Investing June 29, 2018

The Case for Using an Institutional Approach for DC Plan Investments

An institutional investment approach uses outcome-oriented investments, broad asset class diversification, best-of-breed investment management, a thoughtful mix of active and passive strategies and are vehicle agnostic, a report notes.

Reported by

A report, “Defined Contribution Investments on Trial,” from the Institutional Relationship Group at PGIM, the asset management arm of Prudential Financial, notes that recent lawsuits have challenged the investment menu selection approach of many defined contribution (DC) retirement plans.

Some plans use what PGIM calls the Retail Approach with a primary focus on appealing to what is believed to be what participants want, using a wide array of choice and an emphasis on name recognition. Others use what PGIM calls the Simple Approach, focusing on minimizing fees and maximizing simplicity, using heavy or exclusive use of passively managed funds and basic asset classes.

Get more!  Sign up for PLANSPONSOR newsletters.

Josh Cohen, PGIM’s head of Institutional Defined Contribution, based in Chicago, tells PLANSPONSOR that maximizing simplicity and cheapness can benefit plan sponsors, calling into question whether fiduciaries are acting in the best interest of participants, unless these plan sponsors truly believe active management doesn’t work. However, he notes institutional peers haven’t come to that conclusion.

PGIM advocates for what it calls the Institutional Approach to DC plan investments, and suggests DC plan sponsors look to the approach of defined benefit (DB) plans, endowments, sovereign wealth funds, insurance company general accounts, sophisticated wealth management platforms and family offices. These institutional investors focus on solutions that are believed to offer a higher probability of meeting a desired outcome.

An Institutional Investment Approach uses outcome-oriented investments, broad asset class diversification, best-of-breed investment management, a thoughtful mix of active and passive strategies and are vehicle agnostic, meaning they consider institutional mutual funds, collective investment trusts (CITs) and separate accounts. According to Cohen, this mindset can be used in the DC plan framework as well.

According to Cohen, institutional investors look at what investments will provide better outcomes. “For example, a DB plan may use liability-driven investing, or LDI. A similar option in DC plans is TDFs, or target-date funds,” he says. Cohen adds that institutional investors have seen advantages from using a broad asset class. There has been a move from just stocks and bonds to credit, private equity and private real estate. He says the types of asset classes may differ based on the institution’s asset size or liquidity needs. He also suggests DC plan sponsors look at emerging markets, emerging market debt and illiquid asset classes, such as real estate.

“Another thing I like is [institutional] investors are thinking about active versus passive. They are all using a combination of active and passive investment, although there may be differences in how they allocate them. But, very few are all in one or the other,” Cohen says. “For example, we asked DB plan chief investment officers how many used passive bonds, and no hands were raised. But many DC plans only focus on simplicity and fees, and their TDFs will have half or more of assets in fixed income funds.”

Cohen says that having an institutional mindset for TDFs means they will have a mix of active and passive underlying investments and diverse asset classes. “There are some off-the-shelf TDFs that fit that bill, but larger plans and a few down market can create customized TDFs taking into account demographic differences of participants,” he says.

According to Cohen, 26% of DC plan sponsors say active funds would be harder to monitor, but he points out that just because plan sponsors go passive, it does not reduce monitoring responsibilities. Plan sponsors must think about to what indexes they will benchmark and the lowest possible share class. He adds that there is no such thing as a passive TDF—underlying investments need to be monitored. “There are plenty of OCIOs and other experts that will share investment monitoring responsibilities with plan sponsors,” Cohen says.

DC plan sponsors should also follow institutional investors’ approach to using multi-manager funds (white-labeled investments can fit this bill), institutional mutual funds, CITs and separate accounts, he adds, pointing out that experts want to work with plan sponsors to determine the best investment vehicles for their plans.

“It’s all about the best interest of participants. To protect plan liabilities and reduce risk, diversifying asset classes really makes a lot of sense,” Cohen says.

He concludes: “The average investor couldn’t get access to these asset classes on their own, and even if they could, they would be paying much higher than institutional prices, so why are we denying individual workers these asset classes?”
Administration June 29, 2018

Administration Basics: What Is a Strategic DB Plan Termination?

Experts with cash balance plan design and administration provider Kravitz define the concept of strategic plan termination—what the pros and cons are, and what an employer’s responsibilities entail under IRS and PBGC regulations.

Reported by

Speaking on a recent webinar, Dan Kravitz, president of Kravitz, Inc., and Chris Pitman, an expert plan termination consultant with the firm, offered an informative overview of the concept of strategic plan terminations.

As the pair explained, the question of “what actually is a strategic plan termination” is one they hear quite a lot from both plan sponsors and advisers. In the simplest terms, a strategic plan termination is a decision by the owners of a company to close their existing cash balance plan or a traditional defined benefit (DB) pension plan, in order to start a new plan that that is fundamentally different from the existing program.

For more stories like this, sign up for the PLANSPONSOR NEWSDash daily newsletter.

Generally speaking, this process will entail a distribution of the assets in the form of annuity purchases and rollovers. And then, immediately thereafter, the employer adopts a brand new cash balance plan, usually with quite a different design and a different interest crediting rate. As Kravitz and Pitman noted, most often this is going to be done by a mature DB or cash balance plan that has a strong business need to make changes.

The pair stepped through the five most common reasons why employers consider this route, as follows. Importantly, none of these should be a sole factor in pushing an employer into a strategic plan termination, because in fact, some of these reasons in isolation could be construed by the Internal Revenue Service (IRS) or the Pension Benefit Guaranty Corporation (PGGC) as a breach of fair conduct:

  • Owners or partners want to transfer current cash balance plan assets to the 401(k) profit sharing plan or to individual retirement accounts, most often to gain more discretion, to broaden investment options and to potentially increase returns. Kravitz consultants find that a lot of the partners and shareholders of companies, and the rank-and-file participants too, have a strong desire to self-direct assets. A strategic plan termination creates a distributable event for participants, so they can roll assets out to a 401(k) or an IRA, or they can accept annuitization. This reason, in particular, is one that could raise the ire of the IRS if taken in isolation.
  • The employer is seeking to reduce the risk associated with guaranteeing an interest crediting rate on increasingly large balances. As a small employer finds success and grows quickly, a once diminutive cash balance plan can balloon in a hurry. The speakers pointed to cases where plans grew from $500,000 in assets to $5 million or even $50 million faster than the employer ever thought possible when creating the original plan design. Especially when an employer guarantees the safe harbor interest crediting rate, it creates an accounting liability that can grow beyond the perceived benefit of offering the cash balance plan as a recruiting/retention tool.
  • The employer wants to replace a traditional DB plan with a new cash balance plan, rather than make the transition to cash balance through a more cumbersome plan conversion process. It is simply a market reality that many employers want to go from traditional DB to cash balance to limit their investment risk in the long-term, the speakers explained. And while an employer can conduct such a conversion directly, the road map for this can be difficult, and it often results in a very complex program on the other end during a wear-away period. According to the speakers, it is often much simpler from the administration perspective to terminate and then start a brand new plan.
  • There is a desire among stakeholders to redesign a pension or cash balance plan following significant growth, a merger/acquisition, an ownership change, demographic shifts in the work force, late-discovered flaws in design, etc. Reducing normal retirement age, for example, from 65 to 62, and reworking the plan to allow for in-service withdrawal distributions (i.e., partial retirements) is a common motivation Kravitz consultants have seen.
  • Finally, larger clients often want to change interest crediting rates from a safe harbor rate to something called the “actual rate of return.” This is another way to reduce risk for the employer, the speakers explained.

Regulatory requirements to consider

Speaking frankly to the matter, Kravitz and Pitman noted there are some misconceptions that this type of a strategic plan termination is outright illegal, but that’s just not true. If an employer has the right goals and follows the right process, they said, strategic plan terminations can be a win-win for the company and for employees.

Importantly, the IRS in particular has very specific rules and guidelines in this area. If these are perceived as being violated, the IRS can step in and disqualify the new cash balance plan or even forbid distributions from the old plan. The speakers observed that they have conducted hundreds of plan terminations and many that could be deemed strategic—but they have not once failed to receive an IRS approval letter for the new cash balance plan.

The speakers suggested it is more or less a general rule—though it is not set in stone—that the IRS outright will not question a plan termination if the plan being terminated has been around 10 or more years. If the plan hasn’t existed so long, strategic termination is still absolutely possible, so long as the process plays out correctly.

Probably most importantly, the new cash balance plan must look at least a little different from the old plan. For example, changing the crediting rate or altering the group of employees covered should do the trick, and there needs to be one or multiple clear business necessities that are cited for making the change. What’s an example of this? Change of ownership, merger/acquisition activity, or significant business challenges, to name just a few possibilities.

In the eyes of the IRS, the determination of whether a strategic plan termination of a plan that is less than 10 years old is going to be based on the real facts and circumstances of the case, not on general rules of thumb, the speakers concluded.

«