Investing January 21, 2015

S&P Charged, Settles with States

The SEC has charged Standard & Poor’s with fraudulent ratings conduct related to ratings of mortgage-backed securities.
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The Securities and Exchange Commission (SEC) announced a series of federal securities law violations by Standard & Poor’s Ratings Services involving fraudulent misconduct in its ratings of certain commercial mortgage-backed securities (CMBS).

S&P agreed to pay more than $58 million to settle the SEC’s charges, plus an additional $19 million to settle parallel cases announced by the New York Attorney General’s office ($12 million) and the Massachusetts Attorney General’s office ($7 million).

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The SEC issued three orders instituting settled administrative proceedings against S&P. One order, in which S&P made certain admissions, addressed S&P’s practices in its conduit fusion CMBS ratings methodology. S&P’s public disclosures affirmatively misrepresented that it was using one approach when it actually used a different methodology in 2011 to rate six conduit fusion CMBS transactions and issue preliminary ratings on two more transactions. As part of this settlement, S&P agreed to take a one-year timeout from rating conduit fusion CMBS.

Another SEC order found that after being frozen out of the market for rating conduit fusion CMBS in late 2011, S&P sought to re-enter that market in mid-2012 by overhauling its ratings criteria. To illustrate the relative conservatism of its new criteria, S&P published a false and misleading article purporting to show that its new credit enhancement levels could withstand Great Depression-era levels of economic stress. S&P’s research relied on flawed and inappropriate assumptions and was based on data that was decades removed from the severe losses of the Great Depression. According to the SEC’s order, S&P’s original author of the study expressed concerns that the firm’s CMBS group had turned the article into a “sales pitch” for the new criteria, and that the removal of certain information from the article could lead to him “sit[ting] in front of [the] Department of Justice or the SEC.” The SEC’s order further finds that S&P failed to accurately describe certain aspects of its new criteria in the formal publication setting forth their operation. Without admitting or denying the findings in the order, S&P agreed to publicly retract the false and misleading Great Depression-related study and correct the inaccurate descriptions in the publication about its criteria.

A third SEC order issued in this case involved internal controls failures in S&P’s surveillance of residential mortgage-backed securities (RMBS) ratings. The order finds that S&P allowed breakdowns in the way it conducted ratings surveillance of previously-rated RMBS from October 2012 to June 2014. S&P changed an important assumption in a way that made S&P’s ratings less conservative, and was inconsistent with the specific assumptions set forth in S&P’s published criteria describing its ratings methodology. S&P did not follow its internal policies for making changes to its surveillance criteria and instead applied ad hoc workarounds that were not fully disclosed to investors. Without admitting or denying the findings in the order, S&P agreed to extensive undertakings to enhance and improve its internal controls environment.  S&P self-reported this particular misconduct to the SEC and cooperated with the investigation, enabling the enforcement division to resolve the case more quickly and efficiently and resulting in a reduced penalty for the firm.

“These enforcement actions, our first-ever against a major ratings firm, reflect our commitment to aggressively policing the integrity and transparency of the credit ratings process.” says Andrew J. Ceresney, director of the SEC Enforcement Division.

Since 2010, several lawsuits filed by pension funds against S&P and other ratings agencies related to ratings of mortgage-backed securities have been dismissed. In August 2014, the SEC adopted revisions to rules governing the disclosure, reporting, and offering process for asset-backed securities, as well as new requirements for credit rating agencies. A lawsuit brought by the California Public Employees Retirement System (CalPERS) against the three major ratings agencies has ultimately survived motions for dismissal.

Administration January 21, 2015

How to Assess Providers for Lifetime Income

Plan sponsors should consider the steps that go into a prudent process for selecting a provider if they want to include a lifetime income solution in their plans. 
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Plan sponsors do not have to provide in-plan lifetime income solutions for their plan participants. However, the topic is heating up as the issue of how participants will manage account balances to provide sustainable lifelong income garners more attention.

Using a prudent process to choose a provider for a lifetime income solution requires several steps, according to “Fiduciary Considerations in Selecting a Lifetime Income Provider for a Defined Contribution Plan,” by Fred Reish and Bruce Ashton, Drinker Biddle attorneys who specialize in Employee Retirement Income Security Act (ERISA) issues. Steven Kronheim, vice president and associate general counsel at TIAA-CREF is the co-author.

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Fiduciaries responsible for selecting annuity providers are not obligated to follow the steps in the safe harbor regulation, the paper notes. But they should consider four main areas—the company’s financial strength; the provider’s evaluation by the rating agencies; commitment and success in the insurance industry; and diversification of business lines—as part of a prudent process.

Of these areas, financial information about a provider is the most important, says Ashton, a partner in Drinker Biddle & Reath’s Los Angeles office, and the section that is most likely to require the assistance of an outside professional, he says.

“In my experience, not too many committee members are going to be very knowledgeable about insurance companies,” Ashton tells PLANSPONSOR. The largest firms are unlikely to have the expertise in-house to really determine the strength of an insurer.

Ashton suggests seeking the assistance of an adviser or consultant with specialized knowledge who is steeped in the industry. “There are some who understand the insurance industry and the strengths of various insurance companies,” he says.

In short, Ashton says, the plan sponsor wants to determine how long the provider has been in business; the size of the business in serving this market specifically, and what their reputation is.

Recently, the Department of Labor (DOL) issued guidance on qualified longevity annuity contracts (QLAC) used in target-date funds (TDFs). Does the guidance at all soothe plan sponsors’ fears about their fiduciary responsibility in choosing a lifetime income provider?

“The short answer is no,” Ashton says. However, he notes that recent guidance from the Internal Revenue Service (IRS) and the Treasury Department—IRS Notice 2014-66 and an accompanying letter from Phyllis Borzi, assistant secretary of the DOL—should give people some comfort that regulators are trying to allay concerns about these types of products.

“The Borzi letter makes it clear that it is certainly permissible that you could engage a 3(38) investment manager to make the determination,” Ashton says.

The plan sponsor and plan committee, Ashton says, can see if the consultant or adviser will take on the role of a 3(38) investment manager, and have them make the decision about choosing a provider. “That’s what the structure was in the 2014-66 notice,” he says. “The letter from Borzi pointed out that if you have an investment manager, they’re making the responsible decision, and that’s OK.”

The aspects of an insurance company’s finances are quite detailed, ranging from analysis of the firm’s asset valuation reserve, to diversification of assets, to liquidity, to Fortune 500 ranking. Drinker Biddle’s paper has a sample checklist in the appendix for use in evaluating an insurance company, and specifics on how to access information: Some can be obtained by asking the insurer; some from independent sources, such as ratings agencies or the National Organization of Life and Health Insurance Guaranty Associations.

The following are characteristics that can be used to assess financial strength:

Bond quality: The National Association of Insurance Commissioners bond quality can be found on the insurer’s website or can be requested from the insurer. Investment-grade bonds should be at least 90% of the bond holdings of the General Account.

Diversification of invested assets: bond type and duration; preferred stocks; common stocks; real estate; alternative investments. Questions to ask include: Are the bonds owned diversified among bond types? Are the bond maturities diversified according to the following time frames? 

Insurer’s asset liquidity: This can be found on the annual statutory statements. Total bonds, total cash and total mortgages can be found on the assets schedule; while the total reserves can be found on the reserve analysis.

Fortune 500 Ranking: Life and Health insurance companies are listed either as a stock or a mutual insurance company.

Analysis of insurer’s statutory capital: Data on the capital, surplus and asset valuation reserve of an insurer can be found in the annual statutory statements (Blue Book) and from the individual rating agencies (Fitch, Moody’s, Standard & Poor’s, and A.M. Best).

Plan sponsors should factor in the quality of the company’s ratings by Fitch, Moody’s, Standard & Poor’s, and A.M. Best. Ratings from each company should be examined to determine the consistency or lack of consistency among the rating agencies. Ratings over a five-year period (or longer) can help determine if the trends have been stable over time or have fluctuated in economic cycles. Read the report that accompanies each rating agency’s rating to see if there are adverse comments that suggest vulnerability to future economic events.

  • Check insurance company annual reports and insurance company websites as well as the individual rating agencies.
  • Acceptable ratings for financially strong companies are considered to be A- or higher by either A.M. Best, Fitch and Standard & Poor’s, and A3 or higher from Moody’s.

Determine the company’s commitment and success. How long has the company been in business? The annuity provider should have enough history to demonstrate the ability to maintain a strong balance sheet through different market cycles. Drinker Biddle recommends that an insurance company have a minimum of 10 years in the annuity industry and annuities with living benefits.

How large is the annuity business? This can be determined by the number of annuity contracts and the amount of annuity assets. A well-established annuity provider would have a minimum of 250,000 contracts, and total traditional annuity assets of at least $15 billion, with at least $5 billion with living benefits.

  • Annuities and income guarantees should be one of the core business lines (at least 10% of annual revenue) of the insurer.
  • Review the insurance company’s Form 10-K for the company’s regulatory history and litigation history, with particular focus on potential impacts to the annuity business.

Determine the business lines—for example, annuities; life insurance; group insurance; retirement plans; other—from the insurance company’s Form 10-K or annual report. While diversification by itself does not insure that an organization is financially sound, it can help with volatility when compared to a single line of business. Any insurance company that has a single or limited line of business should be closely scrutinized.

  • Is the company broadly diversified across different lines of business?
  • What is the revenue (in millions) by business line or division for annuities; life insurance; group insurance; retirement plans; other? 

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