Administration September 27, 2019

Natural Disasters Damage Retirement Accounts, Too

What options do participants have when a natural disaster affects them, and are there steps plan sponsors can take to reduce the impact on retirement savings?
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Art by Davor Gromilović

Natural disasters are known to damage communities and properties. Less understood, however, is the harm they can cause to participant retirement accounts.

When a participant’s home or property is destroyed, dipping into his defined contribution (DC) plan account may be one of the first actions he takes. This leads to early distribution taxes and penalties and cuts savings accumulated. And, because participants will take a period of interrupted employment to work on their homes and communities, this makes a dent into their retirement account as well since retirement contributions are disturbed too, says Steve Friedman, a shareholder who advises employers on employee benefits law at Littler Mendelson.

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“If somebody has a home that is damaged, it certainly opens up the prospect of that person needing some money to get themselves financially through,” he says. “That gets into the question of what rules govern their access to 401(k) or 403(b) assets.”

Earlier this year, the Department of Labor (DOL) provided guidance to employee benefit plans, plan sponsors and workers affected by severe storms in Nebraska, Iowa and Alabama, and in June, Congress added a special tax relief to the newly-signed Disaster Relief Bill. This relief granted access to the retirement funds of those affected by federally declared disasters in 2016 and 2017, and allowed these participants to repay distributions within three years, avoid additional early distribution taxes, borrow supplementary funds as a plan loan, and more.

More recently, the IRS has amended hardship withdrawal rules modifying the safe harbor list of expenses in the Internal Revenue Code for which distributions are deemed to be made on account of an immediate and heavy financial need by adding a new type of expense to the list, relating to expenses incurred as a result of certain disasters. The IRS says this is “intended to eliminate any delay or uncertainty concerning access to plan funds following a disaster that occurs in an area designated by the Federal Emergency Management Agency (FEMA) for individual assistance.”

However, it’s important to note that while afflicted participants may take hardship withdrawals, that is only the case if the plan allows for hardship withdrawals. Employers are not required to offer hardship withdrawals in their plan.

“Any type of hardship withdrawal has to be pursuant to the retirement plan,” says Wesley Stockard, co-chair of the Employee Retirement Income Security Act (ERISA) and Benefit Plan Litigation team at Littler Mendelson. “These are not a benefit that must be provided, an employer has to have them as a provision that employees can take advantage of.”

“Employees need to keep in mind that though there has been a terrible circumstance, there is still a process that needs to be gone through,” he adds. “Doing this process correctly protects the employer and employee from any accusations.”

Friedman and Stockard recommend employees consult the summary plan description (SPD) should they have any questions regarding plan benefits. An SPD acts as a basic ERISA disclosure document for employees to understand. Following these steps ensures compliance for both employers and participants, especially in times of natural disasters where there is increased urgency.

IRS hardship withdrawal rules were amended in a way that could help reduce the impact on retirement savings from having to take a hardship withdrawal. Six-month bans placed on 401(k) or 403(b) contributions of participants taking a hardship distribution no longer not apply. Employees do not have to take a loan first, although plan sponsors may still require that, and the IRS has made it easy for participants to provide proof of their financial need.

A guide published by Fidelity examines the topic of retirement plan hardship withdrawals, with the objective of improving the long-term financial health of those who take them. Fidelity reminds plan sponsors that they still have discretion over limiting the amount of hardship withdrawals, and it recommends helping participants establish emergency savings to avoid having to take a distribution.

If participants choose to take a plan loan instead, they need to understand the differences from taking a hardship withdrawal. While plan loans are not subject to penalties since employees are borrowing the money, if a participant leaves his employer before paying off the loan, he is still required to pay the residual balance.

An analysis from Deloitte finds that more than $2 trillion in potential future account balances will be lost due to loan defaults from 401(k) accounts over the next 10 years. This figure includes the cumulative effect of loan defaults upon retirement, including taxes, early withdrawal penalties, lost earnings, and any early cashout of defaulting participants’ full plan balances. For a typical defaulting borrower, this represents approximately $300,000 in lost retirement savings over a career.

It recommends plan sponsors establish and enforce robust education and loan risk awareness programs designed and curated for fiduciary responsibility, prior to lending approval. Plan sponsors may also reduce the permissible loan amounts and number of loans outstanding per participant, and increase flexibility in payback timelines, as well as enforce waiting periods for plans that are currently designed to allow participants to take multiple loans.

Deloitte points out that the DOL states that loan programs should not diminish a borrower’s retirement income or cause loss to the plan, and views loans as investments, requiring the same fiduciary oversight as any other plan investment option.
Investing September 24, 2019

Considerations for Offering SDBAs in Retirement Plans

A report from Schwab found self-directed brokerage accounts can result in good outcomes, but a brokerage window is not for every retirement plan.
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Art by Julie Benbassat

A recent report from Charles Schwab might give retirement plan sponsors reason to think about offering their participants a self-directed brokerage account (SDBA), particularly one that offers the participants the service of an adviser.

Schwab’s “SDBA Indicators Report” found that while only 20% of participants in a brokerage window worked with an adviser as of the second quarter, their average balance of $448,515 was nearly twice as much as the $234,673 held by non-advised participants. In its first quarter report, Schwab found those participants who used advisers displayed a more diversified asset allocation mix and had a lower concentration of assets in particular securities. According to the 2018 PLANSPONSOR Plan Benchmarking Report, 20.3% of all employers offer a self-directed brokerage account (SDBA).

However, many retirement plan advisers are not in favor of SDBAs because they think retirement plan investors are not sophisticated enough to make successful individual trades. In fact, Eric Droblyen, president and CEO of Employee Fiduciary LLC in Saint Petersburg, Florida, worked at Schwab in the 90s, when it was the first financial services firm to offer its workers a brokerage window, he says. And even though the market was rising during those years, “those in the brokerage window were the ones who lost money, even when the market was going gangbusters,” Droblyen says.

So, what should sponsors consider before offering a brokerage window? According to a paper written by Drinker Biddle & Reath, LLP partners Frederick Reish and Bruce Ashton, “Fiduciary Considerations in Offering a Brokerage Window,” “deciding to offer a brokerage window is a fiduciary decision, [but] there is little guidance on the considerations a fiduciary should use in making the decision. The considerations for deciding whether to offer a brokerage window have not been specified in the law or by the Department of Labor (DOL).”

That said, the lawyers say the brokerage window should be made available to all participants and the sponsor should “consider the investment sophistication of the employee population and/or whether any employees desire to work with investments advisers who could assist them in investing through a brokerage window.”

Reish and Ashton say sponsors should also ask their participants to honestly consider their investment sophistication before participating in a brokerage window and to tell them that the plan’s fiduciaries will not be selecting or monitoring the investments available in the window.

As to the selection of a brokerage window provider, the DOL has been specific, the lawyers note, citing a DOL Field Assistance Bulletin in 2007 that states, “With regard to the prudent selection of service providers generally, the Department has indicated that a fiduciary should engage in an objective process that is designed to elicit information necessary to assess the provider’s qualifications, quality of services offered and reasonableness of fees. The process also must avoid self-dealing, conflicts of interest, or other improper influence.”

So, for whom might a brokerage window be appropriate? Droblyen says it is typically professionals such as doctors and lawyers who are highly paid. However, says James Veneruso, a senior vice president at Callan in Summit, New Jersey, “We find utilization of brokerage windows tends to be very low, and even when it is offered, they account for a mere 5.3% of plan assets.” The reason some sponsors offer brokerage windows is they don’t want to have too large of a fund lineup, he says.

Best practices sponsors should consider when offering a brokerage window include that the window should comply with Employee Retirement Income Security Act (ERISA) requirements of section 404(c), according to Droblyen. “This absolves fiduciaries from being liable if the plan participant makes bad investment decisions,” he says. “If an employer is considering brokerage accounts, they should ensure the core funds meet 404(c) requirements.”

It is also common for sponsors to set limitations on the percentage of a participant’s balance that they can invest in the brokerage window, like 10%, 25% or 50%, says Andrew Oringer, a partner at Dechert LLP in New York. “This gives participants the flexibility they are yearning for, yet limits their risk to an extent.” Sponsors may also limit the types of investments that can be used in the window, perhaps excluding them to only traditional stocks, he adds.

Constantine Mulligan, a partner and director of investments for the retirement plan services group at Cerity Partners in Chicago, says his clients typically restrict the investors in brokerage windows to only invest in mutual funds and they are also careful to ensure that investors in the window are not investing in the same product available at a lower cost on the investment menu. And it is very common for a publicly traded company to restrict the percentage of the company stock that participants can purchase “to make sure they are not putting their entire nest egg in an over-concentrated allocation.”

Lastly, sponsors should ensure that investors in brokerage windows are paying separate fees, and they should consider having participants sign an indemnification agreement stating that they understand the risks of investing in a brokerage window, the experts say.

Mulligan says he sees two scenarios where a sponsor might decide to offer a brokerage window. “The first is where the retirement plan committee knows they have participants who need options outside of the core menu,” he says. “The second is where high-level executives who are sophisticated investors ask for it. These are the two ways that I see this happening in an appropriate fashion.”

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