Compliance February 11, 2022

ERISA Advisory Council Recommends Reviewing Penalties for Plan Leakage

Its report suggested ways the DOL can expand retirement plan access and provides novel recommendations to close retirement savings gaps for women and minorities.

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A Department of Labor advisory council, in a report to Secretary of Labor Marty Walsh, has recommended ways to close the retirement savings gaps for people of different races and ethnicities, as well as for women.

The report, titled, “Gaps in Retirement Savings Based on Race, Ethnicity and Gender,” was prepared by the DOL’s Advisory Council on Employee Welfare and Pension Benefit Plans—which is typically called the ERISA [Employee Retirement Income Security Act] Advisory Council—to examine underlying reasons why retirement security lags among these cohorts. The body advises Walsh on matters related to welfare and pension benefit plans. 

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Testimony to the council confirmed persistent coverage gaps, according to the report. 

“The retirement system in the United States reflects the imperfections of its labor markets with regards to people of color and women,” the report states. “The voluntary approach embedded in ERISA has not moved the needle to encourage the employers of half of the American workforce to sponsor a retirement plan for their employees. Our recommendations attempt to find ways within the existing voluntary system to expand retirement plan coverage and participation.”

Council Recommendations

The council received more than 50 recommendations from over 25 witnesses, and it reviewed 25 of the suggestions that were within the scope of the review.

The body consolidated those recommendations into 16 explicit recommendations for action the DOL should take, and it organized these into five primary suggestions:

  • Enhance coverage;
  • Increase participation and improve retention of retirement assets and minimize leakage;
  • Increase education and outreach to underserved individuals and communities;
  • Enhance women’s access to retirement benefits; and
  • Update the department’s regulations, technical bulletins and rules to explicitly address the shortfall issue for these communities and underserved groups.

After conducting research and listening to testimony, the council then made several recommendations to address the gaps in retirement savings based on race, ethnicity and gender. It suggested the DOL:

  • work to expand retirement plan access;
  • increase interagency cooperation and coordination on retirement policy affecting underserved groups and expand its financial education;
  • address gaps in retirement security for women where lack of information, divorce and unpaid caregiving responsibilities negatively impact retirement savings;
  • update existing regulations to provide safe harbors and encourage plan designs that would address this issue, that track and reflect the current dynamics of the workforce; and
  • recognize the need for service providers to include diversity, equity and inclusion elements to provide underserved populations with relatable retirement professionals.

Lawmakers have made several attempts to expand retirement plan access through legislation and regulation, including 2019’s Setting Every Community Up for Retirement Enhancement Act. The council notes that an estimated 50% of the American workforce does not have access to retirement plan.

The body recommended the DOL expand on prior guidance to encourage development of ERISA-covered retirement plans, including multiple employer plans, pooled employer plans and state-sponsored plans.

Additionally, the council made recommendations concerning the impact of leakage in retirement plans.

Novel recommendations from the council included that the DOL work with the Department of the Treasury and Internal Revenue Service to review penalties on involuntary small payments and hardship withdrawals, and to relieve the penalty tax for early distributions of small amounts.

The council noted that testimony addressed situations in which workers in low-wage, high turnover sectors “often accumulate a small balance of retirement savings only to see the balances distributed as involuntary payments of small amounts and/or hardship withdrawals,” the report states.

The distributions include tax penalties that are harmful to workers and that reduce their already small retirement savings, the report notes.

The council also suggested that the department encourage an employer match on employee contributions (including pre-tax, after-tax and Roth), permit a match on contributions to emergency funds and student debt payments, and promote nonelective (i.e., profit-sharing) contributions and Roth contributions.

“Given the relatively small impact of the marginal tax rate on lower-wage workers, the council also recommends the department promote plan designs that utilize nonelective employer contributions and employee Roth contributions to minimize the tax penalty impact on small retirement accounts,” the report states.

Council Observations

Coverage gaps are particularly acute among women and minority women, according to the report.

“Testimony confirmed that women, and especially minority women, are more likely to have lower retirement benefits due to divorce, lower career earnings, lack of access to employer-sponsored retirement plans, gaps in employment due to raising children and caring for elderly parents, lack of financial literacy, as well as the current fragmented retirement system,” the report states.

Research has also shown that retirement savings among Hispanic families have lagged other groups. The impact of the COVID-19 pandemic has had uneven effects on participants preparing for retirement across generations and in different racial and ethnic groups. It has also been particularly harmful to women’s retirement confidence.

The council notes that personnel from the Employee Benefits Research Institute presented findings from the firm’s 2021 “Retirement Confidence Survey” identifying persistent gaps between different genders, races, ethnicities and income groups, specifically gaps between white people and people of color—regardless of income.  

“The survey found that low-income wage earners (earning less than $35,000) and Black middle-income wage earners (up to $75,000) are less likely to have $1,000 saved for retirement,” the report states. “In addition, the survey showed problematic debt levels by race and ethnicity, with debt negatively impacting Black and Hispanics at a greater rate than whites.”

Investing February 11, 2022

Fiduciary Diligence Demanded as CITs Shine

A significant regulatory concern is that banks should not simply “rent their charters” to third-party registered investment advisers seeking to use the bank’s status as a fiduciary to sponsor one or more funds on their behalf.  

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Wilmington Trust recently published an in-depth report that examines the evolving collective investment trust marketplace. While written mainly for the benefit of CIT providers, the analysis also can help retirement plan fiduciaries ensure they are living up to their own responsibilities.

CIT Momentum Is Clear

As noted by report authors Thomas Roberts, a principal at Groom Law Group, Chartered, and James Bowlus, associate general counsel in the legal division at Wilmington Trust, plan sponsors and other fiduciaries responsible for 401(k) plan investment menu construction, including their advisers, are demonstrating growing interest in adopting CITs. The pair say several powerful market forces are driving this trend.

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“First, the investment strategies and related teams of investment professionals available to 401(k) plans through mutual fund complexes are becoming increasingly available through CIT structures,” the report explains. “Second, the exemptions from registration under the federal securities laws available to CITs may afford them cost advantages relative to their mutual fund counterparts, because CITs can avoid the expenses associated with mutual fund registration, prospectus and annual report updating and mailing, and the like.”

Further, CITs are relatively flexible arrangements—a feature that is particularly compelling in today’s volatile and rapidly evolving equity and fixed-income markets.

As Roberts and Bowlus write, CIT structures can implement new investment strategies and approaches “quickly and easily.” Accordingly, banks and trust companies that offer CIT products are able to respond to market demand for customized products quite effectively, particularly in the target-date fund segment.

“With all of these advantages, it is unsurprising that CITs have attracted an ever-larger percentage of 401(k) plan assets over the past 20 years,” the pair write.

Of course, with this growth comes additional diligence demands. According to Roberts and Bowlus, the policies and procedures of banks and trust companies offering CIT products to retirement plans covered by the Employee Retirement Income Security Act may warrant additional consideration by plan fiduciaries when making investment option decisions. They note that modern CIT structures have been shaped by and reflect a triad of regulatory influences—arising, respectively, under the body of state and federal laws governing the exercise of trust powers by banking institutions, the federal securities laws enforced by the Securities and Exchange Commission, and ERISA.

Emerging Points of Scrutiny

After providing a detailed history of the role the Office of the Comptroller of the Currency and various state regulatory bodies played in the creation of the CIT marketplace, the Wilmington Trust paper highlights some of the current pressure points regulators are tracking.

In particular, with respect to the widespread use of sub-advisers by CIT providers, a significant regulatory concern is that banks should not simply “rent their charters” to third-party registered investment advisers seeking to use a bank’s status as a fiduciary to sponsor one or more funds on their behalf.

“The OCC has emphasized that a bank’s use of outside third parties to perform functions on its behalf does not diminish the responsibility of the bank’s internal management team to ensure that those functions are performed in a safe and sound manner and in compliance with applicable laws,” the report warns. “The OCC expects a national bank relying upon third parties, including CIT sub-advisers, to maintain risk management processes that are commensurate with the level of risk and complexity of the third-party relationship.”

Accordingly, the OCC expects that banks using the services of CIT sub-advisers will exercise periodic reviews of the sub-adviser’s performance, style consistency and the investment of fund assets in a manner consistent with applicable investment guidelines.

Retirement plan fiduciaries, like the regulators, should be sure that their CIT provider can demonstrate control over the documents that afford clients access to CIT investment funds, including the maintenance of original documentation in a secure, centrally controlled location. The bank or trust company also should maintain a system of internal controls, the analysis explains, including an effective audit program for assuring that the bank is adhering to the terms and conditions of CIT instruments.

What Can Go Wrong With CITs

As an example of how CIT providers can run afoul of such expectations and raise fiduciary concerns for retirement plans, the paper points to an enforcement action undertaken by the SEC back in 2006. The case involved a common trust fund claiming exemption from registration under SEC rules, specifically the rules requiring that CITs be “maintained by” a bank or trust company even when it has engaged a sub-adviser.

The SEC concluded that the “maintained by” requirement is not satisfied when a CIT serves as a de facto intermediary vehicle for investors to indirectly invest in privately offered investment funds that were otherwise unavailable for direct investment.

“In that case, the SEC expressed the view that the bank did not truly ‘maintain’ the common trust fund but was merely a directed investment arrangement, because investors in the fund instructed the trustee as to the ultimate investment of the common trust fund into underlying private investment vehicles,” the report explains.

More recently, in 2020, the SEC determined that a CIT trustee similarly failed to satisfy the “maintained by” requirement for both its common trust and collective trust funds. In that case, the trust company sponsoring the funds relied upon the services of an affiliated investment adviser to assist with the management of the funds. Ultimately, the SEC faulted the trust company for engaging in only “minimal oversight” of its investment adviser affiliate, alleging that the advisory affiliate performed virtually all investment activities on behalf of the funds, including investment due diligence, investment selection, purchases, sales activities and monitoring for performance and risk.

The SEC also noted that the trustee’s oversight of its adviser affiliate was “cursory,” largely limited to the passive receipt of information and reports submitted by the adviser that rarely resulted in any investment changes or feedback to the adviser in respect of the funds’ investment strategy.

“The federal securities laws compliance needs for well-designed and implemented CIT governance practices are clear and unmistakable,” Roberts and Bowlus write. “CITs are ‘maintained by a bank’ and therefore eligible for the federal securities laws exemptions that may allow for cost savings relative to mutual funds only where the bank exercises substantial investment authority, including through sub-adviser oversight and contemporaneous or advance approval of sub-adviser recommendations.”

CITs and ERISA

The paper concludes with a discussion of the intersection of CIT rules and ERISA requirements.

“Banks that maintain CITs are responsible as fiduciaries when they manage the assets of those plans,” the paper notes. “As such, banks are required to manage those assets prudently, solely in the interests of the plans and in a manner that avoids giving rise to a non-exempt prohibited transaction.”

According to Roberts and Bowlus, while the common practice of engaging one or more expert investment advisers to assist the bank in its management role is consistent with the principles of prudence, it is insufficient, in and of itself, to discharge that duty.

“Consistent with the duties of prudence and loyalty that ERISA imposes, where a fiduciary relies upon an expert, including a sub-adviser, it is obligated to evaluate and consider the expert advice and recommendations that it receives, including the qualifications of the provider(s) of that advice,” the analysis concludes. “Such a process would also seek to avoid non-exempt prohibited transactions. Well-governed bank CITs apply these principles by engaging in regular oversight of expert sub-advisers and of their recommendations and by taking appropriate steps to ensure ongoing compliance with applicable prohibited transaction exemptions.”

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