Bill to Rescind DOL Rule Extending Pension Coverage Sparks Fierce Debate

The concern is that employers may push participants out of their private plans and into those run by the state.

In a move that is sparking a firestorm of protest regarding the extension of retirement plans to uncovered workers, the US House of Representatives advanced two bills to overturn federal rules that would make it simpler for states to start individual retirement accounts (IRAs) for private-sector workers who do not have 401(k)s.

The February 15 vote in the Republican-controlled House of Representatives seeks to delay a US Department of Labor (DOL) regulation that was passed in August 2016 that set up a procedure for individual states that would allow workers to enroll in IRAs that would be funded through employer’s payroll deductions.  Currently, these plans are available in about half of the 50 states.

At issue are whether the plans, known as Secure Choice Plans (SCPs), or “auto-IRA plans,” would allow designated private-sector employers to automatically deduct a percentage of their workers’ pay and forward it to state-sponsored IRAs and 401(k)s.

The proposed IRAs would have contribution limits of $5,500 each year, plus $1,000 for employees 50 and over. These are similar to current IRA limits.

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One operational sticking point was that the rules in the Employee Retirement Income Security Act (ERISA) of 1974 regarding 401(k) plans did not allow states to implement payroll deduction IRAs because it wasn’t clear how ERISA would regard state-based 401(k) plans. However, the DOL rule enacted last summer would prevent ERISA from pre-empting state law. In this case, states that already had their own regulations would be able to establish IRAs and be exempt from ERISA.

But on the political front, well-funded advocates on both sides are lining up to push their positions. At issue is whether workers with no retirement coverage in the private sector should be able to enroll in state-sponsored 401(k)s.  The concern is that employers may push participants out of their private plans and into those run by the state.

The number of workers without access to 401(k)s is huge: AARP estimates that 55 million workers cannot save for retirement from their regular paycheck. A Government Accountability Office (GAO) study found that about half of private-sector workers in the United States, especially those working in low-income jobs or employed by small firms, lacked coverage from an employer’s retirement savings program primarily because they lacked access. According to GAO’s analysis of 2012 Survey of Income and Program Participation (SIPP) data, about 45% of private-sector US workers participated in a workplace retirement savings program. The GAO said among those not participating, the vast majority (84%) lacked access because they either worked for employers that did not offer programs or were not eligible for the programs that were offered.

In its 2015 recommendation, the GAO suggested that Congress “consider providing states limited flexibility regarding ERISA preemption to expand private sector coverage. Agency actions should also be taken to address uncertainty created by existing regulations. Agencies generally agreed with GAO’s recommendation.”

So far, 28 states have enacted or are exploring legislation to allow workers to have access to retirement plans, according to the Pension Rights Center. States that have enacted this legislation to date are California, Connecticut, Illinois, Maryland, Massachusetts, New Jersey, Oregon and Washington.

The Massachusetts plan is currently available for workers at small nonprofits, but the state has introduced legislation to expand the program to private-sector workers who don’t have a 401(k).

California’s Secure Choice program is one of the newest efforts to be put in place. Gov. Jerry Brown signed a bill into law in September 2016 that established the program.

Extending Retirement Benefits Become Political

While the proposal is straightforward, the House of Representatives vote has ignited a firestorm of competing positions from the political right and left.  Republicans generally consider a plan that extends retirement savings accounts to uncovered workers to be an imposition of state and federal regulation into the private sector.

The conservative Heritage Foundation said the proposed program would hurt savers and cost taxpayers.” An article by Rachel Greszler, Senior Policy Analyst, Entitlement Economics at the Heritage Foundation, argued the SCP program was “the equivalent of Obamacare for retirement savings—that is, if you like your current 401(k), you may not be able to keep it.” 

Similarly, Will Hansen, senior vice president of retirement policy for ERIC, a group representing the largest 100 corporations in the US, said his group was opposed to the DOL rule to rescind coverage because “we realize that states are infringing on rules that offer retirement plans. We are not against the state implementing a state-run plan as long as it does not infringe on employers that already run retirement plans.” 

As an example of state overreach, Hansen cited legislation in Oregon that might regulate employers who are already offering a plan, but would imposed minimum standards that exist at the federal level, such as who is eligible to be covered, rules covering minimum number of hours worked annually, and age. The Oregon legislation would force employers to include seasonal workers and those under age 21, he said. ERIC’s position, he said, was that the DOL rules should “not infringe on any employer who offers a federally-compliant, ERISA retirement plan. We needs to agree on retirement coverage in America, but our members think this DOL rule is going to hurt our members and their ability to enroll in a plan,” he said.

In an ERIC report, the group also said it was concerned by the addition of a 90-day requirement that would force an employer who provides a retirement plan to employees to file an exemption or conditional exemption if the employer offers the retirement plan to all or some of its employees within 90 days of being hired.

ERIC said this would harm “large employers who design their retirement plans with a range of eligibility dates, so long as the eligibility date is in compliance with federal laws and regulations.”

An alternative view was offered by Hank H. Kim, Executive Director and Counsel, National Conference of Public Employee Retirement Systems, Washington, D.C., who said in a written response:

“The Secure Choice Pension model is a beacon of hope for the 55 million Americans who don’t have access to a workplace retirement savings program. A dozen states and cities have chosen to facilitate the creation of workplace savings programs after years of analysis, study, debate, and legislative action, and more are poised to follow suit. Now, Congress could hobble these innovative programs by using an obscure law to get rid of regulations that provide legal protection to state-facilitated IRAs.

“These state-facilitated plans were devised to fill an unmet need that American workers and small business owners are clamoring for. Employer-based retirement plan sponsorship rates have been declining for decades. Today, only about one-half of workers are even offered a plan. The private sector has not solved this problem, and that’s why states invested years in research and study to develop public-private sector solutions.

“We’ve heard the alternative facts advanced by the sponsors of these resolutions, but they don’t hold up under scrutiny. State-facilitated retirement savings plans would be responsibly managed for the benefit of savers and only savers, would meet the needs of employers, and would ultimately save taxpayers billions of dollars. Helping the states navigate the most effective way to provide additional retirement security for Americans is the right thing to do.”

But due to its scope and complexity, this is not a black-and-white issue. Chris Tobe, vice president of investments, First Bankers Trust, said that while he is “a huge supporter of the fiduciary rule and hopes that Republicans let it continue, I like the concept of providing lower-fee options for non-government employees, but I have been very suspicious of this initiative. I see this as connected with the Hillary Clinton initiative backed by Blackstone, which has been frustrated by its inability to get its high-risk, high-fee products into corporate 401(k) plans. Like in public defined benefit plans exempt from ERISA, I believe Blackstone felt that a public DC plan could be a back door for them to get their products into this market. I believe because of Citizens United, these public plans would be susceptible to politicians pushing them into high-fee products in exchange for untraceable donations to their super PACs, etc.”

James Watkins III, CEO and Managing Member at InvestSense, said “While I believe the House’s actions are mainly motivated by the desire to help big business, their point about the fact that SCPs do not provide the consumer protections that ERISA does is a valid concern, since SCPs would be administered by the states, some of which do not have the best track record in fiscal management.

“On the other hand, when over half the workers in the US (54.6%) do not have access to some sort of a pension plan, that’s obviously a situation that has to be addressed. As an ERISA attorney, when I first heard about these plans, my first two questions were first, do the rules have meaningful provisions to truly protect a plan’s participants, since SCPs would not be covered under ERISA? And secondly, what provisions are included to effectively control the costs associated with the plans and ensure prudent investment of the plans’ funds?

Watkins advocates for low-cost index funds to be included in any SCP since they are cost effective and minimize any potential conflicts of interest. He also suggests that the best option would be some sort of hybrid SIMPLE-IRA plan. “This plan would provide the protections provided under ERISA with minimum, and relatively easy, regulatory/compliance time and costs. The employer would make the contributions and receive the tax deduction. The plan participant would have the right to select the investments in their plan, which would be limited to index funds as investment options. Again, there are no clear black and white answers here, but I think a modified SIMPLE-IRA plan has merit in terms of cost efficiency and being in the “best interests” of plan participants in terms of providing protection and a meaningful chance to save for retirement.”

By Chuck Epstein

The Cost of Being Average

Investors are embracing indexing as a cheap guarantee against underperformance—but can they afford to abandon active management?

Art by Gérard DuBois

Nearly a decade ago, Warren Buffett made a bet: Over a ten-year period, and judged net-of-fees, the S&P 500 would beat a portfolio of actively managed hedge funds. Active investors, he argued, would, in aggregate, do just about average—so why not skip the fees and get those same average returns in the form of an index?

Almost ten years later, Buffett’s logic holds sound. With a little less than a year to go, the Oracle of Omaha is easily winning the million-dollar bet, thanks in part to an eight-year bull run in US equities. (Challenger Protégé Partners’ decision to go with funds-of-funds—layering additional fees on top of the existing hedge fund fees—did not help its cause.) Buffett is not the only investor to embrace average in recent years. Assets have flooded into passive strategies as investors—retail and institutional alike—have opted out of active management and into low-cost indexes. In 2016 alone, Morningstar reported a record $504.8 billion in asset flows to passive funds. Meanwhile, actively managed mutual funds suffered outflows of $340.1 billion as investors grew increasingly dissatisfied with paying high fees for low performance.

But even as allocations to indexes grow higher than ever, pure beta portfolios aren’t looking as good as they once did. In the early years of Buffett’s bet, the S&P 500 delivered double-digit returns as markets bounced back from the recession. But today, with allocators, managers, and consultants all predicting diminished gains in the years ahead, consensus estimates place future expected returns for a classic 60/40 portfolio at no better than 5%—well below the performance levels necessary to fund pensions and keep endowments around in perpetuity. Moreover, an aging bull run means heightened probability of volatility—putting index investors at risk of absorbing the full brunt of a significant drawdown.

Manager’s Performance in Bond Market (5-Year Returns)

Passive funds may, as Buffett argued, guarantee average results at minimum fees—but management fees aren’t the only premium associated with investing. What, then, is the true cost of being average?

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Let’s just get this out of the way: In pure expense ratio terms, indexes are a bargain. An index tracking the S&P 500—such as Buffett’s pick, the Vanguard 500—can be had for under 20 basis points, and other passive funds are similarly inexpensive compared to their actively managed counterparts. If you want broad exposure to a market segment, indexing is the cheapest way to go.

“The only sure thing in investing is fees,” says Jay Love, an Atlanta-based partner at Mercer Investment Consulting. “Excess returns are a maybe. Fees are definite. Trying to minimize fees is a good first step.”

Take into account the fact that the majority of active managers have underperformed the index in most markets over the past five years, according to S&P Dow Jones’ SPIVA database, and it makes sense that investors would turn to the cheaper alternative.

“If a cheap index is beating managers, why not just buy the index?” asks Tim Bruce, director of traditional research at NEPC. Index investors, he explains, got serious bang for their buck in the years immediately following the recession, when the S&P 500 grew rapidly as markets recovered.

“Starting in March of 2009, all you wanted to do was own the S&P 500,” he says. “It didn’t matter how cute you were with your managers and asset allocation—you would’ve done really well just by owning the S&P 500 and core bonds. Investors don’t have an unlimited tolerance for underperformance, so they gave it about three years before they said, ‘Okay, I’m done,’ and started taking money out of their active managers and just buying indexes.”

The result? Passive flows spiked in 2012—and have only continued to grow.

“There’s definitely been a continued flow of assets into passive strategies out of active strategies,” says Lori Heinel, chief portfolio strategist at State Street Global Investment Advisors (SSGA). “With fixed income in particular, we’ve seen more of an appetite and interest in passive approaches than there had been historically.”

Although the majority of asset owners still retain at least some active managers, there are those who have fully embraced passive. Take the Nevada Public Employees’ Retirement System (PERS), for example.

Since he was named CIO in 2012, pension chief Steve Edmundson has brought the $35 billion fund to 100% passive positions in its public markets allocations, which account for roughly 90% of the total portfolio. (A 10% private markets commitment, invested with private equity and private real estate managers, rounds out the fund.)

“We see indexing as the most efficient, cost-effective tool to get the market exposures that we’re looking for,” Edmundson says. The CIO is quick to point out he has nothing against active management per se—”We’re not making a statement that active management can’t beat indexing,” he says—it’s just that he believes the time and energy necessary for manager selection could be better spent elsewhere.

“Asset allocation is what drives—depending on what study you look at—in excess of 90% of investor returns,” Edmundson says. “We made an overt decision to focus on what’s going to drive our total fund returns.” With active managers, he adds, allocators often end up “handing over the keys” to asset allocation to some extent. Indexing provides the exact exposures Nevada PERS wants—and it’s inexpensive.

“We keep our fees among the lowest in the industry,” he says. So far, the strategy has proven successful. The fund returned 9.8% in the year ending in September 2016, with three- and five-year returns of 7.1% and 10.1%, respectively. Performance has been driven largely by the portfolio’s sizeable allocation to the S&P 500, which has continued to rise eight years into the current bull run. But while investing in the index has cost the pension very little in terms of fees, an un-hedged exposure to risky assets comes with a price. 

Manager’s Performance in Equity Market (5-Year Returns)

“We’re all always focused on returns, but we can’t forget to think about the risk side,” says Mark Baumgartner, CIO at the Institute for Advanced Study. “If we were just concerned about returns, we would have no trouble—we could just lever up a passive investment in equities and get whatever return number we want. The issue is that we’d be required to take unacceptable levels of risk to get those returns.”

For Baumgartner, as CIO of a sub-billion dollar endowment responsible for roughly two-thirds of his organization’s budget, “unacceptable” means risking a loss of more than 15% at any given time. With such a strict risk budget, he can’t afford to invest in indexes—regardless of how cheap the fees are. “By investing passively, you’re achieving your fee objective— you’re paying almost no fees,” he says. “But you may fail on your main objective, which is to deliver your return target at an appropriate level of risk.”

Being average might mean you never underperform the market—but it also means that when the market crashes, so does your portfolio. And today, with the market cycle growing older by the minute, and with volatility predictors like the Chicago Board Options Exchange’s SKEW Index reflecting heightened fears among investors, the risks inherent in passive investing are worth reexamining.

“There are a number of unknowns in the world,” SSGA’s Heinel says. “The policies of the new administration could certainly lead to some skittishness in the market; there’s a number of upcoming elections in the Eurozone; Brexit is still being sorted; there are concerns about a China slowdown. So there are clearly a number of risks out there that could lead to another drawdown, and it’s wise for investors to think about volatility and how that might impact them.” For example, passive investing may not always be in the best interests of a fully funded pension plan.

“Their primary worry isn’t returns; it’s losses,” says Bruce at NEPC. “Indexes are volatile, so if you’re trying make sure you don’t lose money, you’re tilting the lever closer toward active and you’re focusing on protecting against volatility.” On the other hand, the consultant adds, an underfunded pension has to be discerning about where it can splurge on active management.

“If you’re at the other end of the spectrum and you’re saying, ‘Listen, we’ve got to make some serious return here,’ then you’re definitely going to be more passive because you don’t want to pay the fees,” he says. “And where you are active, you have to focus on the highest return-seeking areas like private equity and emerging markets.” A passive portfolio like Nevada PERS might be more risky—but as Edmundson puts it, volatility is a price return-seeking investors have to pay.

“I don’t think anybody’s going to escape market volatility, whether they’re actively managed or indexed,” the CIO argues. “What’s going to be the deciding factor is how much of your fund is allocated to risk assets—and anyone with a total fund return objective north of 7% is going to have to embrace investing in volatile assets.”

What happens when return objectives become harder to achieve? Average is great in years like the period between 2009 and 2012, when returns were abundant. But what about in low-return environments? With just about everyone predicting diminished beta in the years ahead, the true cost of indexing may not be low fees or volatility, but a much higher price: insufficient outcomes.

“The expectation that I have, and that many have, for passive investments going forward is not strong,” Baumgartner says. “It’s a lower-than-typical return at higher-than-typical risk. You’re just going to have to look elsewhere for returns.”

Rob Manilla, CIO at the Kresge Foundation, agrees. “The reality is no matter whose forecast you use, no one has asset allocations that tend to earn 7.5% going forward,” he says. “So what are my choices? My choices are to take more risk, lever my portfolio, and find active management to make up that difference through alpha. Being average isn’t an option.”

“We’re not going to spend any time looking for active managers in efficient markets—but in markets that are less efficient, we spend a lot of time, energy and effort trying to find managers we think can generate alpha.”

Over the past decade, Manilla has succeeded in generating significant alpha in his equity portfolios by taking active bets in inefficient markets. Two-thirds of the Kresge Foundation’s domestic equity investments are in actively managed small-cap funds, while the foundation’s hefty emerging markets allocation is 100% actively managed through individual country mandates. The result? Annualized excess returns of 2% in US equities and 9% in emerging markets over the last ten years.

“We are big believers that active management can work in less-efficient markets, and it’s been proven out in our history,” Manilla says. “We’re not going to spend any time looking for active managers in efficient markets—but in markets that are less efficient, we spend a lot of time, energy and effort trying to find managers we think can generate alpha.”

The approach is in line with what consultants like NEPC and Mercer recommend as the best practices for active management: Stick to inefficient markets, find managers worth their fees, and make sure you know exactly why a strategy is going to work—because if you don’t know, it probably doesn’t work.

“Active management is difficult,” says Mercer’s Love. “It’s a zero-sum game. For everybody who outperforms, somebody underperforms, and just because you need higher returns doesn’t mean active management is going to give them to you. If you can’t identify why you’re going to win, you’re probably the loser.”

Even following all the rules doesn’t guarantee you’ll hit your return target. As Baumgartner points out, “true alpha” is difficult to find, and many funds face constraints that make excess returns hard to come by.

“We’re all challenged to meet our objectives, and when you add in investment constraints—if you’re geographically constrained or you can’t invest in certain stocks or your portfolio is of a size that a meaningful investment is too small to move the needle for you—all of those things make it even harder,” he says. “The likelihood of success for various organizations in the next five or ten years is very low in my mind, and it gets lower the bigger you get. The less alpha you can bring into the portfolio and the less diversification you have, the worse your outcome is potentially going to be.”

Size, it turns out, does matter—at least when it comes to active management. A small endowment like the Institute for Advanced Study or $3.5 billion fund like the Kresge Foundation can succeed in finding alpha because they are small enough to access it. But a mid-size pension plan like Nevada PERS isn’t so well-positioned.

“The larger your portfolio gets, the tougher it is to generate abovemarket returns,” Love says. “Somewhere after $10- or $15 billion there’s just not enough capacity in a lot of the more attractive areas or niche asset classes to put money to work in a meaningful way.” Buffett’s bet, after all, hinged on the idea that active investors are no better than average when taken in aggregate. The larger a fund, and the more managers necessary to fill an active mandate, the more the portfolio will resemble the aggregate—and the aggregate isn’t looking so great. As NEPC’s Bruce points out, the same 1% management fee on an active investment eats up a larger portion of the total return when the returns are under 5% then when they’re over 10%. At that point, why not just take the low-fee option? Indexing may not be enough to get returns to 7.5% in the coming years—but at least for some investors, it may still be their best bet.

In investing, as with everything, there are prices that must be paid. Sometimes it’s management fees. Sometimes it’s taking risk. And sometimes it’s recognizing that return expectations might not be realistic.

“We did a study a year ago that was kind of alarming,” Heinel says. “We asked 400 institutional investors globally what their expected portfolio returns were on a prospective basis, and the average was over 10%. By our own estimation, we think a balanced beta portfolio is likely to deliver something south of 5%. That’s a pretty big gap.”

The truth is the cost of meeting objectives is high, and getting higher. Passive investing or active management—neither method guarantees that pensions will be paid or endowments won’t shrink. But CIOs like Manilla and Edmundson aren’t giving up: They have something worth betting on. 

 

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