Investing February 10, 2017

Rates, Inflation and Uncertainty All Rise in 2017

A look at this year’s market expectations, and what defined benefit plan sponsors and defined contribution plan participants should know.
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As 2016 scored a hectic 12 months in economic and market rates, (most notably for pension funding),  the question remains for 2017—what should defined benefit (DB) plan sponsors and defined contribution (DC) plan participants expect throughout the year’s course?

Well for starters, according to Milliman’s Pension Funding Index (PFI), released in January, under an optimistic forecast with rising interest rates (reaching 4.55% by the end of 2017 and 5.15% by the endof 2018) and asset gains (11.2% annual returns), the funded ratio would climb to 92% by the end of 2017 and 105% by the end of 2018. Under a pessimistic forecast with similar interest rate and asset movements (3.45% discount rate at the end of 2017 and 2.85% by the end of 2018 and 3.2% annual returns), the funded ratio would decline to 75% by the end of 2017 and 69% by the end of 2018. 

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Jason Shoup, senior portfolio manager and fixed income strategist of Legal & General Investment Management America (LGIMA), believes sponsors should be wary of seeing both highs and lows, as he expects enhanced growth with fatter tails in the coming year.

“What we’re contending with is an expectation of modestly improved growth in the U.S.—but an outlook that has much, much fatter tails to it, and as a result, a rates outlook that has much fatter tails to it as well,” he says. “Through the lens of a pension administrator and pension plan, you really need to be ready to act here, and you need to be poised in thinking about these issues because on the one hand, we may be seeing the highs of the market in terms of rates, or we may be seeing the lows.”

While rates are anticipated to rise over the year, Shoup adds that uncertainty will continue to heighten, mainly because of the indeterminate nature specific qualities and transactions have in affecting rates. 

“When we think about the outlook in the rates market, it’s something of a wild card, because you talk to economists, you talk to interest rate strategists, and there really is no historical precedent to translate what that improvement and confidence might do to capital expenditure (CAPEX), hiring, the mergers and acquisitions (M&As), to animal spirit, and how that may ultimately translate to growth and higher rates,” he says.

NEXT: Politics, market volatility may lead to de-risking strategies

Additionally, LGIMA’s 2016 Market Commentary reports that upcoming potential legislation in response to the new Trump administration adds worry to political risk. “The new administration may succeed in extending the current business cycle, but the possibility that politics fail to live up to expectations seems remarkably high and argues for some degree and caution,” the report reads.

Shoup adds, “There’s quite a bit of uncertainty with respect to how high rates can go, and on the other side, if you have a misstep from the administration on corporate tax reform, on trade, on immigration, it’s quite possible that you have significant downside risks as well.”

The LGIMA report finds that despite market volatility, establishing de-risking strategies are imperative for plan sponsors. Report findings see plan sponsors interested in customized liability-driven investments (LDI) strategies, such as raising their fixed income allocation, liability benchmarking, completion management and hedging strategies associated with glidepaths.

Shoup and Jodan Ledford, head of U.S. Solutions for LGIMA, believe LDI will play a significant role in de-risking strategies for 2017. “In a DB perspective, I would think that in 2017, LDI will be a very strong conversation, where you will see flows,” says Ledford.

NEXT: Asset allocation solutions for DC participants and DB sponsors

A report from Northern Trust’s Investment Manager Fourth Quarter 2016, which surveyed 100 investment managers in Northern Trust’s multi-manager platforms—including outsourced chief investment (OCIO) services—found that 78% of those responded forecast inflation to increase throughout 2017, a large increase from last quarter’s 47%.

Still, Mark Meisel, senior investment product manager of the Multi-Manager Solutions group at Northern Trust, believes managers will not see inflation increase dramatically over the course of the year. Therefore, he suggests that retirement portfolios be strategically asset allocated with adequate money in stocks and bonds, and to also diversify among asset classes to the best ability.

“If I were a participant and I saw the results, I would be making sure that I have enough allocated to asset classes that do okay in a rising rate environment—not dramatically rising rate—but a slow rising rate environment, and one where inflation is beginning to take impact again,” he says.

Meisel recommends real asset classes, including real estate investment trusts (REITs), Treasury Inflation Protected Securities (TIPS), and the global listed infrastructure. However, he warns that while commodities hold paramount correlation to inflation, they also have high volatility.

“That may be something that depending on the risk tolerance of the client, they may not want to invest in,” Meisel says. “Some of these other real assets I think would be important to have, with consideration for an appropriate allocation for their risk tolerance in those type of classes.”

For DB plan sponsors, Meisel suggests similar advice in reviewing asset allocations. “They should, again, look at their asset allocation amongst the asset classes and make sure they have enough inflation hedges in there.”

A State Street Global Advisors Market Outlook of 2017 found that forward return expectations for equities are less than 5%, while expectations in fixed income came in between 1% and 2%.

Lori Heinel, deputy global chief investment officer for State Street Global Advisors, believes that because of this, most DB plan sponsors—especially in the public space—will have a tough time achieving a return on asset assumption.

In response to the expectations, Heinel encourages clients to consider volatility management, illiquid assets and additional asset sources.

“Think a lot about volatility management, because in an era of lower returns, higher volatility can be deadly,” she says. “Also, look at things like illiquid assets, so whether it be private equity and private real estate or infrastructure, other kinds of things are often asset classes that they can take advantage of.”

Compliance February 9, 2017

DOL Fiduciary Rule Wins Another Court Victory

A district court judge in Texas concluded the crafting and implementation of the fiduciary rule fit squarely within the DOL’s authority.
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In a lengthy decision penned by U.S. District Court Judge Barbara Lynn of the Northern District of Texas, little deference is shown to retirement industry providers’ arguments that the Department of Labor (DOL) fiduciary rule was improperly established, or that it will harm the adviser-provider-client relationship.

The decision represents a major setback for one of the first legal challenges to have been filed against the rule, put forth by a small group of national financial and business trade organizations including the U.S. Chamber of Commerce, Financial Services Institute, Financial Services Roundtable, Insured Retirement Institute, Securities Industry and Financial Markets Association, and others. Their self-stated objective was to “challenge the improper Department of Labor’s fiduciary rule for brokers and registered investment advisers serving Americans with individual retirement accounts (IRAs) and 401(k) plans.”

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Their complaint argued that the rule will “hinder many of our member firms’ ability to continue providing the level of holistic financial advice and suitable investment options their clients are accustomed to.” Plaintiffs cited a series of by-now familiar potential “unintended consequences of the ambitious rulemaking,” stressing in particular that advisers servicing small-business plans “will be left with no choice but to limit or stop servicing those retirement plans … significantly reducing the retirement savings options available to their millions of employees.”

The trade groups asserted claims under the Administrative Procedure Act and the First Amendment to the United States Constitution, challenging the rule itself and the related “prohibited transaction exemptions” (PTEs) promulgated by DOL. Plaintiffs charged that DOL vastly overstepped its authority and is creating impermissible burdens and liabilities for the advisory and brokerage industries, “undermining the interests of retirement savers.” They suggested such work as redefining the role of investment advisers, as well as the grounds on which they can be dragged into 401(k) and individual retirement account (IRA) litigation, if it has to be done, should be undertaken by the Securities and Exchange Commission (SEC).

With the more-or-less outright failure of these arguments, ERISA attorneys and industry commentators are left even less certain than before—if that is even possible—as to what will come next with the rulemaking, set to start taking effect in just eight weeks or so. Ostensibly the White House has the authority to review and consider revising the rulemaking, demonstrated by the President’s most recent memorandum-order directing the DOL to do just that. But it is far from clear whether the effort to pull the teeth out of the rulemaking can be completed by the first deadlines in April, or even before the more strenuous compliance deadlines that will run by later in 2017 and 2018.

As one attorney told PLANSPONSOR recently, “this leaves firms in the uncomfortable position of not knowing with 100% accuracy whether the fiduciary rule will be delayed or not.”

NEXT: From the text of the suit 

Interesting to note, many of the areas the DOL is directed to review in the Trump administration memorandum are directly confronted in the text of the Texas judge’s decision—and the conclusions drawn therein don't exactly bode well for opponents of the rulemaking. The 81-page document patently rejects many arguments put forth by retirement and investment industry trade groups to the effect that the fiduciary rule was crafted and implemented outside the normal authority of the agency, for example, and it strongly denies the likelihood that simply strengthening consumer protections will lead to millions of Americans being shut out of the advice market.  

At one point in the wide-reaching decision, the judge observes that Congress never ratified the fiduciary standard currently applied under ERISA, and so there can be little weight given to plaintiffs’ argument that because Congress has repeatedly amended ERISA since 1975, without ever amending the five-part test that underlies the current fiduciary standard, that test has de facto been incorporated into ERISA by way of ratification.

“Generally, congressional inaction deserves little weight in the interpretive process … and lacks persuasive significance because several equally tenable inferences may be drawn from such inaction,” the court finds. “At the same time, if Congress frequently amended or reenacted the relevant provisions without change … Congress at least understood the interpretation as statutorily permissible … There is a stark difference between Congress acquiescing to a permissible interpretation and Congress affirmatively deciding that an interpretation is the only permissible one …  If plaintiffs’ argument were correct, the DOL could never revisit the five-part test because it has been, in effect, enshrined into the statute. To the contrary, courts have consistently required express congressional approval of an administrative interpretation if it is to be viewed as statutorily mandated.”

Various arguments are applied along these lines to suggest the rulemaking and its prohibited transaction exemptions fit squarely within the DOL’s authority. Much of that discussion centers on extensive analysis of precedence established in the well-known case ERISA industry lawsuit from 1984, Chevron, U.S.A., Inc. v. Natural Resources Defense Council, Inc.

With all this in mind, ERISA attorneys continue to speculate that the DOL’s newly ordered review will in fact determine that the fiduciary rule is inconsistent with Trump Administration policy, and so it may eventually issue for notice and comment a proposed rule rescinding or revising the DOL fiduciary rule and the best-interest contract exemption. How this could unfold before April 10, while the Trump administration has yet to see its Labor Secretary confirmed, is becoming increasingly hard to see. And it may further be noted, with this latest decision in the Texas lawsuit, it will not necessarily be easy to prove the rule is inherently flawed or that it even in fact runs against what the populist Trump Administration hopes to accomplish.

NEXT: Plaintiff reaction comes quickly 

Plaintiffs in the failed lawsuit wrote to PLANSPONSOR to say they are disappointed with the ruling—but they are far from backing down from the fight.

“We continue to believe that the Department of Labor exceeded its authority, and we will pursue all of our available options to see that this rule is rescinded,” the trade groups suggest. “While we have long supported a best interest standard, this is a misguided rule that will harm retirement savers and financial services firms that provide needed assistance and options to their clients, including modest savers and small business employees.  The President’s recent directive to the department, reflecting well-founded, ongoing and significant concerns about the rule, is a welcome development.”

Other involved parties also shared some interesting perspective, including the American Council of Life Insurers Executive Vice President and General Counsel Gary Hughes.

“We are disappointed with the decision from the U.S. District Court, Northern District of Texas, on our joint legal challenge with the National Association of Insurance and Financial Advisors to the U.S. Department of Labor’s fiduciary regulation,” he writes. “ACLI and NAIFA continue to believe that the regulation is arbitrary and capricious, contrary to law and violates the First Amendment. We support responsible and balanced regulations that protect the interests of retirement consumers. But the regulation is neither reasonable nor balanced. It will harm the very people it is meant to help.”

Hughes urges the Trump administration “to act immediately to delay this misguided regulation,” suggesting a delay will provide time for the administration to “conduct a thoughtful review and to work with ACLI, NAIFA and other stakeholders toward public policies that help Americans achieve their financial and retirement security goals.”

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