allowed people to retire because their take-home pay was perhaps a little bit less in order to pay for their retirement benefit which could be a fair amount more. The discipline in that was not employee-driven, but plan design and ERISA-driven.

Now, the motivation is largely gone and the discipline is largely gone. People are living longer and a lot of them are going to have to work for a long, long time.

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.

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.

The Election Happened, Now What?

As the politicians like to say, the people have spoken. Now what?

There are lots of things I could say here about the policies of either side and what I think is right, wrong, or beyond comprehension, but that would be as worthless as much of the blather that occurs inside the Beltway.

What we have now is the same President that we have had for the past four years, roughly the same makeup of the Senate, albeit very slightly more left-leaning it appears and the same House of Representatives although perhaps slightly more right-leaning in its ideology. What we also have is an Administration which no longer needs to be in campaign mode. This means that policies and regulatory agendas which perhaps were on hold for political or non-political reasons may move forward.

Before moving forward, I caution you that what I am about to write is nobody's opinion but my own and that it is only my opinion on the morning of November 7, 2012. It may be different this afternoon, tomorrow, or some other day, but I hope that it doesn't change too much.

PPACA (health care reform or ObamaCare if you prefer) remains the law and it will remain. Whether they like the law or not, companies must prepare for 2014 when many of the key provisions of the law will take full effect. As an American, I hope that most employers do not make the decision to convert many employees from full-time to less than 30 hours for the sole purpose of excluding those employees from semi-mandatory coverage, but that is a decision that some will make.

The President is a strong believer in nationalized benefits programs (see, for example, ObamaCare). Look for his Administration to put forth a proposal for mandatory employer-provided retirement coverage with the option being contributing to a national retirement exchange. Retirement plans will look much more portable in this proposal. And, more coverage means more tax expenditures which must be paid for. Look for them to be paid for with tax savings generated from reductions in 415 limits and 402(g) limits. In other words, the highest earners will not be able to save as large a percentage of their incomes for retirement.

Historically, the Democrat Party has favored defined benefit (DB) plans more than the Republican Party. Republicans as a group have viewed that such plans are not representative of individuals taking responsibility for themselves. However, unless Congress really seeks the assistance of outside experts, do not look for any sort of resurgence in the DB world. Every effort from Washington to promote DB plans has been fraught with agency intrusion that moves employers away from DB.

At the same time, look for the President to leave Ben Bernanke in charge of the Federal Reserve and Tim Geithner in charge of Treasury. This will likely mean continuing low interest rates in an effort to spur the economy. The pension funding stabilization provisions of MAP-21 have, in the short run, allowed companies to not have exorbitant expenditures to fund their DB liabilities, but accounting disclosure often attached to loan covenants and credit-worthiness of companies that sponsor the plans will be unaffected by funding rules. In fact, companies that choose to make the MAP-21 minimum required contributions will have their accounting disclosures look worse.

President Obama has made it clear that he plans to raise taxes on high earners. We've previously written here about the FICA tax increases under ObamaCare as well as the 2013 combination of tax increases sometimes referred to as Taxmageddon. When marginal tax rates increase, deferred compensation becomes more valuable. Look for more companies to focus on nonqualified deferred compensation plans for their executives.

Similarly, the estate tax, or death tax, if you prefer, is due to return with a 55% top rate. Individuals who have accumulated significant wealth will be looking for ways to transfer that wealth to their heirs. Privately-owned companies will frequently look to ESOPs perhaps through so-called 1042 exchanges to plan for wealth succession.

Executive compensation is going to be a huge issue. As tax rates increase and the limitations in qualified plans likely decrease, deferred compensation will be become a bigger issue. With increases in deferred compensation come larger risks both for the executive and the employer. Funding such plans has become increasingly difficult while failure to fund them leaves unmitigated risk for both parties.

Dodd-Frank was one of the hallmark laws of the first Obama Administration. Seven key executive compensation provisions remain unregulated, but look for all of them to be regulated soon. Particularly critical among them are:

• Policy on erroneously awarded compensation
• Disclosure of pay versus performance
• Pay ratio disclosure

Look for the Administration to consider policies that would cut the million dollar pay limit under Code Section 162(m). While the original 162(m) codification probably backfired, most Americans would not consider it particularly controversial to limit the amount of compensation that is not performance-based that top executives receive.

Finally, in all areas, look for increases in required disclosures. Thus far, regulatory guidance in this arena has gone to levels under the Obama Administration not seen before. For employers, this means additional administrative burden. For employees, unless disclosures can be more useful, this will mean more stacks of paper for the trash bin.

And, look for gridlock once again as each side blames the other. Who will blink first? I'll report on the first blinkage here.