Update from the "Other" Washington: Washington D.C.

There’s a lot going on in Washington D.C. related to employee benefits so we thought a quick update was in order:

1) The senate passed a bill that would allow participants to do a Roth conversion within their 401(k) and 403(b) plans.

• However, in order to be eligible for the conversion participants must have incurred a “distributable event.”
• Our sources in Washington indicate the House is expected to approve the Senate Bill in the coming weeks.

2) This same bill also include pension funding relief.

• Allowing employers that sponsor defined benefit plans to amortize investment losses over a greater number of years.

3) We expect the House Ways and Means committee to mark up it’s version of a 401(k) Fee Disclosure bill today Wednesday, March 17.

• This bill has support of key members of the house, so it has a good shot of getting passed.
• It includes service provider and participant fee disclosures.
• See our webinar from this past fall for background on 401(k) plan fees.

4) The DOL has proposed new regulations on the provision of investment advice to participants in 401(k) plans and IRAs.

• The new regs touch on the active v. passive debate with respect to computer model generated advice.

5) The DOL and SEC recently held a rare joint hearing examining Target Date funds.

• Both agencies are looking for enhanced disclosure.
• Consumer “perceptions” and provider “reality” for 2010 Target Retirement Date Funds were “night and day.”
• The DOL's concerns stem from the fact that the default investment rules allow Target Date Funds to be a Qualified Default Investment Alternative (QDIA) within a 401(k) Plan.

6) We also hear that the DOL wants to rethink and refresh ERISA’s fiduciary standards and definitions, “revolutionizing” them for today's marketplace.

• In particular they are rethinking how to influence participant behavior when it comes to retirement distributions (i.e. lump sum v. annuities).
• See their recent request for information on this topic.

7) Finally, news was made this week when Senator Dodd unveiled the “new and improved” Financial Services Reform Bill.

• The current version gives the new Consumer Financial Protection Agency (CFPA) jurisdiction over plan investment service providers.
• It also recommends a single set of Fiduciary standards for brokers (FINRA) and advisors (SEC).
• Unfortunately a last minute change gave the CFPA jurisdiction over Pension Consultants and Recordkeepers (like Spectrum).
• This is all we need, another regulator to compete with the DOL, Treasury, and PBGC!

March 2010 has proven to be very pivotal, and thus we are entering extremely interesting times. Stay Tuned!

Household Income in America and Retirement Savings

Household income in America typically refers to all income of residents in every household over the age of 18. Income is usually made up of:

• Wages and Salaries
• Unemployment Insurance
• Disability Payments
• Child Support Payments
• Regular Rental Receipts
• Personal Business, Investment, or other Income received routinely

In 2007, the Median Annual Household Income rose 1.3% to $50,233 according to the Census Bureau, with approximately $7.896 Trillion in total income.

Median Annual Household Income for the state of Washington ranked #10 in 2008 at $58,078.

If every American Household deferred 10% of Household Income into tax-deferred retirement savings vehicles such as 401(k)s or IRAs, based on 2007 Census Bureau numbers, approximately $790 Billion would be tax deferred. Unfortunately, the Average American defers significantly less (closer to 5%).

Interestingly enough, the U.S. Department of Commerce, Bureau of Economic Analysis shows the following earnings changes from 2001-2009 in this Interactive Chart:

• $4,183B ('01) to $5,148B ('09) in Private Sector
• $804B ('01) to $1,184B ('09) in Government

All Private Sector earning Americans had an earnings increase of 23%, and All Government earning Americans as a whole had an earnings increase of 47%.

The same source reports Personal Savings Rate, as a percent of Disposable Personal Income in Flow of Funds Accounts (FFAs) was:

2006: (0.2)%
2007: 4.8%
2008: 8.7%
2009: ?

Bankruptcy Protection for Retirement Assets

In these uncertain financial times we get more and more questions about whether 401(k)s and other retirement vehicles are protected in case of bankruptcy.

The short answer is yes.

The Employee Retirement Income Security Act of 1974 (ERISA) and the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (BAPCPA) provide federal protection for retirement assets upon bankruptcy.

However, there can be significant differences in protection based on the type of retirement account.

So, here is a longer answer:

ERISA provides the strongest protection for retirement assets. These rules state that your retirement assets can not be assigned or alienated, except under very limited circumstances (e.g. IRS tax levy, qualified domestic relations order, participant loan default). This means that ERISA protected assets are exempt from the employer’s and employee’s bankruptcy estate.

Historical Note: While ERISA has been around for a while, it wasn’t until 1992 that the Supreme Court unanimously ruled that the anti-alienation rules of ERISA apply to bankruptcy cases. This ruling settled a long standing difference among the federal appellate courts.

401(k), profit sharing, defined benefit and most other employer sponsored retirement plans are covered under ERISA. There are a few notable exceptions. ERISA does not cover:

• Solo 401(k) plans (i.e. plans covering only self employed individuals)
• Certain deferral only 403(b) plans
• SIMPLE and SEP IRAs
• Traditional and Roth IRAs
• Certain governmental plans (e.g. 457)

Fortunately, since October 17, 2005, we have BAPCPA to protect these other types of plans. This law provides bankruptcy protection for “tax-exempt” assets held in these accounts.

Protections under BAPCPA are not as strong as those under ERISA. Specifically BAPCPA doesn’t protect IRA assets in excess of $1 million. (This cap doesn’t apply to SIMPLE, SEP and rollover IRAs. Meaning if you rollover your 401(k) to an IRA the entire rollover amount is protected even if it exceeds $1 million.)

In addition BAPCPA doesn’t protect retirement assets in non-bankruptcy judgments, such as civil lawsuits. ERISA’s stronger anti-alienation rules protect retirement assets in almost all instances. (An interesting exception is the use of a fiduciary’s ERISA protected account to repair a fiduciary breach.)

Hopefully these answers help employers and participants sleep easier knowing their retirement assets are protected.

Haddock v. Nationwide and Revenue Sharing

An interesting decision was handed down last month in the much watched Haddock v. Nationwide 401(k) fee case. The courts, for the first time, certified a class consisting of all pension benefit plans using a specific provider, in this case Nationwide. Here is the class definition from the ruling made by U.S. District Judge Stefan Underhill:

“All trustees of all employee pension benefit plans covered by ERISA [The Employee Retirement Income Security Act of 1974] which had variable annuity contracts with Nationwide or whose participants had individual variable annuity contracts with Nationwide at any time from January 1, 1996, or the first date Nationwide began receiving payments from mutual funds based on a percentage of the assets invested in the funds by Nationwide, whichever came first, to the date of November 6, 2009.” Haddock v. Nationwide Financial Services Inc., No. 3:01-cv-1552 (SRU) (D. Conn)

Background:

In 2001, the trustees for a handful of 401(k) plans filed suit against Nationwide Financial Services Inc., claiming Nationwide’s contracts with mutual fund companies and retention of revenue sharing was a breach of Nationwide’s fiduciary duty. Central to their claim is the assertion that revenue sharing is a plan asset, which implies that Nationwide’s alleged quid pro quo engagement with mutual fund companies involving revenue sharing violates ERISA’s prohibition of fiduciary “self-dealing”.

Revenue sharing is a practice whereby mutual fund companies pass a portion of their management fees to other “intermediaries.” In the context of a 401(k) plan the mutual fund company passes a portion of the fund expense ratios to other service providers such as the plan’s custodian or recordkeeper. For fuller treatment of plan fees, including revenue sharing, click here.

In 2006 the court denied the defendant’s motion for summary judgment, finding “triable issues of fact” relating the characterization of revenue sharing as a plan asset. In its ruling, the court noted that no explicit definition of plan assets can be found in ERISA and that the regulations and current case law do not provide a definition of plan assets as they relate to revenue sharing. The court called for a “functional approach” to defining plan assets using a two pronged test. According to the ruling plan assets would include benefits received by defendant (1) as a result of its exercise of fiduciary discretion or authority, and (2) at the expense of plan participants or beneficiaries. See Haddock v. Nationwide Fin. Servs., 419 F. Supp. 2d 156 (D. Conn. 2006) for details.

Needless to say this ruling was widely read and discussed within the 401(k) community.

Recent Ruling:

Judge Underhill found that the class of “all trustees of all pension benefit plans…which had contacts with Nationwide” meets the numerosity, commonality, typicality and adequacy requirements for class certification. Judge Underhill also found that the primary purpose of the class would be to obtain injunctive and declaratory relief (i.e. to stop Nationwide from continuing its practices related to “revenue sharing”) and that monetary relief is secondary.

At the heart of this issue is the allegation that Nationwide used it’s collective pool of 401(k) money as leverage to negotiate with mutual fund companies for more revenue sharing in exchange for inclusion of their funds on its 401(k) platform; and that the revenue sharing received was not used to offset a pre-disclosed fee, but rather was additional income for Nationwide. Indeed, the plaintiffs

"allege that the revenue sharing payments were not made in return for any services, arguing that those services were already being paid for by the Plans and participants through the standard fees charged by Nationwide…In other words, Nationwide was already being compensated for those administrative tasks, and, therefore, the revenue sharing payments were pure profit."

Judge Underhill in a prior ruling found “the Trustees have raised a triable issue concerning whether Nationwide in fact performed services in consideration for those payments.”

Because Nationwide was (allegedly) leveraging its collective pool of plan assets for its own benefit, then the trustees of these plans constitute a class that has standing in relation to the fiduciary breach claim.

Conclusion

As a provider we are certainly wary of any developments that would impede our industry’s ability to provide quality and cost-effective services. However, Nationwide is not alone in its treatment of revenue sharing. Many providers either don’t disclose revenue sharing and/or don’t use revenue sharing to offset pre-established fees. We often analogize 401(k) fees to icebergs: you only see the small amount “above the surface.”

I hope this case will call attention to some of these less than transparent practices and will drive more providers to disclose all of their revenue, not just to plan sponsors, but also to plan participants.

The impact of this case will ultimately dependent on whether congress passes real fee disclosure rules for the financial services industry. But that is a discussion for another blog post.

Top Ten Thanksgiving Day Retirement Plan Posts

Rather than go into detail about something sophisticated or technical in nature, the purpose of this post is to look at some of the most interesting developments since the beginning of the year:

10) 401(k) practices under new scrutiny - Congress looks at investment approaches that risk Americans' savings while benefiting fund managers 1:03 PM May 29th

9) Retirement confidence drops among workers 50-64 - Only 44% of Workers have confidence living 5 years in retirement, down from 63% in 2007 10:36 AM Jun 3rd

8) Small-Business Owners Worry about Keeping 401(k) Match: 44% of Survey say they may have to Cut Back or Cut Out Match 10:48 PM Jun 14th

7) SEC Chair Schapiro said Target-Date Funds ("TDF") on Regulators’ Radar Because 31 Year 2010 TDF posted returns from -3.6% to -41% in 2008 3:12 PM Jun 22nd

6) 7 Legged Retirement Stool: Social Security, Pension, Savings, Health/Long-Term Care, Employment, Housing, Family/Community Assistance 5:31 PM Jun 23rd

5) 11% of Wealthy (>$1.0M in Assets Excluding Primary Residence) Stop 401(k) Contributions; 8% Said Spouses or Partners have Done the Same 10:35 AM Jul 8th

4) Newest Discussion: Should Clients Annuitize their Retirement Assets? People Insure their Cars, Homes, Lives, etc., is the 401(k) Next 2:55 PM Jul 17th

3) GAO: Higher fees more likely in 403(b) Plans: Private Sector 401(k) Plans Trump Public Sector 403(b) Plans - Resources, Information Access 11:21 AM Oct 7th

2) EBSA Stats for FYE 09/30/2008: 2,696 Civil Cases with Monetary Results of $1.2B in Civial/Criminal, 212 Criminal Cases with 101 Indictments 6:03 PM Oct 13th

1) Roth IRA Conversions Coming in 2010; Will 401(k) Participants be able to Convert Balances to Roth 401(k)? Some Experts Think "Yes" 7:40 PM Nov 6th

Problem with the 401(k) System?

Here is a great article that illustrates one of the shortfalls of our current 401(k) retirement system: the people in charge either don’t want to be in charge or don’t have the time, skills and/or knowledge to be successful in managing the 401(k) plan.

The article gives three case studies that in my experience are representative of many plan sponsors.

Case 1: [The Business Owner] only agreed to set up the plan on two conditions: It wouldn’t cost the company a dime, and he wouldn’t have to deal with it.

Case 2: “As long as you don’t charge us any fees”

Case 3: “It was nice to think there was enough smartness in the group to help pick [the plan’s investment options],” says…the general surgeon who chairs the committee…Smartness isn’t always enough, though.

Quite often 401(k) plans sponsors believe that once they setup the plan and hire the broker all responsibility has been passed to someone else (e.g. the broker and/or participants). However, from a legal standpoint, and I would argue from a business and policy standpoint, this is wrong. See our webinar on Fiduciary Best Practices: A Guide for Small Employers for details.

Also, many 401(k) plans sponsors, being good business people, will make sure the fees paid by the company are reasonable and fair. (Or even better then fair as illustrated by the above quotes!)

However, sponsors are much less likely to worry about the investment fees paid by the plan participants. 401(k) providers know this and use it to their advantage by burying hidden fees in the various investment products they sell.

Even really smart people – doctors, lawyers, scientists – generally don’t have the knowledge or time to unravel the complicated mess that is their 401(k) plan fees, again a fact that providers know and exploit.

There are a number of bills currently pending in congress that would require full fee disclosure both to plan sponsors and, most importantly, to plan participants. Let’s hope one of these bills can make it into law without being too watered down.

For more information on plan fees see our recently completed webinar: Understanding Retirement Plan Fees.

Labor Day Brings Presidential and Congressional Focus on Retirement Plans

Although Health Care continues to be the focal point on Capital Hill during the month of September (the month that brings Congress back to session) Retirement Plans received a pivotal focus to start the month from members of Congress and President Obama. Senior Obama administration officials issued a package of Treasury Department and Internal Revenue Service guidance to promote workplace retirement savings, releasing the documents early Sept. 5 in time for President Obama’s planned weekly radio address on retirement savings. In this address, President Obama said it is “essential” to the economic recovery to make it easier for people to save for retirement, and spoke specifics on:

1) Intention to Propose the Automatic IRA Proposal in his Budget,
2) Expansion of the SAVER’s Credit,
3) Tax Deductions to be Automatically deposited into an IRA,
4) Proposal to allow payments from Unused Sick and Vacation Time to be deposited into Retirement Plans,
5) New Government Website aimed at helping People Learn how to Save for Retirement.

On the Qualified Retirement Plan front, taxpayers can expect the focus to be on Defined Benefit Funding Relief, 401(k) Fee Disclosure Regulations, as well as Independent Investment Advice. Rep. Richard Neal (D-MA) is the key Congressperson on the House Ways & Means Committee, as Chairman Charles B. Rangel’s (D-NY) “Deputized Leader” on the subject matter.

“If you work hard your whole life, you ought to have every opportunity to retire with dignity and financial security. And as a nation we ought to do all we can to ensure that folks have sensible, affordable options to save for retirement.”

-- President Barack Obama

Is Participant Choice a Good Idea?

The mainstream media has often commented on the shift from defined benefit plans to defined contribution plans over the last few decades (see PBS FRONTLINE report). But there has also been a shift within defined contribution plans from “trustee” directed “pooled” accounts to “participant” directed “individual” accounts.

Years ago it was common place for employers to sponsor a “pooled profit sharing” plan. Each year the employer would determine how much to contribute and these contributions were held in a single account. The employer would appoint a trustee and/or investment manager to determine how to invest the contributions on behalf of all participants.

Then came the rise of the 401(k) plan. For some reason in a 401(k) plan it was decided that participants ought to choose their own investments. At the meetings I attended where sponsors contemplated adding a 401(k) provision, the logic went something like this: because participants would see the money comes out of their paychecks they will want to (and perhaps ought to) be more involved in the investment decisions.

Some providers also told employers that by handing over investment choices to participants they rid themselves of fiduciary responsibility (for more on the fallacy of this idea please see our recent webinar on Fiduciary Best Practices: A Guide for Small Employers.)

We have moved from a situation where employees didn’t have to make any decisions, or have any choices, about retirement savings (e.g. the traditional DB plan) to a situation where employees have all the decisions, and have perhaps too much choice, (e.g. today's typical 401(k) plan).

Is this good or bad? Here are two studies that provide some illumination:

# 1: The Deloitte 401(k) Benchmarking surveys
In these annual surveys,

• Employers consistently report that the biggest barrier to plan participation is a “lack of employee understanding.”
• Employees most often report “Where to invest/which funds to use” and “How Much to Save for Retirement” as the more confusing parts of their retirement plans.

While automatic enrollment features and default investments may alleviate some of these problems, they are not perfect solutions (see prior post on PPA’s automatic enrollment provisions).

# 2: Pension Research Council Working Paper: The Efficiency of Pension Menus and Individual Portfolio Choice in 401(k) Pensions
This working paper analyses a rich set of participant account data from Vanguard. Their findings include:

• The vast majority of the plans in their study offer reasonable investment menus (i.e. the menus are “efficient” compared to market benchmarks)
• Most “real-world” participants make mistakes by investing inefficiently and not diversifying their investments enough.
• The participant’s investment mistakes account for the majority (76%) of their poor performance.
• These investment mistakes have a significant impact on retirement savings, reducing wealth by 1/5th over a 20 year career.

The study also has interesting findings regarding investment menus:

• More is not always better: adding more than about 9 well chosen mutual funds does not improve participant investment performance.
• Index bond and index domestic equity funds improve plan efficiency.
• Actively managed domestic equity funds hurt plan efficiency.

So what does this mean for today’s 401(k) plan sponsor? If you offer participants a choice, do it right:

• Have a well chosen list of investment options covering all asset classes.
• Use no more than 9-12 funds.
• Consider having participants select between pre-mixed model portfolios instead of individual mutual funds.
• To the extent you provide investment education, focus on answering the basic questions: How to enroll in the plan?, How much to save? and Where to invest?
• Provide employees easy to use savings guidelines when they enroll in the plan (try the FPA Journal - National Savings Rate Guidelines for Individuals).
• Periodically review participant asset allocation, individual investment performance, and retirement readiness. You can’t manage what you don’t measure.

Will the Pension Protection Act of 2006 (PPA) accomplish its purpose? Part 2 of 2

This is the second and final post addressing whether PPA will accomplish its purpose. Click here for part one.

Purpose #2: Expand Opportunities to Save

PPA definitely expanded opportunities. However, the real question is whether this expansion will solve the problems with our retirement system. In particular, will PPA increase coverage, savings, and investment return rates significantly enough that 401(k) plans will provide workers with enough retirement income? I don’t believe it will.

Auto-enrollment was a major part of PPA and some claimed this provision as the cure-all for our nation’s retirement problems. Many studies, both before and after PPA, show that auto-enrollment significantly increases participation:

• A recent Hewitt study reports that the average participation rate for 401(k) plans overall in 2008 was 74.2%, compared to 82.3% for automatic enrollment plans.
• In addition providers like Fidelity and Vanguard are reporting large increases in the number of employers converting to auto-enrollment as well as low “opt-out” percentages among workers in these arrangements.

This is promising news and may eventually validate some of the claims that the PPA auto-enrollment provisions will close the retirement savings gap.

However, not all the news about auto-enrollment is positive. Some are claiming that auto-enrollment decreases the amount that participants save. The same Hewitt study referenced above reports that the average deferral rate decreased from 7.9% in 2006 to 7.4% in 2008. This decrease may be due to the fact that the default percentages in auto-enrollment plans are relatively low (e.g. 3% for a typical plan). Thus auto-enrollment may actually cause employees to save less than they should based on what is needed for an adequate retirement.

In addition most of the increase in auto-enrollment is among larger employers (100+ employees). We have a huge percentage of employees at small businesses that don’t have a retirement plan. PPA did nothing to address this issue.

Also, the so-called fiduciary advisor provision of PPA has been a big flop. I don’t know anyone in the industry who actually provides investment advice under this provision. I have even heard talk that this provision may be repealed by congress in upcoming legislation.

The problem is not that we don’t need investment help. A DALBAR study shows that the average equity investor earned an annual return of 1.87% over the last 20 years, compared to 8.35% for the S&P 500. The problem with the PPA provisions was the limited incentives for employers and providers and the lengthy and complicated compliance rules.

So my conclusion: PPA is a step in the right direction. It increases protections and expands opportunities to build retirement nest eggs. But these protections and opportunities are no where near the comprehensive solution needed to solve to this country’s retirement problems.

First Mutual Fund Family Cuts Management Fees

During a time when Employers, Employees, and Governments are all doing what they can to cut hours, costs, and run a successful enterprise, finally, a Mutual Fund family is following suit.

Putnam Investments made an announcement this week, subject to shareholder approval, that it would lower costs for its mutual funds by:

1) Cutting expense ratios,
2) Implementing performance driven expense ratios, and/or
3) Adjusting pricing breakpoints

Analysts expect a 10-13% price reduction.

Who else will follow suit, and why did it take so long?