8. Impact Of Fin Prod Innov On Ret Plans

Question 1

Several factors have come together that focus on the need to help older workers convert their DC ret plans to periodic income. What are some of the factors? (6)

Answer 1

1. A study by the GAO highlighted: ~2/3rds of older workers’ plans don’t have payout options intended to last a lifetime; ~3/4ths don’t offer annuities
2. A bipartisan policy report by a nonprofit group recommended: lifetime income options should be added to DC plans
3. Regulatory developments are enabling the use of ret income sol’ns in tax-qualified DC plans
4. Surveys indicate: older workers need & want help with developing ret income
5. The DOL issued regs that req’d fin advisors & institutions that provide advice re: tax-qualified ret acts to act as fiduciaries. Tho these regs were ultimately rescinded, such action caused some market participants to embrace a fiduciary approach
6. Reports show ERs & fin insts can construct ret programs in DC plans and demonstrate analytical techs they can use to help them design the programs.

Question 2

What are the major challenges older workers confront when they need to convert their DC plan assets to periodic lifetime income? (6)

Answer 2

1. Ret savings may need to last anywhere from 20-30+ yrs
2. Market volatility adds another level of complexity to the task of managing savings in ret
3. Many older workers are unable to accurately calc the amount of savings needed to generate lifetime income
4. Not many retirees have a formal strategy for how to draw down savings
5. Many older workers with moderate savings don’t have access to skilled, unbiased fin advisors, or may not know how to ID & select them
6. Older workers looking for ret income sol’ns face a rapidly evolving marketplace that is difficult to navigate

Question 3

List 5 typical retirement goals

Answer 3

1. Desire for liquidity to meet emergencies
2. Maximize expected ret income
3. Income doesn’t decrease due to capital market volatility
4. Income keeps up w inflation
5. Income that retiree cannot outlive

Question 4

The Society of Actuaries (SOA) and the Stanford Center on Longevity (SCL) collab’d to produce a study that provides an analytical framework for planning ret income. What were the (6) key results?

Answer 4

1. There is a distinct, quantifiable trade off bt liquidity & maximizing income
2. For most retirees, using a portion of ret savings to delay SS benefits increases expected total lifetime income & helps protect surviving spouses
3. Once a retiree achieves a basic level of guaranteed income, optimal solutions should significantly invest remaining assets in equities
4. RMDs can be a reasonable sol’n that can be implemented with ease by plan sponsors & retirees
5. Funds fully allocated to TDFs right up to retirement render older workers vulnerable to market crashes
6. Combo sol’ns 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” sol’n.

Question 5

The SOA/SCL research project supports a ret income menu design with at least 3 distinct retirement income generator (RIG) options:

Answer 5

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 SS benefits in order to increase total ret income

Question 6

Plan sponsors that want to help retirees convert DC plan assets to ret income while recognizing their fiduciary duties will want to conduct a due diligence process that includes which (5) steps?

Answer 6

1. Assess the needs & abilities of their older workers
2. Learn about various RIGs, including the ret planning goals each RIG addresses, their dis/advantages, & how much income can be reasonably expected
3. Learn about the capabilities, costs, & comms support that can be provided by their existing plan admin, & the capabilities of alt vendors
4. Develop criteria for the design of the ret income program, and assess how each potential RIG & ret income sol’n meets these criteria
5. Develop a reasonable timeline w plan admin for implementing & communicating the ret income program

Question 7

Describe the regulatory suggestion made in the SOA/SCL study for helping retirees convert DC plan assets to ret income:

Answer 7

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

Question 8

What are the advantages to retiring EEs of an ER-sponsored program of taking retirement income from a DC plan? (3)

Answer 8

1. Institutional pricing has the potential to increase ret incomes by 10-20% compared to retail solutions
2. Sol’ns are more likely to be implemented successfully if it is easy for retiring EEs to implement their decision
3. The ER’s plan is a safe place to keep ret savings away from fraudsters who target seniors.

Question 9

Describe the basic purpose of a QLAC

Answer 9

Provide retirement income to individuals starting at an advanced age. 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.

Question 10

Describe the regulatory obstacle that, in the past, prevented the use of longevity contracts

Answer 10

Before release of the final rules, the IRS req’d that the value of any longevity contract must be included as part of a participant’s acct balance for RMD purposes. If participants included the annuity in their acct balance, and that balance dropped substantially, they might be req’d to start taking disturbs from the longevity contract much earlier than desired!!

OTOH if they did not include the value of any longevity contract as part of their acct balance, they risked incurring substantial penalties.

The final regs 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 def’n of a QLAC.

Question 11

Do all types of ret plans qualify as QLACs? Explain?

Answer 11

Only DC plans (incl. 401k & profit-share), trad’l IRAs, 403b and 457b gov’t plans are eligible to hold QLACs.

Question 12

Describe the contract features of QLACs with regard to:
1. The max premium that can be paid
2. The max age to commence pmts
3. Prohibited contract features

Answer 12

1. The total prem cannot exceed the lesser of $145k (in 2022, indexed for inflation) or 25% of a participant’s agg acct balance.
2. 85
3. Variable contracts, indexed (or similar) contracts, and contracts w commutation benefits and cash surrender values are prohibited. Additionally there are restrictions on the death benefits that can be available under a QLAC.

Question 13

Describe features required of QLACs, besides premium, max age of commencement, and prohibited features…

Answer 13

• Must contain specific language that identifies it as a QLAC
• Subject to an annual reporting req that includes, among other things: info about the plan & plan sponsor, annuity start date, amount of pmt, whether the start date may be accelerated

Question 14

Are annuities widely available in US qualified ret plans?

Answer 14

No.

While annuities are widely supported by academics & policymakers, they’ve been slow to attract consumers and are not widely available in US qualified ret plans.

Question 15

What is a longevity annuity?

Answer 15

AKA “longevity insurance,” “deferred income annuity”

An insurance product that pays retirees a permanent income lasting as long as the buyers live.

Specifically, individuals use a portion of their pre- or post-tax savings to purchase a deferred income annuity that begins paying a monthly income beginning at least a year from purchase. The goal of the product is to convert ret savings into guaranteed income for life.

Question 16

How has the SECURE Act responded to fiduciary concerns re: offering longevity annuities within qualified plans?

Setting Every Community Up for Retirement Enhancement = SECURE Act

Answer 16

The SECURE Act responded to fiduciaries’ past concerns that they could be held responsible for an insurer’s solvency, if they selected an annuity provider. SECURE Act addressed this issue by stipulating that if insurers are selected prudently, the fiduciary is held harmless from legal liability.

Also, Act permitted plan participants who leave an ER or retire, to move their annuity to another plan or to an IRA without paying surrender charges.

Question 17

Are the provisions of the SECURE Act sufficient to encourage large-scale adoption of longevity annuities within qualified plans?

Answer 17

Maybe not.

The provisions of the SECURE Act represented clear progress in promoting longevity annuity adoption within qualified ret plans, but these provisions may not be sufficient for a majority of plan sponsors.

Question 18

What changes likely need to occur in order to have the adoption of longevity annuities scale as an offering in qualified plans? (4)

Answer 18

-Clearer rules for insurer & product selection are needed; longevity annuities should be added to the QDIA; annuity products should be made easier to purchase over time.

1. Designing clearer rules about how insurers can qualify for the safe harbor. SInce the Dodd-Frank Act discouraged referencing credit ratings, practitioners have difficulty identifying the conditions under which insurers can qualify for the SECURE Act safe harbor. It would be useful to establish objective, easily verifiable parameters
2. Clarifying rules: which kinds of annuities can be offered in ret plans? Similar to objective rules for receiving a QLAC designation and RMD exemption, similar rules would be helpful in fostering annuity adoption in qual plans.
3. Designating longevity annuities as qualified default investment alternatives (QDIAs). If the goal is to enhance retirees’ lifetime income, there needs to be a default, which should be a QDIA.
4. Permitting micro deposits in these products. Few insurers accept funds in small increments, so some technological and reporting challenges must be overcome.

Question 19

Must ERISA investments always follow mainstream and popular strategies to be considered prudent?

Answer 19

On a historical basis, no.

Many innovative investment developments have occurred since the passage of ERISA, such as index funds, stable value investment options, emerging market mutual funds, TDFs. The belief by many that ERISA investments, particularly participant-directs investments, must always follow mainstream/popular strategies, and that deviation from such is imprudent, but on a historical basis, this isn’t the case.

Question 20

Distinguish bt baseline prudent investment practices under ERISA and enhanced ERISA prudent best practices for innovative investments

Answer 20

Baseline prudent investment practices resulted when ERISA Ss. 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 EBPs.

Within Ss.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 DOL.

Question 21

Many parties are involved in an ERISA ret plan. However, when selecting plan investments, only the needs of 2 parties must be served:

Answer 21

Participants & their beneficiaries.

The decision to add an investment to an ERISA ret plan portfolio must be based solely upon the needs of the participants and their beneficiaries. 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.

Question 22

DOL has specified the responsibilities fiduciaries have when setting up a monitoring system for the fees associated with an investment: (3 points)

Answer 22

Trustees have an obligation to set up a monitoring system that:
1. Determines the needs of a fund’s participants
2. Reviews the services provided & fees charged by a number of different providers
3. Selects the provider whose service level, quality, and fees best match the fund’s needs & financial situation.

Question 23

Define the “prudent man” standard required of ERISA plan investments

Answer 23

Requires investments to be made “with the care, 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.”

Question 24

Explain the relationship bt modern portfolio theory (MPT) and the diversification requirement in ERISA

Answer 24

MPT constructs a risk/reward frontier that assumes diversification always eliminates non systematic risk. Since MPT is a bedrock tenet of ERISA, the diversification req 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, under the circumstances it is clearly prudent not to do so.’

Question 25

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 (6) features of a good IPS for innovative investments:

Answer 25

1. 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. 2. It should be flexible enough that it can be implemented in a complex & dynamic financial environment 3. It should not be SO detailed as to require constant revisions and updates 4. It should be drafted in a way that does not increase the risk of failure by the investment fiduciaries 5. It should be carefully drafted, typically by an attorney familiar with EB issues, working in concert w the fiduciaries & their investment consultants 6. The investment criteria in the IPS should be written in the context of meeting the needs of the participants

Question 26

In Sulyma v. Intel, the Intel plaintiffs argued that the Intel ERISA investments underperformed a passive index, and therefore should be considered imprudent. Does poor investment performance constitute imprudent investment mgmt under EIRSA?

Answer 26

No. Prudent investing isn’t judged on the results in hindsight, but rather by the process employed to investigate & monitor the investment. The mere fact that Intel investments underperformed the passive index doesn’t create an imprudent process.

Question 27

ERISA imposes an exacting standard of conduct for fiduciaries of EB 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?

Answer 27

ERISA *does not have any* specific restrictions or guidelines on the types of investments a plan can hold, nor any guidelines or restrictions on the types of transactions —other than the fact that fiduciaries must confirm that making the investment (and engaging in any other activities associated w the purchasing, holding and eventual redemption/sale of the investment) will not constitute a “prohibited transaction.”

Question 28

Many ERISA plans hire professional investment advisors to enable the plan fiduciaries to obtain expert investment guidance. Explain the 3 possible tiers of investment assistance from which fiduciaries can choose.

Answer 28

1. Provision of investment data 2. Investment advice, with final decision making authority reserved to the plan’s named fiduciary 3. Investment mgmt Details - 1. A plan’s record keeper/consultant/publication service/other vendor may simply collect & format data to render it accessible to the plan fiduciaries, without making investment recommendation or otherwise injecting its viewpoint into the process 2. This arrangement, often called a 3(21) arrangement, involves the rendering of investment advice for a fee or other comp 3. A so-called 3(38) arrangement involves a bank, insurance co, 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.

Question 29

Does hiring an investment advisor/investment manager eliminate the fiduciary’s liability?

Answer 29

No. Hiring an investment advisor/manager doesn’t relieve the named fiduciary from understanding the nature of the plan’s investments and chosen investment strategies. It’s in the interest of fiduciaries to understand the investment professional’s strategy, and to make sure they obtain enough info about investments to verify the chosen strategy remains appropriate and that the plan’s actual investments align w the strategy.

Question 30

Mutual funds are often used as an investment vehicle in ERISA plans. Describe these wrt their 1. Liquidity 2. Gov’t regulation 3. Appropriate disclosure docs

Answer 30

1. 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. 2. Mutual funds aren’t subject to direct ERISA regulation, but they are subject to regulation under the Investment Company Act of 1940, and must meet reg standards re liquidity of the portfolio, presence of independent directors on the governing board, compliance oversight ,& other matters 3. A mutual fund is req’d to provide appropriate disclosure docs, meaning that the fiduciaries of a participant-directed plan don’t need to design customized fund descriptions for participants.

Question 31

What are 6 basic considerations for an ERISA fiduciary in evaluating the possibility of selecting mutual funds as a loan asset?

Answer 31

1. 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. 2. IN selecting a mutual fund, fiduciaries should consider the fund’s performance, expenses, alignment w desired asset class parameters, and other relevant factors. 3. Fiduciaries should make sure that they have selected the appropriate share class. E.g., plans making a large enough investment may qualify for the more favorably priced institutional class shares 4. Fiduciaries need to make sure all selected investment products are prudent & appropriate 5. Fiduciaries need to review expenses by reviewing more than just the expense ratio. Redemption fees, min holdings, and other terms must be considered 6. Fiduciaries need to understand the dis/advantages of revenue sharing. These arrangements involve a fee paid to the plan’s recordkeeper directly for certain fund-related services.

Question 32

How do closed-end funds differ from open-end mutual funds?

Answer 32

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 bt the redeemability of closed-end funds and ETFs requires a deep discussion.

Question 33

Is the overall approach to investing in closed-end funds or ETFs the same as that for investing in mutual funds?

Answer 33

Similar, yes. Fiduciaries select the asset class & mgmt style that suits the plan’s needs, 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 vs its share price.

Question 34

What are collective investment trusts (CITs)? What are 6 of the important topics fiduciaries of the investing plans should focus on?

Answer 34

CITs are pooled investment funds offered by a bank that acts as trustee, and is managed by the trustee or a professional investment manager. They’re offered only to Ben plans. Similar to mutual funds, but the assets in the trust are subject to ERISA regs, and are not subject to the same disclosure reqs as mutual funds. Focus on: 1. Reviewing the disclosure & filings offered by a particular CIT in order to understand what will be available to their plan 2. Make sure they understand the fund’s valuation & financial oversight process 3. Make sure the valuations provided by the investment providers are reasonable & appropriate 4. Obtain copies of all governing docs; review them with counsel & inv professionals 5. Understand the terms & rules re investment liquidity. e.g., some funds limit redemptions to specific intervals 6. Understand whether a fund permits securities lending, what sorts of risks/returns are involved, what rules are in place to prevent prohibited transactions, what sort of fees are charged in connection w securities-lending activities

Question 35

Briefly describe the fiduciary duties that are involved when *annuity contracts are purchased by an ERISA plan*

Answer 35

Fiduciaries should document their conclusions re the ways in which the chosen annuity provider meets the criteria outlined in the regs. Fiduciary should work with a professional advisor familiar with the annuity marketplace.

Question 36

When a plan invests in individual securities, the plan fiduciary needs a detailed investment mgmt agrmt with an inv mgr. List 9 items/features this agreement should contain:

Answer 36

1. Guidelines for investment & proxy voting 2. Identification of any special brokerage arrangements/restrictions 3. Manager’s compensation 4. Representations by the manager re its fiduciary status and professional quals 5. Protection for the confidentiality of plan info 6. Provision for appropriate indemnity protection 7. Identification of any threshold insurance reqs 8. Expectations re record keeping and reporting by the manager to the plan 9. The procedure for amendment & termination, that ensures the plan can terminate on reasonably short notice without penalty

Question 37

What are white label funds? What are 4 concerns plan fiduciaries should have about these funds?

Answer 37

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 mgr in accordance w plan guidelines, may be offered on its own, or as part of an inv option combining the acct with other managers’ accts, or a pooled vehicle. The plan fiduciary selects the managers, and sets the inv guidelines for each acct. The participants in the plan can then choose which of the white label funds in the acct they wish to use. Areas for fiduciaries’ concerns: 1. WL Funds may involve significant costs & burdens bc of costs such as: higher record keeping fees, higher audit fees, legal fees for manager contracts, legal & vendor fees for preparation of customized fund disclosures 2. These require a considerable investment of time by plan fiduciaries & staff 3. Special regulatory issues may be associated with WL funds. Some types of investment activity might trigger additional obligations. 4. Fiduciaries need to be sure that disclosure materials adequately y meet ERISA standards & sufficiently give participants the necessary info to make investment decisions.

Question 38

Explain why investments in ER securities pose a significant litigation risk for plan fiduciaries

Answer 38

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

Question 39

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 ~11 similar issues for plan fiduciaries:

Answer 39

1. Private investments are complex arrangements and mostly suitable for sophisticated fiduciaries w experienced professional advisors who are knowledgeable about the relevant investment product. 2. If the vehicle is created ex-US, 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/under foreign law 3. Fiduciaries also need to determine whether the vehicle is governed by ERISA, or if the fund qualifies for one of the exemptions from “plan assets” status in ERISA 4. Fiduciaries should understand what actions a non-ERISA fund will take if the fund subsequently becomes subject to ERISA 5. Fiduciaries should know the ways in which the fund’s mgmt can control the terms of the fund’s governing docs 6. Fiduciaries should be cognizant of the potential for T&Cs to be varied for different investors 7. Liquidity is a consideration for private investments 8. Alternative investments may be fraught with special tax implications. Bc 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 & complexity of the investment 9. Admin concerns should be taken into acct 10. Fiduciaries need to understand the overall economics. In addition to stated mgmt fees & perf data, fiduciaries should review anticipated expenses, mgmt comp possible prohibited transaction probs, and how the fund values its assets 11. Fiduciaries need to be sure that info will be available in time for the plan to meet its audit & annual reporting obligations.