Investing April 11, 2018

The Benefits of the OCIO Model

Shifting responsibility of investment decision making to a discretionary manager offers a host of benefits to defined benefit plan and defined contribution plan sponsors, such as cost savings and better returns—benefits that trickle down to participants.
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The outsourced chief investment officer (OCIO) model is a shifting of responsibility in investment decision making—a discretionary investment manager shares fiduciary responsibility with a retirement plan sponsor related to the investment portfolio, explains T.J. Kistner, director for Segal Marco Advisors in Chicago.

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Most of the time, the OCIO discussion is related to defined benefit (DB) plans. Together, DB plans and nonprofits continue to represent the majority of the assets under management (AUM) of OCIOs polled by Cerulli Associates (81.1%), and while the OCIO model was once limited to small or mid-sized institutions that felt they lacked the size and resources needed to effectively manage their investment portfolios, a recent report from Greenwich Associates, “Winning in the New World of Outsourced CIO,” finds that larger institutional investors are now embracing the model.

However, the OCIO model is akin to the 3(38) investment manager model for defined contribution (DC) plans, as Kistner says, “Any time responsibility for investment decisions is outsourced—whether for DB plans or DC plans—it can add value.”

Rich Joseph, leader of the OCIO business in the U.S. at Mercer based in Boston, says his firm has about $40 billion in DC OCIO assets today in the U.S., about the same as it has in DB OCIO assets. He says using an OCIO model allows both DC and DB plan sponsors to be more strategic.

“For DC plans, they can discuss with OCIOs why they offer the plan, their objective and the outcome they want for participants—how to ensure participants are retirement ready,” he notes. In addition, he points to the tremendous amount of legal action being taken against DC plans over investment menus, and suggests that focusing on participants is easier in the OCIO framework.

“On the DB side, many plans are headed to exit,” Joseph says. “The complexity in managing DB assets is extraordinary today. How should plans align with Trump tax reform? Is it the right time to accelerate contributions? With the whipsaw in the markets in the last two months, DB plan sponsors should consider whether they are managing the plan as effectively as they can. Historically DB plan sponsors were focused solely on performance, but now they are focusing on funded status and getting liability and assets in tandem to get the plan off their balance sheet.” For those not planning a DB plan exit, he says the focus is how to reduce the volatility of performance to reduce balance sheet risk.

The Greenwich Associates research confirms that funds change their asset allocation considerably when turning to OCIOs. This presents an opportunity for managers who are able to bring greater sophistication to the table.

In comparing the allocation decisions of current OCIO users to more independent, like-sized peers with under $500 million in assets, there are several notable differences. For one, OCIO users show a shift away from the most liquid asset classes—average active U.S. equity allocations for OCIO funds are 27%, compared to 32% for peers of similar size. Likewise, OCIO funds are reallocating these assets up the risk-return spectrum, as evidenced by their more globalized portfolios. The research shows that mean active international equity and fixed-income allocations within OCIO portfolios sit near 25%, while like-sized institutions average only 17%.

Kistner agrees that managing complexities of the investment program is one of the benefits of the OCIO model. “The sheer number of investment managers and strategies available to asset owners presents the challenge of identifying best-in-class investment ideas. An OCIO can relieve asset owners of some of these complexities by providing the decision-making framework and operational discipline necessary for managing a successful investment portfolio,” he says.

But, Kistner points to many other benefits of the OCIO model for plan sponsors. First, it allows them to focus on their core responsibilities to their plans. There is also great potential for fee and cost savings due to the scale of an OCIO’s platform. “OCIOs can combine a plan’s assets with a larger pool of assets under its platform to drive down fees, and plans that on their own couldn’t participate in certain investments due to required minimum amounts can do so with an OCIO’s platform,” he says.

“Some of these benefits taken together with others can lead to better risk-adjusted performance,” Kistner says. “A discretionary investment manager has the ability to react quickly and efficiently in today’s market.” In addition, Kistner points to an enhanced governance structure. “Utilizing the OCIO model can provide the governance and committee structure needed to ensure the portfolio is being managed and monitored frequently, as opposed to the typical meeting cycles of a board of trustees, investment committee or other governing body,” he says.

All these benefits trickle down to retirement plan participants. Joseph says DB plans will be better funded, and Kistner notes that cost savings impact DC plan participants’ fees and produce better returns.
Administration April 6, 2018

Roth Accounts: A Different Type of Retirement Savings Diversification

Just as people diversify their investments, the Roth option is viewed as a way to diversify the tax treatment of savings. Here’s what plan sponsors need to know about Roth accounts and in-plan Roth conversions.
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For retirement plan sponsors that have not considered offering a Roth option for a 401(k) or 403(b) plan, findings from the Plan Sponsor Council of America (PSCA) should give them pause. In 2016, 63.1% of plans offered a Roth, more than double the 30.3% of plans that did so in 2007.

Similarly, the 2017 PLANSPONSOR Defined Contribution Survey found the percentage of plan sponsors offering Roth accounts in their plans increased from 52.4% in 2013 to 68.5% in 2017.

Experts say Roth accounts, which allow participants to defer income for retirement savings after taxes are withheld, represent another way that participants can diversify their savings, in this case via taxes. They also say that they make the most sense for younger workers who are in lower tax brackets. Paying taxes today before putting their savings into a retirement account so that they can then withdraw the savings tax-free in retirement, is a powerful way to “turbo charge” savings, says Gregg Levinson, senior retirement consultant with Willis Towers Watson in Philadelphia.

“In the retirement industry, we focus greatly on the diversification of investments in a participant’s account,” says John Geli, president of retirement solutions at DST in New York. “Such diversification allows a participant to weather the ups and downs of the market. Similarly, diversifying the tax impact of your qualified plan account allows an individual to be prepared regardless of what their personal tax situation ends up being upon retirement.”

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Many workers are aware of the Roth option, says Gary Weir, vice president, retirement solutions at Frenkel Benefits – an EPIC Company, based in New York. “The few times an employer has started a new plan and not offered a Roth contribution, one of the first questions we get from employees is if they can contribute on a Roth basis,” Weir says. “Qualified retirement plans often add Roth provisions to increase the flexibility and attractiveness of the plan to all workers and to appeal to younger workers or those in a lower tax bracket, for whom the prospect of long-term tax-free gains are more attractive than current tax savings.”

Amy Oullette, head of operations at Betterment for Business in New York, agrees that Roth accounts may make the most sense for younger workers, who have a longer period of time to amass earnings on their savings.

 

Conversely, “if a participant expects that Social Security will be their primary source of income in retirement, they may not derive as much benefit from a Roth account, since they may be in a very low tax bracket,” adds Steve Bogner, managing director at HighTower Treasury Partners in New York.

What sponsors need to know

Zovistoski says there are six steps/points that plan sponsors need to take or be aware of before offering a Roth option. First, they will need to work with their third party administrator (TPA) to update their plan document to include information about the Roth option. Second, they need to contact their payroll provider to ensure it can handle both pre- and post-tax contributions.

Third, they should be aware “that eligible employees can contribute to a traditional pre-tax retirement account, a Roth retirement account or both—but that the combined IRS [Internal Revenue Service] maximum deferral amount is applied to both accounts,” Zovistoski says.

Fourth, should a participant elect to defer on both a pre-tax and a Roth basis, the recordkeeper needs to maintain two separate accounts for each because they are taxed differently, he says.

Fifth, participants’ “Roth contributions are eligible for employer matches, just like traditional contributions, and like traditional contributions, the employee is immediately 100% vested,” he says.

 

Sixth, should the plan decide to use automatic enrollment, the default is typically a traditional retirement account; employees would need to affirmatively elect the Roth option, he says.

 

Participants in Roth 401(k) accounts or 403(b) accounts cannot take a distribution from their account without being subject to the 10% tax on early withdrawals until five years from their first Roth contribution or reaching age 59-1/2, adds Jamelle Moody, retirement plan consultant with DWC – The 401(k) Experts in Houston.

In-plan Roth conversions

Few sponsors that offer a Roth option permit in-plan Roth conversions, Weir says. However, the 2017 PLANSPONSOR Defined Contribution Survey found more than four in ten (41.2%) do.

 

Should a participant decide to convert his savings in a traditional retirement account to a Roth account, he needs to be aware that the amount converted will be subject to ordinary income tax in the year in which the participant makes the conversion, Weir says. Thus, if a participant has a $300,000 balance but is only earning $50,000 a year, the participant would most likely be unable to pay the taxes on the full balance, so it would make sense for “the employee to work with their tax adviser to structure their conversions in such a way that the taxable situation can be spread over several years so there is not an adverse tax consequence in any one year,” he suggests.

It is also critical for participants to realize that once they make the conversion, it cannot be reversed, adds Cindy Wilson, financial consultant director, institutional financial services at TIAA in Los Angeles. And, plan sponsors have the option of allowing either unmatched pre-tax deferrals or matched pre-tax deferrals to be converted, Wilson says.

Once a participant has decided to make a conversion, Zovistoski says, they should go through certain steps to ensure it is done properly. First, he should make sure that the Roth option is, indeed, available at his company. “Second, just because a company offers a Roth option does not mean it also offers in-plan Roth conversions,” Zovistoski adds. “Half of the plans with Roth do not allow for in-plan conversions.”

The participant needs to be aware that he will be responsible for the taxes on any amount that he decides to convert. The participant then needs to obtain the forms to conduct the conversion from the human resources department. Zovistoski adds, “they need to look at their next quarterly statement or log onto their account online to make sure the conversion was handled properly, and, finally, they need to look for a 1099-R form at the end of the year, which will tell them how much” retirement savings is taxable.

Unfortunately, Levinson says, “the challenge with Roth is that it is complicated to explain, which is why I think many people do not use it. We just did our DC [defined contribution] survey, which showed an uptick in sponsors offering the Roth option, but among those who don’t, they say it is too complicated for participants to understand. This has to change. Roth needs to be brought into the mainstream because defined benefit plans are gone, and not enough people are properly prepared for retirement. People need every tool possible,” and the Roth option is one that can really boost savings, he says.

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