Spring Fiduciary PIERspective

Fiduciary Commentary Q1, 2012

Regulatory Guidance Addresses Retirement Income Annuitization

America’s private retirement systems long-term trend away from guaranteed pensions and toward the self-directed investment style found in defined contribution plans, has placed little emphasis on the distribution phase of retirement. This, coupled with the longer lifespan of retirees, has drawn attention to the many risks present when managing savings in retirement.

In an effort to combat and address these threats, on February 2, the IRS and the DOL issued proposed regulations to make it easier for retirees to manage the risk that they will outlive their retirement savings. The new rules would allow individuals to purchase annuity contracts designed to pay distributions as lifetime income payments.

Qualified Longevity Annuity Contract

The proposed regulations add the term, “Qualified Longevity Annuity Contract” (QLAC) to the Internal Revenue Code. A QLAC is a fixed annuity issued by an insurance company. It must be purchased from the assets of a defined contribution plan including 401(a), 403(b), governmental 457 plans or traditional IRAs (the QLAC rules are not applicable to defined benefit plans, ROTH portions of qualified plans, or ROTH IRAs). The purchase of QLACs would allow participants to hedge against the risk of outliving their retirement savings through the purchase of an annuity that produces an income stream, which begins at an advanced age and continues for the remainder of their lives.

A QLAC must meet specific requirements including a payment beginning no later than age 85 and limit the amount used to purchase the annuity to the lesser of $100,000 (adjusted for inflation) or 25% of the participant’s account balance. QLAC payments cannot be altered, forfeited or surrendered for a lump-sum. Additionally, survivor benefits after the participant’s death would be conditionally allowed. If the sole beneficiary is a surviving spouse, the payments can be paid as an annuity over the spouse’s life, as long as the payments do not exceed the amount paid to the original participant.

The rules also exclude specific types of hybrid insurance products including variable or equity indexed contracts. The products must also maintain restrictions on death benefits and other contract features.

Required Minimum Distributions (RMDs)

The proposed regulations provide special relief from the minimum distribution requirements. RMDs are typically calculated from the prior year-end account balance of a retirement plan or IRA. The rules would modify the current RMD rules to facilitate the purchase of longevity annuities by providing an adjustment to the year-end balance by the value of the QLAC.

Annual Reporting and Disclosure

A new concept in the proposal is the designation of a responsible party to provide IRS reporting and disclosures to plan participants. In this case, it is the issuer of the investment product, not the administrator of the plan, who is the accountable party required to provide annual, calendar year reports to the IRS and disclosures to the annuity owner.

Plan Administration

The proposed regulations (and a related revenue ruling) confirm that an annuity contract can be treated as a plan investment rather than a plan benefit arrangement. This distinction provides clarity that annuity payments can be paid under the terms of the annuity contract rather than having to structure the annuity to conform to the terms of the plan document.

Portability of guaranteed products has been a concern for some time. Unanswered questions relating to the insurance contracts upon plan termination or the transition of plan recordkeeper were sources of unknown liability to plan sponsors. The proposed regulations support the notion that the transition of contracts would be treated as an in-kind distribution from the plan.


Longevity risk has surfaced as a crucial issue to the nation’s retirement system. In recent years we have witnessed the first attempt of financial product manufacturers to introduce retirement income management and annuitization products to the retirement marketplace. These proposed rules will serve as a starting point to a larger regulatory initiative and streamline the process through which guaranteed products can be offered in IRAs and defined contribution plans. Future guidance will surely address the many issues yet unanswered, but for the present, the path seems clear for the development of future products.

Legal Corner

Court Decision Provides a Glimpse at Current ERISA Fiduciary Thinking

In the Prudential Retirement Insurance and Annuity Co. (Prudential) v. State Street Bank and Trust Co. case, the Southern District of the New York US District court decided against State Street. The court’s February 2012 decision concluded that State Street had violated its fiduciary duties under ERISA and awarded Prudential $28.1 million in damages. Prudential claimed that State Street breached its fundamental fiduciary duties by failing to manage the bond funds prudently, failing to manage the bond funds solely in the interests of the plans, and failing to adequately diversify the assets in the bond funds.

Shortly after the start of the financial crisis, several plaintiffs sued financial service firms claiming the mismanagement of pension funds by investing in poor performing subprime mortgage-backed securities. Although some of these ERISA lawsuits were class actions on behalf of employees, others were suits against investment managers alleging the mismanagement of plan assets and breaches of fiduciary duty.

Prudential brought suit against State Street on October 1, 2007, on behalf of nearly 200 qualified retirement plans that invested in two bond funds managed by State Street through Prudential separate accounts. Prudential sought to recover losses incurred by the plans resulting from their clients’ investments in the State Street managed bond funds. Prudential alleged that State Street was both an investment manager and a plan fiduciary.

The court found State Street liable for ERISA violations and awarded damages to Prudential for losses sustained as a result of this breach. They also concluded that State Street was classified as an ERISA fiduciary because it “exercised authority and control over management of the plan’s assets.” It was considered an investment manager under Section 3(38) of ERISA and thus a prudent expert standard was required of its actions.

The court found State Street had violated its ERISA mandated fiduciary duties with respect to:

  • Duty of Care, Skill, Prudence and Diligence – ERISA requires fiduciaries to act with the care, skill, prudence and diligence. The court found State Street had breached its duty to act prudently in managing the bond funds and the place bond funds have in the construction of a portfolio. Further, State Street’s investigation into the subprime securities seemed to have been ignored when analyzing the risk of the subprime mortgages.
  • Duty of Loyalty – A fiduciary must fulfill its duties “for the exclusive purpose of … providing benefits to participants.” The court did not find any evidence of breach of loyalty by State Street though determined that it had acted imprudently (as stated above) in the management of the bond funds.
  • Duty of Diversification – The court determined that State Street breached its duty to diversify plan assets. The court found State Street investment in subprime securities was an “undiversified risk for the bond funds.” The case is an important reminder of the basic requirements and duties required of plan fiduciaries and investment managers under ERISA.


End of the Road for Stretch IRAs?

Regulations currently permit beneficiaries of inherited retirement accounts, including 401(k)s and IRAs, to stretch distributions over their individual life expectancies. Depending on the age of the beneficiary, retirement assets could remain in tax-sheltered accounts for decades and accumulate plentiful assets for their heirs.

The Senate Finance Committee attached a proposal to the recent Highway Bill requiring retirement accounts to be fully liquidated within just 5 years after the death of the account owner for non-spouse beneficiaries. Although the initiative did not survive committee, the proposal was estimated to raise $4.6 billion over 10 years from accelerated tax collections.

This failed proposal is an important reminder about retirement tax policy: the idea behind the preferential tax treatment for IRAs and other qualified accounts is to assist individuals to save for their own retirement, not to make tax-advantaged gifts to heirs. As budget pressures continue to be at the forefront of tax policy, North Pier believes this issue could again surface in future budget debates. Additionally, this issue reminds us that the rules we often use as the basis for making financial decisions (often large ones) can change with the stroke of a pen.

Federal Thrift Savings Plan to Offer ROTH

The Federal Thrift Savings Plan is set to unveil its new ROTH investment option to Federal employees by late April or May. If the experience of the private sector is any indication of what the federal government might expect when offering ROTH contributions to employees, it may take longer than expected for employees to embrace its benefits. After becoming available in 2006, many companies amended their 401(k) plans to offer the opportunity to make ROTH deferrals. However, many employees have not yet adopted ROTHs nor made
them part of their savings strategy.

Despite the marketing of the potential benefits of a ROTH, namely, tax-free withdrawals, tax diversification and RMD avoidance, the adoption rate of ROTH deferrals in 401(k)s has been anemic. Some of the nation’s largest recordkeepers have seen ROTH participation rates ranging from as little as 6% to 15% of participants.

Although the ROTH 401(k) is easy to understand, many believe that this sluggish uptake is due in part to the challenging financial assessment that is required to determine if ROTH contributions are advisable, thus preventing participants from making the switch.

Reasonable Rate of Interest

In a recent IRS discussion forum regarding participant loans, an IRS representative stated that interest rates on participant loans of a rate less than the prime rate plus 2% might not meet the reasonable standard as required under the Internal Revenue Code. After clarification, the IRS identified previous DOL guidance on the determination of a reasonable interest rate for a participant loan. Several examples highlighted from DOL regulations described a process that should be followed when determining a reasonable rate. They include the current commercial lending rates for loans to individuals of similar creditworthiness, not necessarily the prime rate plus 2%.

Spring Market & Economic PIERspective

Spring Forward – Fall’s Behind

Recently, many have remarked how the U.S. stock market has soared straight up from the end of Q3 2011. And viewed in that specific window… it has. Looked at from the bottom of the Q3 correction, the market has climbed nearly 30% in 6 months. Focus on this viewpoint has prompted comments along the lines of the following:

However, when observed with a longer perspective and the hindsight that the underpinnings of last fall’s correction proved to be meritless, the recent assent of the U.S. market seems much more moderate, a modest 8.5% over one year.

It is my assertion, that the recent run-up was just the correction of a misguided mistake made by emotionally fragile markets, and the subsequent resumption of a longer-term secular bull-recovery.

How the Markets Fared

Globally, equity markets steadily marched forward for much of the first quarter. A simple lack of bad news accompanied firming economic data to provide a stead wind at the back of stocks. Smaller names generally fared slightly better than those of larger companies, traditional growth categories provided marginally better returns than cyclically sensitive values stocks, and while foreign developed markets lagged those of the US, both were generally bested by international emerging markets. All in all however, returns were robust, with global equity indexes seeing gains in the tight range of 11%-15%.

The fixed income markets saw a broader dispersion in performance during the quarter. Higher quality bonds of longer maturities saw a pullback in value as interest rates climbed back up from record lows. Yields on the 10-Year and 30-Year U.S. Treasuries rose 33 and 45 basis points respectively leading to meaningful drops in bond prices at the long end of the market. As the global economic outlook continued to firm, risk spread continued to tighten (in the same way they did in Q4 2011). Bonds with deeper credit exposure, such as domestic high yield and emerging market debt, saw moderate gains in value during the period. Stuck in the middle with nominal returns were the aggregate indexes, which benefited somewhat from their credit exposure, offsetting losses to their government components.

By The Numbers:

The “E” is for Ebbing

Q1 marked the first drop in S&P 500 earnings in the 10 quarters since the beginning of the recovery. Although this is not unusual during an economic expansion (the 2001-2007 expansion had four such drops) it does mark a potential pause. The low hanging fruit may be off the tree. If earnings continue to rise as expected (S&P expects earnings in Q4 2012 to be 10.5% stronger than Q4 2011), a change in the makeup of where we have been finding earnings growth will have to develop. Margin improvement has been the major contributor in earnings growth until recently. In order for U.S. companies to continue to grow profits, it appears that increases in sales will begin to be the new driving force. And I suspect they will.

“Morning of the Top to Ya’!”

Where does top-line growth come from? Increases in sales can come from a multitude of places in today’s environment. Read on for the data that supports what I see as key contributors to this potential.

  • As I have said all along, “It’s the emerging consumer, stupid!” U.S. multinationals are well positioned to take advantage of the reacceleration in emerging market economic growth. JPMorgan estimates that GDP for these developing nations will accelerate from 5% to nearly 6% by year’s end. This is crucial as these emerging economies continue to represent an increasingly important share of global consumption.
  • Businesses continue to drive us forward. Both the Services and Manufacturing side of the ISM Report on Business® (formerly referred to as the Purchasing Managers Index) continue to show that we are in expansion mode. Manufacturing continues to improve, climbing to the 53.4 in March (a reading over 50 indicates expansion). The service side of the economy is growing even quicker, according to its March reading of 56. Strength in new orders from both sides of the report indicated that that this trend should continue into the near future. The reports are also indicating that the recent trend of increased hiring is going to continue as well.
  • Increasing employment at home should provide a two pronged contribution to our domestic spending. Each 1% improvement in the employment rate means over 1.5 million workers added to the economy, with the ability to resume consuming. Further, strengthening employment has historically had a high correlation to a bolstering in consumer confidence for those who are already participating in the workforce. If the unemployment rate declines into the mid 7% range in between now and the election, the effects of the progress will be multiplied.
  • In fact, improving sentiment is already well underway. Similar to the latest stock market rebound, consumers recovered quickly from their fear-state last fall when the predictions of a double-dip-recession proved to be unfounded. We recently detailed how Christmas 2011 was a resounding success. Now, confidence is challenging its highest levels since the 2008 crisis. This is, in no doubt, finally helped by housing prices which have leveled out over the last year and a half and in some markets have begun to turn upward. Also as we have previously commented, the average household’s financial statement continues to look outright rosy; with lower debt payments, record high credit scores and strong savings levels (~4%).
  • Need more evidence than a strong Christmas? New auto sales have recently returned to their norms of 15 million units a year. Construction spending has risen a respectable 6% year over year, with 10% gains in the private sector helping to offset declines of 1% from government projects. We are clearly poised for a meaningful contribution to the recovery from a reinvigorated consumer if these trends continue.

I could go on and on, mentioning the recent growth in the money supply (and its velocity), increases in housing starts, record home affordability, etc. All signs would point to a continuation, if not an outright acceleration of the recovery. If these indicators hold, then top-line growth will materialize bringing bottom line earnings up with them. It is my PIERspective that they will.

No So In-Materials

If there is a potential stumbling block lying ahead in the road of global recovery, it’s that things could get too good, too fast. As the world continues to wake from its economic slumber, the scarcity of resources will be revealed in a way we have only glimpsed. How quickly 2007’s $150 per barrel price for oil faded from memory once the financial crisis hit in 2008. In 2007, material costs for essentials like copper and steel, let alone food, were weighing on many family’s already stretched budgets. Fast forward to 2012’s moderate economy and we already see signs that higher prices may be ahead. The Dow Jones U.S. Basic Materials Index was up over 9% in Q1 alone.

According to Engineering News-Record, even in this anemic environment, March’s Materials Cost Index rose 3.3% year-over-year. Steel was up almost 6%. Though these increased costs have yet to materially impact inflation readings like CPI, one wonders how much slack we have in the system before they appear. With the Federal Reserve’s bold commitment to keep interest rates near zero well into 2014, my concern is that our monetary policy makers will react too slowly if demand begins to outpace supply as quickly as it did in 2007. Since that time, the globe has added well over 100 million new consumers. A tipping point on prices may hit even more quickly this time around. How would the recovery react in the face of flash-flood-inflation? I suspect, not well.

“We’ve Come a Long Way, Maybe”

Now that my future inflation concerns have been stated once again, I believe we have a ways to go before it becomes an issue. The recovery in developing markets can likely sustain some headwinds from rising costs. Locally we may be a bit more sensitive, both literally and psychologically. Nonetheless, rising prices are still likely to mean rising profits, at least at their onset. As I stated before, in order to grow E, companies need to increase their top-line.

PIERing Ahead

On the way to rising prices we can expect to enjoy accelerating economic conditions. Labor should continue to improve, as should asset prices. Houses are more affordable than they have ever been, and people are finally taking notice. Despite the recent 30% run, equities are still trading at a 20% discount to longer-term norms. In fact, even with record earnings in the S&P 500, we are still over 10% away from 2007’s prior peak in the market. It seems to me that the lowered expectations that seem to dominate the media these days create even more opportunity for upside surprise. For how long this phase of advancement will last remains the key question… in my PIERspective.