Investing November 7, 2016

Average Deferrals Are Higher Among Managed Account Users

Morningstar argues the increased savings benefits measured among managed account users are likely to outweigh the costs of such products over TDF pricing. 

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Morningstar Investment Management published a new research paper, “The Impact of the Default Investment Decision on Participant Deferral Rates: Managed Accounts vs. Target-Date Funds,” which is sure to stoke some serious debate among the investment industry.

Key data points cited in the research paper suggest those investors who were previously defaulted into managed accounts tend to save around 1% more on average compared with those defaulted into a target-date fund (TDF). The data comes from 66,000 actual participants enrolled in 195 defined contribution plans that offer either a target-date fund or managed accounts as the plan default investment.

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Important to note, the difference in deferral rates declines to approximately 0.5% after controlling for plan and participant attributes, such as industry or tenure, but Morningstar stresses this is still a significant contribution gap that can have a big impact on wealth by the end of a 30- or 40-year investment cycle. In fact, Morningstar argues the increased savings benefits measure among managed account users are likely to outweigh the costs of such products over TDF pricing, especially for those with smaller account balances relative to their incomes.

“The average participant, who is assumed to be 45 years old and does not roll over a balance upon enrollment, would benefit from using a managed account if the annual fee were 2.4% of total assets or lower—as long as savings rates increase, not taking any other potential benefits of managed accounts into consideration,” the report claims.

Other findings suggest outperformance of managed account investors compared with TDF investors at the median is even stronger, with those DC participants defaulted into a managed account saving 2% of salary more than the median participant defaulted into a TDF, at 6% and 4%, respectively.

NEXT: Controlling for employer characteristics 

“At the median plan level, defaulted managed accounts participants saved 1% of salary more than those defaulted in target-date funds, at 6% and 5%, respectively,” Morningstar clarifies. Much, but not all, of the difference can be explained by different attributes of participants in plans that utilize managed accounts as the default (vs. TDFs).

For example, plans with managed accounts as the default tend to have older participants with higher levels of plan tenure and higher salaries, and each of these attributes are associated with higher savings levels. However, after controlling for these variables and other important plan characteristics, individuals defaulted into managed accounts still tend to save more for retirement at the average and the median, “although the level differs by model (i.e., regression) ranging from 0.3% to 1.9%.”

Other data shows participant deferral rates are generally lower for plans with automatic enrollment, versus voluntary enrollment, unless the default deferral rate is at least 6%.

“A plan with a 3% default enrollment rate will have deferral rates that are approximately 1.6 percentage points lower than if the plan offered voluntary enrollment,” Morningstar observes.

The research concludes that managed accounts and TDFs alike are important parts of the investment product continuum, but “managed accounts participants exhibit a much wider dispersion of equity allocations, especially near retirement, showing the greater customization capability of managed accounts.”

The full analysis is available for download here. 

Compliance November 7, 2016

IRS Clarifies Interest Crediting Rules for Pension Equity Plans

In particular, the IRS addresses applicability of final hybrid plan regulations to implicit interest PEPs.
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The Internal Revenue Service (IRS) has issued Notice 2016-67 describing the applicability of the market rate of return limitation rules to a defined benefit plan that expresses a participant’s accumulated benefit as the current value of an accumulated percentage of the participant’s final average compensation, highest average compensation, or highest average compensation during a limited period of years (a type of plan often referred to as a pension equity plan or PEP). 

In particular, this notice addresses the applicability of the market rate of return limitation rules to a type of PEP that applies a deferred annuity factor to the participant’s accumulated benefit in order to determine deferred benefits (a type of PEP often referred to as an implicit interest PEP). The IRS explains that such a PEP is often referred to as an implicit interest PEP because preretirement interest is implicitly reflected in the deferred annuity factor.

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Under an explicit interest PEP, because the accumulated benefit is adjusted with interest credits to determine the benefit payable at annuity starting dates after principal credits cease, those interest credits are subject to the market rate of return limitation rules under hybrid plan regulations issued in 2015. Thus, any amendments necessary to bring the interest crediting rate into compliance with the market rate of return limitation rules under the hybrid plan regulations must be made by the applicable deadline of the transition regulations (generally before the beginning of the first plan year that begins on or after January 1, 2017) in order for the amendments to be eligible for the exception from rules against reducing benefit accruals provided by the transition regulations.

NEXT: Implicit interest PEPs not subject to interest crediting rules

By contrast, under an implicit interest PEP, the preretirement interest that is implicit in applying a deferred annuity factor to the accumulated benefit is not included in the definition of an interest credit under rules because the accumulated benefit remains a constant percentage of average compensation and is not adjusted with interest credits after principal credits cease, the IRS explains. Thus, under the hybrid plan regulations, no amendment is required to the deferred annuity factors under an implicit interest PEP in order to reduce the preretirement interest that is implicit in those factors to a rate that does not exceed a market rate of return and the exception from rules against reducing benefit accruals under the transition regulations does not apply to such an amendment.

The IRS says stakeholders have expressed uncertainty as to whether the market rate of return limitation rules under the final hybrid plan regulations apply to implicit interest PEPs. Due to this uncertainty, some plan sponsors of implicit interest PEPs might have believed that the preretirement interest that is implicit in a deferred annuity factor was subject to the market rate of return limitation rules and, as a result, might have already adopted plan amendments to reduce that interest in accordance with the rules under the transition regulations that apply to amendments reducing interest crediting rates that exceed a market rate of return. 

Even though the preretirement interest that is implicit in a deferred annuity factor under an implicit interest PEP is not subject to the market rate of return limitation rules in the final hybrid plan regulations, the Treasury Department and the IRS are considering whether to propose amendments to those regulations that would subject implicit preretirement interest to the market rate of return limitation. The IRS is requesting comments about adopting amendments.

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