Administration November 26, 2019

DB Plan Cash Flow Needs Are Greater Than Ever

In these days of low interest rates, and following money market reform, investing strategies are needed to meet cash-flow needs from retiring Baby Boomers and pension risk transfer actions.
Reported by
Art by Katherine Streeter

With Baby Boomers retiring every day, defined benefit (DB) plan sponsors have more cash needs now.

Jeff Whitehead, head of client investment solutions at Aegon, based in Cedar Rapids, Iowa, believes if a DB plan isn’t already experiencing negative cash flow, it’s headed that way.

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Peter Yi, director of short-duration fixed income and head of credit research at Northern Trust Asset Management (NTAM) in Chicago, says his firm is having conversations with DB plan sponsors about how they can be more thoughtful on optimizing cash holdings. “We are challenging our client to rethink cash and more effectively and efficiently use it. For the time being, DB plans are holding more liquidity and less risk assets,” he says.

Money market funds were at one time an effective cash preservation vehicle. NTAM believes the Securities and Exchange Commission (SEC) money market fund reforms requiring higher cash (or similarly liquid vehicle) ratios at daily and weekly intervals redefined “illiquid” securities, restricted lower quality securities in fund makeup and stricter maturity limits on fund components, resulting in their income levels becoming extremely modest.

In a paper, it says, “Investors are developing a sharper understanding of the tradeoffs among safety of principal, income and access to funds in managing liquidity. Many now recognize a single product solution may no longer be viable. The regulatory and ultra-low rate environment is forcing them to be more open-minded about the broader menu of investment options available in today’s liquidity investing marketplace.”

According to Whitehead, what most DB plan sponsors do is either raise money every quarter by selling assets from certain funds or maintain a short-term bond fund (duration of 2) and raise money from that.

He points out that DB plans don’t want to hold too much cash—if they are raising money once a quarter, they could have at least three months of cash on their balance sheet only earning 1.5% or 2%. He suggests combining cash and a short-term bond fund customized to the plan with inflows coming in and outflows going out—a portfolio that provides money as needed month after month. “With this strategy, DB plan sponsors are not selling assets at an inopportune time and investment committees don’t have to decide what to sell,” he says.

Cash flow-driven investing

According to Whitehead, cash flow-driven investing (CDI)—an investment approach focused on delivering a consistent, reliable stream of cash flow to meet the obligations of a DB plan—is growing in popularity. “If a plan has cash and a short-term bond fund, which most would, take those asset allocations and add some other fixed income allocation to create a special portfolio,” he suggests.

Whitehead explains that with CDI, a laddered portfolio is created to provide cash flows that mature at the right times to meet outflows. CDI can be tailored to different situations. For example, if a plan has far more retirees than active or terminated, vested participants, it is more cash flow negative and needs additional money. Other plans may not need as much.

“I think CDI works for other plans as well, especially for public funds or multiemployer plans, church plans, hospitals—any plan that doesn’t discount at the AA rate. Many of these plans are not as well-funded and tend to focus more on their expected return on assets,” he adds.

According to Whitehead, some plan sponsors may question whether CDI will cost them in returns. His answer: “It doesn’t have to, especially in the current yield environment because treasury rates are so flat they are all the way out to where a core aggregate portfolio will be built.” A core aggregate portfolio is primarily focused on investment grade corporate bonds, foreign and U.S. government securities, and mortgage-backed and asset-backed securities, with limited allocations to high-yield securities. Whitehead adds that DB plans do get more yield when they take credit risk, so Aegon’s strategy is take credit risk on the front end to have a higher yield than a core aggregate portfolio.

Cash segmentation strategy

Another strategy for managing cash-flow needs, advocated by NTAM, is to segment cash based on what plan sponsors need and when they need it.

The three segments, or portfolio buckets, plans need are Operational, Reserve and Strategic. Yi explains that Operational is the most critical bucket for immediate or very short-term liquidity needs (1 day to 30 days). Recommendations for investments are government securities vehicles with a sweep function and of the highest credit quality. A sweep account automatically transfers cash funds into a safe but higher interest-earning investment option at the close of each business day, for example, a money market fund. Sweep accounts try to minimize idle cash drag by capitalizing on the immediate availability of high-interest accounts.

The Reserve bucket is for intermediate spending needs (up to 90 days), according to Yi. Investment vehicles used for this bucket offer investors a better balance between risk and reward—e.g., separately managed accounts (SMAs), conservative ultra-short funds, and prime money market funds. Yi explains these vehicles offer direct investment with the ability to get daily liquidity. Not all are eligible for a sweep, there may be modest amounts of principal fluctuation, but DB plans get a better yield.

The Strategic bucket covers a DB plan’s longer-term spending needs (six months to 18 months). Yi says investment vehicles are still high-quality but designed to have a better balance of risk and reward. DB plan investors turn to ultra-short bond investment vehicles. “The Strategic bucket has a total return structure, offering a little less liquidity, more principal fluctuation and better yield,” he says.

According to Yi, ultra-short product use has been growing. “Low interest rates and how long they’ve been low has brought a lot of investors into ultra-short products,” he says. NTAM has created the Ready Assets Variable Income ETF, or RAVI, an ultra-short duration exchange-traded fund (ETF) with a variable net asset value (NAV), designed for investing liquidity. The parameters of RAVI are broader than registered money market funds and not quite as standardized as other ultra-short products. DB plan investors can transact during equity trading hours, and they know exactly what price they get in at and get out at, Yi says.

With cash segmentation, Yi says the goal is to find the right allocation between the buckets. It will create a portfolio optimizing cash but with a better balance of risk and reward across cash holdings.

Both cash segmentation and CDI are aided by actuary and investment committee communication. “When actuaries do their math, plan sponsors can know the liabilities that need to go out on certain date. This helps them have a level of precision in forecasting what they need,” Yi says.

According to Whitehead, in any plan of a decent size, the amount paid out month-to-month is pretty stable, but there will be new retirees and there will be retirees passing away. “Actuaries can predict these cash-flow changes, and that is important,” he says.

Whitehead adds that communication is also very important if there is going to be a big change, such as pension risk transfer activity. “DB plan sponsors should work closely with their actuaries to determine how much money will be paid out during a lump-sum distribution window or when buying an annuity,” he says.

Administration November 22, 2019

Retirement Plan Sponsors Need Strong Cybersecurity Defenses

A plan sponsor could face legal liability if a breach or fraud of participant accounts occurs.
Reported by
Art by David Plunkert

In October, a former participant in the Estee Lauder 401(k) plan sued the plan sponsor and plan providers for failing to safeguard her retirement account.

According to the complaint, in September and October 2016, an unknown person or persons stole the participant’s retirement savings by withdrawing a total of $99,000 in three separate unauthorized distributions from her account in the plan.

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The lawsuit highlights the importance of retirement plan sponsors having robust cybersecurity defenses.

The two areas of cybersecurity defense that sponsors should be mindful of are breaches and fraud, says Lynda Abend, chief data officer with John Hancock. “A breach is where there is a compromise to your information systems, and there is a large extraction of data,” she says. “Fraud is when that data is used to perpetrate a financial crime.”

Surprisingly, “there is no formalized guidance on cybersecurity, although a number of regulations are coming out,” Abend says. “There are the GDPR privacy regulations in Europe. California is coming out with the Consumer Protection Act, which will impose fines on corporations with data breaches.”

Should a breach or fraud occur, “a sponsor could be liable if the claimant establishes that it failed to follow a prudent process to safeguard the plan data,” says Joan Neri, counsel in Drinker, Biddle & Reath’s ERISA practice. “That is how a liability could develop, and the consequences could be severe. The sponsor would need to make the plan whole, to send notifications about the breach and fraud to participants, and to provide them with identity theft protection. There would be business interruption and reputational risk.”

Neri says sponsors need to be mindful about the sensitive data they manage on behalf of retirement plan participants: their dates of birth, Social Security numbers and account balances. Breaches could occur through phishing, malware or a stolen laptop, she notes.

The first thing that sponsors should do is to ensure that their fiduciary insurance policies have riders that cover cyber breaches, Neri says. “A lot of insurance companies are now offering standalone cyber insurance that is far more complete than a rider,” she adds. “They include things such as access to cyber breach response experts, credit monitoring and technical assistance with public relations.”

Related to receiving underwriting for such insurance are measures sponsors should be taking to avoid a breach or fraud, she says. “Underwriters look at three major factors. First, what sponsors are doing in the way of careful hiring practices and whether they are providing training on cybersecurity best practices. Second, they look at how data is transmitted and who has access. Finally, they scrutinize sponsors’ processes for hiring service providers. There is a whole network of third parties involved in the management and administration of a retirement plan. It is imperative for sponsors to prudently select and monitor their service providers.”

When hiring service providers, sponsors should also look to see whether or not they have a clause about how they handle cybersecurity in their contract, Neri says. “The contract should address limitations and restrictions on how the service provider is using the plan data. They should be encrypting data and destroying data they no longer use, and, if they have subcontractors, it should spell out how they interact with them.”

Most importantly, it should detail “how they will respond to a cybersecurity breach and how they will take efforts to prevent future occurrences,” Neri says. “They should also state that they will preserve evidence because it might be needed to track down the person who perpetrated the breach. It should also include language that they agree to be liable in the event of a breach, and that they will share the costs.”

Indeed, many recordkeepers now offer cyber guarantees that make up for losses up to a certain point, says David Kaleda, a principal in the fiduciary responsibility practice group at Groom Law Group, Chartered. “In a typical recordkeeper agreement or third-party agreement, there are indemnification and warranty clauses,” he says. “Sponsors should check to see if they include provisions that will make a plan whole again” in the event of fraud.

Service providers should also have conducted a SOC (Service, Organization, Control) 2 audit, according to Abend. “Those audits look at their security, availability, processing, confidentiality and privacy of data—and their controls around them,” she says. 

SOC 2 reports are derived from the American Institute of Certified Public Accountants (AICPA) Trust Service principles, Abend explains. They were developed to provide assurance on internal IT controls related to information handling in the Cloud in order to minimize risk and exposure.

In order to handle all of this, it is important to work with an Employee Retirement Income Security Act (ERISA) attorney who is familiar with cybersecurity, Neri says.

It is also important for sponsors to educate participants on best practices for protecting their data, says Jason Lish, chief security, privacy and data officer for Advisor Group’s advisor solutions team. “They can encourage participants to set up multifactor authentication and other types of anomaly identification,” Lish says.

Just as important is “having a cybersecurity management plan in place whereby all of the retirement plan fiduciaries understand what that plan is and how it is executed,” Abend says.

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