Module 8: Impact of Financial Product Innovation on Retirement Plans

Explain why investments in employer securities pose a significant litigation risk for plan fiduciaries. (Textbook, pp. 314-315)

At present, benefit plan investments in employer securities remain a significant litigation risk. If the price of the employer's stock declines significantly, and particularly if the employer experiences severe distress or bankruptcy, a lawsuit is likely to follow. Conversely, fiduciaries are at risk if they opt to divest employer stock and the price then goes up. Further, fiduciaries who have inside information face a conflict between their fiduciary duties and restrictions imposed by the securities laws.

Distinguish between baseline prudent investment practices under ERISA and enhanced ERISA prudent best practices for innovative investments. (Text, pp. 292-293)

Baseline prudent investment practices resulted when ERISA Section 404 was codified. This section sought to install longstanding principles of fiduciary conduct that had been developed under the common law of trusts with the specific intent of protecting participants in employee benefit plans. With Section 404, Congress mandated baseline or core prudent practices for all ERISA plans using even the simplest of investments. The enhanced fiduciary best practices for innovative investments are a second and necessarily deeper layer that magnifies the baseline. This secondary, supplemental standard has been created by intermittent publications from the Department of Labor (DOL).

How do closed-end funds differ from open-end mutual funds? (Text, p. 307)

Closed-end funds, in contrast to open-end mutual funds, generally do not redeem their shares, although some do so at specified intervals. Instead, investors sell shares on the market to other investors. This structure often makes closed-end funds problematic for participant-directed plans. Some of these funds tend to be actively managed and thus often are more expensive. (The distinction between the redeemability of closed-end funds and exchange-traded funds (ETFs) requires a deeper discussion than what is provided in the textbook.)

What are "collective investment trusts," and what are some of the important topics fiduciaries of the investing plans should focus on? (Text, pp. 307-309)

Collective investment trusts are pooled investment funds offered by a bank that acts as trustee and is managed by the trustee or a professional investment manager. They are offered only to benefit plans. Although similar to mutual funds, assets in the trust are subject to regulation by ERISA and are not subject to the same disclosure requirements as mutual funds. The items that fiduciaries of the investing plans should focus on include: (a) Reviewing the disclosure and filings offered by a particular collective investment trust, in order to understand what will be available to their plan (b) Making sure that they understand the fund's valuation and financial oversight processes (c) Making sure that the valuations provided to them by their plan investment providers are reasonable and appropriate (d) Obtaining copies of all governing documents and reviewing them with legal counsel and their investment professionals (e) Understanding the terms and rules regarding the liquidity of their investment, for example, some funds limit redemptions to specific intervals (f) Understanding whether a fund permits securities lending, what sort of risks and returns are involved, what rules are in place to prevent prohibited transactions and what sort of fees are charged in connection with securities-lending activities.

Mutual funds are often used as an investment vehicle in ERISA plans. Describe these investment vehicles with regard to their (a) liquidity, (b) governmental regulation and (c) appropriate disclosure documents. (Text, pp. 304-305)

(a) Mutual funds issue redeemable shares, meaning that investors wishing to leave the mutual fund sell their shares back to the fund. Consequently the fiduciary can generally expect the investment to be liquid in normal market circumstances. (b) Mutual funds are not subject to direct regulation by ERISA, but they are subject to regulation under the Investment Company Act of 1940 and must meet regulatory standards regarding liquidity of the portfolio, presence of independent directors on the governing board, compliance oversight and other matters. (c) A mutual fund is required to provide appropriate disclosure documents, meaning that the fiduciaries of a participant-directed plan do not need to design customized fund descriptions for participants.

Describe the contract features of QLACs with regard to (a) the maximum premium that can be paid, (b) the maximum age to commence payments and (c) prohibited contract features. (Text, pp. 287-288)

(a) The total premium cannot exceed the lesser of $125,000 (indexed for inflation) or 25% of a participant's aggregate account balance. (b) The maximum age at commencement of a QLAC is currently set at the age of 85. (c) The following features are currently prohibited: variable contracts, indexed (or similar) contracts, and contracts with commutation benefits or cash surrender values. In addition, there are restrictions on the death benefits that can be available under a QLAC contract.

What are some basic considerations for an ERISA fiduciary in evaluating the possibility of selecting mutual funds as a plan asset? (Text, pp. 305-306)

An ERISA fiduciary should consider the following factors when evaluating mutual funds as a plan asset: (a) Fiduciaries should be sure to understand whether the fund uses an "active" or "passive" strategy. Passive funds typically seek to match an index of securities, while active funds attempt to outperform the market. (b) In selecting a mutual fund, fiduciaries should consider the fund's performance, expenses, alignment with the desired asset class parameters and other relevant factors. (c) Fiduciaries should make sure that they have selected the appropriate share class. For example, plans making a large enough investment may qualify for more favorably priced "institutional" class shares. (d) Fiduciaries need to make sure all selected investment products are prudent and appropriate. (e) Fiduciaries need to review expenses by reviewing more than just the expense ratio. Redemption fees, minimum holdings and other terms must be considered. (f) Fiduciaries need to understand the advantages and disadvantages of revenue sharing. These arrangements involve a fee paid to the plan's recordkeeper directly for certain fund-related services.

Describe the regulatory obstacle that, in the past, prevented the use of longevity contracts. (Text, pp. 286-287)

Before release of the final rules, the Internal Revenue Service (IRS) required that the value of any longevity contract must be included as part of a participant's account balance for RMD purposes. If participants included the annuity in their account balance and that balance dropped substantially, they might be required to start taking distributions from the longevity contract much earlier than desired. On the other hand, if they did not include the value of any longevity contract as part of their account balance, they risked incurring substantial penalties. The final regulations provide relief from this situation by allowing participants to exclude the value of a longevity annuity contract for RMD purposes if the annuity meets the definition of a QLAC.

What are the major challenges older workers confront when they need to convert their DC plan assets to periodic lifetime income? (Text, p. 277)

Challenges for older workers when they attempt to generate lifetime retirement income include: (a) Retirement savings may need to last anywhere from 20 to 30 years. (b) Market volatility adds another level of complexity to the task of managing savings in retirement. (c) Many older workers are unable to accurately calculate the amount of savings needed to generate lifetime retirement income. (d) Not many retirees have a formal strategy for how to draw down their savings. (e) Many older workers with moderate savings do not have access to skilled and unbiased financial advisors, or they may not know how to identify and select them. (f) Older workers looking for retirement income solutions face a rapidly evolving marketplace that is difficult to navigate

DOL has specified the responsibilities fiduciaries have when setting up a monitoring system for the fees associated with an investment. Outline this obligation. (Text, pp. 294-295)

DOL has noted that trustees have an obligation to set up a monitoring system that: (a) Determines the needs of a fund's participants (b) Reviews the services provided and fees charged by a number of different providers (c) Selects the provider whose service level, quality and fees best match the fund's needs and financial situation.

ERISA imposes an exacting standard of conduct for fiduciaries of employee benefit plans. To what extent does ERISA set forth specific guidelines as to the types of investment vehicles and other property that a plan can own or the types of investment transactions in which a plan can engage? (Text, p. 302)

ERISA does not have any specific restrictions or guidelines on the types of investments a plan can hold. It also does not have any guidelines or restrictions on the types of investment transactions in which a plan can engage—other than the fact that fiduciaries must confirm that making the investment (and engaging in any other activities associated with the purchasing, holding and eventual redemption or sale of the investment) will not constitute a "prohibited transaction."

Does hiring an investment advisor or investment manager eliminate the fiduciary's liability? Explain. (Text, p. 304)

Hiring an investment advisor or investment manager does not relieve the named fiduciary from understanding the nature of the plan's investments and chosen investment strategies. It is in the interest of fiduciaries to understand the investment professional's strategy and to make sure they obtain enough information about investments to verify that the chosen strategy remains appropriate and that the plan's actual investments align with the strategy.

Many parties are involved in an ERISA retirement plan. However, when selecting plan investments, only the needs of two parties must be served. Identify these parties. (Text, p. 293

It is the needs of the participants and their beneficiaries solely upon which the decision to add an investment to an ERISA retirement plan portfolio must be based. A detailed checklist is recommended to cover all known conflicts of interest, and documentation should be maintained to demonstrate that the decision was made solely in the interest of the participants.

Describe the basic purpose of a QLAC. (Text, p. 286)

QLACs provide retirement income to individuals starting at an advanced age. They are designed to provide added financial security to retirees in case they exhaust their retirement investments—such as by "living too long" or experiencing a major market downturn.

Plan sponsors that want to help retirees convert DC plan assets to retirement income while recognizing their fiduciary duties will want to conduct a due diligence process that includes which steps? (Text, pp. 282-283)

Key steps to be taken by plan sponsors that want to conduct a due diligence process to help retirees convert DC plan assets to retirement income include: (a) Assess the needs and abilities of their older workers. (b) Learn about various RIGs, including the retirement planning goals each RIG addresses, their advantages and disadvantages, and how much income can be reasonably expected. (c) Learn about the capabilities, costs and communications support that can be provided by their existing plan administrator and the capabilities of alternative vendors. (d) Develop criteria for the design of the retirement income program, and assess how each potential RIG and retirement income solution meets these criteria. (e) Develop a reasonable timetable with the plan administrator for implementing and communicating the retirement income program.

Explain the relationship between modern portfolio theory (MPT) and the diversification requirement in ERISA. (Text, p. 299)

MPT constructs a risk/reward frontier that assumes diversification always eliminates nonsystematic risk. Since MPT is a bedrock tenet of ERISA, the diversification requirement is very important. It reduces the risk of large losses ". . . by diversifying the investments of the plan so as to minimize the risk of large losses, unless under the circumstances it is clearly prudent not to do so."

Describe QLAC required features other than those described in the previous question. (Text, p. 288)

QLACs must contain specific language in the contract that identifies it as a QLAC. Also, QLACs are subject to an annual reporting requirement that includes, among other things, information about the plan and plan sponsor, the annuity starting date, the amount of the payment and whether the starting date may be accelerated.

Do all types of retirement plans qualify as QLACs? Explain. (Text, p. 287)

Only DC plans (including 401(k) and profit-sharing plans), traditional individual retirement accounts (IRAs), 403(b) plans and government 457(b) plans are eligible to hold QLACs.

What are some of the concerns plan fiduciaries should have about white label funds? (Textbook, pp. 313-314)

Possible areas of concern for plan fiduciaries are: (a) White label funds may involve significant costs and burdens because of costs such as higher recordkeeping fees, higher audit fees, legal fees for manager contracts, and legal and vendor fees for preparation of customized fund disclosures. (b) These funds require a considerable investment of time by plan fiduciaries and staff. (c) Special regulatory issues may be associated with white label funds. Some types of investment activity might trigger additional obligations. (d) Fiduciaries need to be sure that disclosure materials adequately meet ERISA standards and sufficiently give participants the necessary information to make investment decisions.

In the Sulyma v. Intel case, the Intel plantiffs argued that the Intel ERISA investments underperformed a passive index and therefore should be considered imprudent. Does poor investment performance constitute imprudent investment management under ERISA? Explain. (Text, p. 301)

Prudent investing is not judged on the investment results in hindsight, but rather by the process employed to investigate and monitor the investment. So the mere fact that the Intel investments underperformed the passive index does not create an imprudent process.

Briefly describe the fiduciary duties that are involved when annuity contracts are purchased by an ERISA plan. (Text, p. 310)

Specific rules apply to a fiduciary's selection of an annuity contract. Fiduciaries should document their conclusions regarding the ways in which the chosen annuity provider meets the criteria outlined in the regulations and should work with a professional advisor familiar with the annuity marketplace.

What are some typical retirement income goals? (Text, p. 279)

Typical retirement income goals can include: (a) A desire for liquidity to meet emergencies (b) Maximizing expected retirement income (c) Income that does not decrease due to capital market volatility (d) Income that keeps up with inflation (e) Income that retirees cannot outlive.

Define the "prudent man" standard required of ERISA plan investments. (Text, p. 297)

The "prudent man" standard requires investments to be made "with the skill, prudence, and diligence under the circumstances then prevailing that a prudent man acting in a like capacity and familiar with such matters would use in the conduct of an enterprise of a like character and with like aims."

Describe the regulatory suggestion made in the SOA/SCL study for helping retirees convert DC plan assets to retirement income. (Text, p. 283)

The SOA/SCL study suggested a safe harbor guidance for the design and implementation of a program that would apply during the decumulation phase, which would be analogous to the safe harbors that apply for investments during the accumulation phase

What are the advantages to retiring employees of an employer-sponsored program of taking retirement income from a DC plan? (Text, pp. 283-284)

The advantages to retiring employees of an employer-sponsored program of taking retirement income from a DC plan include: (a) Institutional pricing has the potential to increase retirement incomes by 10% to 20% compared to retail solutions. (b) Solutions are more likely to be implemented successfully if it is easy for retiring employees to implement their decision. (c) The employer's plan is a safe place to keep retirement savings away from fraudsters who target seniors

Must ERISA investments always follow mainstream and popular strategies to be considered prudent? (Text, pp. 291-292)

The belief by many is that ERISA investments, particularly participant-directed investments, must always follow mainstream and popular strategies and that deviation from such strategies is imprudent. However, on a historical basis, this is not the case. Many innovative investment developments have occurred since the passage of ERISA. A few examples of such innovations include index funds, stable value investment options, emerging market mutual funds and TDFs.

Although an investment policy statement (IPS) is not expressly required under ERISA, fiduciary best practices indicate that an IPS should be in place. List the features or characteristics of a good IPS for innovative investments. (Text, p. 300)

The following are the features or characteristics of a good IPS for innovative investments: (a) It should be more detailed than an IPS for standard investments, to help assess the innovative investment and, most importantly, to help monitor the innovative investment on an ongoing basis. (b) It should be flexible enough that it can be implemented in a complex and dynamic financial environment. (c) It should not be so detailed as to require constant revisions and updates. (d) It should be drafted in a way that does not increase the risk of failure by the investment fiduciaries. (e) It should be carefully drafted, typically by an attorney familiar with employee benefit issues working in concert with the fiduciaries and their investment consultants. (f) The investment criteria in the IPS should be written in the context of meeting the needs of the participants.

When a plan invests in individual securities, the plan fiduciary needs a detailed investment management agreement with an investment manager. List the important items or features that this agreement should contain. (Text, p. 312)

The important items or features that this agreement should contain include: (a) The guidelines for investment and proxy voting (b) The identification of any special brokerage arrangements or restrictions (c) The manager's compensation (d) Representations by the manager regarding its fiduciary status and professional qualifications (e) Protection for the confidentiality of plan information (f) Provision for appropriate indemnity protection (g) Identification of any threshold insurance requirements (h) Expectations regarding recordkeeping and reporting by the manager to the plan (i) The procedure for amendment and termination that ensures that the plan can terminate on reasonably short notice without penalty.

The Society of Actuaries and the Stanford Center on Longevity (SOA/SCL) collaborated to produce a study that provides an analytical framework for planning retirement income. What were the key results from this study? (Text, pp. 279-281)

The key results from the SOA/SCL reports were: (a) There is a distinct, quantifiable trade-off between liquidity and maximizing income. (b) For most retirees, using a portion of retirement savings to delay Social Security benefits increases expected total lifetime income and helps protect surviving spouses. (c) Once a retiree achieves a basic level of guaranteed income, optimal solutions could significantly invest remaining assets in equities. (d) Required minimum distributions (RMDs) can be a reasonable solution that can be implemented with ease by plan sponsors and retirees. (e) Funds fully allocated to target-date funds (TDFs) right up to retirement render older workers vulnerable to stock market crashes. (f) Combination solutions that generate income from invested assets until an advanced age with qualified longevity annuity contracts (QLACs) delivering income thereafter can be difficult to implement as a "set and forget" solution

Is the overall approach to investing in closed-end funds or ETFs the same as that for investing in mutual funds? Explain. (Text, p. 307)

The overall approach to investing in closed-end funds or ETFs is similar to the approach to investing in mutual funds. The fiduciaries select the asset class and management style that suits the plan's needs and then select an appropriate fund. Fiduciaries should pay particular attention to the anticipated market for the shares and the exit strategy in the event the plan decides to discontinue its investment. Investment strategies involving these funds also call for special attention to the valuation of the fund's underlying assets versus its share price.

The SOA/SCL research project supports a retirement income menu design with at least three distinct retirement income generator (RIG) options. What are these three options? (Text, p. 282)

The three RIG options are: (1) A systematic withdrawal program from invested assets in the plan (2) Guaranteed, lifetime annuities offered by an insurance company (3) A temporary payout from plan assets that enables delaying Social Security benefits in order to increase total retirement income.

Many ERISA plans hire professional investment advisors to enable the plan fiduciaries to obtain expert investment guidance. What are the three possible tiers of investment assistance from which fiduciaries can choose? (Text, pp. 303-304)

The three possible tiers of investment assistance from which plan fiduciaries can obtain expert investment guidance are: (1) Provision of investment data—A plan's recordkeeper, consultant, publication service or other vendor may simply collect and format data to render it accessible to the plan fiduciaries, without making investment recommendations or otherwise injecting its viewpoint into the process. (2) Investment advice, with final decision-making authority reserved to the plan's named fiduciary—This arrangement, often called a 3(21) arrangement, involves the rendering of investment advice for a fee or other compensation. (3) Investment management—A so-called 3(38) arrangement involves a bank, insurance company or registered investment advisor that has acknowledged fiduciary status in writing and that has the authority to make investment decisions without further involvement from the named fiduciary.

Several factors have come together recently that focus on the need to help older workers convert their DC retirement plan balances to periodic income. What are some of these factors? (Text, p. 276)

These factors are: (a) A recent study by the Government Accounting Office (GAO) highlighted the fact that the majority of older workers do not have access to retirement income solutions in their 401(k) plans. In this study, about two-thirds of the plans did not offer payout options that are intended to last a lifetime, and about threefourths did not offer annuities where an insurance company guarantees a lifetime payout. (b) A bipartisan policy report by a nonprofit group recommended that lifetime income options be added to DC plans. (c) Regulatory developments are enabling the use of retirement income solutions in tax-qualified DC plans. (d) Surveys indicate that older workers need and want help with developing retirement income. (e) New regulations require financial advisors and institutions that provide advice regarding tax-qualified retirement accounts to act as fiduciaries. (As of this writing, the regulations are being reviewed, and it is possible that they may ultimately be rescinded.) (f) Reports show how employers and financial institutions can construct retirement income programs in DC retirement plans and demonstrate analytical techniques they can use to help them design these programs.

The broad term alternative investments generally encompasses private equity investments, hedge funds and other private vehicles. Although these vehicles vary in design and form of organization, they tend to present a number of similar issues for plan fiduciaries. What are these issues? (Textbook, pp. 315-318)

These issues are: (a) Private investments are complex arrangements and mostly suitable for sophisticated fiduciaries with experienced professional advisors who are knowledgeable about the relevant investment product. (b) If the vehicle is created outside the United States, local counsel should be consulted and fiduciaries should focus on forum selection clauses, governing law clauses and other provisions that may result in the need to litigate any disputes in a foreign country or under foreign law. (c) Fiduciaries also need to determine if the vehicle is governed by ERISA or whether the fund qualifies for one of the exemptions from "plan assets" status in ERISA. (d) Fiduciaries should understand what actions a non-ERISA fund will take if the fund subsequently becomes subject to ERISA. (e) Fiduciaries should know the ways in which the fund's management can control the terms of the fund's governing documents. (f) Fiduciaries should be cognizant of the potential for terms and conditions to be varied for different investors. (g) Liquidity is another consideration for private investments. (h) Alternative investments may be fraught with special tax implications. Because many hedge funds use leverage, a plan may need to invest in an offshore fund if it wants to avoid unrelated, business-taxable income, which adds to the expense and complexity of the investment. (i) Administrative considerations should be taken into account. (j) Fiduciaries need to understand the overall economics. In addition to stated management fees and performance data, fiduciaries should review anticipated expenses, management compensation, possible prohibited transaction problems and how the fund values its assets. (k) Fiduciaries need to be sure that information will be available in time for the plan to meet its audit and annual reporting obligations.

What are white label funds?

White label funds are separate accounts that invest directly in stocks, bonds or other types of individual securities, in lieu of a pooled fund. The account, consisting of plan assets managed by a professional investment manager in accordance with plan guidelines, may be offered on its own or as part of an investment option combining the account with other managers' accounts or a pooled vehicle. The plan fiduciary selects the managers and sets the investment guidelines for each account. The participants in the plan can then choose which of the white label funds in the account they wish to use.