Sub-prime Time

Here we go again.

I’ve been in this business long enough to call to mind several big financial scandals. Not Enron and WorldCom types—ultimately, those were, to my way of thinking, pretty isolated cases, albeit driven by the motivation that seems to drive all financial scandals: greed and hubris.

However, over the past couple of weeks, retirement savings balances have been buffeted about by concerns about liquidity in the market, triggered by issues regarding institutions that have (apparently) loaned money to people that were based on property values that were projected to go up—when they haven’t. The problem, of course, isn’t just people being overextended on their mortgages (though that is a problem), or the firms that have allowed that situation to occur (though that is also a problem); it’s that the latter have created a whole category of investments that consist of those unraveling mortgage commitments—and lots of us have money tied up in those investments – or impacted by money tied up in those investments - whether we know it or not.

Signs of Trouble

It’s not like we couldn’t see this coming. People have been wringing their hands about the housing bubble bursting for quite some time now. Just like we did about junk bonds (before we called them “high-yield”), derivatives (before we started referring to them as “alternative” investments), and hedge funds (which are also sometimes called alternative investments, but here mainly because, IMHO, many have really been alternatives TO investing, à la betting against the market). Now, I’ll concede that the latter hasn’t imploded yet, at least not on a broad-scale, but the signs are all there, and we’ve already seen a couple “blow up.” But, as for our most recent problem, let’s be honest with ourselves—those who buy into (or take on) something called “subprime” certainly can’t plausibly say they didn’t see the potential for problems.

None of this is inherently bad, of course. Part of the beauty of our free market system lies in its ability to create new ways for innovative minds to raise capital and make money. Where we get into trouble is (a) when everybody “catches on” to the latest idea (thus drying up much or all of the opportunity), and (b) when “they” do so via “leverage”—that is, spending money they don’t have. Now, leverage, too, can be an enabling thing, but when everybody is doing it, well, sooner or later, the people who lend money always seem to want to be repaid—and, generally speaking, when the collateral that supports such investments can least afford that demand.

Not that that rationalization is likely to be of much solace to the retirement plan participants whose accounts are currently taking it on the chin, however. It’s not their fault (unless, of course, they contributed to the problem by taking out a mortgage they couldn’t afford, betting on the continued rise in house prices—just another form of borrowing money you don’t have), and yet they, as investors in and beneficiaries of the investment markets, must ride out the bad as well as the good.

The current “tumult” (we seem to be past the “crisis” stage, at least for the moment) should serve to remind us all of the dangers. You already may be hearing questions from plan sponsors and participants—about what is going on in the markets, about what has happened to their account balances—maybe even about what you recommend they should do about it all.

Questions are good. It means people are paying attention. But wouldn’t it be nice if the people who created these crises did - - - before they got to be the people who create these crisis?

- Nevin E. Adams, JD

PPA's SWAY

These days, the Pension Protection Act of 2006 (PPA) is sometimes referred to as the “Pension Destruction Act.” That’s too harsh an assessment, IMHO, but it certainly has a foundation in reality.

Without question, the PPA (it was just a year ago Friday that President Bush signed the legislation into law) imposed some new—and for many plans, harsh—restrictions on funding and accounting for funding. Additionally, it did so after many of the worst offenders and abusers of the system were already “out” (legislation frequently closes the barn door after the cow has escaped), and it did so at a time when many plans seemed particularly vulnerable, and many through no real fault of their own.

We may never know how many problems were averted by its passage—and by the time its new defined benefit provisions took hold, investment markets, interest rates, and contribution levels had combined to make the problems confronting pension plans much less severe than they were at the time of the law’s passage. Mind you, I’m not prepared to say that it protected any pensions, but it probably didn’t—on its own, anyway—trigger the early demise of many programs, either (though it may have accelerated the deliberations). Moreover, the PPA’s explicit sanction of the cash balance design, by some accounts, has given a new lease on life to that hybrid approach, at least in some market segments.

Defined Contribution Impact

As for defined contribution plans, I think the PPA did some good in putting structure around some of the “automatic” solutions, and, for the very most part, took into account some of the aspects of those programs that needed tending to; notably state wage law preemption and the ability to return those “mistaken” contributions. We now have some discrimination testing relief for plans that adopt the automatic enrollment approach codified in the PPA, and if some find the matching contribution requirement too expensive, the contribution acceleration provision distasteful, or the testing relief unnecessary (current safe harbor plans already enjoy much of that relief)—well, it’s optional, after all, not mandatory. If you like automatic enrollment, but not the PPA’s particular flavor, nothing prevents you from implementing your own version. As for the qualified default investment alternative—well, the DoL was working on this ahead of the PPA. Ironically, passage of the PPA may have actually slowed the timing of this particular enhancement—but we’ll have clarity soon enough.

The PPA’s participant notification requirements have been something of a burden, and almost certainly aren’t the aid to participant clarification that they ostensibly were mandated to provide. As for the concept of a fiduciary adviser—well, there’s perhaps not as much precise clarity there as some would prefer. But we do now understand (from the PPA and FAB 2007-01) that the plan sponsor’s fiduciary responsibility is for the selection/monitoring of the adviser, not the advice provided—and for many plan sponsors (and no doubt many advisers), that’s a welcome clarification. And within the guidelines of the PPA, there is another way for qualified fiduciary advisers to be compensated for their services.

Of course, almost overlooked in all the attention paid to the new tools included in the PPA is the fact that it removed the legislative “sunset” on an enormous number of crucial provisions of the Economic Growth and Tax Relief Reconciliation Act of 2001—EGTRRA—including the Roth 401(k), increased contribution limits, repeal of the multiple use test, and modification of the top-heavy rules.

All in all, there may not be much “protection” in the Pension Protection Act—but, IMHO, there’s still a lot of good to be found there.

- Nevin E. Adams, JD

Incentives Eyed

We don’t have a large yard, but it’s big enough to be “unruly.” Despite my best efforts to ignore the unruliness (winter’s coming, after all), my wife—who thinks about things like having a yard that looks like we were in Cabo for the summer—was of a different mind.

While there are three teenagers living under our roof at present, we long ago realized that we couldn’t rely on them to see that something needs doing, much less to, on their own initiative, undertake to do something about it (dads can be pretty oblivious as well, but teenagers give a whole new meaning to the notion). They CAN, however, be bribed—er, “motivated”—and their mother made them an offer it would be hard to refuse; cold, hard cash. And while it was a sum well short of what we’d have to pay one of the ubiquitous yard services that swarm through our neighborhood, it was a lot of money to cash-starved teenagers. And it appears to be working.

What's In It For Them?

I was talking to an investment analyst this past week, and after a long conversation about automatic enrollment, QDIA prospects, discrimination testing, and how many working Americans were (and weren’t) covered by a workplace retirement plan (even today, less than half are, incredibly), he posed a simple question: “So, what’s in the Pension Protection Act that would encourage an employer to set up a 401(k) plan?”

I pondered that question for a moment before I finally—and somewhat hesitantly—offered, “Nothing, really.” Now, I went on to talk about the things that were in the PPA that might make it easier for plan sponsors who currently offer a program to continue doing so: how design “sanctions” like the automatic enrollment safe harbor could surely help on troublesome aspects like participation rates and discrimination tests; how the emergence of a true, clear definition of a qualified default investment alternative (QDIA) could remove some of the uncertainty behind some of the toughest decisions for plan sponsors; how access to professional help via the new financial adviser role might make it easier for participants to make better decisions. Still, when I stopped to think about it, I couldn’t imagine that any of those “new” approaches would have any sway in convincing an employer who didn’t already offer such a program to do so.

That’s a real problem for the retirement security of this country, of course. As I noted above, the Bureau of Labor Statistics says that only about 43% of working Americans are covered by a workplace retirement program today. While we rightly spend much time and energy worrying about the savings habits of those 43%, we are literally missing the big picture if we ignore the reality that a majority of working Americans lack the support of the kind of retirement programs many of us take for granted.

Why Knots?

There are reasons for employers to offer these programs, of course—potential workers care about them, and current workers often stick around for these benefits. Employers do receive some tax benefits for offering them as well, though in many cases, perhaps not enough benefit to counter the costs associated with sponsoring the program, not to mention the fiduciary risks attendant with choosing to do so.

IMHO, we tend to take for granted that employers will “do the right thing”; that they will simply care enough about their workers to take on these additional costs and risks. Fortunately, many do—but just as obviously, while they can clearly see the need, like my teenagers, they have other priorities (in fairness, those priorities frequently include “little” things like meeting a payroll). There are those in Washington who already are taking a hard look at the numbers of working Americans not covered by a workplace program and looking for ways to balance that out, to “level the field.”

Unfortunately, for some, that doesn’t involve encouraging more employers to get in, it means developing alternatives that don’t require the involvement of an employer; and some, I’m sure, would be perfectly content to take the existing enticements, such as they are, away altogether and—in an ironic display of nonpartisanship—rely solely on individual initiative or the support of the federal government. Either direction would, IMHO, serve only to encourage employers who are currently providing such programs to rethink that commitment, and the rumblings certainly do nothing to engender interest on the part of employers who aren’t currently doing so from changing that position.

Still, we can all attest to the tremendous impact of workplace retirement plans in helping ensure individual retirement security, whether it is through workplace education, the employer match, and even “peer pressure” in terms of encouraging participation. What we seem to have lost along the way is a sense that we need to provide incentives to employers to make that commitment.

Failing those incentives, is it any wonder that so many are still on the sidelines?

- Nevin E. Adams, JD