Fiduciary Commentary |Winter 2018/2019

By: Brant Griffin

Top Compliance Risks for Employer Plans

For many retirement plan sponsors the mere thought of plan compliance is overwhelming.  Filing deadlines, internal controls, fiduciary duties… the list continues to get longer and more complex. Nonetheless, retirement plan compliance must be a top priority for plan fiduciaries to ensure company benefit plans are sound.

Plan compliance is a top concern to regulators, and every year thousands of employee benefit plan audits are conducted by the IRS and DOL. In fact, in recent years nearly one in three workplace retirement plans have been audited. Most employers are horrified at the thought of having to undergo a regulatory agency audit due to the fear that an unknown plan failure will be discovered.

Qualified retirement plans are generally policed by two federal agencies, Employee Benefits Security Administration (EBSA) through the Department of Labor (DOL) and the Internal Revenue Service (IRS) through the Department of Treasury. Each agency has their own focus and jurisdiction when conducting plan oversight. EBSA is focused on fiduciary compliance, reporting and disclosure and ERISA centric responsibilities, while the IRS is concentrated on the qualified status of plans and ensuring the plan is abiding by the standards that permit its tax-favored status.

The frequency of retirement plan audits seems to vary based on a wide range of factors. While the regulatory agencies do not divulge its audit selection criteria, it is often a function of geographical region and the agency’s budget. However, there appears to be several focal points in DOL and the IRS audits. The following are common audit risks for qualified retirement plans.

Late Deposit of Salary Deferrals

The most common finding during an audit continues to be delinquent employee payroll deposits. The law requires that employers contribute the participants’ salary deferrals to the plan trust on the earliest date that the deferrals can reasonably be segregated from the employer’s general assets. However, in no event can the deposit be later than the 15th business day of the following month (this is a firm deadline, not a safe harbor). With that being said, the DOL has established a seven business day safe-harbor rule for plans with fewer than 100 employees.

In practice, the DOL will review the history of the employer’s deposit patterns and identify the quickest that the company was able to make contributions to the trust and then apply that time period as the maximum deadline for payroll deposits over the scope of the audit. If employee contributions are not found to have been made in a timely manner, errors are typically corrected through the DOL’s Voluntary Fiduciary Correction Program which will require the calculation of earnings attributed to the contribution delay. Additionally, the DOL may require a completed Form 5330 along with an excise tax penalty of 15% of the earnings amount.

Offering Target Date Funds

Another issue that auditors have begun to turn its attention to is due diligence of a plan’s target date funds (TDFs). TDFs are investments that contain a mix of various assets that change their risk characteristics over time so that as the participant approaches retirement age, the investment becomes more conservative. TDFs are commonly offered as the plan’s qualified default investment alternative (QDIA) and are therefore held to a higher level of scrutiny. The DOL has issued guidance (February 2013) on target date retirement funds for plan fiduciaries detailing the selection and monitoring criteria of TDFs and other investments. Plan fiduciaries should establish and document their process in comparing, selecting and monitoring TDFs including their performance, understanding of the underlying investments, glidepath and review of the fund’s expenses, among other attributes.

Updating the Plan Document

The failure to amend a plan to reflect recent tax law changes is another top audit issue. Qualified retirement plans are required to maintain a formal written plan document that meets all the terms and conditions of applicable law, namely the Internal Revenue Code and ERISA. When a new tax law is passed, the IRS will identify a timeline for amending the trust to conform to the new tax laws.

Additionally, these plan amendments will typically necessitate updates to the plan’s other formal documents. A review should include the comparison of adoption agreements and summary plan descriptions to determine if amendments are required to reflect any changes made to the plan for the tax law change. Finally, board of director resolutions and/or minutes reflecting the adoption of such amendments should be drafted. A periodic review of plan documents and related plan materials is also strongly suggested.  Plan sponsors should periodically compare their retirement plans against an IRS list of required amendments to confirm that their plans are in compliance.

Lost Participants and Force Outs

A recent wave of audits has revealed a new DOL focus, participant force-out distributions and locating lost participants. Today, nearly all plans have a “force out” provision in plan documents for account balances less than $1,000. While employers are generally aware of this provision, it is not applied consistently. Many plan documents are drafted with language that states employers “will” force out benefits, not “may”. As a result, failure to routinely distribute small balance accounts will produce an ERISA violation.

Further, the DOL has begun targeting plan procedures relating to lost participants and beneficiaries as it has been recognized as the cause of investors losing track of their plan benefits. While it would seem logical that the responsibility to update plan address would fall to the participant, it is not the case. Due to the requirement that employees receive numerous plan communications, without current participant address information these obligations cannot be satisfied. Therefore, employers are required to attempt to locate missing participants on a regular basis.

Employers should review the force-out provisions and coordinate with their custodians to determine the best method for distributing these amounts on a periodic basis. They should also initiate a process to regularly receive a list of lost participants, so efforts can be made to track former participants without up to date address details.

Definition of Compensation

Failing to follow the plan’s definition of eligible compensation is a common plan error. Various definitions of pay are identified throughout plan documents for use in calculating benefits, contribution limits and discrimination testing (ADP/ACP and top heavy). Frequently, the complexity of compliance and risks are amplified with larger corporations use of numerous payrolls.

Auditing the proper administration of the plan with the terms of the document is done by contrasting plan document definitions to the payroll codes for such deductions as participant plan deferrals. As compensation errors are often identified when plan limits are exceeded, such as an employee’s compensation or deferral limit, identifying errors is easy for auditors to find.

Plan sponsors should conduct periodic reviews of the various definitions of plan compensation in the plan document. Plan sponsors should ensure their payroll department’s application of these definitions are being applied properly and consistently.

Internal Controls

Another hot topic for the DOL upon audit are the company’s internal controls. A company’s internal controls demonstrate how the company and/or the plan sponsor documents its processes with respect to the plan. Retirement plan committee minutes and resolutions must be reviewed to make sure that they are complete and accurate. This proves to the DOL that there is likely a procedure being followed and the right processes are in place and documented.t

Proactive compliance reviews of plan operations and processes should be given a high priority at organizations. Plan failures discovered internally can be fixed comparatively easily through voluntary correction programs.  After being notified of an audit, correction programs are no longer available and plan failures are remedied through fines or excise taxes.  Establishing and maintaining sound compliance program is the best defense and if the IRS or the DOL decides your plan is next on the list, be ready for them.


Market & Economic Commentary|Winter 2018/2019

By: Josh Mackenzie & Jim Scheinberg – February 13, 2019

Too Much Ado About Somethings?

The last quarter of 2018 proved to be quite a shock to most investors, completely erasing the hard-fought gains for the year in U.S. equities. As renewed headlines and conjecture about a trade war with China caused pessimism to rise in the equity markets, ill-timed statements from Fed Chairman Powell added fuel to the fear. The Fed was thought in late November to have indicated that they were hell-bent on continuing to tighten monetary policy well into 2019, regardless of a potential slowing in the U.S. economy. Markets feared that the Fed was out of touch and would surely push the economy, which they thought was teetering, over the edge into recession. Add in light reductions in the outlook for Europe’s economy and a swift decline in oil prices, and global equity and subsequently credit markets got hit with wave after wave of selling, the likes we haven’t seen in since the financial crisis of 2008/2009.

How the Markets Fared

Equities

After a rough Q2, which was weighed down by many of the same fears that raised their heads in the most recent quarter, markets began to claw their way back as confidence was restored. But when investors were again faced with the possibility for slower global and U.S. growth in 2019, markets became distraught, quickly reversing their appetite for risk in the third quarter. Equity investors were hit particularly hard, catching many off-guard. The S&P 500 was down 13.5% for the quarter, briefly flirted with bear market territory before beginning a recovery rally in the last few days of 2018. International and emerging market equities also declined. Value oriented-stocks outperformed growth sectors as investors fled from high-valuation names in the tech and telecom space. In the United States the Russell 1000 Value index preserved capital better than its growth counterpart by over 4%, for what felt like the first time in ages.

DebtQuality was king in fixed income as well. Fearing an economic slowdown in the coming year, investors fled bonds that had any risk exposure, driving prices down and widening credit spreads. Government bonds outperformed both corporates and high yield meaningfully. Commodities prices were not spared either. Oil, one of 2018’s best performing assets through the first three quarters, was quickly trounced as concerns about slowing demand and oversupply dominated trading. Prices fell from a high of $75 a barrel in early October to $42.5 in December, a peak-to-trough decline of 44% at a pace that rivaled the 2015/2016 plunge. No doubt, PTSD from oil’s plunge from $100 to $26 just three years ago likely fueled the panic that hit stock, commodities and credit markets alike.

2018 was a peculiar year, short-term government T-bills (cash equivalents) were the only major taxable asset class to generate positive returns. For the last 10 years, holding any cash was a drag on performance. Its paltry 10-year annualized return of 0.37% would have seen inflation quietly erode investor’s purchasing power. No longer; cash is now a viable investment. By tightening monetary policy in 2017 and 2018, the Federal Reserve has elevated short-term interest rates above the level of inflation for the first time since the financial crisis. These rising interest rates pressured both stocks AND bonds in 2018, resulting in the rare phenomenon of simultaneous negative returns in both asset classes. One would need to venture back to 1974 to find a calendar year in which both the S&P 500 and an index of U.S. government bonds posted negative nominal returns. And these markets weren’t alone. Practically every major asset class lost money in 2018, making this one of the worst environments for diversification in history.

Annal Performance

2018 was bookended by extremes. Coming into the year investors were undeniably exuberant. Tax cuts and Bitcoin were all the rage. Continuing on a meteoric 2017, January saw the S&P rise 5.6% before volatility made a comeback, accelerating into February as the stock market sharply, yet briefly corrected. After bouncing around for a few months between trade headlines and stellar corporate earnings, the domestic markets took off again in Q3. However, while markets in the United States had recovered to new all-time highs, surpassing the levels reached in late January, international markets were struggling. Foreign markets were dealing with higher U.S. interest rates and continued dollar strength, putting pressure on returns (when measured in dollar-terms). This led to a divergence in equity performance that climaxed late in the third quarter:

2018 Cumulative Performance The pessimism that was weighing on international markets caught up with domestic counterparts in the fourth quarter as concerns about global growth dominated the final three months of the year. The gloom was not entirely unfounded, as data out of China and the core of Europe began to signal a slowdown in those regions. China has been caught in a catch-22; deleveraging their economy while maintaining economic growth has thus proved to be quite a challenge. Whether directly or indirectly, China has become an increasingly important source of global economic growth as developed Western nations recovered from the financial crisis. yearlyUnfortunately, China is undoubtedly slowing as its economy continues to mature. Auto sales fell on a year-over-year basis for the first time in over two decades. Anecdotal data from companies like Apple and FedEx led many to project that a weaker Chinese economy is likely to persist into 2019. Europe also ran into road blocks in the second half of 2018. Using German manufacturing PMI as a barometer for European activity, we can see this measure was consistently declining in 2018 after peaking in late 2017. A reading above 50 is still expansion territory but the negative momentum is noticeable.

PIERing Ahead

The United States economy will likely log its strongest annual performance since the recession a decade ago. Annual GDP growth should exceed the stubborn 3% threshold for calendar year 2018 and the unemployment rate remains at multi-generational lows. Despite the recent market turmoil, confidence among businesses and consumers remained robust throughout the year, and continues in that direction in 2019. Though the rate of growth for 2019 is expected to recede from last year’s elevated levels, many forecasters are still projecting 2.2%-2.5% growth, which would be considered good economic performance in most environments. Moderation is bound to happen eventually; but talk of a recession is premature at this point, and is based mostly on conjecture and not hard economic data. Yes, sentiment based confidence reports ebbed after the market shocks of December, but most have since firmed. Less elastic data, like labor statistics, still show a strong and resilient environment that is showing little signs of reversal. Global equity markets are now trading at discounts to long-term norm, seemingly factoring in further deceleration ahead. Though there are many paths that could lead to that conclusion, at North Pier, we see it far more likely that markets have overcorrected and that the next surprise could be to the upside. If the globe moderates and firms, instead of slipping into malaise or worse, present valuations will prove to be bargains and the coming year will be a good one for value-oriented investors.

Most of the recovery saw Wall Street doing better than Main Street but their fortunes seemingly reversed in 2018.

Consumer confidence remained high:

consumer1

Wage growth accelerated to its highest level in the cycle:

earnings

And yet financial assets performed poorly. The shift from expansionary monetary policy & restrictive fiscal policy to normalizing monetary policy & fiscal stimulus (tax cuts, large federal spending increases) may be part of the reason.

Credit spreads widened in 2018 but are hardly problematic:

spread

Political volatility on both sides of the Atlantic continued. France has been roiled by weekly protests, Italy’s fiscal position remains a point of contention and Brexit uncertainty persists. Europe will need to find firmer footing in 2019 as the European Central Bank removes monetary accommodation and prepares to raise interest rates for the first time in years. Not to be outdone, stateside politics remained turbulent. The political parties now with split control of government are likely to remain combative as ever. We are getting a taste of what the next two years will bring as we muddle through what has become the longest government shutdown in American history. The trade war continues to be a drag. All these factors fed into negative fourth quarter sentiment.

The 2019 outlook remains unclear. While the United States economy remains well situated at present the rest of the world must contend with headwinds. In my opinion a rotation to more value-oriented equity and quality fixed income should continue as investors grapple with volatility and contemplate an aging economic cycle that will eventually hit its expiration date. The strong dollar will continue to be the largest detractor from global growth and I see no signs that the currency is destined to weaken in the near term.

broad

The Federal Reserve remains committed to reducing their bond and mortgage backed security portfolios and are still projecting a couple more interest rate hikes, though they will probably be postponed until the second half of the year. Other major powers are still easing (Japan / China) tentative on policy tightening (Europe), or just confused (Britain). There doesn’t seem to be the necessary pressure on the dollar to drive it lower as the other currencies all have issues of their own. A decisive and productive conclusion to the trade war could provide the necessary catalyst to reprice the dollar lower. While investors may yearn for a return to 2017 it is likely that 2019 will share more in common with 2018 as many issues that dominated headlines remain unresolved. 2019 is off to a great start with markets bouncing hard off the Christmas Eve lows and sustaining that momentum into January’s first half. It may be prudent for investors use the recent strength to consider their risk exposure and contemplate a more defensive position to protect some of the gains that have accrued during what truly has been an incredible decade of market returns.