DCIIA Says Illiquid Assets ‘Manageable’ in DC Plans

Daily valuation and trading issues associated with illiquid asset classes do not outweigh their potential performance benefits within DC plans, an analysis finds.

Especially when included in a retirement plan menu as part of a target-date fund (TDF) or another automatic asset-allocation solution, illiquid private equity investments can significantly benefit defined contribution (DC) account owners.

An analysis from the Defined Contribution Institutional Investment Association (DCIIA) finds that “a strong case can be made for including such assets in DC plans,” and numerous precedents for non-market pricing methods exist to guide plans through the implementation process.

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An important fact acknowledged first by the DCIIA is that the Department of Labor enforces strict liquidity rules under the Employee Retirement Income Security Act (ERISA), which have historically weighed down the use of private equity and other illiquid asset classes on DC menus. But, according to DCIIA’s new report, “Capturing the Benefits of Illiquidity,” daily liquidity needs can be effectively managed as part of a broader asset-allocation solution and with cash buffers, through which plans can maintain sufficient trading liquidity without precluding use of illiquids.

DCIIA identifies three categories of illiquid investments that may fit well within a given DC plan— hedge funds, private real estate and the broader category of private equity. Plan participants are not likely to have the sophistication to use these investment styles effectively as stand-alone options, DCIIA warns, but within a smartly crafted TDF or perhaps a managed account, the potential downside protection and reduced volatility these asset classes present are compelling.

“These assets can provide significant potential for improved total return performance and can help serve as an important tool to diversify portfolios,” explains Lew Minksy, executive director of DCIIA. “They reduce reliance on traditional equities and bonds, decrease volatility, and mitigate against downside risk.”

The DCIIA report derives key considerations from early adopters of illiquid strategies within DC plans, including the determination of fair market value, liquidity management and fee controls. Overall the analysis finds “valuation and trading issues with illiquid assets are manageable” and really only come to the fore during periods of severe market stress. It’s key for illiquid equity options to be presented to participants within TDFs or other approaches that take trading and asset-allocation decisions out of the hands of participants, DCIIA concludes, but this should not discourage their use.

NEXT: Daily valuation has a downside

According to DCIIA, the ability of defined benefit (DB) plans to use illiquid assets more freely than DC plans has resulted in a clear performance dispersion favoring DB. Relying on figures from CEM Benchmarking, DCIIA finds over the last 18 years, DB plans have at least a 1.1% advantage in annualized investment performance.

The advantage comes in small part from better performance in traditional asset classes, but among the biggest drivers of DB plan outperformance is a broader exposure to less-liquid real estate funds, hedge funds and other forms of private equity. Inclusion of these asset classes, according to DCIIA, leads to better volatility-adjusted returns and over time reduces reliance on market beta as a source of return.

Other experts have shared similar sentiments with PLANSPONSOR, including Toni Brown, a long-time retirement industry professional and senior defined contribution (DC) specialist at American Funds. Brown recently suggested daily liquidity has improved the ability of retirement plan participants to move money around on demand, but, she asks, is this really such a good thing?  

Part of the problem with including alternatives and illiquid assets comes from the culture of the DC workplace investment industry and its regulators, Brown notes. “There is a perception that you have to have daily liquidity to use something in a DC plan. I think it’s unfortunate that the DC industry was designed that way, because this really doesn’t line up with the long-term nature of the savings effort one is making in a retirement plan.”

Brown, like DCIIA researchers, feels DC plan officials “should want to give up some liquidity for greater potential long-term gains. I think it would be better if individuals weren’t looking to move assets on a daily basis, especially when they are just reacting to financial media headlines or water cooler gossip.”

Brown says she still occasionally, albeit rarely, sees 401(k) plans organized with only annual liquidity. Participants can’t pull their money out at a moment’s notice, Brown observes, but the plans manage to remain in compliance and deliver strong outcomes. 

NEXT: Fiduciary considerations

“The success comes from the way these plans build their portfolios, in an efficient way,” Brown says. “The lack of liquidity is not a problem for participants in the plans because they are informed at the start—they understand they won’t be able to pull their money out on a moment’s notice and they’re okay with that."

It’s something for the industry to spend some time thinking about: whether it’s possible or preferable to get the daily liquidity genie back in the bottle. 

Not all plans, however, will want to take on the challenge of running only annual or quarterly liquidity—especially those with a more traditional mindset and approach to DC. Brown agrees with the DCIIA analysis that, for this group, the best place to include illiquid asset classes will be within the qualified default investment alternative (QDIA).

DCIIA also urges plan officials to consider implementing alternatives in DC plans via custom portfolios or white-label investment options. Whatever the approach settled on, another helpful strategy is to carefully control cash flow to illiquid investments, creating a “liquidity buffer” that can give participants some extra leeway in pulling money back.

“As custom QDIA options grow in size, support for including alternatives also increases,” DCIIA researchers note.

DCIIA further suggests plan officials should, before making any major investment lineup decisions, conduct gap analyses of legal risks and available tools, such as legal structuring, contracting, disclosures and insurance. Use of a 3(21) co-fiduciary, or even full delegation to a 3(38) fiduciary investment manager is often advisable, DCIIA suggests, especially in cases where internal expertise is lacking.

The full report is available here as a free download.

Health Plan Compliance Issues to Consider

Mercer has published the top 10 compliance-related issues health benefit plan sponsors should address in planning for the upcoming year.

Many employers are in the final stages of designing their 2016 health benefit programs, contribution strategies, vendor terms, and employee communications.

To assist in this effort, Mercer has recently published the top 10 compliance-related issues with respect to the Patient Protection and Affordable Care Act (ACA) and other health benefit regulations employers should address in planning for the upcoming year.

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At the top of the list are refining the ACA employer shared-responsibility (ESR) strategy and getting ready for ESR reporting. Employers should ensure that their intended goal of avoiding or paying ESR assessments for 2016 coverage is supported by coverage offers, administrative and recordkeeping processes, and benefit documents.

Judy Bauserman, interim leader of the Washington Resource Group and partner at Mercer in Washington, D.C., notes that 2015 was the first year employers were required to offer coverage meeting certain requirements for employees or to pay assessments. “The rules are complex and the definition of full-time employee is not intuitive, so employers have had a challenge determining who full-time employees are,” she tells PLANSPONSOR. “The law requires coverage of a certain percent of the employee population and employers have had to learn how to determine that and make sure changes in the employee population will not trip them up.” Bauserman says employers should have figured most of this out for 2015, but many employers will still be refining strategies in 2016.

Bauserman adds that reports are due for the first time in the beginning of 2016 to both the Internal Revenue Service (IRS) and employees related to health coverage in 2015. Employers will need to arrange data sources, systems, and administrative processes to collect all information about enrollees with minimum essential coverage (MEC), full-time employees, and coverage offers needed for reporting. They should also create a process for correcting any erroneous IRS filings and personal statements.

“The reporting is complicated and electronic filing is required,” she says. “Employers have to figure out how to develop software themselves or what vendors can do this for them. Some employers are well on their way and many have outsourced, but what providers are developing and what employers are expecting don’t always align properly.”

Bauserman says these first two items have been so all-consuming for employers this year, but there are many other issues related to health benefits on which to focus.

NEXT: ACA-related compliance issues

According to Mercer’s list, employers need to ensure “non-grandfathered” group health plans comply with the final ACA rules and recent guidance about cost-free preventive services. Plans must cover certain services that are considered preventive services without any cost-sharing. Bauserman explains that the government updates these on an ongoing basis, so employers should make sure they are aware of changes, and they should have procedures in place to stop covering services that go off the list. She warns that there is no set timing on when the government makes updates; whenever the scientific body addressing an issue publishes a new recommendation and the government changes its list, the employer has until the beginning of plan year following a year after the recommendation is made to change its coverage.                 

There are other ACA reporting and disclosure requirements. Mercer suggests employers review delivery operations for summaries of benefits and coverage (SBCs) and watch for revised SBC templates. Employers should also prepare for round two of online submission and payment of ACA’s reinsurance fee. Bauserman says SBCs describe the terms of a plan in fairly generic terms, and are supposed to allow employees to compare plans since all are presented in the same format. “Regulators are working on revising templates and anticipate releasing a revised version in January,” she says. “Employers will have to adapt to changes in 2016. She also reminds plan sponsors that in the last quarter of this year, the second round of reinsurance fee submissions is due, with the covered-lives count delivered by November 15, and initial payments dues soon thereafter.

In planning for 2016, employers need to decide whether to permit midyear changes to cafeteria plan elections for either or both of the status-change events in IRS Notice 2014-55. Bauserman explains that one event is when an employee changes from full-time to part-time status and wishes to cease coverage under the employer’s plan. The second event is when an employee wants to drop coverage in the employer plan to purchase in a public exchange either at annual enrollment of upon an event that allows enrollment in a public exchange.

Employers may have been hoping that regulators would make changes to the ACA’s out-of-pocket maximum rules, but the Department of Health and Human Services says no changes are planned, according to Bauserman. Employers should verify that self-only and other (e.g., family) coverage tiers in “non-grandfathered” plans meet ACA’s 2016 out-of-pocket (OOP) limits for in-network care, and confirm that family coverage also satisfies ACA’s self-only OOP limit for each enrollee.

Mercer recommends employers review fixed-indemnity and supplemental health insurance policies to ensure they qualify as excepted benefits under the ACA and the Health Insurance Portability and Accountability Act (HIPAA). Bauserman explains that these are types of policies that pay a certain amount for critical illness or a certain amount for each day in the hospital. If they are structured properly they are considered excepted benefits, meaning they don’t have to comply with all of ACA health reform requirements for plan design, such as annual and lifetime dollar limits and the obligation to cover preventative services. She says a few pieces of guidance have been issued to limit the types of plans that can be considered excepted. For example, a fixed-indemnity policy must pay on a per period basis not a per service basis—a new requirement. “Some plans had to be amended for some provisions, and some rules are not clear, so employers should not assume their policy is an excepted benefit. They should talk to their insurance company about changes,” Bauserman suggests.

NEXT: Other health benefits rules

In June, the U.S. Supreme Court ruled that under the Fourteenth Amendment, states cannot deny same-gender couples the right to marry, and it is illegal for states to not recognize same-gender marriages performed in another state. Employers should assess how this decision affects their benefit programs and employment policies. 

The Supreme Court decision will affect who is eligible for health benefits, Bauserman says, particularly if employers have a self-funded plan and do not already offer coverage to same-gender spouses. In addition, employers that have been offering domestic-partner coverage are considering whether to drop it or not. According to Bauserman, this consideration is more complex for multi-national employers if they have employees working in a country where same-gender marriage is not recognized.

Mental health parity rules should also be a focus for health benefits plan sponsors. Mercer suggests making sure that plan designs and operations provide parity between medical/surgical and mental health/substance use disorder (MH/SUD) coverage. Federal audits of health plans now evaluate compliance with the final Mental Health Parity and Addiction Equity Act (MHPAEA) rules that took effect in 2015.

Bauserman says that although the rules have been in effect for most plans for several months already, they are complicated, particularly in the way plan sponsors must evaluate non-quantitative rules such as pre-authorization for mental services but not others. “Parity rules require processes to set those types of limitations to be comparable; the analysis to figure that out is difficult and time-consuming,” she states. “Many employers don’t have the bandwidth to focus on these rules, but litigation, Department of Labor (DOL) audit activity and state attorney general efforts are increasing, so the risk associated with plan design features that may not provide full parity will be greater in the coming years.” She adds that some plan provisions that may have been common are being called into question, so employers will have to turn their attention to whether design changes are needed.

In April, the U.S. Equal Employment Opportunity Commission (EEOC) published a Notice of Proposed Rulemaking (NPRM) describing how Title I of the Americans with Disabilities Act (ADA) applies to employer wellness programs that are part of group health plans. Mercer suggests that employers review employee wellness programs against the proposed EEOC rules requiring voluntary participation and restricting incentives for completing health risk assessments and/or biomedical screenings, and they should be prepared to make changes after EEOC finalizes these rules.

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