Compliance December 15, 2020

DOL Adopts New Prohibited Transaction Exemption

The regulator has finalized a potentially important new prohibited transaction exemption.

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The U.S. Department of Labor (DOL) has published the final version of its updated fiduciary rule regulation, which it has titled “Improving Investment Advice for Workers & Retirees.”

The new regulation package stretches to nearly 300 pages, so it will naturally take some time for the full implications to be realized. However, a preliminary review suggests the final version resembles the version proposed this summer. Namely, the final regulation confirms the reinstatement of the traditional “five-part test” for determining fiduciary status, and the package includes the establishment of a new prohibited transaction exemption that aligns with the Securities and Exchange Commission (SEC)’s Regulation Best Interest (Reg BI).

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Under the DOL’s five-part test, for assistance or instruction to constitute “fiduciary investment advice,” a financial institution or investment professional who is not a fiduciary under another provision of the law must trigger all of the following stipulations:

  • Render advice to the plan as to the value of securities or other property, or make recommendations as to the advisability of investing in, purchasing or selling securities or other property;
  • On a regular basis;
  • Pursuant to a mutual agreement, arrangement or understanding with the plan, plan fiduciary or individual retirement account (IRA) owner, that;
  • The advice will serve as a primary basis for investment decisions with respect to plan or IRA assets, and that;
  • The advice will be individualized based on the particular needs of the plan or IRA.

According to a fact sheet shared by the DOL, advice pertaining to IRA rollovers will not necessarily trigger fiduciary status under the new paradigm. Here’s how the fact sheet describes whether rollover-related guidance is in fact fiduciary investment advice: “Advice to take a distribution from an employee benefit plan and roll over the assets to an IRA may be an isolated and independent transaction that would fail to meet the regular-basis prong of the five-part test. On the other hand, advice to roll over employee benefit plan assets can occur as part of an ongoing relationship or an anticipated ongoing relationship that an individual enjoys with his or her advice provider.”

It is likely that this provision of the rulemaking will receive significant scrutiny in the coming days and weeks, given the interest consumer protection organizations have in addressing potential abuse related to IRA rollovers into higher-fee products and services.

According to the fact sheet, the new proposed class exemption would be available to registered investment advisers (RIAs), broker/dealers (B/Ds), insurance companies, banks and individual investment professionals who are their employees or agents.

“The new proposed class exemption would permit investment advice fiduciaries to receive compensation as a result of providing fiduciary investment advice, including fiduciary investment advice to roll over a participant’s account in an employee benefit plan to an IRA and other similar types of rollover recommendations,” the fact sheet states. “The new proposed class exemption would also permit investment advice fiduciaries to enter into ‘principal transactions’ in which they could sell or purchase certain securities and other investments from their own inventories to or from plans and IRAs.”

The DOL says the proposed class exemption would require fiduciary investment advice to be provided in accordance with the following criteria: “A best interest standard, a reasonable compensation standard and a requirement to make no materially misleading statements about recommended investment transactions and other relevant matters.” Ostensibly, by complying with Reg BI, advisers or other investment professionals will satisfy all three of these criteria.

Data and Research December 15, 2020

Plan Design Decisions Can Reduce Overconcentration in Company Stock

Research from Vanguard supports the continuation of rethinking decisions about company stock offerings in defined contribution plans.

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A recent analysis from Vanguard explores the gradual abandonment of company stock in defined contribution (DC) plans.

In the report, “Company Stock in DC Plans,” authors John A. Lamancusa and Jean A. Young note that at the time the Employee Retirement Income Security Act (ERISA) was adopted, defined benefit (DB) plans were the dominant type of retirement savings plan in America. ERISA imposed a 10% limit on company stock holdings in DB plans; however, no comparable company stock restriction was imposed on DC plans.

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The authors also note that employee stock ownership plans (ESOPs)—which are invested principally in company stock—and the offering of company stock in 401(k) plans are attempts to incentivize employees by aligning their interests with interests of the company. Yet concentrated stock positions are in opposition to ERISA’s fiduciary standard to diversify plan investments.

For decades, DC plan sponsors have faced litigation alleging plan fiduciaries continued to offer company stock as an investment when it was no longer prudent to do so. Lamancusa and Young note in their report that high-profile losses in DC plans that offered company stock led to diversification rules being included in the Pension Protection Act (PPA) of 2006. Under these rules, plan participants are able to diversify their company stock holdings purchased with their own contributions at any time and can diversify holdings purchased with employer contributions once the participants have been credited with three years of service.

But, while the PPA enhanced participants’ ability to diversify from company stock holdings, litigation continued, and, in many cases, courts decided plan sponsors were afforded a “presumption of prudence” when offering company stock in ESOPs or other DC plans. In 2014, the U.S. Supreme Court negated this presumption. Since then, plan sponsors have continued to evaluate the prudence of offering company stock in their retirement plans.

Vanguard examined the changing incidence of company stock in plans it recordkeeps by analyzing 826 plan sponsors that were continuously on its recordkeeping systems between December 2005 and June 2020. Over that period, the percentage of plan sponsors offering company stock fell from 11% to 7%, a relative decline of 36%. The percentage of participants with a concentrated stock position (greater than 20% of total account balance) dropped by nearly three-quarters.

Between December 2005 and June 2020, 54% of company stock funds were closed to new money and/or eliminated from the plan.

Plan Design to Mitigate Risks

“A concentrated position in company stock can pose a substantial risk to a participant’s retirement security,” Lamancusa and Young say in their report. “It also raises litigation risks for plan fiduciaries.”

A Vanguard analysis found demographic characteristics such as age, income, education, job tenure and nonretirement wealth, while statistically significant, are not strongly related to the percentage of company stock in a participant’s account balance. The researchers found plan sponsor design decisions have the strongest relationship to the proportion of participant holdings in employer stock.

When a sponsor directs the employer match to company stock, a typical participant holds 3.3 percentage points more company stock than when an organization matches “in cash.” If a sponsor restricts the participant’s exchanges into company stock, the typical participant holds 1.3 percentage points less in company stock. When an organization restricts exchanges out of company stock, the typical participant holds 12.8 percentage points more in company stock.

Many sponsors have come to recognize the risks associated with single-stock ownership—for participants and for plan fiduciaries—and have imposed restrictions on concentrated company stock holdings. Two-thirds of sponsors limited employee contributions and/or exchanges into company stock as of June. And permitting immediate diversification of employer contributions directed to company stock has become the norm, even though the PPA allows a three-year service requirement.

The authors point out that the average five-year annualized company stock fund return was 4.8% for the organizations in Vanguard’s data set. However, there was wide variation in those returns—the five-year annualized return was negative 16.5% at the fifth percentile and 20.1% at the 95th percentile. “This wide range underscores the risk of company stock. A five-year annualized return of negative 16.5% translates to a cumulative loss of 59% over the period, whereas a five-year annualized return of 20.1% translates to a cumulative return of 150%,” the report says. “Prior research suggests that participants holding company stock do not understand the risks involved.”

A Word About ESOPs

In its analysis, Vanguard found that plans that offer company stock as an investment tend to be more generous and better-funded than non-company-stock plans. Median account balances are higher in company stock plans, as are median employee and employer contributions.

One reason for the greater generosity, according to Vanguard, is the prevalence of employer matching or other employer contributions. All plans with company stock make matching or other contributions, compared with 96% of all Vanguard-recordkept plans. Three-quarters of organizations with active company stock funds make both matching and other employer contributions to participant accounts—compared with 35% of all Vanguard plans.

Organizations that actively offer company stock make employer contributions that are about one-third more generous. Their participants have account balances that are about 7% larger after controlling for participant demographic and plan design features.

Another point the researchers made about the Vanguard data is that large employers, which are more likely to offer company stock, are also more likely to sponsor multiple DC plans. As a result, participants at large companies often have more than one DC plan account with the plan sponsor. For example, participants at one company might have a 401(k) account with no company stock and a standalone ESOP account with company stock. At another company, participants may have a 401(k) plan/ESOP plan with company stock and a standalone profit sharing plan with no company stock.

Offering more than one DC plan seemingly solves the lack-of-diversification issue.

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