By: Brant Grifﬁn – August 22, 2013
Revenue Sharing Revisited
The last several years have witnessed numerous industry developments relating to the revenue derived from qualified plan investments. Against the backdrop of 2012’s DOL fee-disclosure regulations, revenue sharing and its affect on the way plan fees are paid, has received its share of national media attention, mostly negative.
As background, revenue sharing is the portion of a plan investment’s expense that is available to offset plan fees. These payments come in the form of 12b-1 arrangements, shareholder and administration service fees, or similar credits. This compensation is intended to offset the plan provider’s costs of services such as plan administration, statement delivery and staffing functions.
Plan payments are often directed into a real or virtual account frequently referred to as an “ERISA Account” or “ERISA Budget Account.” Specific provider agreements vary, but typically the sponsor will direct the qualified plan expenses of consultants, attorneys or other service providers to be paid from this source. Any remaining revenue in the account can be allocated to the plan’s participants.
DOL Advisory Opinion – Revenue Sharing as a Plan Asset
In July 2013, the DOL delivered an Advisory Opinion in reference to a plan administered by the Principal Life Insurance Company (Principal). The letter described Principal’s practice of capturing investment revenue sharing payments and establishing an ERISA Budget Account for its plan clients.
The Advisory Opinion concluded that Principal’s receipt of plan investment payments in a non-plan account, and often maintaining a bookkeeping record of the payments, did not warrant the treatment of the revenue as a plan asset for purposes of ERISA. However, the opinion noted that any revenue payments that were eventually paid into the plan (such as remaining revenue after plan fees are paid that is directed to participants) would then become plan assets.
The identification of “plan assets” is a critical distinction as it activates ERISA rules relating to trust requirements and prohibited transaction regulations as well as the identification of plan fiduciaries. The latter mandating an elevated code of conduct.
Recent Case Law – Tibble v. Edison
The Court of Appeals recently ruled that fiduciaries must choose investment share classes that provide the best value for their plans. In the case of Tibble v. Edison, the court found that Edison’s plan fiduciaries acted imprudently by choosing more expensive retail share classes of the plan’s mutual funds instead of cheaper institutional share classes offered for those same investments. The court ruled that fiduciaries must factor all the available share classes into their decision-making process.
The court’s decision focused on the reasonableness of investment expenses in light of the plan’s collective purchasing power. Thus, plan sponsors must ensure they make decisions based on the different share classes available their plan’s investments. Since mutual funds frequently have multiple share classes, fiduciaries must be diligent to ensure they understand that different share classes may be offered and evaluate which provide the best value for the plan and their participants given its plan’s size. In light of Tibble v. Edison, fiduciaries now have the increased responsibility of choosing share classes that provide the most value to plan participants.
As revenue payments from plan investments often vary from fund to fund, different investments can subsidize plan costs in varying amounts. When looked at in a different light, one participant that allocates his savings to investments that produce larger plan revenue payments will be subsidizing more plan costs than another participant who selects investments with lower revenue producing amounts (like some passively managed index funds).
Should one participant with an identical account balance as another participant, offset more plan costs solely because of how they allocate their savings among the plan investments? This may be problematic, especially if it is found that more non-highly compensated employees (HCEs) are invested in larger revenue producing investments. This could potentially be found to be an ERISA violation if the non-HCEs are shouldering a larger proportion of the plan’s costs. As case law surrounding this issue evolves, it is entirely possible that future court decisions may find this arrangement discriminatory and unreasonable.
The potential for inequality, stemming from Tibble v. Edison and other recent plan fee cases, have led some plan sponsors to change the way their plans are paid for. Some organizations are moving to a payment arrangement where
each plan participant would pay an identical amount by equalizing the plan’s investment revenue. Alternatively, some sponsors have evaluated an arrangement where participant accounts are charged directly for plan costs and the investments do not include revenue sharing at all.
Plan revenue sharing has received its share of attention over the years, and the DOL’s fee disclosure regulations have again highlighted this controversial plan arrangement. Due to the volume of litigation surrounding this issue, fiduciaries should be well versed in the recent developments surrounding revenue sharing and regularly review industry best practices in managing this plan feature. Despite the criticism, revenue sharing is an economic reality for most qualified plans, performing a critical role in how plans are paid for – and it’s not likely to go away any time soon.
Yale Professor Sends Accusatory Letter to Plan Sponsors
Yale Law School Professor Ian Ayres has sent a shocking letter to over 6,000 retirement plan sponsors implying that they have potentially violated their fiduciary duties by maintaining plans with above average costs. In the letter, the Professor threatens that his study will be published in spring 2014 and call out the plans identified as having high plan fees. Further, he states that his findings will be disseminated to the news media and popular social media outlets. The letter reminds plan sponsors that “fiduciary duties are the most stringent imposed by the law, and require administrators to act solely in the interest of the plan participants.”
Plan sponsors should be aware that the study’s findings may be inaccurate. There are a few important deficiencies in the claims made by Professor Ayres, including:
- The study uses data from 2009 that may no longer accurately represent what a plan pays and does not illustrate whether the sponsor is paying some or all of its plan fees.
- The study does not factor qualitative plan data including unique plan services provided to the plan. This is critical in the determining if the plan is paying a reasonable amount for the services provided.
- The study does not factor the complexity of the plan design and resulting costs.
The tone of the letters is shocking. The implicit accusation of fiduciary impropriety made by Professor Ayres raises obvious concerns among plan sponsors. Due to the recent DOL plan and participant fee disclosure regulations, many companies are hypersensitive to any suggestion that its plan may be inefficiently priced.
Nonetheless, companies that have received the letter (and truly all plan sponsors) are advised to address the issues raised within the letter even if they feel such claims are wrongly asserted. This event is an opportune time for fiduciaries to review this critical element of fiduciary oversight that mandates plan fees are reasonable in view of the services provided.
Follow US to Recovery
By: Jim Scheinberg – August 22, 2013
There can be no mistake that the United States is leading the global advance in stocks, and I theorize in a broader cyclical economic recovery as well. That would make sense, seeing that if we led the world into this mess in 2008 with the collapse in our real estate markets and related fallout, then a recovery in this area would be the driving force as we emerge back to more prosperous times. If our thinking is correct, then in the coming quarters we will see strength return to the consumer-sensitive global manufacturing regions such as China. Once they begin to thrive again, the U.S., Europe and Japan will benefit as a result of accelerating infrastructure spending. So be forewarned; as we report below on the dispersion of equity performance between the U.S. and the rest of the globe, don’t assume that this is a trend that will continue. In fact, we believe that there are bright days ahead for most all global markets.
So, just how did the Markets Fare?
Domestically, the stock market performed reasonably well, continuing the amazing rally of the First Quarter right through May. However, as concerns over high risk economic policies in Japan and a global slowdown in Asia and Latin America emerged, markets globally slumped into the final 5-6 weeks of the quarter. The net result here in the U.S. was that stocks added another few percent to their record breaking Q1 returns. Developed international markets in the EU and Japan ended with modest net losses. The emerging markets were hit hardest, with Asia finishing down over five percent and Latin America plunging over 15½% (led by declines in Brazil).
The long awaited rise in interest rates finally commenced during Q2. The yield on the 10-Year Treasury shot up from 1¾% to nearly 2½% during the quarter. High quality corporates, mortgages and agencies similarly saw a rise in rates. This led to a drop of over 2.3% in the BarCap Aggregate Bond Index. The bubble in Treasury Inflation Protected Securities (TIPS) that we have been commenting on for years may be deflating as well. The exodus out of TIPS forced prices down nearly 7½% in second quarter alone. This will certainly be a shock for unwitting TIPS investors that expect safety from these guaranteed government bonds.
REAL E(c)S T A T(ic)
As our regular readers know quite well, we have been forecasting a rapid recovery in residential real estate for over two years now. In fact, I coined a term for my expectations, a ‘check-mark recovery,’ hypothesizing that once the initial observation was made that prices had bottomed and turned ( v ), there would be a hurried stampede of buyers grabbing up the bargain prices, sending values up sharply off the bottom. As optimistic as I was at that point, even I under-predicted the pace of the advance. The recently released Case Shiller data for May showed better than a 12% year-over-year increase for prices for its 20 City Index. Southwestern markets like L.A., San Francisco, Phoenix and Las Vegas enjoyed 20% or better returns. Though shocking in magnitude of their advance, home prices still likely have a ways to go before gains moderate. This is largely due to continued tight supply. At the current pace of sales, there is presently less than 4 months of supply available on the market, compared to over 12 months at the peak of the crisis. Even with the recent price gains, still low home values and cheap mortgage rates are making buying the clear choice over renting for those who are inclined to commit. Further, The Federal Reserve quarterly Senior Loan Officer Opinion Survey on Bank Lending Practices indicates that banks continue to ease on lending standards. Add this all together, and we are likely just at the beginning of this boom in real estate.
The Disposition of Acquisition
We are seeing US consumer confidence growing more and more optimistic these days. The Conference Board index for July was reported at 80.3. Though slightly down from a five year record of 82.1 in June, this still represents a marked advance from the 61.9 reading back in March. This follows logically since a main driver in this area is confidence in home values. The other key factor is conditions in the labor markets. Though not improving as rapidly as domestic real estate, the employment situation in the U.S. continues to improve steadily, if not monotonously. With the exception of a couple of outliers to the upside, we’ve added about 175,000 jobs, plus or minus 35,000, each month for the last year. This has helped the unemployment rate ratchet down to a post crisis low of 7.4%. More people at work and confidence in the stability of the jobs of those who are currently employed fuels spending. Since consumption accounts for nearly 7 of every 10 dollars of U.S. GDP, when people in the U.S. are spending more, it leads to adding more jobs, additional corporate profits, and increased tax receipts… a self-perpetuating cycle.
Back In Business
After a brief pause, the business-to-business sector appears to be back off to the races. The manufacturing component of the Institute of Supply Management’s July Report on Business (ROB) shot up to 55.4 in July (indicating robust growth) after hovering near 50 for the last three months. An explosive gain in new orders and declines in inventories led to the spike. A similar spike in new orders helped lift the non-manufacturing ROB to 56 from 52.2 last month. Confirming this optimism, the recent Vistage CEO Confidence Survey continued to exhibit optimism from business leaders about the coming period. If conditions on the ground hold or even improve, the International Monetary Fund’s widely accepted forecast of just 2¾% growth for U.S. GDP in 2014 should prove to be meaningfully underestimated. If the ISM data proves accurate, it suggests the coming year will see more than 4.0% growth in GDP, which is more in line with North Pier’s expectations. That type of upside surprise would bode well for not only the United States, but the global economy as a whole.
PIERing Ahead: Seems Pretty Fair To Me
The S&P 500 presently trades at 14.9 times expected consolidated earnings of $116 for the index’s coming year. That is about the normal high reached as market multiples expand (with the exception of the overvalued dot com era). However, with earnings expected to grow nearly 20% next year, this represents a big discount to normal PEG ratios (Price to Earnings Growth). If our theory holds, and the globe is at the dawn of a new cyclical economic expansion, earnings will accelerate and multiples will eventually expand beyond historic norms, not just to them. So the fair values that we find ourselves at today, in my opinion, are actually quite cheap at this point in an economic cycle.
Of course, this all depends on continued gains in real estate values, jobs, and resultant economic activity, which we believe is quite likely. The challenge will be in managing volatility when interest rates are eventually allowed to float back to naturally supported levels as the economy solidifies its footing. Note that I said volatility and not growth, which we think is assured. To illustrate my point, when interest rates jumped up nearly 0.40% over 6 trading sessions in mid-June, the equity markets sold off nearly 5% out of fear of what higher rates would do to the economy. This is clearly irrational thought, as we are still several percentage points below longer-term norms. However, the emotional impact of rates climbing is very real. It is my PIERspective that it’s not whether the economy and our equity markets continue their advance from here that is in question. It is how smooth or jagged this ascent proves to be, which remains unanswered.