Mutual Fund Fees-Some Good News

In the United States, there has been a strong, unremitting focus on mutual fund fees for decades. This focus is now being turned to retirement plan and annuity fees, and even there, the focus in 403(b) and 457 markets is more recent and much more intense. A recent study of mutual fund fees by country has some interesting implications for that focus.

The study was conducted by Ajay Khorana of the Georgia Institute of Technology, Henri Servacs of the London School of Economics, and Peter Tufano of the Harvard Business School. The result? The United States has a relatively low fee level (and, oddly, Canada has a high level). This low fee level results from several factors, including economies of scale for larger funds and fund families, better courts, higher per capita GDP, higher education levels, separation of banking and fund management industries, higher investor protection in both general stock markets and mutual fund markets and mutual fund industry maturity.

Managing a mutual fund is different from managing a retirement plan or account. Most important is that certain fees (e.g., prospectus vs. SPD or other communications) are borne once by each fund but once by each plan or account. This is the core cause of a tension between the need to pay for the work that has to be done to get tax deferral for the investments and the human desire to get that done for free. The compliance costs are real, and somebody has to pay them. This urge is the basic reason why there are separate markets for annuities and mutual funds, with annuities having a higher expense structure that is generally advantageous for smaller accounts and smaller asset totals, and mutual funds being used more often with larger plans and larger account balances.

Of course, there are other factors operating in 403(b) and 457 markets. Employers who want to say they don't have a plan leave their employees in the position of individual investors, and they tend to hear more often from annuity providers than from mutual fund providers because of the superior profitability of annuitiew at smaller scales. The fact that mutual fund providers are fairly new to the markets is another cause, because of the dominant market position of a short list of providers offering annuities that have technical competence and an interest in the market. But the underlying economics that result from having mutual funds with relatively low fee structures reinforces these market anomalies.

All in all. though, investors in the United States are fortunate. Move north to Canada, and the fees increase by something like 175%. The fact that these fees can't carry the compliance costs for tax deferral are a lot less important than this fundamental advantage.

2007 Limitations

A reminder of the 403(b) and 457 limitations for 2007.

Overall Limit--$45,000
403(b) Deferrals--$15,500
Age 50 Catch-Up--$5,000

Primary 457 Limit--$15,000
Age 50 Catch-Up--$5,000

I Says What I Means...

The Eighth Circuit allowed a reduction in disability benefits for earnings while receiving benefits in Riddell v. Unum Life Ins. Co. of America (8th Cir. 8/10/2006), and the case contains a useful lesson for any 403(b) or 457 employer.

The policy based benefits on a monthly earnings definition that excluded bonus payments. The policy also head residual/partial disability benefit provisions, under which benefits could be reduced based on "disability earnings" that were defined to take into account bonus payments. The physician receiving benefits under the policy argued that a category of payments he received was in the nature of a bonus, and that those payments should not be used to reduce disability benefits because the two definitions were internally inconsistent. Rather than just calling the argument hogwash, the court more politely pointed out that the reduction provisions always used the "disability earnings" definition and never used the first, and more generally applicable, definition of monthly earnings.

This case may seem unglamorous, but it should remind all concerned of the need to use plan documents that are decently written. In the 403(b) and 457 markets, and retirement plan markets generally, this is not always the case because the focus of drafting is on technical compliance. Try reading your plan documents; if you don't know what they mean, you should ask for an explanation or a rewrite, because the participants won't understand it either.

In 403(b) and 457 environments, there is one particularly important issue to cover, and cover clearly - ERISA/fiduciary status. As long as the funding vehicle is not a trust and the employer or plan are not subject to ERISA (church and governmental, non-plan 403(b) and top-hat 457), the non-ERISA, non-fiduciary status should be crystal clear in the plan document. If the issue might ever come up, it will help a great deal to have a document that clearly states employer/plan status and the ramifications of that status.

McKay Hochman PPA Effective Dates

McKay Hochman has an excellent list of effective dates for PPA. You can find it at:

http://www.mhco.com/Commentary/2006/PPA_Effective_Date_083106.htm

PPA Part 2-Qualified Default Investment Alternatives

If you are concerned only about non-ERISA plans and arrangements, you can stop reading here if you want. Otherwise, you have to learn another acronym, QDIA, for Qualified Default Investment Alternatives.

Once again, the Department of Labor has chosen to make a directed investments rule too complex. This time, it is the QDIA.

Section 624 of the Pension Protection Act amended ERISA 404(c) to create the QDIA concept and required that the Department of Labor issue regulations defining a QDIA by 2/1/2007. The DOL has now issued proposed regulations.

The function of a QDIA is to solve a problem created in the overly complex existing ERISA 404(c) regulations. The protection from fiduciary duties under ERISA 404(c) applies only "if a participant or beneficiary exercises control over the assets in his account (as determined under regulations of the Secretary)". It seems clear that the parenthetical clause would have allowed a decision not to exercise after notice to be treated as an exercise, but the DOL did not do so. This meant that all the participants who got notice and did nothing were not subject to ERISA 404(c) and left the question of what to do with their accounts.

The answer seemed pretty clear, invest it how you would invest the plan that did not have a directed investments provision-de facto meaning invest it in a balanced portfolio. However, many plan sponsors decided that putting the money in a stable value or money market investment would reduce their actual risk because the participants' accounts would never show losses. And, given how people normally behave, it may have been the safest answer.

Theoretically, there were three ways to resolve this issue. The first alternative, and the cleanest, easiest one, would have been for the DOL to issue Regulations modifying the 404(c) regulations to treat inactivity after notice as an exercise of control. The second alternative was for the DOL to say that the funds had to be invested in an investment that would be appropriate for the plan as a whole, which would have in effect mandated a balanced fund in each plan. The third, and worst, option was the creation of the QDIA, because its enactment and definition have been an occasion to increase the administrative burdens on plans.

The QDIA rules have two parts. One defines the sort of investments that can be a QDIA. This part is not too complex for a 403(b) plan or arrangement. Essentially, the investment has to (1) be a mutual fund or managed by an investment manager under ERISA 3(38), and (2) be (a) a target retirement date or lifestyle fund, (b) a balanced fund, or (c) a fund managed by an investment manager taking into account, individually, the participant's age, target retirement date and life expectancy. The choice between the first and second types of mutual funds is easy, based on what funds are available and how many funds the plan wants to offer (a general balanced fund being one fund and an array of lifestyle funds being more than one). The managed fund option is a viable option only if you can find an investment manager willing to look at all the small (since those with large accounts will likely make their own decisions) accounts in the plan and take responsibility for them. My opinion has always been that every plan should have a sound, well-managed balanced fund, so my general recommendation would likely be to use that as the default investment before or after the QDIA rules become effective.

The second part of the QDIA rules is procedural, and more complex and burdensome than it needs to be. First, and pretty obvious, is that there should not be too many barriers to moving out of the QDIA; specifically, transfers out must be allowed at least quarterly and must not cost the participant more money. Second, the participant must be given an opportunity to direct investments-this will never be an issue because the QDIA rules only apply where a participant with the right to direct investments doesn't. Third, the participant has to be given a notice at least 30 days before amounts are invested in the QDIA and 30 days before each plan year; this is duplicative of the normal notices given in plans with directed investments and plans using a 401(k) safe harbor and the requirements can be met by extending the coverage of existing notices.

Fourth, the plan document must require that the plan, and the plan must in fact, send to the participant all material received by the plan relating to the QDIA or a participant's investment in the QDIA, presumably within a reasonable time. This one is potentially a problem, because of the vagueness of the word "material." All we know is that it includes account statements, any prospectus and voting proxy materials; we do not know if it includes e-mails from brokers, periodic reports by TPAs, Morningstar or other similar items, or even the contents of phone calls (unless we assume that the received "material" has to be material). You can safely bet that lawyers will be asking, sooner or later, for everything anybody involved with the plan receives from anybody any time. This requirement is not contained in the PPA, and so the ambiguity is a gratuitous part of a gratuitous requirement. In addition, since the IRS takes the position that failure to administer a plan in compliance with its terms is a qualification issue, it has the effect of adding the IRS as an enforcer of fiduciary duties in this context.

The last requirement is that the plan offer investments, including the QDIA, which meet the requirements of ERISA 404(c). Since QDIA status only matters as a fix to a hole in the 404(c) regulations, this is wholly unnecessary.

PPA Changes Affecting 403(b) and 457

The PPA made too many changes affecting 403(b) and 457 to cover in one post. This blog will, instead, cover them essentially one at a time, to allow for context and comments. This is the first such post.

The most important thing the Pension Protection Act did was to make permanent the changes in the law passed by EGTRRA. Just as a reminder, these are (as described in the PPA Blue Book and as having relevance to 403(b) or 457):

Individual retirement arrangements (“IRAs”)

• Increases in the IRA contribution limits, including the ability to make catch-up contributions (secs. 219, 408, and 408A of the Code and sec. 601 of EGTRRA); and

• Rules relating to deemed IRAs under employer plans (sec. 408(q) of the Code and sec. 602 of EGTRRA).

Expanding coverage

• Increases in the limits on contributions, benefits, and compensation under qualified retirement plans, tax-sheltered annuities, and eligible deferred compensation plans (secs. 401(a)(17), 402(g), 408(p), 414(v), 415, and 457 of the Code and sec. 611 of EGTRRA);

• Modification of the top-heavy rules (sec. 416 of the Code and sec. 613 of EGTRRA);

• Repeal of coordination requirements for deferred compensation plans of state and local governments and tax-exempt organizations (sec. 457 of the Code and sec. 615of EGTRRA);

• Option to treat elective deferrals as after-tax Roth contributions (sec. 402A of the Code and sec. 617 of EGTRRA);

and

• Certain nonresident aliens excluded in applying minimum coverage requirements (secs. 410(b)(3) and 861(a)(3) of the Code).

Enhancing fairness

• Catch-up contributions for individuals age 50 and older (sec. 414 of the Code and sec. 631 of EGTRRA);

• Equitable treatment for contributions of employees to defined contribution plans (secs. 403(b), 415, and 457 of the Code and sec. 632 of EGTRRA);

• Faster vesting of employer matching contributions (sec. 411 of the Code and sec. 633 of EGTRRA);

• Modifications to minimum distribution rules (sec. 401(a)(9) of the Code and sec. 634 of EGTRRA);

• Clarification of tax treatment of division of section 457 plan benefits upon divorce (secs. 414(p) and 457 of the Code and sec. 635 of EGTRRA);

• Provisions relating to hardship withdrawals (secs. 401(k) and 402 of the Code and sec. 636 of EGTRRA); and

Increasing portability

• Rollovers of retirement plan and IRA distributions (secs. 401, 402, 403(b), 408, 457, and 3405 of the Code and secs. 641-644 of EGTRRA);

• Treatment of forms of distribution (sec. 411(d)(6) of the Code and sec. 645 of EGTRRA);

• Rationalization of restrictions on distributions (secs. 401(k), 403(b), and 457 of the Code and sec. 646 of EGTRRA):

• Purchase of service credit under governmental pension plans (secs. 403(b) and 457 of the Code and sec. 647 of EGTRRA):

• Employers may disregard rollovers for purposes of cash-out rules (sec. 411(a)(11) of the Code and sec. 648 of EGTRRA); and

• Minimum distribution and inclusion requirements for section 457 plans (sec. 457 of the Code and sec. 649 of EGTRRA).

Strengthening pension security and enforcement

• Automatic rollovers of certain mandatory distributions (secs. 401(a)(31) and 402(f)(1) of the Code and sec. 657 of EGTRRA);

Reducing regulatory burdens

• Repeal transition rule relating to certain highly compensated employees (sec. 663 of EGTRRA);

• Treatment of employees of tax-exempt entities for purposes of nondiscrimination rules (secs. 410, 401(k), and 401(m) of the Code and sec. 664 of EGTRRA);

• Treatment of employer-provided retirement advice (sec. 132 of the Code and sec. 665 of EGTRRA).

Lest we forget, the failure to repeal these changes would have set back progress in 403(b) service markets dramatically. The effect of the changes was to make 403(b) more like 401(k), but with some nice special rules. Before, simple tasks like determining maximum contributions, was a nightmare and very few providers could handle them, which caused most TPAs to avoid 403(b) like the plague. Now, in essence, you can run a 403(b) like a 401(k), and only look at the differences if there is a problem (e.g., ADP test, annual limits, 402(g) deferral limits). This is opening up new providers to 403(b) employers and should serve to increase quality and service levels while decreasing price for all 403(b) plans or arrangements. At Benefit Plan Solutions, we are seeing a steady increase in activity helping 401(k) providers move into a new market with very soft competition.

Delay in Effective Date for Regulations Under Section 403(b)

From the IRS:

WASHINGTON —The Internal Revenue Service announced today that the general effective date for the regulations regarding section 403(b) arrangements that were proposed in 2004 (including the related controlled group regulations under section 414(c)) will be extended.

In order to provide employers, employees, insurance carriers, and mutual funds involved in section 403(b) arrangements a reasonable advance period before the regulations go into effect, the final regulations generally will not be effective earlier than January 1, 2008.

Effects of Expense Subsidies

Jeb Graham CEBS, CIMA® of CapTrust Financial Advisors has written an excellent article at 401khelpcenter.com on plan fees. The article can be read at:

http://www.401khelpcenter.com/401k/graham_stable_value.html

Preliminarily, he focuses on stable value fund economics. Stable value fund is such a loose term that different stable value funds may be invested in different asset types and may have different expense structures. Expenses may not even be fixed in amount or by a formula.

The more essential point made by Mr. Graham is that fees that are not disclosed, but are instead applied to reduce the expenses of plan administration through, e.g., sub-TA fees, are inevitably allocated unfairly.

For example, suppose two employees invest the same amounts in different funds, and one has an expense total of $100 while the other has an expense total of $200. Because the extra expense of $100 reduces the second participant's income, the plan and that participant are bearing that cost, which may or may not be reasonable. If the extra $100 is, instead, paid to the plan’s TPA, then (a) the extra is clearly not needed by the investment provider to operate the investment, (b) the use of the extra money to reduce plan administration is needed to restore fairness to the plan, and (c) the second participant, by selecting the more expensive investment, is subsidizing the operations of the plan.

If the plan’s sponsor would otherwise pay the extra $100, because the sponsor pays the plan administration fees, then there is an indirect benefit to the sponsor of $100. This may constitute a prohibited transaction under §4975 of ERISA §406, although since the effect is to pay for plan administration, and plans are allowed to defray administration expenses, it should not be a prohibited transaction, or at least not a violation of the exclusive benefit rule.

If the plan receives a subsidy from the investment provider and uses it to reduce total plan administration expenses paid by the plan, then the plan as a whole is treated fairly but there is, in effect, a subsidy of the first participant who invested in the lower-expense investment by the second participant who bore higher expenses that now reduce everyone else’s costs.

To eliminate the subsidy from one set of participants to another, the plan would have to apply the subsidy it receives to reduce the expenses only of those participants who invested in the higher-expense investment.

But look at the result of doing so. If the participant bears the higher expense through reduced investment yield, then gets it back through an expense reduction, the whole exercise is pointless. That is, the investment provide‚’s setting up of the arrangement only makes sense if it is not returned to the participant who bears the expense.

The only reason to jump through the hoops needed to create the arrangement is to use the money to influence the behavior of the plan or its advisers in the fund selection process. (To encourage use of the investment by participants, the best approach would be to eliminate the extra fee and have a higher product yield.) If the subsidy is created to encourage sales outside of employee benefit plans, and a full rebate is made, the arrangement may be defensible, although the plan needs to know about the subsidy to decide if it should be specially allocated. Otherwise, defending such an arrangement cannot be much fun.

What's Not a Top-Hat Plan

A thank you to PlanSponsor for finding Guiragoss v. Khoury, E.D. Va., No. 1:06vy187, 8/10/06, a case determining that a plan was not a top-hat plan exempt from ERISA. Unfortunately, the case is not all that useful, as is true of most cases on top-hat plan status. At least it makes clear one way to screw up top-hat status.

The plaintiff and sole participant was a clerk for the employer jewelry store, so the result is hardly surprising. Some of the language is troubling, saying "Guiragoss had no influence on the terms of the agreement and never consulted with an attorney prior to signing the agreement." Both of these statements are true of most top-hat plan participants, which is why the language is troubling. With any luck, and because this is a District Court decision, future courts will ignore that language and focus instead on the participants'' bargaining power, or lack thereof, rather than whether there was any actual bargaining.

A Reminder About Moral Hazard

There is an interesting post at http://www.bostonerisalaw.com/, the blog of Steven D. Rosenberg of the McCormack Firm in Boston relevant to reviews of claims decisions by benefit plan administrators. Those of us who do not subscribe should thank Mr. Rosenberg.

The post refers to a New York Times article that says, essentially, that some people who receive disability benefits don't go back to work when they could. No professional who has worked with plans that offer disability benefits, including LTD, STD, subsididized disability benefits under defined benefit plans or vesting up defined contribution account balances on disability, is surprised by this statement. Nor is any worker's compensation lawyer on either side. All one really has to do is notice (1) that the word "lie" exists and is frequently used, and (2) the statement that "Money is the root of all evil."

A disproportionate number of cases on reveiw standards under ERISA relate to subjective, non-verifiable symptoms, and particularly reported pain. Insurance companies are used to people who lie, but many of the cases appear to we cynics to, in essence, find some reason to reduce the deference given to the plan administrator, ignore the possibility that the, e.g., reviewing physician simply thought the claimant was lying, and take the claimant's word.

The response to this is (1) to be explicit when credibility affects a decision, and (2) to use experts and/or research to remind the court that the concept of moral hazard has always been a core component of insurance economics, not a novel way of arguing for deference to plan administrators under ERISA.