BNA Pension and Benefits Blog

Another Piece of the Extended Puzzle - Proposed DOL Regulations Reach to General Prudence Rules

Issues relating to fees to service providers have become high-profile issues, with a proliferation of indirect-fee class actions and the inevitable follow-on press reports. These issues have given rise to a four-piece puzzle, with activity regarding (i) regulations under ERISA Section 408(b)(2), (ii) the rules governing Form 5500, Schedule C, (iii) the "404(c)" rules for covered plans with participant-directed investments, and (iv) a number of legislative proposals in Congress.

The issue is clearly front-burner for the DOL, which is trying to proceed with a coordinated new regime that would have a real impact on the quantity and quality of information available to participants. There has already been movement in the first two arenas, with proposed 408(b)(2) regulations and new rules for Form 5500, Schedule C, both of which have been controversial. Congress has proceeded, too, with the proposed Miller bill. The only theater that had remained dark was the one relating to the 404(c) rules.

Section 404(c) is the section that gives plan fiduciaries the opportunity to limit their liability in the case of plans which provide for participant-directed investments and which satisfy the regulatory Section 404(c) requirements. Thus, the DOL had broad discretion to impose such informational requirements as it saw fit under Section 404(c). Showing how much attention it is giving to the question of participant information, though, the DOL took this opportunity to expand the expected scope of its rulemaking and issue rules proposed to apply under ERISA's general prudence rules, whether or not the protection of Section 404(c) is sought. The general prudence rules, like the 404(c) rules, give the DOL a fairly free regulatory hand, as there is no clear limitation on the abilty to add regulatory color on what it means to be proceeding in accordance with general prudence-type considerations.  Thus, the new proposals would generally apply to all plans under which participants have the right to direct investments, even if the plan sponsor is willing to forego Section 404(c) relief. It is clear that that the DOL is making a concerted effort to establish a set of rules that will significantly change the nature of the information that is broadly available to participants in plans where they direct their own investments.

It remains to be seen whether the market will view the balance that has so far been struck by the DOL as being the right one. I expect the comment process regarding this particular piece of the puzzle to be extremely active in terms of submissions on all sides of the market, including participant-advocacy groups, employers, financial services organizations and administrators. One thing seems certain - the old rules, with a much more generic approach to the provision of information, seem eventually to be a thing of the past.

Would You Buy an Annuity for Your Mother?

Much has been made of the fact that employers are increasingly turning to 401(k) plans rather than defined benefit plans. Employers are implementing a number of strategies to help employees achieve retirement security in this brave new world. Most of these strategies, such as automatic enrollment and automatic increases in participant deferrals, focus on the asset accumulation phase. At the BNA conference earlier this year on Redesigning Pension Plans and Executive Compensation, Henry Eickelberg of General Dynamics talked about an innovative program that a number of large employers negotiated to help their employees buy annuities at reasonable prices.

The employer group isn't offering the annuities in their qualified plans but instead is making them available to employees for both plan rollovers and direct investment. The annuities include both fixed annuities, with and without inflation protection, and variable annuities. The group negotiated low commissions (.5% on the fixed annuity product). The good news is that these annuities are not limited to the employer group but are available to the public so other employers can bring them to the attention of their employees and financial planners can consider them for their clients. You can check them out at on the website for the Elm Income Group.

Years ago, before the Department of Labor issued its guidance on purchasing the safest available annuity for participants in terminating plans, Interpretive Bulletin 95-1, I advised a client that the standard was "Would you purchase an annity for your mother (not your mother-in-law) from this carrier." So I was intrigued years later by an article that Ron Gebhardstbauer wrote for the Women's Institute on a Secure Retirement (WISER) on the advice he gave his mother at age 77. She began receiving the required minimum required distributions at age 70 1/2 and he determined  that she would do better with an annuity than with the annual payouts, with the added advantage that she wouldn't see her annual payouts decrease as she got older. (Ron is the Senior Pension Fellow for the American Academy of Actuaries and the former Chief Actuary for the PBGC, so he can readiy figure these things out, unlike the rest of us.) I recently checked with Ron and his mother is still enjoying her annuity in her mid-80s.

You may be able to find a better deal through your own plan. I compared the payout on a single-life annuity for a male age 70 from Elm for someone who has $100,000 to invest to the same annuity offered by the federal Thrift Savings Plan (TSP), the 401(k) plan for federal employees. The annual payout under the Elm annuity was slightly less ($814 compared with $834 from TSP). Similar results for a female beginning payouts at age 60 ($605 from TSP versus $664 from Elm). However, most employers don't offer annuities to their DC plan participants and, even if they do, they may not have rates as competitive as TSP. The Elm annuities are definitely worth checking out. And kudos to the employer group that made an effort to bargain these good rates for their employees.

I'd be interested in hearing about any other sources for annuities that offer better rates. With the increasing elimination and freezing of defined benefit plans, employees will need to engage in self-help on the payout side of the 401(k) ledger just as they have to do on the investment side.

So What Else Is New In DC?

In journalism theory, the headline is a literary genre unto itself. It's supposed to capsulize what follows it so that the reader's own unassisted, low-tech browser linking eyes and brain can discern in a flash whether he or she has an interest in reading more.  Ideally, the headline should also smack of some news value. Or create a sensation. Wuxtry! Wuxtry!

That thought passed me as I looked at my Philadelphia Inquirer business section on a slow-news Saturday this month to spot a business section article headlined "Fewer large firms offering traditional pension plans," picked up from AP.  Not exactly news, certainly not to anyone peeking into this blog.  It's sorta "duh" stuff, or as Yogi would put it, déjâ vu all over again.  But making allowances for that, I read on.

The really new news lay in quantifying "fewer" not just to characterize what has already taken place but what is expected to happen in 2008 and beyond within the top-tier of American industry, the Fortune 100.  We have been told before not to sell the Fortune 100 short on their continuing to maintain, among themselves, DB plans that cover significant numbers in their workforce.  But the trend has been clear. The new numbers, in a fresh survey released in May by Watson Wyatt Worldwide, Inc., are that of 89 DB plans maintained by the companies in the 1986 vintage, only 35 were still being offered in 2006, and in 2007, currently, it is already down to 31.  Explained another way, WWW found, the 10 firms that offered primary DC plans in 1986 had grown to 37 by 2005 and numbered 42 in 2006. And 27 of the firms that featured DB plans in 1986 had moved to "hybrids" from the single such plan 20 years before.

Misnomer as it now stands, the Pension Protection Act of 2007 is widely expected to accelerate still further the terminations or freezes of DB plans in favor of 401(k) plans. Further, provisions of the PPA now sanction certain cash-balance and other hybrid plans as forms to pass muster as DB plans under the IRC and the anti-discrimination laws that protect older workers.  A spokesman for the WWW consultancy indicated that other Fortune 100 companies are "strongly considering" hybrid and DC plans right now, raising expectations that those plans will be on the increase again in 2008.

These trends continue at a time when 401(k) plans are undergoing judicial scrutiny in class actions attacking plan service providers, including mutual funds and their contractual partners in revenue-sharing, for charging excessive and improper fees to plan participants. See 34 BPR 1043 (5-1-07).

Perhaps not as visible as multiple class actions are the implications of an increasing number of studies wiithin the financial and academic communities which are highlighting the "reverse multiplier" phenomenon that almost inheres in DC accounts funded by mutual funds. 

From Economics 101, we learned of the classic "mutliplier" in consumer purchasing power, where $1 of spending in, say, a retail purchase is then "re-spent" several times over as the retailer applies that revenue dollar, variously, to pay wages, add to or replace inventory, procure business services, and on and on, as parts of that one dollar are recycled over and over through the economy.

We are now learning more and more about a form of "reverse multiplier" -- in which the loss to savers that arises from the shortfall between (x) gross market returns from, say, equity mutual funds and (y) the net returns after all expenses are passed on to the fund participants translates to a mutliple of that shortfall in the percentage reduction of retirement payments obtained in annuitizing the final account balance.

Well-managed DB plans are more successful in moderating the "reverse multiplier" because of the economies inherent in scale and risk-pooling and the expertises employed that individual plan partiicipants almost invariably lack. These factors tend to shrink the shortfalls between gross and net returns during the accrual period, making possible more bang for the buck of single-sum present-value that can be converted to a guaranteed life income at retirement.

The metrics are beginning to pile up.  The co-authors of "The Performance of U.S. Pension Funds" headed by Professor Rob Bauer at the University of Maastricht recently found that individual investors give up 250 basis points per year in agency costs in a comparison between their mutual fund returns and pension fund (DB plan) portfolio returns. This fairly confirms the conclusions reached by John Bogle, the former CEO of the Vanguard Group, that mutual funds are far more expensive than traditional pension funds and that an annual shortfall of 250 basis points per year in equity mutual funds is to be expected.  Going further, Bogle has maintained that a similar shortfall, of around 225 points per year, would be experienced in mutual fund bond funds. 

In the stratosphere of advanced financial analysis, Keith Ambachtsheer has examined such studies in the real-world context of "pension delivery organizations,' including mutual funds, and suggests that, compared to DB plan participants, mutual fund participants incur a reduction of at least 1% per annum during their years of employment, with a resulting 20% loss in life income benefits. In "The Ideal Pension-Delivery Organization: Theory and Practice" presented in March 2007 at an Amsterdam conference, Ambachtsheer posits that a combination of fund governance improvements and mitigation of agency costs offers a potential for doubling the pension per dollar of retirement savings, versus the end-results to be expected from persistent agency conflicts and poor governance. Ambachtsheer's paper, available on the Internet, contains an extensive bibliography and a series of endnotes referencing studies for policy consideration in this area.

It's in this realm of the math of individual-account savings plan returns that the continued trend of replacing DB plans with DC plans should arouse the most serious dismay.  Post-PPA, the status quo begs for  truly revolutionary institutional change if financial security in retirement is to remain an achievable goal for the vast majority of American workers.

Abbott A. Leban

Fees for what?

There has been a lot of conversation about the fees paid by retirement plans. Most of that attention has been paid to the level of the fees.  The implication seems to be that a high fee is bad and a low fee is good.  That would be true if the service being delivered was exactly the same, but that is rarely--dare I say--never, the case.  So, we know that it is tough to even decipher the level of certain kinds of fees.  Let's say that some system is devised to inform decision makers of the exact fees that they are going to pay.  Those decision makers still need to decide whether that know fee is "reasonable" for the services being rendered.

It should be obvious what services are being rendered.  For investments, it may be access to that investment and tracking that information by participant.  But, what about other services - TPAs, claims administrators, trustees, attorneys, accountants?  I have lost count of the number of meetings I have been in where some plan has incurred a testing failure.  The plan sponsor was sure someone else was supposed to be doing this and all of the advisors believed that another advisor was doing it.  In my dream world, all benefit plan sponsors would have competent ERISA counsel.  Said competent counsel would give the sponsor a written list of all of the duties that were required to operate the plan.  Said list would be periodically updated for changes in the law.  Each advisor would have a contract with the sponsor where they affirmatively take responsibility for assisting the sponsor with one or more of those duties.  The sponsor would have 2 or more people assigned to oversee these service providers. 

Even that idealistic dream world has a problem.  How does the sponsor know whether the advisors that they have selected are actually competent to do the job assigned to them? 

Last fall the DOL announced their "Consultant Advisor Program," see http://pubs.bna.com/ip/BNA/PEN.NSF/5e4e99760472d68285256b57005a3bcc/6e80eff6edcb2c8e8525721700797cc8?OpenDocument and http://pubs.bna.com/ip/BNA/PEN.NSF/5e4e99760472d68285256b57005a3bcc/76088bb353741bda8525721700797caf?OpenDocument for a discussion of this program.  This program focuses on one quality component - the risk of a conflict of interest between the plan and the advisor.  That is an important element - objective advice should be better.  To date, however, there has been little additional discussion of this program.

So, back to the issue - how does a plan sponsor determine whether they are paying a reasonable fee for competent advice? I can only respond from my experience as the accountant:

1. Retirement plan administrators, claims administrators and certain fund managers or trust departments:  There is an accounting industry product - the SAS 70 report.  This is Statement on Auditing Standards No. 70 - Reports on the Processing of Transactions by Service Organizations.  This is an audit of the internal controls of a service organization.  A Type II SAS 70 report assess the nature of the internal controls AND whether or not they are actually working as designed.  These are typically very long and pretty boring reports, but if a service provider has such a report, the report tests the procedures that apply to your situation and there were no exceptions found in the test, the sponsor may have some comfort about that service provider.  There is no requirement for TPAs or claims administrators to obtain such a report.  The absence of such a report doesn't mean that their systems are flawed.  But the presence of a clean report should provide some sense of confidence. 
   
   Note, many service providers have multiple control systems - one might handle the investment decision processing, one might handle testing, another might handle distributions.  To take comfort from the existence of a clean SAS 70, you need to make sure that such a report exists for the systems that your plan uses.
2. Auditing firm - Taking comfort from the SAS 70 sounds nice, but that is a report prepared by an auditing firm, where can you get some sense of confidence that the auditing firm is skilled at what it does?  Within the benefit plans community, the American Institute of Certified Public Accountants has created the Employee Benefit Plans Audit Quality Center.  CPA firms can join this center.  To be a member the firm must make a commitment to train their benefit plan audit teams, conduct an annual review of the benefit plan audit practice and otherwise stay engaged in the industry.  Membership in the audit quality center is not a stamp of approval, but in a recent DOL audit of benefit plan auditors, the DOL did find significantly fewer audit issues with the work of center members than with non-member auditors. 
   
   The Center's web page is:  http://ebpaqc.aicpa.org/  It contains a lot of helpful information that a plan sponsor can use in evaluating an audit firm.  In addition, the DOL issued a tool to assist plan sponsors in selecting an auditor.  See http://www.dol.gov/ebsa/publications/selectinganauditor.html

For other professions, I don't know what to say.  The credential sponsor Financial Service Standards, LLC invited retirement advisors and plan sponsors to participate in a short "Retirement Credential Survey," last February. This is expected to generate a 2007 Retirement Credential Comparison Chart to be published in May.  It will be interesting to see what, if anything, comes from this effort.

Participant Diversification Requirement

Employers are being inundated with a press of new guidance issued by government agencies on many new employee benefit requirements with which the failure to comply can result in some fairly stiff penalties.  Guidance such as that issued by Treasury at the beginning of this month on section 901 of the Pension Protection Act of 2006 (the Act) which establishes participant diversification rights for publicly traded employer securities held in defined contribution retirement plans (other than certain ESOPs).  While the guidance is certainly welcomed because it fills some "need to know" gaps in the short run, the Notice raises some immediate significant areas of concern for employers.

The Act establishes as a new plan qualification requirement (new Code section 401(a)(35)) for investment diversification applicable to publicly traded employer securities held by defined contribution plans and certain ESOPs.  IRS Notice 2006-107, provides guidance on the new Act diversification rules, one of which requires 30 days advance notice to participants before the first day that participants are eligible to direct diversification of their accounts out of employer securities.  The Notice provides employers with some breathing space and advises employers that the new participant notice requirement can be satisfied as late as January 1, 2007, for calendar year plans.  This still means, however, that employers have to figure out who must get the notice and what the notice should say and send it by year end. 

One issue is whether employers that already allow participants to diversify out of employer stock (i.e., their plans already contain full diversification rights), have to advise participants by January 1, 2007, of their right to do so, which likely would be duplicative especially if the information already is contained in an SPD).  The Notice contains a model notice (requiring customization), but the IRS has requested comments on ways to improve the model notice.

While the reason for the new statutory provision is to ensure that participants in defined contribution plans (sponsored by publicly traded employers) receive diversification rights where the employer's plan invests in comapny stock, has a company stock fund or matches employee contributions with company stock, as a result of ENRON and the spate of litigation that followed in its wake, many employers already have modified their plans to allow employees to diversify out of employer stock.  What is hitting many employers who have already provided for diversification out of employer stock in their defined contribution plans is how to comply with these notice requirements.  Does it make sense for an employer to send out 50,000 notices to employees in its 401(k) plan by the end of the year telling them about a right they already have (and presumably already know about)?

Some government representatives at Treasury and the IRS have pointed to an alternative purpose of the employee notice -- to educate employees concerning the importance of diversifying their investments.  When asked whether an employer needs to send notices (by year end) to employees in plans that already contain the required diversification, these representatives have suggested that notices may still be required.

Should publicly traded employers with defined contribution plans holding company stock send out notices before the end of the year even if their defined contribution plans satisfy the diversification requirements of the statute?  Although some practitioners think this is absurd, this practitioner thinks it is better to be safe than sorry.  Any thoughts?

A Turning Point for Labor?

Since the signing of the Pension Protection Act, the aura of pessimism that continues to hang over the future of private-sector DB plans has been relieved in many quarters by bullish excitement over the potential that the DC plan provisions of the PPA may hold in store for the American workforce -- particularly for the majority of working Americans who are unprotected by any income floor in retirement other than Social Security.

This past month, your blogger has been struck by press reports that Big Labor seems to be moving to the front burner, for serious discussion, hybrid structures that in an earlier day might have been stored away in Labor's research drawer marked "Contingency Plans," to be opened only in the event of a general DB meltdown. Damon Silvers, one of Labor's staunchest advocates, has been quoted to concede that "[o]ur current [pure DB] system is failing," and urges moving away from it now because "[b]y the time [the failure] becomes apparent to the majority of employees, it will be too late."  Silvers's own employer, the AFL-CIO, has formally announced principles of retirement income policy that embrace carefully structured DC plans. Reportedly, the SEIU also has in mind a hybrid plan model that employs individual, portable accounts but with pooled investment risk and primarily an annuity form of distribution at retirement. 

Commentators on the pension scene view it as highly significant that these major unions, traditional supporters of DB plans, are looking at models that, while preserving some elements of those plans, aim to expand the role of DCs in building atop the Social Security floor to provide retirement income at an adequate "replacement" level.  In this lexicon, adequacy translates to 70% of pre-retirement income.

Both within and beyond the labor camp, the bullish outlook on the future for DC plans rests on the most salient features of the PPA reforms: automatic enrollment, default investment options and, within the latter, managed accounts. These features were made all the more concrete by last week's DoL/EBSA release of the PPA regulations proposed as 29 CFR Part 2550 (Default Investment Alternatives Under Participant Directed Individual Account Plans) (71 Fed.Reg. 56806 (Sept. 27, 2006). Like so many works in the rule-making genre, the proposed rule itself occupies little more than four columns, or about 1.35 pages of FR text, preceded by more than 16 pages of the required preliminaries, which in this case put a lot of flesh on the barebones rules.

I especially commend for the serious attention of policy wonks the social research sources cited and summarized in midget font in many of the footnotes throughout these pages -- most often the product of outstanding scholars in the field of what an increasing number of institutions label Financial Gerontology. Among other issues, the sources deal empirically with the incidence of automatic enrollment, its impact on participation, and the percentage distribution of default investment options actually chosen under automatic enrollment plans today.

As one might expect, overall a clear majority of DC plan participants pick the most conservative options (fixed-income, no equity).  The proposed rule clearly seeks to inject into the default investment choices a mix of asset classes consistent with capital preservation or long-term capital appreciation, or a blend of both, with age meant to be most often the driving factor in guides to the participant.  The aim is to defeat mindless default investing that over the career of the employee "is not likely to generate sufficient savings for a secure retirement." 17 FR at 56806.

Readers will have direct access to summaries of the proposed rule in BNA and other commercial services as well as in CLE program materials. 

Of greatest interest to me, with my practice focus on issues of shareholder rights and corporate governance, is the provision of proposed § 2550.404(c)-5(c)(4) of the rule which requires, for a default investment alternative to make the grade as a  "qualified default investment alternative" (a "Q-DIA"?), that material provided to the plan relating to a participant's or beneficiary's investment in a Q-DIA, including prospectuses and proxy voting material, will be provided to the participant and beneficiary.  Employing assumptions from other parts of other economic analyses in the preamble to the proposal, DoL makes the assumption that at any given time, 5.3% of the participants and beneficiaries in participant-directed individual account pension plans, or more than 2.3 million individuals, will have default investments that will call for providing them with these "pass-through" materials on a quarterly basis, certain of them on other occasions as well. This "paperwork," estimated to amount to 9,404,000 responses (distributions of these materials) to participants per year, obviously iimpose additional cost burdens but come with the territory. 

From a shareholder perspective, I would guess that the proxy-voting materials among these distributions in the Q-DIA sector would turn out to be mostly those applicable to mutual funds under management by an investment manager or the fund groups themselves, and much less frequently those on voting individual company shares in the kind of professionally "managed account" that may equally qualify as a Q-DIA. It is questionable whether the union and Taft-Hartley funds that today attempt to exert their DB-plan-rooted "pension power" on director elections, executive compensation plans, and other proxy ballot items can make their proxy voting policies and worker education efforts felt at the beneficial owner level of participant-directed plans that go the Q-DIA route.

Over decades, the continuing decline, freezes and many ultimate terminations of DB plans in the private sector, combined with the widely hoped-for and expected robust growth in both pure DC and hybrid individual-account plans, with a heightened role for long-term equity allocations, will gradually result in fragmenting to a significant degree the "pension power" that labor constituencies have plied in their corporate affairs programs.  This then may be one of the prices that Labor may pay for improvements in the American workers' retirement security system which depend on advancing and promoting the growth and heft of DC plans in that system.

By way of postscript, it warrants saying that the proposed rule, and all else that has been noted here, apply only to the ERISA-covered world.  As charted in DoL's preamble, the rule does not apply to state, local, and/or tribal government plans. Attacks against traditional DB plans in that sector are both political and parochial and the inroads of DC plans, other than as supplemental to DBs, have been relatively slight.