Investment Consulting November 4, 2008 Washington State Transit Insurance Pool Governmental Defined...

Investment Consulting

November 4, 2008Washington State Transit Insurance Pool

Governmental Defined Contribution Retirement Plan Sponsors and Fiduciary Responsibility in 2008

Greg SettleVice President

Aon Investment Consulting1420 Fifth Avenue, Suite 1200

Seattle, WA 98101


I. Governmental DC Plan Sponsors and Fiduciary Duties– Status November 2008: Where we are today– How we got here: History of public retirement plan evolution, the

legal/regulatory environment and fiduciary awareness– Attributes of the typical “Vendor Driven” Defined Contribution Plan– The Vendor Driven Plan and Fiduciary Responsibility

II. Proven Practices in Addressing Fiduciary Issues– A Well-Trodden Path– The Rise of the “Fiduciary Driven” Plan– Process for creating a Fiduciary Driven Plan– Case Study: Investment Utilization in a Vendor-Driven Plan– About DC Plan Industry Fees– First Steps to Demonstrating Fiduciary Oversight

Today’s Agenda


I. Governmental Retirement Plan Sponsors and Fiduciary Duties


Where We Are Today…• The Public Sector’s primary defined contribution (DC) retirement plan, the

“457 Deferred Compensation Plan”, has matured in terms of assets and participation

• Many local governments have also adopted 401(a) DC plans

• There has been remarkable technological innovation in the DC industry, which has increased expectations from plan sponsors and created new capabilities in plan design, investments and features, and reduced costs

• Both private and public sector defined contribution plans have been the subject of increasing legislative and regulatory attention, as well as litigation… mostly regarding fees and quality of oversight

• For all these reasons, there is increasing recognition of the responsibility of, and risk to, retirement plan sponsors: “Fiduciaries”


What is a “Fiduciary?”• Those persons who:

– Exercise discretionary authority over plan assets (as in choosing/retaining a vendor or plan investment vehicles)

– Have discretionary authority in the administration of the plan– Appoint or remove individuals who exercise either of these functions

• A person may be a fiduciary through appointment, or though performance of a fiduciary function

• The “Exclusive Benefit” Rule:– “Plan fiduciaries are required to discharge their duties for the

exclusive benefit of participants and beneficiaries of the plan”

Fiduciary standards derive from State law, though ERISA standards are often seen as a model for guidance


• The “Prudent Expert Rule”– To act “with the care, skill, prudence, and diligence under the

circumstances then prevailing that a prudent man, acting in a like capacity and familiar with such matters, would use in the conduct of an enterprise of a like character and with like aims.”

– This is the ERISA version, stricter than the traditional “prudent man rule” which is measured against the “prudent average person”

– For Public sector plan fiduciaries, even though not subject to ERISA, it is probably wise to assume that the Prudent Expert Rule is the standard to which you would be held…

Definitions of Fiduciary Responsibility


• Most 457 plans (and 401(a) plans) began in the early 1980’s

• They were often viewed as a payroll slot/convenience, rather than as a “retirement plan”

• Originally, almost all 457 plans were purely voluntary- no employer contributions

• Few employers thought about oversight, as assets were few and account balances were small

• It was a world dominated by “Vendor-Driven Plans”, with no virtually no customization and little plan sponsor understanding of fees or alternatives in program design

A Brief History of Public Sector Plans…


• Assets and average account balances are up- often exceeding $50,000– Up from $30,000’s just a few years ago, even with recent market losses– Many participant balances exceed $400,000

• There’s been a technological revolution in plan administration– Costs have been cut dramatically – Makes plan customization and investing tools affordable for many– Most vendors can now offer funds from a universe of thousands instead of a few

• Many plans now include employer contributions– Particularly when “replacing” Social Security or a defined benefit plan– Implied higher level of fiduciary obligation

• There is increasing scrutiny of defined contribution plans of all types– Congress and DOL looking at outcomes and issues in DC plans– Class action and other lawsuit activity at all types of DC plans

But things have changed…


• “Voluntary Participation Only” plans have unique characteristics– Participants “self-select” and are more likely to be financially literate– Failing to participate does not necessarily imply a “loss of value”– The Plan Sponsor still has a duty to offer a sound program

• “Employer Contribution” 457 and 401 plans have multiple implications– Disinterested, financially under-educated employees participate as well– Failure to participate has a real economic cost– Failure to invest appropriately has costs as well– Assets, participation and average account balances tend to be higher

• Plans that are employer funded in the absence of other benefit programs have special responsibilities– Social Security “replacement” plans– Defined Contribution Plans that are utilized instead of DB Plans (PERS)– Other funding sources of DC plans derived from trade-offs affecting other

benefit arrangements

On the Rise: Employer Funded Plans


The Evolution of Plan Sponsor Fiduciary Awareness in the Public Sector

• 1994: Orange County, CA Bankruptcy Issue: Threatened 457 Plan assets, leading to a new era of scrutiny and legislation for public plans

• Federal laws passed in 1996 “rang the bell”, as 457 plan assets were transitioned from being general employer assets to “assets held exclusively for the benefit of participants and their beneficiaries”

• In 2001 EGTRRA was passed, further reducing the differences between private 401(k) plans and public sector 457 plans

• By 2002 many larger public employers had begun to recognize their fiduciary obligations and taken steps to address them

• Many of these began to adopt processes and policies developed for ERISA-governed 401(k) Plans


2006-2008: Defined Contribution Plan Sponsors Face Increasing Regulation and Legal Action

• Pension Protection Act of 2006: Generally seen as urging ERISA Plan Sponsors to go beyond a focus on “Good Process” to a focus on “Good Out-Comes”

• Regulatory activity and legal actions in the DC world are on the increase, with multiple class action lawsuits in 2006-2007, mostly focused on fees and fee disclosure in 401(k) , 457 and 403(b) plans

• 403(b) Plan Regulation- A mandate from Congress to “make 403(b) plans look more like private sector 401(k) plans”; IRS issues new regs requiring plan documents, etc.

• May 2008: GFOA releases “Recommended Practice” piece urging employers to get on top of plan fees and other aspects of their 457 and 401(a) defined contribution plans.


Why ERISA Matters

• ERISA: Employee Retirement Income Security Act (1974)– Defines Department Of Labor (DOL) rules for private sector qualified plans– Continuously updated and interpreted through the DOL, courts and legislature– Provides “safe harbor” provisions to protect employers from litigation if they follow

specific guidelines regarding plan oversight, investments, process and education

• Governmental plans are exempt from ERISA, but…– It provides a convenient, clear and high-profile standard for employers to follow– In the absence of clear statutory guidance, courts may look to it as well– In the absence of other guidance, it is what most large public employers are following

• States rarely have clear alternative law in place– Exception: California has set fiduciary standards for public plans, resemble ERISA– Other standards of care exist, found in common law and various state statutes– The “Prudent Man” rule, and the “Prudent Expert” rule


Attributes of the common “Vendor-Driven” Plan

• Standardized, “One Size Fits All”, retail-style product

• Core investment offerings are often heavily weighted to the vendor’s own fund family and other proprietary investment products

• Fees tend to be dictated rather than negotiated, and are poorly understood by both participants and plan sponsors

• There is seldom any independent professional review of investment performance, service delivery and features

• Multi-vendor plans are common, though inefficient


“Multi-Vendorism”• Arose because:

– It was the only way to increase investment options in the 80’s and 90’s– Allowed for more distribution flexibility under pre-EGTRRA law– As a way to gain better participant services (in theory)– Sometimes, due to relationships and other non-plan considerations

• Weaknesses:– Complexity, more work for HR and Payroll staff– Competitive environment focuses vendors on sales instead of education– Promotes investment selection driven by marketing rather than logic– Confusion for participants– Higher cost, due to weaker economics for each vendor

• No longer the preferred model because:– Distribution flexibility issue was eliminated by EGTRRA– Modern programs provide broad investment choice with a single vendor– Recognition that plan structure should be dictated by sound fiduciary

analysis, rather than or other considerations– Participant counseling and education can now be better tailored to meet

employee needs with a single vendor


The Vendor-Driven Plan Structureand Fiduciary Duties, Liability and Risk

• Employer cursory oversight allows vendors of plan administration, record-keeping and investments to essentially “evaluate themselves”

• Most plan administration vendors will not assume any fiduciary responsibility

• Most vendors cannot serve as the Plan’s investment advisor, as they are retailers of investment products, creating a potential conflict of interest

• The employer retains the majority of fiduciary liability and is ultimately responsible for selection of all Plan investments and services

• To reduce this risk and enhance their plans, many employers are turning to a “Fiduciary-Driven” approach, similar to that often found in the private sector


II. Proven Practices in Addressing Fiduciary Responsibilities and Duties


Adopting a Fiduciary-Driven Approach:A Well Trodden Path

• It’s the only rational approach, if leaving “nobody” in charge is not a viable solution

• Don’t Panic! Others have done the hard, pioneering work– Over two dozen Northwest cities, counties and special districts– Hundreds of public sector employers nationwide

• Northwest examples include:– Cities of Anchorage, Seattle, Portland, Tacoma, and Spokane– Counties of King, Pierce, Multnomah, Lane, Clark and Clackamas– Smaller cities like Redmond, Gresham, Eugene and Bellevue


• Based on analysis of 108 NW Governments and Special Districts, excluding schools and hospitals

2008: Percentage of NW Public Employers Who Have Adopted a Fiduciary-

Driven Approach for their DC Plans, by Plan Asset Size in $ Millions

18

0102030405060708090

100

$100+ 80-100 60-79 40-59 20-39 1O-19


Process for Adopting a Fiduciary-Driven Approach

1. The Plan Sponsor recognizes its fiduciary role and decides to takes steps to meet its fiduciary obligations and minimize risk

2. An oversight committee is formed and educated– Fiduciary education is conducted– Training about Plan rules and investments– Education about modern industry best practices, features and services

3. The Committee adopts processes and policies to assure oversight of the Plan and document its activities. These should include:– Create a Committee Mission Statement – Take minutes of all Committee meetings– Create A Statement of Investment Policy


Process for Adopting a Fiduciary-Driven Approach (Cont.)

4. The Committee conducts an independent review of the Plan– Investment array structure and content– Investment performance benchmarking– Program fees and expense analysis and benchmarking– Review of features, education and services vs. modern industry

standards

5. Most often, a revised program emerges from this process– Through RFP or RFI to existing vendors– Streamlined, logically designed investment array– Lower participant fees– Customized education and service package

6. The Committee goes forward with on-going monitoring and maintenance of the Plan


More than a Risk-Management Exercise: An Opportunity for Real Plan Improvements

• Investments– Avoid unwarranted domination of fund array by proprietary products– Eliminate needless duplication and confusion– Weed out poor performers and high expense ratios– Build a complimentary core of funds that strive to be “best in class”

• Plan Services and Features– Choose services and features that fit your agency’s demographics and

retirement plan environment– Avoid vendor programs and features that fit their agenda more than yours– Implement on-site education and counseling that meets your needs

• Fees and Expenses– Choose fee structure that fits your circumstances– Minimize expenses through benchmarking and competitive bid


Case Study: Washington City DC Plan; 450 participants

Plan Investment Option Utilization Data (50 Options)

• Options with 10 or less participants contributing: 19

• Options holding less than 1% of Plan assets: 31

• Percentage of assets held in proprietary funds: 81%

• Percentage of assets held in portfolio products: 22%

• Percentage of participants funding portfolio products: 65% (!)


Washington City Case Study: Asset class redundancy and

participant fund selection in the Large Cap Growth category

Fund Name Morningstar* 12-31-07 12-31-07

5 Yr Ranking 5 Yr Return % of Cat. Assets

• Vendor’s Growth Fund 2 11.02% 73%

• Alt Growth Fund 1 5 17.99% 22%• Alt Growth Fund 2 3 12.71% 2.3%• Alt Growth Fund 3 4 13.94% 2.3%• Alt Growth Fund 4 3 10.48% < 1%

• Large Cap Growth category constitutes 19% of all Plan Assets

• Vendor’s Growth Fund is also present in most of the Portfolio products, so it is actually a larger percentage of overall plan assets

* Morningstar is a trademark of Morningstar Services LLC.


About Defined Contribution Plan Fees• Are almost always expressed as a percentage of assets- fees rise as

account balances increase

• Are “netted out” of investment returns, rendering them “invisible” to the untrained eye

• Vendors usually collect revenue from both “plan administration” fees and investment product fees

• Combined “Vendor Revenue” in many plans exceeds 1% of assets– For a $50,000 average balance, that equals $500 per year, per head– Recent bids for new plans are often coming in at under $150 per head– There is often a good deal of room for improvement

• Fees are lowest for plans with more assets and higher average account balances


Recent Examples of Fee-Driven Legal Activity in DC Plans From a Recent Aon Fiduciary Group Bulletin

• “Class action: (Beesley v. International Paper Co., 9/30/08) Class action was certified in a tax code Section 401(k) plan participants' action, alleging that their employer breached its ERISA fiduciary duties by paying unreasonable and excessive fees to the plan's service providers”

• “Class action: (Zhu v. Schering-Plough Corp., 9/30/08) Class action was certified in a tax code

Section 401(k) plan participants' action alleging that the plan sponsor breached its fiduciary duties by allowing its employees to invest in sponsor's stock when it was allegedly imprudent to do so.”

• “Class action: (Lively v. Dynegy Inc., 9/30/08) $17.9 million settlement is approved in tax code Section 401(k) plan participants' action alleging plan sponsor and others breached their ERISA fiduciary duties because they knew or should have known that sponsor's stock was artificially inflated and was imprudent investment for plan, yet they failed to discontinue plan investment in sponsor's stock”

• “Class action: (Spano v. Boeing Co., 9/26/08) Class Action was certified in a tax code Section 401(k) plan participants' lawsuit alleging employer and others breached their ERISA fiduciary duties by paying excessive fees to the plan's service providers”


Fee Reductions and Administrative Allowances

• For many larger employers, plan administration fees have been reduced to “zero”; the vendor receives enough on the investment side to meet their revenue requirement- and sometimes more

• When the vendor’s revenue requirement is less than the revenue paid to the vendor by the plan’s investment provider, the excess is can be returned to the Plan Sponsor, as an “administrative allowance”

• This money belongs to Plan Participants, not the Employer!

• If not used for legitimate Plan expenses, it must be returned to Participants


First Steps Employers Can Take to Demonstrate Fiduciary Responsibility

• Create or formalize a Plan Oversight Committee, educate it, meet regularly and keep minutes: Having a “Process” is so important!

• Document your awareness of Plan investment performance, fees, vendor education and marketing practices, and industry trends

• Promote participation, appropriate asset allocation and sound distribution decisions by your participants

• Always benchmark your decisions about the Plan against the “Exclusive Benefit Rule”


Thank You!

• Questions

• Discussion

• For more information…– Contact us at: [email protected]– National Association of Governmental Defined Contribution Plan

Administrators: nagdca.org


Speaker Biography

• Gregory T. Settle: Vice President, Aon Investment Consulting– Designing, implementing and managing governmental retirement plans since 1984– Experience with hundreds of cities, counties and special district plans– Implemented and managed Washington State TRS III, SERS III and PERS Plan III record-

keeping, education and participant counseling programs– BS, Finance-Law, Portland State University, Cum Laude, 1983

• Aon Investment Consulting, Seattle Office– Consultants to public and private retirement plan sponsors– Investment Advisors and Consultants to 457 and 401(a) Plans– Public sector team with over 60 years combined 457 plan experience

Investment Consulting November 4, 2008 Washington State Transit Insurance Pool Governmental Defined...

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