Americans understand diversification, but not inflation - Articles - Employee Benefit News

Image via WikipediaAmericans understand diversification, but not inflation - Articles - Employee Benefit News Surprisingly, most Americans showed understanding of diversification, asset allocation and dollar-cost averaging, while flunking basic questions about other financial concepts in a survey for Northwestern Mutual. This discrepancy is consistent with findings in a 2006 study.

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DoL Broadens Fiduciary Net

Image via WikipediaOctober 21, 2010 (PLANSPONSOR.com) – For the first time in a generation, the Labor Department has taken another crack at the definition of a fiduciary under the Employee Retirement Income Security Act (ERISA).

The proposed rule was unveiled today by the Department of Labor (DoL), which noted that its adoption “would protect beneficiaries of pension plans and individual retirement accounts by more broadly defining the circumstances under which a person is considered to be a ‘fiduciary’ by reason of giving investment advice to an employee benefit plan or a plan’s participants.”
The proposed rule is designed to “take account of significant changes” in both the financial industry and what was described as “the expectations of plan officials and participants who receive investment advice,” as well as to protect participants from “conflicts of interest and self-dealing.”

Testing, Tested

Image via WikipediaIn explaining the proposal, the Labor Department noted that while Section 3(21)(A) of ERISA provided a “simple two-part test for determining fiduciary status,” a subsequent (1975) regulation served to “significantly narrow” the “plain language” of the legislation; effectively replacing the two-part test that would impose fiduciary status when a person renders investment advice with respect to any moneys or other property of a plan, or has any authority or responsibility to do so and receives payment (direct or indirect) for that advice, with a 5-part test that included conditions that: the advice regarding plan investments be rendered “on a regular basis,” that the advice would serve as a primary basis for investment decisions with respect to plan assets, that the recommendations are individualized for the plan, that the party making the recommendations receives a fee for such advice, and that it be pursuant to a mutual understanding of the parties. Moreover, the Labor Department noted that it further limited the definition of “investment advice” in a 1976 advisory opinion, when it concluded that the valuation of closely-held employer securities in an employee stock ownership plan (ESOP) relied on in purchasing those securities would not constitute investment advice.

…[The] Labor Department noted that the financial marketplace and the types and complexity of services have expanded dramatically. The proposal notes that although professionals such as consultants, advisers, and appraisers “…significantly influence the decisions of plan fiduciaries, and have a considerable impact on plan investments,” if they are not deemed fiduciaries under ERISA “…they may operate with conflicts of interest that they need not disclose to the plan fiduciaries who expect impartiality and often must rely on their expertise, and have limited liability under ERISA for the advice they provide.”
In essence, the Labor Department now says that ERISA does not compel it to apply its own five-part test, and that new facts and circumstances mean it is now time to update the investment advice definition. Specifically cited is that the proposal no longer requires that the advice be provided on a “regular” basis, not does it require that there be a mutual understanding that the advice will serve as a primary basis for plan investment decisions. [emphasis added']
Advice Description
As for what constitutes advice, the proposal now includes the provision of appraisals and fairness opinions as a type of advice [emphasis added], noting that the incorrect valuation of employer securities was a “common problem” identified in the DoL’s recent national enforcement project, including cases where plan fiduciaries have “reasonably relied on faulty valuations prepared by professional appraisers.” The proposal also makes specific reference to advice and recommendations as to the management of securities and other property, including such things as voting proxies or recommendations regarding the selection of persons to manage plan investments.
Finally, in what was described as reflecting “the Department’s longstanding interpretation of the current regulation,” the proposal makes clear that fiduciary status “may result from the provision of advice or recommendations not only to a plan fiduciary, but also to a plan participant or beneficiary.” [emphasis added]

Distribution Advice
The proposal notes that while the DoL has previously taken the position that a recommendation to a plan participant to take a permissible plan distribution would not constitute investment advice, even when combined with a recommendation as to how the distribution should be invested, “[c]oncerns have been expressed that, as a result of this position, plan participants may not be adequately protected from advisers who provide distribution recommendations that subordinate participants’ interests to the advisers’ own interests.” As a result, the Labor Department is now seeking comment “on whether and to what extent the final regulation should define the provision of investment advice to encompass recommendations related to taking a plan distribution.” [emphasis added] The proposal notes that the agency is specifically interested in:

• information on other laws that apply to the provision of these types of recommendations,
• whether and how those laws safeguard the interests of plan participants,
• the costs and benefits associated with extending the regulation to these types of recommendations.

The proposal says that the definition of advice does not include “the preparation of a general report or statement that merely reflects the value of an investment of a plan or a participant or beneficiary, provided for purposes of compliance with the reporting and disclosure requirements,…unless such report involves assets for which there is not a generally recognized market and serves as a basis on which a plan may make distributions to plan participants and beneficiaries.” [emphasis added]
Other Points
The proposal says that the DoL believes that explicitly claiming ERISA fiduciary status, orally or in writing, is sufficient to result in fiduciary status, if provided for a fee (in that it “enhances the adviser’s influence, and gives the advice recipient a reasonable expectation that the advice will be impartial and prudent”).
Consistent with existing regulations, the proposal acknowledges that the provision of investment education materials (plan information, general financial and investment information, asset allocation models, and interactive materials) would not be deemed advice.
The proposal notes that the “marketing or making available” investments or an investment menu (e.g., through a platform or similar mechanism) “without regard to the individualized needs of the plan, its participants, or beneficiaries…will not, by itself, be treated as the rendering of investment advice within the meaning of section 3(21)(A)(ii) of ERISA”—if the person making those investments available “discloses in writing to the plan fiduciary that the person is not undertaking to provide impartial investment advice.” Additionally, the provision of information and data to assist a plan fiduciary’s selection or monitoring of investments isn’t deemed to be rendering advice “if the person providing such information or data discloses in writing to the plan fiduciary that the person is not undertaking to provide impartial investment advice.”
The proposal does set aside some limitations, exempting from the fiduciary umbrella persons that can demonstrate that the advice recipient “knows or, under the circumstances, reasonably should know, that the person is providing the advice or making the recommendation in its capacity as a purchaser or seller of a security or other property, or as an agent of, or appraiser for, such a purchaser or seller, whose interests are adverse to the interests of the plan or its participants or beneficiaries, and that the person is not undertaking to provide impartial investment advice.” [emphasis added]
Finally, noting that a necessary element of fiduciary status is that the advice be rendered for a fee or other compensation, the proposal states that that includes, but is not limited to, “brokerage, mutual fund sales, and insurance sales commissions,” [emphasis added] and that it includes fees and commissions based on multiple transactions involving different parties.
Effective Dates
The proposal is set to take effect 180 days after publication in the Federal Register tomorrow, but the Labor Department is first seeking comments on the proposal. The comment period for the proposed regulations will end 90 days after publication of the proposed rule in the Federal Register. That means that the comment period will end January 20, 2011. Comments can be submitted electronically by e-mail to e-ORI@dol.gov (enter into subject line: Definition of Fiduciary Proposed Rule) or by using the Federal eRulemaking portal at http://www.regulations.gov/.

The DoL notes that persons submitting comments electronically are encouraged not to submit paper copies. More information on paper submissions is available (along with the proposal itself) at http://www.ofr.gov/OFRUpload/OFRData/2010-26236_PI.pdf

Judy Ward
editors@plansponsor.com

Vanguard - Cash balance plans can hold hidden risks for plan sponsors

Vanguard

Vanguard | 08/31/2010

Legislative and accounting changes that require faster funding and balance-sheet pension cost disclosure—not to mention a 2008 market that devastated funding ratios—have given rise to a new respect for risk and volatility on the part of defined-benefit (DB) plan sponsors.

Plan sponsors who move to a cash balance plan from a traditional defined benefit (DB) plan may not always realize they are trading interest rate risk for investment risk, Vanguard’s chief actuary maintains.

“Generally, cash balance plan sponsors have the same goals and desires as any other plan,” said R. Evan Inglis, a principal in Vanguard Strategic Retirement Consulting and the chief actuary supporting Vanguard’s clients. “They are looking into ways that they can reduce risk. But reducing investment risk is actually easier with a traditional plan.”

That’s because while cash balance plans are technically DB plans since they provide a guaranteed level of benefit payable to a participant, the benefit is expressed as a lump-sum amount.  However, a traditional pension plan expresses its benefit as an annuity, payable over the participant’s lifetime.

As a result, it is more difficult to invest in assets that match the liability of the cash balance plan than it is to invest in assets that match the liability of a traditional pension plan, Mr. Inglis said. A traditional plan’s liability acts as a long-term bond, which means long bonds can be used to hedge the risk inherent in pension funding levels, he said. This can be a powerful risk-management tool because pension liabilities and bonds both change in value the same way when interest rates change. Investing in long-term bonds minimizes risk, but also allows for potentially a relatively high return.

On the other hand, the liability for a typical cash balance plan is not very sensitive to interest rates, Mr. Inglis said. The liability itself is more stable and predictable, especially because final average pay and early retirement provisions add volatility to a traditional plan. However, because there are no specific assets that will match the liability, the funded status of a cash balance plan is difficult to control, he said.

The original concept for cash balance plans was to credit a relatively low rate of interest to participant accounts and invest in a balanced portfolio that would generate investment earnings higher than the interest crediting rate, he said. That is likely (but not certain) to work fine over a very long time frame, but doesn’t allow for substantially eliminating uncertainty and volatility, Mr. Inglis said.  The reason is that most cash balance plans invest in a traditional balanced portfolio and cannot take advantage of liability-driven strategies that effectively reduce risk, he said.

Cash balance plan features
There are different ways, however, that cash balance plans can be structured, affecting the level of risk and ability to minimize risk.
Most cash balance plans credit a market rate of interest, which changes each year. The most common interest crediting rate is the 30-year Treasury rate. … For a cash balance plan that credits the 30-year Treasury rate to participant accounts, however, investing in 30-year Treasuries doesn’t match the liability, Mr. Inglis said. Each year when the interest crediting rate changes, there would be a gain or loss on the 30-year Treasury assets that’s not matched to the accounts, he said.
Other common interest crediting rates are the 10-year or 1-year Treasury rates. Plans that use the 1-year Treasury rate to credit interest on participant accounts can match the liability pretty well by investing in 1-year Treasuries, Mr. Inglis said. Doing so, however, sacrifices quite a bit of return relative to a traditional portfolio made up of 60% stocks and 40% bonds, he said.
Cash balance plans that use a fixed rate of interest for participant accounts are interest rate sensitive and allow for somewhat easier risk mitigation at higher rates of return, he said. Other plans have interest rate floors. “For example they may credit the 10-year Treasury rate with a minimum of 5%,” Mr. Inglis said. “When you do that you’ve introduced some interest rate sensitivity.” It’s hard, however, to actually invest in anything that matches the liability, he said. There may be some complex derivative strategies that match such a structure, Mr. Inglis said.  But it’s unlikely that most sponsors of cash balance plans are interested in such complicated approaches….
Accepting the efficient frontier

Image via Wikipedia

Beyond such strategies, however, there is little cash balance plan sponsors can do but accept that managing a cash balance plan means taking on investment risk they wouldn’t have to face managing a traditional DB plan.

“There’s just really no reasonable strategy you could adopt to minimize that risk other than to invest in cash or short bonds,” Mr. Inglis said. “That’s kind of the traditional efficient frontier approach.”
It’s a distinction that often goes unnoticed by many plan sponsors, he said.
“Plan sponsors with a traditional pension plan think: ‘Well, there’s a lot of volatility in this plan. We want to get rid of that and replace it with this cash balance plan because it is less risky, less volatile,’” he said. That’s true, however, only if both a cash balance and traditional DB plan invest in the same mix of stocks and bonds, Mr. Inglis said. Sponsors of traditional DB plans are more and more moving to a strategy when it can match its liability with long bonds.
It’s understandable that some employers have moved to cash balance plans. Many employees seem to understand the account balance concept offered in cash balance plans and appreciate the value of an account balance more than the value of a promised annuity. Also, younger participants may appreciate that the value of their benefit increases faster than in a traditional pension plan where much of the value accrues after age 45.
However, the potential to reduce risk and make costs predictable has to be considered alongside potential advantages.