Square Pegs, Round Holes and ‘Convenient’ Conclusions

  Every so often a report comes along that says less about retirement policy than it does about the temptation to reduce complex issues to a simplistic scoreboard — that fits a particular agenda. 

Even if it amounts to jamming a square peg into a round hole.

This week’s entry comes from a report arguing that 401(k) plans without private equity and other alternative investments “significantly outperformed” pension plans that invested heavily in those alternatives. The implication, of course, is that pension plans — and perhaps the experts managing them — somehow got it wrong. More precisely, it takes to task the decision(s) by those once-vaunted defined benefit plans for having the temerity to invest in … private markets (gasp!). 

Now, there are plenty of reasons to approach the introduction of private markets to defined contribution plans with caution — and that was before the recent Labor Department proposal.[i] But any credible retirement plan professional understands that defined benefit and defined contribution plans have COMPLETELY different timeframes, objectives, and risk factors to consider. Comparing their returns[ii] without acknowledging those differences is a bit like comparing the performance of a fire department and an ambulance service based solely on fuel efficiency.

Technically measurable? Sure.

Useful? Not so much.

The report headlines with an assertion that DC plans’ “superior performance was a result of the defined contribution plans’ simpler portfolio mix, and the outperformance holds even when controlling for plan size and risk.” 

Yes, but. Defined contribution plans are accumulation vehicles. Their objective is largely straightforward: maximize participant account growth over time, subject to participant behavior and investment elections. Particularly over the past 15 years — a period dominated by one of the strongest public equity runs in modern history — that has proven to be a very favorable environment for equity-heavy portfolios. Oh, and they’re under the direction of millions of different individual savers, with widely divergent interests, needs, expertise and — attention spans.

To put it mildly, defined benefit plans operate under a different mandate entirely.

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They aren’t simply trying to maximize returns. They are trying to ensure that promised benefits can actually be paid — not just next quarter, but decades into the future. That means managing liabilities, liquidity needs, funded status volatility, cash flow demands, and demographic realities. Mature pension plans with large retiree populations often must maintain substantial allocations to fixed income and diversifying assets precisely because they have obligations that continue regardless of what the markets are doing.

And that, ironically enough, was once considered a virtue (see Goal Lines).

For years, many of the same voices now criticizing pension plan allocations celebrated the advantages of defined benefit investing: professional management, institutional discipline, diversification, long-term investing, risk pooling, and access to asset classes unavailable to most individual investors.

Pension plans were often held up as examples of how retirement investing should work — insulated from participant panic, emotional trading, and the limitations of retail investing.  To this day many industry experts promote shifts toward the DB-ification of DC plans.

Now, after a prolonged bull market in public equities, the narrative has, apparently, shifted.

Suddenly, diversification is evidence of caution. Liability management is evidence of underperformance. And 401(k) plans — once criticized for placing too much responsibility and risk on individual workers — are being celebrated for the very market exposure that once made them suspect.

Funny how market cycles can reshape philosophy.

The report’s comparison period also matters. Measuring outcomes beginning in 2009 effectively captures nearly the entirety of the post-financial crisis equity surge. In hindsight, portfolios with heavier public equity exposure were almost destined to look superior over that period.

Then again, hindsight has always been the easiest investment strategy.

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None of this is to argue that pension plans are beyond criticism, or that alternative investments always justify their fees or complexity. Reasonable people can debate those questions — and should.

But treating pension plans and 401(k)s[iii] as though they are interchangeable investment products competing for quarterly bragging rights misses the larger point.

Let’s face it — the gap in investment returns may well have something to do with the allocation to private market investments at a particular point in time. But the commonsense conclusion is that the real explanation goes so far beyond that that the comparison is … ludicrous. One can only imagine that those resharing the headline of this particular report seem only to care about the conclusion it draws, rather than the arguably shaky foundation upon which it was based.

The real issue here isn't whether the square peg or the round hole is somehow superior. It's the insistence on forcing one into the other and then declaring victory even when the fit looks awkward.

Sometimes a square peg is supposed to be square. And sometimes the problem isn't the peg at all — it's who’s holding the hammer — and why.

• Nevin E. Adams, JD

 

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[i] Which, for my money, mostly reminds us just how complicated and fraught with concerns that process is. See Talking Points: Retirement Income, Defaults and Fiduciary Duty.

[ii] Not to mention blurring the potential distinctive differences between all the defined benefit plans and all the various defined contribution plans that are being aggregated together to get those (gulp) AVERAGE results.

[iii] Not to mention the vast array of plan types being “mushed” together to derive these conclusions: “Using complete Form 5500 filings for all open U.S. private sector defined benefit plans and all defined contribution plans (over 58,000 plans, $7.7 trillion in combined assets) between 2009 and 2024, and incorporating verified return data for U.S. state and local public pension systems from the Public Plans Database…”

 

A PEP-spective on Fiduciary Reviews

  Some months back, the Labor Department published an intriguing three-part “proposed rule” that, to my eye, offered helpful fiduciary tips that go well beyond pooled employer plans (PEPs).

The title alone — “Pooled Employer Plans: Big Plans for Small Businesses” — told you all you needed to know about the motives behind the publication. And, true to form, both the data provided on the current state of pooled employer plan adoption and the focus of the request for information (RFI) included were very much in the spirit of removing barriers to PEP adoption, if not outright promotion of the same.

But what I viewed as the third part of the publication (though it’s labeled V. Fiduciary Tips for Small Employers Selecting a PEP) was, to my eye, the most intriguing aspect, in no small part because it served as a valuable reminder that there ARE fiduciary considerations in making that choice — something that purveyors of that option have been known to gloss over.

As I was recently scanning these — it occurred to me that these admonitions could — and should — be broadly applied to pretty much any new plan option — and not just for small employers.

To that end, consider the following as a fill-in-the-blank template, replacing the word PEP with, say — alternative investments, cryptocurrency, retirement income, or a managed account. Consider:

The Considerations

1. Consider what ________ [i] has to offer you and your employees.

The PEP-focused explanation emphasizes an opportunity to leverage economies of scale, as well as to free up time for plan fiduciaries to run their business “…while simultaneously providing your employees with an opportunity to save and achieve retirement security.”  While that buries the lead a bit, it’s a reminder that your actions need to be prudent and in the best interests of plan participants and beneficiaries” — but mostly a reminder to consider the benefits and costs of the service(s) under consideration.

• Make sure you understand the type of ____________ under consideration.

The PEP-focused explanation notes that, while this option has certain things in common, they aren’t all the same, and don’t operate in the same way — that plan fiduciaries should consider the needs and best fit, and the importance of considering several before making a choice. The same thing is true with pretty much every option that might be under consideration, as the labels retirement income, alternative investments, and managed accounts are widely applied to very different products and operational considerations.

• Make sure you consider the experience and qualifications of the _______.

While the pooled plan provider (PPP) is mentioned here, every service offering is delivered by a provider of some type, and as this tip reminds, “understanding the experience and qualifications” of this entity “…is one of the most important — if not the single most important — aspects….” That means you need to ask and understand “questions relating to the quality of their services, customer satisfaction, prior litigation or government enforcement matters…” as well as “the number of employers and participants in the plan and the amount of its assets….” Basically, you want to make sure that the entity is capable — and has a track record — to fulfill the promises that have been made, and the needs of your plan.

• Make sure you ask questions about ________ fees.

This one really doesn’t need any more explanation, other than a reminder not only to find out what the fees are and who pays them, but also who is getting paid, notably any third parties — or third parties that might be providing compensation to the provider you’ve hired.

• Make sure you understand the investment options.

Of course, for some of the possibilities noted above, this (alternative investments, crypto) is the investment option under consideration and definitely should be understood. Ditto retirement income, which comes in many shapes and sizes (and was recently included in the executive order regarding alternative investments).

• Ask questions about your exposure to fiduciary liability for investments.
• Ask questions about your exposure to fiduciary liability should you join _____.
• Don't forget to monitor ________ on an ongoing basis.

One of the interesting call outs in the PEP document was that “under federal law, employers joining a PEP are legally responsible as fiduciaries for the proper selection of investment options for their employees unless the pooled plan provider hires an investment professional to act as a fiduciary with respect to investment selection.”  Interesting in that, again, some of the purveyors of those options have tended to gloss over/downplay this aspect.

That said it’s good to remember that, barring some kind of special provision, you are personally liable for the prudent selection and ongoing monitoring of all plan investments and services. All of which are embodied in the three tips listed above.

• Make sure you fully inquire about the implications of exiting _____.

I’ve heard it said that it’s a lot easier to get INTO a PEP than to get out of it (though that may just be a nasty rumor, and is doubtless a function of the PEP you have gotten into) — but the same could apply to any number of the other services outlined above, notably retirement income and alternative investments.

The tip here notes that it’s good to ask about any timing or penalty-imposed restrictions from a PEP, but similar impediments might, of course, be found with retirement income or different types of alternative investments. The bottom line here is that while you may not need to exercise an “exit” strategy, you need to know what the implications for the plan and participants would be if it came to that.

In Sum

So there in a nutshell you have it. For any/every product service being considered, make sure you know what benefits/costs it brings to the plan/participants, the capabilities/sustainability of the entity providing it, the fees (and who’s getting them), the process/costs for exiting — and that you have an ongoing personal liability/responsibility for monitoring the services, once engaged.

• Nevin E. Adams, JD

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[i] Just fill in the blank with the applicable service/product under consideration: managed account, retirement income, alternative investments, crypto, etc.

Between a Rock and a Hard Place

  Plan fiduciaries might well have gotten a case of severe whiplash last week.

I’m referring of course to the dual announcements from the Labor Department (a) rescinding its previous position on cryptocurrency in retirement plans and (b) indicating  that it in some fashion plans to review/change the current so-called ESG rule through a formal regulatory notice-and-comment period — presumably rather than defend the current version which had been challenged in court. That, and any day now it’s expected that the Administration will (similarly) soften, if not shift, its previous take on private equity investments in defined contribution plans.

Doubtless many are cheering these new developments; others, of course, will see this as either a danger, or a diminution of fiduciary responsibility. And some, surely, will like one, but not the other. 

Regardless, if you’re a plan fiduciary trying to figure out what is right and prudent to consider as plan investments — well, by any rational measure these shifts are abrupt, if not contradictory in effect if not purpose.   

Now, admittedly the world has changed since the Labor Department first staked out positions on these matters — markets have matured, definitions (notably ESG) have “evolved,” and while time inevitably allows us to review past experiences in a different light — we all know what has actually happened is that the Trump Administration looks at the world of retirement plans (and markets generally) differently than the Biden or Obama and even the Bush Administration(s). And even if the standards of conduct established by ERISA haven’t changed, the application of those standards apparently has. Yes, over the course of time and experience, as you would hope/expect, but more accurately over the course of change in administrations.

Worse, we live in a time when the plaintiffs’ bar — without a hint of irony — manage to find fault both with failing to add a stable value option, and the decision to add one rather than a money market alternative, to challenge as imprudent target-date funds that don’t mirror the (different) glidepaths of the rest of the “pack,” or to claim that following the legal terms of the plan document in forfeiture dispositions runs afoul of one’s fiduciary obligations. 

Add to that the growing industry chorus that a less-than-active consideration of mechanisms like in-plan retirement income constitutes a failure to consider “best interests” — and it’s no wonder that prudent plan fiduciaries feel themselves stranded in the middle of a “damned whether you do – or not” minefield.

The reality is that plan fiduciaries have always had to thread a needle of sorts; trying to act solely in the best interests of participants on matters in which they often lack the requisite expertise to make that evaluation — and in matters for which they bear personal responsibility. It’s why many do — and all arguably should — tap into the insights and experience of those who have that expertise. 

But in this “rock and a hard place” environment, you can’t fault plan fiduciaries for choosing to avoid or defer making big changes in plan design when the rules — and rule makers — change so abruptly.

• Nevin E. Adams, JD

7 Things to Know About the New ESG Regulation

A little more than a week ago, the U.S. Department of Labor unveiled its much-anticipated final ESG rule.  There’s a lot to unpack in that regulation (and the rest of the 236-pages that help explain its process and rationale), but here’s a few things that seem particularly important to note at the outset.

There are some (important) things that did NOT change.

First, and to my mind, foremost, the Labor Department noted that “The duties of prudence and loyalty require ERISA plan fiduciaries to focus on relevant risk-return factors and not subordinate the interests of participants and beneficiaries (such as by sacrificing investment returns or taking on additional investment risk) to objectives unrelated to the provision of benefits under the plan.

But it also included an important clarification:

“…the final rule amends the current regulation to make it clear that a fiduciary’s determination with respect to an investment or investment course of action must be based on factors that the fiduciary reasonably determines are relevant to a risk and return analysis and that such factors may (emphasis mine) include the economic effects of climate change and other environmental, social, or governance factors on the particular investment or investment course of action.”

It does away with “pecuniary” as a standard (or at least as a word claiming to be the standard).

The Trump Administration’s version defined pecuniary (a term “introduced” to the ERISA lexicon by the United States Supreme Court in the Fifth Third v. Dudenhoefer decision[i]) as “a factor that a fiduciary prudently determines is expected to have a material effect on the risk and/or return of an investment based on appropriate investment horizons consistent with the plan’s investment objectives and the funding policy established pursuant to section 402(b)(1) of ERISA.” 

However, that word choice was determined by the Labor Department to be causing “confusion” and to have a “chilling effect” — “deterring fiduciaries from taking steps that other marketplace investors would take in enhancing investment value and performance, or improving investment portfolio resilience against the potential financial risks and impacts associated with climate change and other ESG factors.”

However, and despite what some saw as an implication in the proposed regulation, the final regulation does NOT mandate consideration of ESG factors.

Quite the contrary—quoting from the Labor Department:

“The final rule makes unambiguous that it is not establishing a mandate that ESG factors are relevant under every circumstance, nor is it creating an incentive for a fiduciary to put a thumb on the scale in favor of ESG factors.” 

“Outside the ERISA context, investors may choose to invest in funds that promote collateral objectives, and even choose to sacrifice return or increase risk to achieve those objectives. Such conduct, however, would be impermissible for ERISA plan fiduciaries, who cannot sacrifice return or increase risk for the purpose of promoting collateral goals unrelated to the economic interests of plan participants in their benefits.”

It treats QDIAs just like any other investment option in the plan.

The Trump Administration in its preliminary regulation had barred funds with an ESG focus from qualifying as a qualified default investment alternative (QDIA), and then—following criticism on that front—in its final regulation modified the provision in the proposal on QDIAs to prohibit plans from adding or retaining any investment fund, product, or model portfolio as a QDIA or as a component of such a default investment alternative, if its objectives, goals or principal investment strategies include the use of non-pecuniary factors.

The new regulation removes that distinction, noting that “QDIAs would continue to be subject to the same legal standards under the final rule as all other investments, including the prohibition against subordinating the interests of participants and beneficiaries in their retirement income to other objectives. QDIAs also would continue to be subject to the separate protections of the QDIA regulation.”

That said, the Labor Department says it expects to see an increase in the number of QDIAs that are ESG funds—though, considering the number currently in the market (and there are some), that hardly seems a controversial call.

Eliminated additional disclosure/labeling requirements associated with alternative investments with collateral benefits.

The Trump era regulation imposed a requirement that competing investments be indistinguishable based solely on pecuniary factors before you could turn to collateral factors to break a tie—oh, and even then, you would have had to comply with a special documentation requirement on the use of such factors.

The final rule, on the other hand, replaces that with a standard that instead requires the fiduciary to conclude prudently that competing investments, or competing investment courses of action, equally serve the financial interests of the plan over the appropriate time horizon—and, having determined that they equally serve those goals, is not prohibited from selecting the investment, or investment course of action (like an ESG focus), based on collateral benefits other than investment returns. 

And they no longer have to document that evaluation (which, interestingly enough, turns out to be one of the cost benefits[ii] associated with the new rule). 

Participant preferences can (still) play a role in menu design.

Now, in my experience, plan sponsors (and advisors) have long considered participant preferences in menu design. Not to the subordination of prudent fiduciary standards, of course—though there have been concerns that some might not see it that way. 

Well, the new regulation contains a new and interesting provision that “clarifies” that fiduciaries “do not violate their duty of loyalty solely because they take participants’ preferences into account when constructing a menu of prudent investment options for participant-directed individual account plans. If accommodating participants’ preferences will lead to greater participation and higher deferral rates, as suggested by commenters, then it could lead to greater retirement security."

Now, notice that while such considerations don’t necessarily violate the duty of loyalty—but there is no setting aside of the standards of prudence in evaluating and monitoring those investments noted above.  More specifically, those decisions need to be evaluated “taking into consideration the risk of loss and the opportunity for gain” compared to the opportunity for gain “with reasonably available alternatives with similar risks.”   

As noted above, there’s a lot to unpack here—and we’ll continue to do so right up to the Jan. 30, 2023 effective date—and beyond.

- Nevin E. Adams, JD

 

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[i] In that case, the nation’s highest court concluded that the responsibilities of an ESOP fiduciary must be directed toward the duty to provide benefits and defray expenses—and that any non-pecuniary interests, such as Congress' strong encouragement of employee stock ownership, did not warrant an alteration of the fiduciary standard.  

[ii] Noting that in view of the “large scale of investments held by covered plans, approximately $12.0 trillion, changes in investment decisions and/or plan performance may result in changes in returns in excess of $100 million in a given year,” the Labor Department estimates that 20% of defined contribution and defined benefit plans (149,300 plans with some 28.5 million participants) will be affected by the regulation “because their fiduciaries consider or will begin considering climate change or other ESG factors when selecting investments.” In the Labor Department’s estimation, for each plan, a “legal professional will need to review paragraphs (b)-(c) of the final rule, evaluate how these provisions might affect their investment practices and assess whether the plan will need to make changes to investment practices. The Department estimates that this review will take a legal professional approximately four hours to complete, resulting in an aggregate cost burden of approximately $91.5 million or a per-plan cost burden of approximately $613.[ii]”

That said, the Labor Department noted that plan fiduciaries “generally already undertake deliberative evaluations as part of their investment selection decision-making process and this final rule does not add burden to those deliberations; but rather, the final rule clarifies that the scope of those deliberations may include climate change and other ESG factors within the confines of paragraphs (b)(4) and (c)(1) of the final rule. The Department does not intend to increase fiduciaries’ burden of care attendant to such consideration; therefore, no incremental costs are estimated for these requirements.”