The Markets August 22, 2011

Economy and Regulations Hampering Investment Managers

The dual impact of the persistently weak economic environment and new regulations is keeping investment management companies on a slow growth track, according to industry executives surveyed by KPMG LLP.
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The survey of 100 U.S. investment management executives conducted in May and June 2011 revealed their biggest concern was about regulatory and legislative pressures, but their views about an overall economic recovery were equally dour.

The burden of new regulations was a focal point, with 61% of the asset managers indicating those pressures pose the most significant barrier to their company’s growth. In addition, 70% of the executives said they are concerned with the overall regulatory climate in the U.S.

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The survey results show investment management executives are not optimistic the economy will experience a recovery anytime soon. While more than half of the executives said they expect a moderate improvement next year, in a separate question, 57% indicated they don’t expect a complete recovery until the end of 2013 or even later.

“The executives told us that the combined impact of the uncertain regulatory and constricted economic environment is significantly inhibiting growth as they try to determine what moves they will need to make to maintain their competitive edge,” said Dave Seymour, head of KPMG’s Investment Management practice. “The good news is that they are putting cash into play to improve their infrastructure and to prepare for future business needs,” he added. 

Dealing with regulatory and internal control needs is expected to represent the second largest increase in spending over the next year, according to the asset managers, coming in behind information technology.

Asked to identify what actions they would need to take to comply with regulatory changes, 68% identified improving existing internal policies and procedures, 63% pointed to strengthening information technology platforms and enabling applications, 59% said strengthening risk management processes, 46% identified developing a strong internal training program for staff, and 40% chose enhancing financial reporting procedures.

In the KPMG survey, 75% of the asset managers said their companies have “significant” cash on their balance sheets and 24% already are investing the cash, and an additional 27% expect to be investing by the first quarter of 2012. The top three high-priority investment areas they expect the cash will be applied to include: technology (25%), strategic acquisitions (21%), and expansion into new markets (18%).

When asked to choose areas in which they are looking to increase spending over the next year, 57% said information technology, 29% identified regulatory and control environment, and 26% said new products and services.

Sixty-one percent of the investment management executives said they are expecting to increase headcount over the next year, with 29% expecting an increase of between 1% and 3%, 20% expecting a 4%-6% increase, and 10% saying the increase will be in the range of 7% to 10%. Only 2% expect an increase of more than 10%. In addition, 29% expect headcount will remain about the same and 11% expect a decrease in headcount.  

More than half (54%) of the executives surveyed believe transparency has improved between investment managers and investors since the financial crisis, while 38% have seen no real change. Nine percent said it is too early to tell.

In addition, nearly half of those surveyed (49%) said they believe relationships between investment managers and investors have improved, while 37% said they have seen no real change, and 15% said it is too early to tell.

In other survey findings, executives believe over the next 12 months, investors’ capital will continue being invested in traditional funds, with 46% choosing long only funds, 15 percent said real estate fund offerings, 14% said private equity and private equity fund of fund offerings, 14% said hedge fund and hedge fund of fund offerings, and 11%  said venture capital.

Compliance August 22, 2011

Tax Court Enforces 10% Penalty on Deemed Distribution

A tax court has upheld a 10% early distribution penalty that the Internal Revenue Service (IRS) imposed on a deemed distribution of a plan loan.
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According to EBIA, the participant in the case took a plan loan from a federal government plan that operates under rules similar to those that apply to 401(k) plans that satisfied the Code’s requirements when the loan was made. Subsequently, the participant was removed from employment under circumstances that resulted in years of litigation before the employer’s action was ultimately upheld.  

Under regulations governing the plan, a participant who is separated from government service must repay any outstanding loan balance in full within the period specified in a notice to the participant. When the participant did not make the full repayment by the date specified in his notice, the plan reported the loan balance as a taxable distribution on Form 1099-R.  

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The participant included the loan balance in his income for that year but did not pay the 10% early distribution penalty. The IRS then issued a notice of tax deficiency for the penalty amount, and the participant filed this action. 

EBIA reported that in tax court, the participant took the position that he had erroneously included the loan balance in his taxable income. Based on an interim ruling that ordered his employment reinstated (later undone), the participant argued that he had not separated from service and, thus, the plan should not have reported his loan balance as a deemed distribution.  

The court found, however, the regulations governing the plan required the participant to notify the plan of his reinstatement in order to restore the loan, which the participant never did. Therefore, the court held that the unpaid loan balance was a deemed distribution.  

Because the participant had not argued that the deemed distribution satisfied an exception to the 10% percent early distribution penalty, the penalty applied.   

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