Two forces that affect investing
In recent weeks we’ve covered two of the key forces that have been affecting pension plan investing lately. First we looked at the mounting trouble that pensions face because of lowered bond interest rates intended to boost the economy in How low can they go? Later, we explored the pros and cons of pension plans investing in hedge funds and private equity and asked you for your thoughts on the topic in our poll: Hedging your pension bets.
Public-sector employees overwhelmingly choose defined benefit plans over defined contribution plans when given a choice, according to a report by the National Institute on Retirement Security and Milliman.
In six states that offer new employees a choice between DB and DC plans, the report found that DB was chosen by most employees, ranging from 75% to 98% among the state plans.
“If you had an election with 75% of the vote (for a candidate), it would be well past a landslide,” Mark Olleman, a consulting actuary and principal at Milliman, said in a telephone interview. Mr. Olleman is co-author of the report, which was issued Thursday, with Ilana Boivie, an NIRS economist.
Statewide DC plans have lower investment returns than DB plans because DB assets are pooled and professionally managed, according to the report.
“Some states have considered moving from a DB-only to a DC-only structure in an attempt to address an unfunded liability,” the report said. “Making this shift, however, does nothing to close any funding shortfalls and can actually increase retirement costs.”
To fix their persistent pension problems, some U.S. states are looking to reshape their retirement plans to resemble those in the private sector, but they may find may employees resistant and the savings elusive.
A new study of the retirement plan choice in the public sector finds that defined benefit (DB) pensions are strongly preferred over 401(k)-type defined contribution (DC) individual accounts. The study analyzes seven state retirement systems that offer a choice between DB and DC plans to find that the DB uptake rate ranges from 98% to 75%. The rate for new employees choosing DC plans ranges from 2% to 25% for the plans studied.
In recent years, a few states have offered public employees a choice between primary DB and DC plans. The new study, Decisions, Decisions: Retirement Plan Choices for Public Employees and Employers, analyzes the choices made by employees and finds that:
When given the choice between a primary DB or DC plan, public employees overwhelmingly choose the DB pension plan.
DB pensions are more cost-efficient than DC accounts because of higher investment returns and longevity risk pooling.
DC accounts lack supplemental benefits such as death and disability protection. These can still be provided, but require extra contributions outside the DC plan, which are therefore not deposited to the members’ accounts.
When states look at shifting from a DB pension to DC accounts, such a shift does not close funding shortfalls and can increase retirement costs.
A “hybrid” plan for new employees in Utah provides a unique case study in that it has capped the pension funding risk to the employer and shifted risk to employees.
In 2010, 60% of large pension plans invested in hedge funds (up from 11% in 2001) and 92% of large plans invested in private equity. Hedge funds and private equity can be very profitable investments but they come with risks beyond those posed by traditional investments. These investments are often difficult to value and can be highly leveraged, which can lead to large rewards, but plenty of risk.
The Pension Benefit Guaranty Corporation (PBGC) has provided relief from certain premium payment penalties and, in certain situations, relief from penalties that are due to an incorrect election of the alternative premium funding target. The PBGC is taking this action as a result of public comments and a White House directive to review and improve federal regulatory processes.
For plan years starting in 2011 and thereafter, if premium payments are not more than seven days late, the PBGC will waive premium penalties that otherwise would be assessed. The PBGC, however, will not waive late-payment interest charges under this relief.
For alternative premium funding target elections, the PBGC is granting relief as follows:
For plan years starting in 2010 and thereafter, the PBGC will provide relief similar to, but more expansive than, the relief provided in its June 2010 Technical Update 10-2 (Variable Rate Premiums; Alternative Premium Funding Target Elections; Box 5 Relief).
For the 2008 and 2009 plan years, the PBGC will waive premium penalties for late premiums in connection with certain Box 5 errors (Part II of the Alternative Premium Funding Target Election of the comprehensive premium filing).
The PBGC will contact the plan administrator if a plan is entitled to penalty relief for either of these premium funding target election issues. The plan administrator is likely to be required to submit an amended filing.
The PBGC’s relief is effective as of its publication in the Federal Register of September 15, 2011.
The Federal Reserve’s ‘Operation Twist’ to bring down bond yields and stimulate the economy is likely to cause pain for the nation’s largest pension funds, already struggling with funding shortfalls from the recent stock market decline.
Hit both by falling stock prices and falling bond yields, the 100 largest pension plans of public U.S. companies have assets covering only 79 percent of their liabilities as of the end of August, down from 86 percent at the end of 2010, according to consulting firm Milliman Inc.
Already approaching its all-time low of 70.1 percent in August, 2010, the funding ratio could fall below 60 percent within two years if equities stagnate and rates decline further, Milliman projected.
“I’ve said rates were at historic lows for three years now and they keep going lower,” John Ehrhardt, a principal in the firm’s New York office, said.
Corporate pensions were well funded back in 2007 before the financial crisis hit, but even though the stock market has recouped most of its losses, falling bond yields have prevented the funds from regaining their solid footing.
The U.S. Department of Labor’s Employee Benefits Security Administration will re-propose its rule on the definition of a fiduciary. Consistent with the president’s January executive order on regulation, the re-proposal is designed to inform judgments, ensure an open exchange of views and protect consumers while avoiding unjustified costs and burdens. When finalized, this important consumer protection initiative will safeguard workers who are saving for retirement as well as the businesses that provide retirement plans to America’s working men and women. The decision to re-propose is in part a response to requests from the public, including members of Congress, that the agency allow an opportunity for more input on the rule.
Today’s decision to re-propose means that this important consumer protection initiative will benefit from additional input, review and consideration. The agency agrees with stakeholders and lawmakers that more public input and greater research will strengthen the rule. This extended input will supplement more than 260 written public comments already received, as well as two days of open hearings and more than three dozen individual meetings with interested parties held by the agency…
Specifically, the agency anticipates revising provisions of the rule including, but not restricted to, clarifying that fiduciary advice is limited to individualized advice directed to specific parties, responding to concerns about the application of the regulation to routine appraisals and clarifying the limits of the rule’s application to arm’s length commercial transactions, such as swap transactions.
Also anticipated are exemptions addressing concerns about the impact of the new regulation on the current fee practices of brokers and advisers, and clarifying the continued applicability of exemptions that have long been in existence that allow brokers to receive commissions in connection with mutual funds, stocks and insurance products. The agency will carefully craft new or amended exemptions that can best preserve beneficial fee practices, while at the same time protecting plan participants and individual retirement account owners from abusive practices and conflicted advice.
The agency is seeking to amend a 1975 regulation, which defines when a person providing investment advice becomes a fiduciary under the Employee Retirement Income Security Act, in order to adapt the rule to the current retirement marketplace. The proposal’s goal is to ensure that potential conflicts of interest among advisers are not allowed to compromise the quality of investment advice that millions of American workers rely on, so they can retire with the dignity that they have worked hard to achieve.
The new proposed rule is expected to be issued in early 2012.
If you are a plan sponsor of a defined contribution (DC) retirement plan, I’m sure you have heard the term “automatic enrollment” and I’m sure you have been encouraged by your consultants or advisors to consider it for your DC plan. If you haven’t already added it, you may be sitting there saying to yourself: “Automatic enrollment, why not? It’s automatic, therefore it will save time, improve plan participation, and allow us to focus on other priorities. Done. Simple.” If you have already added it, I’m sure you’re reading that last statement and saying to yourself, “Yes, I thought the same thing.”
I’m not writing to put the kibosh on this design. Quite the contrary. Automatic enrollment has its place and I have recommended it to clients when the pros and cons of adding automatic enrollment were evaluated in the context of the overall design and goal of the employer. But let me be clear on this: unless you are an employee of an auto-enrollment plan that takes absolutely no initiative, there is nothing automatic about auto enrollment.
As a plan sponsor, it is crucial to identify goals. Whether it is improving participation, improving discrimination results, or perhaps improving the benefits to a key set of employees, the goals identified will help to guide design considerations. And if one of these considerations is automatic enrollment, you should be aware of the following:
The American Academy of Actuaries thinks No, and I’m inclined to agree.
The Pension Protection Act generally requires defined benefit (DB) plans to pay a minimum contribution each year that is comprised of two parts, namely (1) the target normal cost and (2) a shortfall amortization. In simple terms, the first component covers the cost of additional benefit accruals and plan expenses for the upcoming year, and the second represents a seven-year mortgage of any debt (i.e., underfunding) that the plan has. A question currently being wrestled with by the IRS as they formalize guidance is whether or not plan expenses in the target normal cost should include “investment related expenses” or just “administrative expenses.”
Administrative expenses ordinarily include things like legal, accounting, and actuarial fees, termination insurance (PBGC premiums), and perhaps some administrative costs of the trustee, such as those involved with cutting checks to retirees or processing contributions. Investment-related expenses in this debate refer to the costs associated with professional management of the plan’s portfolio of assets. Broken down to one of its most basic decision levels, the choice facing a plan sponsor with regard to investments is whether to pursue “active” or “passive” asset management. Passive management usually entails investing in index funds, which are designed to have little maintenance and low cost. Active management involves professional advisors seeking out opportunities in their niche markets in search of superior returns with various risk and reward characteristics. With passive management, the goal is to track the market. With active management, the goal is to beat the market.