Compliance May 14, 2015

Fiduciary Rule Could Have Unintended Consequences

The proposed conflicted investment advice rule from the DOL is designed to protect retirement plan and IRA participants, but experts attending the ASPPA Virtual Conference aren’t sure the rule can deliver.
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In 2010, the Department of Labor proposed a new definition of fiduciary. But, it retracted that proposal based on retirement industry concerns, and has recently reissued what it now calls a proposed conflicted investment advice rule.

CEO of the American Retirement Association Brian Graff, during the American Society of Pension Professionals and Actuaries’ (ASPPA’s) first-ever virtual conference, noted that the proposed rule is not just changing the definition of fiduciary under the Employee Retirement Income Security Act (ERISA)—it adds two new prohibited transaction exemptions (PTEs), six amendments to existing PTEs, and pulls individual retirement accounts (IRAs) and IRA holders into the definition of fiduciary investment advice.

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Graff added that the proposed rule is very broad in whom it captures as an ERISA fiduciary, and he contended the proposal creates a significant challenge for conversations with participants about what to do with their money. “The proposed rule applies to retirement plans, but doesn’t apply to retail products, and that’s one of the problems with the rule,” he said.

As an example, Graff noted that a retirement plan participant who has been working with a plan adviser for 20 years may want to continue working with the adviser after he leaves the plan because he trusts the adviser. However, the plan adviser may propose that because the participant is going to require more comprehensive advisory services after rolling over his plan balance to an IRA, he will charge a higher level fee than he charged to the plan.

According to Graff, under the DOL proposal, if the level of fees in an IRA is structured differently than the fees in the plan, a rollover to that IRA would be considered a prohibited transaction. This means the adviser would have to establish and comply with the rule’s Best Interest Contract (BIC) prohibited transaction exemption. The adviser would have to notify the DOL’s Employee Benefit Security Administration of the intent to use the exemption, enter into a written contract with the participant, and adhere to standards set forth in the proposed rule, including multiple disclosures.

On the other hand, Graff said, if the participant’s relative has a friend who is an independent financial adviser, even if that adviser would charge the participant a higher fee than the plan’s financial adviser would, there would be no prohibited transaction from the rollover of the plan balance into that financial adviser’s IRA and no need for the contract or disclosures.

NEXT: How the rule may affect buy-and-hold investors and participant education.

Ilene H. Ferenczy, managing partner at Ferencszy Benefits Law Center LLP, told virtual conference attendees this is an example of the rule not protecting who it intended to protect—unsophisticated investors. Bob Kaplan, ASPPA Government Affairs Committee co-chair and national training consultant with Voya Financial, added that participants who want to continue a relationship with plan providers would be handed large contracts and multiple fee disclosures that may confuse them and make things more complicated. Graff said, “It’s as if participants and advisers are being punished for an ongoing relationship.” He added that advisers may say if the account is small it’s not worth the additional contract and disclosure costs.

Graff discussed the DOL’s examples of acceptable fee structures for advisory firms and noted that while they are not required, the DOL says they should be considered and if they are used, no BIC exemption is needed. “Basically, the DOL is saying, if you do business the favored way, it’s business as usual, but is it okay for the government to decide what an acceptable business model is?”

According to Graff, under the proposal, if an adviser is getting commission-based pay and approaches a small (<100 participants) employer to sell a start-up plan, that is a prohibited transaction. Craig P. Hoffman, ASPPA general counsel, says this demonstrates how the proposal sets up protections for participants, but not plan sponsors. Graff added that he feels this will reduce the number of new plans because small business owners aren’t thinking about retirement plans, they’re thinking about keeping the business going, so they need someone to approach them.

In addition, Graff feels the proposal as it relates to fee structures may hurt “buy-and-hold” investors. As an example, he showed how an IRA investor that wants to buy a portfolio of income-producing stocks with the intention of holding on to those stocks until the required minimum distribution rules require liquidation and taking distributions of the dividends could be hurt by the proposed rule’s fee disclosure requirements. Adviser A may receive a 5% commission on the purchase and sale of the stock. Because her compensation varies with account activity, she must provide a point of sale disclosure which could show estimated cumulative one-, five- and 10-year fees of $10,000, $10,000 and $11,350, respectively. Adviser B will receive a 1.0 % per year advisory fee.  Because this percentage does not vary with account activity, no point of sale disclosure is required.

Based on information provided, the investor may choose Adviser B, but cumulatively, because he is a buy-and-hold investor and Adviser A’s commission is based on the purchase or sale of stock, the investor would pay less with Adviser A.

Finally, Graff noted that one part of the DOL’s proposed rule hurts participant education efforts (see “Changes Plan Sponsors Would See with New Fiduciary Rule.”). Under current rules, plan sponsors or advisers providing participant education may give examples of appropriate portfolios based on participant age or risk tolerance and use names of funds they have access to in the plan’s investment lineup. The education material must include a disclaimer that there are other funds available besides the ones shown that would fit into the example allocation. Under the proposed rules, the education may no longer include specific examples from the plan’s fund menu. “The DOL says it believes disclaimers do not work,” Graff said.

Ferenczy contended that participants, especially unsophisticated investors, need these examples. “Taking out the ability during enrollment meetings to list investments that are on the plan menu does not protect the unsophisticated investor; it leaves them blind,” she stated.

Data & Research May 14, 2015

Low Interest Rates Ease Pension Debt Restructuring

In finance as in physics, investment market forces produce both upside and downside. It's a phenomenon that is especially apparent when discussing low interest rates.
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Prolonged low interest rates have prevented pension plans from riding record-setting equity markets to a higher aggregate funded status—but there is a flip side to low interest rates when it comes to risk transfers and pension debt restructuring.

Jim Gannon, managing director of asset allocation and risk management for Russell Investments, observed during a recent interview with PLANSPONSOR that, of the 10 or so mega risk transfer deals the market has seen in recent years, the moving sponsors share a few common characteristics.

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“First off, these deals have all generally involved very large pension plans relative to the overall size of the sponsoring organizations,” Gannon explains. “In other words, the liability value divided by market capitalization has been very high, on average.”

These companies, from Motorola and Verizon to Bristol-Myers Squibb and General Motors, were early movers in an expanding pension risk transfer (PRT) market that saw a 120% increase in deal volume last year, reaching $8.5 billion in 2014, compared with the $3.8 billion total in 2013, as measured by the LIMRA Secure Retirement Institute. Sales in the PRT buyout market have exceeded $3.5 billion for three consecutive years, according to survey results from the insurance and financial services trade association, and the trend is expected to continue. 

The early mega-movers also all generally display a great deal of financial flexibility and strong access to cash and the capital markets, Gannon notes. They were either transferring risk from relatively well-funded plans, or they had the ability to pull cash from within the company to make contributions to fund these transactions—or they had the ability to access the necessary cash through borrowing.

This is the upside to the low interest rate downside, Gannon suggests. Several of these plans were able to successfully issue debt via the capital markets (at very affordable rates), with the intent of better- or even fully funding the pension plan “with relatively cheap dollars.”

“They issued debt and then they funded the pension plan with the cash they received from investors,” Gannon continues. “When rates are low it means the funded status will be lower, because the discount rate used in funded status calculations is lower. But when rates are low that also means it’s a favorable time to issue debt, and you can use the debt to fund a PRT transaction shortfall. It’s yet another way to get pension risk off the balance sheet.”

Gannon was on an analyst’s call following the announcement of the Motorola deal, and this strategy was specifically cited by Motorola leadership. “They talked about how the low interest rate environmental seemed favorable from the borrowing perspective,” Gannon explains. “They made some strong arguments, and I think this method may make a lot of sense for some plans out there looking for a path forward towards PRT.”

Gannon says the Motorola executives cited some important benefits to this approach that largely made up for the cost of issuing new debt to cover legacy pension liabilities. “It can be really beneficial from a business performance and valuation perspective,” he explains, “because a standard bond issue you will use to fund a pension shortfall or risk transfer will have terms that are very well defined. The sponsor can say, ‘I’m issuing this amount of debt for this many years and I’ll be paying interest at this rate and this frequency.’ It is straightforward debt—and analysts deal with that kind of debt all the time when they’re analyzing companies and they can be more comfortable with this debt.”

Compare a standard bond issue with pension debt and the argument has some force. Pension debt is paid off over an uncertain number of years that is highly contingent on participant longevity, capital market outcomes, interest rate movements, and various other factors such as lump-sum payments, litigation risk and even regulatory changes.

“If a sponsor can replace this pension debt, which is difficult to value and fully understand, with debt that is much more straightforward and comfortable for analysts to understand, it can help the valuation of your company,” Gannon says. “We’ve seen this play out in real time with some of the recent deals.” 

Of course, issuing debt via the capital markets is not an option for all plan sponsors, and doing so successfully requires some serious financial savviness. The sponsor will undoubtedly have to seek approval and support from beyond the HR and benefits delivery side of the business—finance and top management will play a key role and will likely have the final say on any major transaction.

“It’s somewhat of a sophisticated strategy that is going to require input from a lot of different groups, including advisory or consulting resources,” Gannon says. ”The sense I have is that this approach will continue to be concentrated among the larger companies with legacy pensions—and those companies that have strong access to cash or the capital markets. Smaller sponsors may have to freeze and hibernate their pensions to get to a point where issuing sufficient debt to cover the cost of a PRT transaction actually makes sense.”

Gannon says there has been a lot of talk that, when interest rates start going up, this will be the catalyst that finally brings funded statuses back to where sponsors want them to be, “and that will trigger another big wave of PRT transactions and more moves to liability-driven investing programs.”

“I think that’s true to some extent, but one point of caution on waiting for interest rates to climb towards historical norms, you may end up having to pay a pretty hefty opportunity premium to do PRT at the same time as everyone else,” Gannon concludes. “If all these plans are moving to do a big PRT transaction at the same time, that could absolutely impact the pricing and we could see a premium emerge out of this big rush for the door.”

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