Investing December 27, 2021

With Pandemic Lessons Learned, Institutional Investors Gear Up for 2022

The first year of the pandemic was defined by a flight to safety, while 2021 brought a risk-on stance and strong returns for many institutions.

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Recently, the Massachusetts Mutual Life Insurance Co. (MassMutual) announced it had finalized the consolidation of Barings’ mutual funds with MassMutual funds onto the MassMutual investments platform. To mark the occasion, PLANSPONSOR sat down with Keith McDonagh, the head of MassMutual’s institutional solutions business, to talk about this and other developments, including the state of competition in the institutional services space and the challenges he is hearing about from brokers, consultants and their institutional investor clients.

At a high level, McDonagh says, the past two years have been challenging for institutional investors, but they have also brought about opportunities to address some long-term financial challenges, especially among employers with active and/or frozen pension plans. Though they have had to contend with substantial volatility, the current funded status of many pensions is higher than it has been for some time, McDonagh says, with many plans in the ballpark of 95% funded. As the end of the fiscal year approaches, for many plan sponsors, this increase in funded status has spurred more discussions on de-risking and end-state objectives.

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Echoing comments made by other experts, McDonagh says the early part of 2022 may be defined by inflation statistics and the at-times counterintuitive impact higher inflation can have on corporate pensions.

In simple terms, inflation can be good for pension funded status in the same way inflation can benefit individual debt holders: If wages (or corporate income) increase with inflation, and if the borrower (or pension) already owed money before the inflation occurred, the inflation benefits the borrower. Of course, if interest rates go up too much in response to rampant inflation, that can in turn impact the value of equity portfolios, which can itself damage pensions’ funded statuses and the holdings of individual investors.

McDonagh says his outlook remains cautiously optimistic, as equities still have room to grow and there are reasons to believe that inflation will moderate as the new year unfolds. Among other implications, this outlook means the pension risk transfer (PRT) market should likely remain robust in 2022, with 2021 clearing close to $40 billion in total PRT transaction volume.

McDonagh’s perspective matches that of Legal & General Retirement America (LGRA)’s third quarter Pension Risk Transfer Monitor, which estimated that more than $16 billion in sales occurred in the third quarter. Fueled by strong equity returns and rising interest rates, third quarter transaction volume was nearly twice the combined $8.8 billion recorded during the first two quarters of 2021.

LGRA also reported that the third quarter was the second highest single quarter to date, behind only the fourth quarter of 2012, when General Motors completed a transaction of $26 billion. With Q4 2021 transactions projected to be between $10 billion to $15 billion, total annual market volume could be between $35 billion to $40 billion, potentially surpassing its previous high set in 2012 at $36 billion.

“Keep in mind, there is still over $7 trillion invested in U.S. pension plans,” McDonagh observes. “Even with all the payouts and the PRT activity that has taken place to date, overall pension liabilities are continuing to increase, and there is a lot of room there for companies to explore de-risking and PRT opportunities.”

Beyond the topic of pension risk transfers, McDonagh expects to spend significant time in 2022 working on the question of how to ensure defined contribution (DC) plan investors can get access to in-plan retirement income solutions. In fact, he says creating effective, scalable and portable DC plan income solutions is the “next holy grail for our industry.”

“I do think we are still in the early days in terms of solution development,” he says. “We at MassMutual, along with our peers in the institutional investor marketplace, are asking ourselves, ‘What is the right design and approach?’ We are wondering, for example, if DC plan investors will favor approaches that allow them to annuitize over time, or if they want a solution that moves a portion of their assets into annuities right at their retirement date.”

McDonagh says he expects DC plan annuities to become a more important part of the broader and ongoing discussion about diversification.

He also says institutional investors should take time in 2022 to revisit their stable value assets, knowing the important but often-understated role capital preservation options continue to play in retirement plan portfolios.

“You may recall that 2020 was a banner year for stable value inflows, and the market increased roughly 15% in asset volumes relative to 2019,” McDonagh says. “Stable value remains a great stabilizer that still comes with a return. Money market funds are paying nil right now, basically, while stable value might have a 1% return floor and might be paying substantially more than that.”

When selecting a stable value option, he says, it is important for sponsors to assess a fund’s performance, risk mitigation, team and process. They should also assess such things as the underlying credit quality of the bonds, noting that some stable value products may generate higher returns but take on higher risk. McDonagh recommends institutional investors look for an experienced team that has been doing this for quite some time and uses a robust process—because not every stable value fund is the same.

Compliance December 23, 2021

Court Denies Summary Judgment for Lawsuit Against ESOP Fiduciaries

The judge found that while the plaintiff might have released all his claims with a separation agreement, the lawsuit was filed on behalf of the plan and the plan did not release its claims.

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U.S. District Judge Dale A. Drozd from the U.S. District Court for the Eastern District of California has denied a motion by defendants in a lawsuit against Kruse Western Inc. for judgment on the pleadings, converted by the court into a motion for summary judgment.

The lawsuit alleges that the company’s employee stock ownership plan (ESOP) had purchased the defendants’ outstanding stock for almost 10 times its actual value as of the end of 2017. The defendants moved for judgment on the pleadings on the basis that the plaintiff knowingly and voluntarily released the claims brought in this action against each of the defendants when he signed a severance agreement with the company. They also said he lacks standing to bring the claims on behalf of the ESOP because he became a participant in the plan after the initial stock purchase.

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The Severance Agreement

According to the judge’s order, upon resignation from his position at the company, the plaintiff signed a severance agreement that provided in part, “Employee  .. hereby releases and forever discharges employer, its subsidiaries and affiliates, and their respective present, former and future officers, directors, employees, stockholders, attorneys, insurers and agents, and their respective heirs, executors, administrators, successors and assigns … from any and all claims, demands, causes of action, obligations and liabilities whatsoever, whether or not presently known or unknown, or fixed or contingent … including, but not limited to, claims, demands or causes of action under … the Employee Retirement Income Security Act [ERISA].”

The defendants allege that the severance agreement was presented to and discussed with the plaintiff during his exit interview and that he was not told he had to sign the severance agreement on that same day. However, the plaintiff says the agreement was not discussed “in any detail with him during the exit interview.” He contends he understood that he would not receive an offered severance payment if he did not sign the documents but was not otherwise told what he was signing.

Drozd agreed with the plaintiff that his claims are brought on behalf of the ESOP, seeking to restore losses to the ESOP as a whole under ERISA Sections 502(a)(2) and (3), and that he cannot have released those claims without the ESOP’s consent.

The judge cites the case Bowles v. Reade, in which a retired plan participant filed an ERISA breach of fiduciary duty lawsuit on behalf of the plan. Two years after the plaintiff’s first complaint was filed, she signed a settlement agreement with the representative of the estate of one of the individual defendants and sought to dismiss all her claims against that defendant. A district court dismissed “all claims against [that individual defendant] belonging to Bowles” but found that “the agreement released ‘only those claims legally brought by Bowles and that Bowles [could not] and did not release the plans’ claims against [the individual defendant].’”

The 9th U.S. Circuit Court of Appeals affirmed the district court’s decision, holding that a plan participant cannot settle, without the plan’s consent, a Section 502(a)(2) breach of fiduciary duty claim seeking “a return to the plan and all participants of all losses incurred and any profits gained from the alleged breach of fiduciary duty.”

In addition, the 9th Circuit affirmed the district court’s decision that Bowles “remained as a plaintiff in her representative capacity on behalf of the plans and the participants notwithstanding the release of her individual claims against [the individual defendant].”

Standing

On the issue of the plaintiff’s standing in the Kruse Western case, the defendants rely on the decision in the Dorman v. Charles Schwab Corp. case to argue that plaintiff’s standing turns on his individual injury because Section 502(a)(2) claims are “inherently individualized when brought in the context of a defined contribution [DC] plan.”

The plaintiff argues that even if he became a participant in the ESOP after the ESOP’s purchase of Kruse Western stock, he “still suffered a concrete loss that is redressable in this lawsuit because the value and number of the shares in his ESOP account were and are affected by the ESOP’s payment of more than fair market value for the stock purchased in 2015.” He asserts that “the loan for this transaction was inflated by the amount of overpayment, thereby reducing the number of shares allocated to ESOP participants each year.”

The plaintiff supports his assertion by pointing out that the ESOP plan document notes that the ESOP borrowed funds for its purchase of the Kruse Western stock, shares are allocated to ESOP participants annually when the ESOP makes loan payments, and the number of shares released to participants is based on the amount of the transaction loan. He asserts that he suffered an injury in fact because he would have been allocated more shares if the ESOP had paid less for the stock than the allegedly greatly inflated value.

However, the defendants argue that the plaintiff suffered no redressable injury because he resolved any claims he might have by signing the severance agreement and its release of claims in exchange for a severance payment. They also dispute the contention that the plaintiff would have received a greater aggregate value in his individual ESOP account if he had in fact received more Kruse Western shares pursuant to an allegedly more accurate valuation of the stock.

Drozd was not persuaded by the defendants’ arguments. He noted that in Dorman, the 9th Circuit held that a former employee’s ERISA claims were subject to arbitration under the plan document’s arbitration provision because both the plan “expressly agreed in the plan document that all ERISA claims should be arbitrated,” and the plaintiff had agreed to arbitration on an individualized basis. However, the appellate court limited the arbitration to “individual claims … seeking relief for the impaired value of the plan assets in the individual’s own account resulting from the alleged fiduciary breaches.”

Drozd said that, unlike in Dorman, in the present case, even if the plaintiff’s release of claims were found to be valid, the defendants do not point to any evidence demonstrating that the ESOP released any of its Section 502(a)(2) claims.

As for whether the plaintiff suffered an injury, Drozd held that even though he became a participant in the plan after the initial stock purchase, he “has an equitably vested interest in those alleged ill-gotten profits held in a constructive trust held for the benefit of the ESOP.” In addition, he said, the losses in a breach of fiduciary claim arising from an ESOP’s purchase of private company stock are determined based “not only on the purchased shares’ price, but also on their value.”

Finally, Drozd found that the plaintiff presented evidence in the form of the ESOP’s plan document to support his contention that if the valuation of Kruse Western’s stock had not been grossly inflated at the time of the initial purchase, he would have been allocated more shares of Kruse Western stock when he became an ESOP participant. “If the alleged valuations prove to be accurate, the plaintiff will have suffered an injury in fact by receiving fewer shares of Kruse Western stock on January 1, 2017,” Drozd wrote in his order.

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