Thursday, June 4, 2015

Many Ifs, Ands & Buts in EBSA’s Fiduciary Solution

When we were young, we may have been told that beginning a sentence with the word “but” was inappropriate.  We believed it because the people who said so were adults, and were supposed to know such things.  Later, we learned that “but” is a “coordinating conjunction,” and many good writers properly begin sentences with it.  Perhaps we had been intentionally misled because “but” is a word of protest often used by children.  “But I don’t want to eat my broccoli!” “But I’m not sorry!” 

Appropriate or not, “But” was the first word that came to mind when I had digested the Department of Labor’s “conflicted advice” – formerly fiduciary definition – proposed regulations, issued in April.  (Some other words that came to mind are less charitable.)  “But how can you propose,” I wondered, “a solution that seems generous to the present advising environment, but sets a snare that can spring future litigation and fiduciary liability even on principled and conscientious advisers?” 
I’m certainly not unsympathetic to the need for retirement savers to receive principled advice when making critical investing decisions.  They deserve no less.  But the most prominent solution being prescribed by the Department’s Employee Benefits Security Administration (EBSA) – the proposed Best Interest Contract – has some ingredients that beg the question of whether the remedy is worse than the malady.

To the genuine relief of many, EBSA’s proposed regulations did not narrowly limit the types of compensation that can be received by advisers or brokers serving retirement savers.  Some had feared that a fee-only approach might be required to avoid prohibited transactions and their inherent liability, which many believe might have caused advisers to flee the small investor market.   On the contrary, EBSA’s proposed regulations make clear that compensation that may vary depending on the investments chosen – like commissions, 12-b1 fees, revenue sharing, etc. – can continue to be a part of the adviser or advising firm’s compensation structure.
But – and it’s an important “but” – the price for this freedom in compensation arrangements is the Best Interest Contract, or BIC, as it is becoming known in industry shorthand.  If variable compensation structures are used to compensate for investment advice, something normally prohibited, an adviser or advisory firm must agree to enter into this arrangement.  It is a contractual one, make no mistake.  In EBSA’s own words, “It would require retirement investment advisers and their firms to formally acknowledge fiduciary status and enter into a contract with their customers in which they commit to fundamental standards of impartial conduct.  These include giving advice that is in the customer’s best interest and making truthful statements about investments and their compensation.”  Fail to meet either general or specific conditions of the BIC, and an advisor could be exposed to potential EBSA prohibited transaction enforcement, IRS excise taxes, and client litigation. 

There are a number of things that stand out as problematic with EBSA’s proposal, but for now we’ll focus on just two.  One is subjectivity.   “Best interest” may be in the eye of the beholder.  How much emphasis should be given to the lowest possible fees?  Are higher fees justified by facts and circumstances, such as a more expensive fund whose manager has a track record for outperforming others?  Would advice that looks questionable today be considered acceptable in the historical context of the time and options available when it was given?  Will those with enforcement and judicial authority have the expertise and the impartiality to make these and other judgment calls?

Another problematic issue is the potential for litigation if a client does not feel that an advisor has lived up to expectations.  An advisor or advisory firm must warrant that it has not only identified possible conflicts of interest, but has adopted measures to take them into account and prevent financial harm to the investor.  Based on such warranties, clients will have a contract law basis for seeking legal remedies, including class actions, and – specific to IRAs – bringing a case under state law without the benefit of ERISA preemption.   

There is nothing new about risk and return; it’s fundamental to investing.  In the case of EBSA’s BIC it now applies to the advisor, as well.  The potential for legal exposure may prove to be an unacceptable risk for some advisors and advisory firms.  Some might say it is appropriate that risk of a fiduciary nature find its way to the doorstep of folks who dispense investment advice to retirement plan participants and IRA owners.   But how much is “too much?”

A major concern of some who question EBSA’s approach is that instead of conflicted advice, some retirement savers will get little or no advice.

Monday, April 27, 2015

The New Fiduciary Rule is Here. But Where is “Here?”

There has probably not been a retirement plan regulations proposal more contentious or debate-stirring than the “conflicted advice” regulations recently issued by the Department of Labor’s Employee Benefits Security Administration (EBSA).  That’s a bold statement, but as a retirement industry professional for nearly three decades, I don’t make it casually.  Controversy and government regulation seem to go hand-in-hand, but these regulations take that maxim to a new level; certainly as far as retirement plans are concerned.

Given the history of this proposal – formerly known as “fiduciary definition” regulations – some may have been in denial that it would ever see the light of day.  After all, the regulations were first proposed in 2010, withdrawn in 2011 after an extremely hostile reception, underwent extensive public comment and cost-benefit analysis, and several promised release deadlines were missed.  Seen by many as a potential political liability for supporters, some questioned whether the proposal might languish, unreleased.

But such unbelief was dispelled when – in February of this year – President Obama spoke at an American Association of Retirement Persons (AARP) event, his message alleging massive losses of retirement income as a result of investment decisions that were based on poor advice.  President Obama quoted from a White House Council of Economic Advisors study entitled The Effects of Conflicted Investment Advice on Retirement Savings.  A fact sheet, FAQs, and other items advising savers on how to protect their retirement assets were also released with this press conference. 
At roughly the same time, the federal Office of Management and Budget (OMB) took delivery of EBSA’s new proposed conflicted advice regulations, rules intended to reduce or prevent the kind of growth-robbing investment advising spoken of by the President.  One might note that the title “conflicted advice” now being used sends a more calculated and urgent message than “fiduciary definition” regulations ever could. 

In an unusually short time, less than two months, OMB cleared these regulations for release to the public.  The package of supporting materials EBSA released with the regulations was impressive, if not unprecedented.  In addition to the regulations and new and amended prohibited transaction exemptions, the non-technical explanatory materials were voluminous.  They included not only a typical news release, but the simultaneous release of a fact sheet and frequently-asked-questions (FAQs), elaborations that are commonly issued sometime after actual guidance.  All this, and a cost-benefit analysis document longer than the actual regulations.  “Well-defended” might be a good way to describe the new regulations.

Without going into minute detail of the new proposed fiduciary definition, it clearly is more inclusive, and if adopted would make it harder for many advisors to be found not to be fiduciaries.  One of the more telling departures from the existing regulations is the inclusion of IRA owners and IRA transactions, with particular emphasis on rollover transactions.  While it’s sometimes noted that the DOL does not have authority over IRAs, a 1978 presidential executive order transferred to the Secretary of Labor the authority to write regulations under Internal Revenue Code Section 4975, the statute governing prohibited transactions.  IRC Sec. 4975 applies to both employer-sponsored retirement plans and IRAs.  Thus EBSA’s claim to the right to regulate those who provide IRA investment advice.

One of the surprises of EBSA’s proposed regulations – surprising to some, at least – was allowing investment advisors as fiduciaries to continue to receive variable compensation for different investments chosen by their clients.  Many had expected that advisor-fiduciaries might be forced into a flat fee or “levelized” fee business model.  Instead, such compensation methods as commissions, revenue sharing, or 12-b1 fees can continue to be part of compensation for investment advice.
But the variable fee option does not come without strings.  An entirely new prohibited transaction exemption would have to be satisfied in order to maintain the option for variable compensation.  It is known as the Best Interest Contract Exemption, and the term “contract” is well chosen.  I'm not going to go over all its details in this particular blog, but several stand out as worthy of mention. 

An advisor or advisory firm would have to inform EBSA of their intent to use the exemption;  potentially attracting examination attention?  The provider of advice must warrant – guarantee – that it has identified possible conflicts of interest, and has adopted measures to prevent financial harm to the client.  Investment advice given must be in the client’s best interest, not merely suitable.  The formidable “prudent person” standard with which we are familiar from ERISA Section 404(c) would apply.  Clients would have recourse under contract law for breaches committed by the advisor, and contractual language limiting or disclaiming liability for violations could not be used.  Strong medicine to be sure.

Some questions, for now unanswered, present themselves.  Does this proposal have a chance to take effect in its present form?  And, how would the advising industry respond if it does?  The 2010 version of the regulations, withdrawn in 2011, generated a preponderance of criticism of a “too restrictive” flavor.  This proposal, however, has drawn criticism from both proponents and opponents of tighter fiduciary regulations.  That being the case, might EBSA be inclined to conclude that it has found a middle ground between its rules being too restrictive and too liberal?  We will be keeping a close eye on the official public comments, which will surely be made available for review.

Will Congress itself make a move to affect the implementation of these proposed regulations?  Well before their issuance, the Republican-controlled House of Representatives passed legislation that would require EBSA to wait for the Securities and Exchange Commission (SEC) to issue fiduciary regulations first.  The Senate has not acted on it, and there are no indications that it is anywhere near the top of that body’s agenda.  The point is probably moot, because any such legislation would certainly be vetoed by President Obama, and there is reason to doubt that enough Democrats would join Republicans in a vote to override such a veto.  In fact, while a number of Democrats openly and actively opposed the 2010 proposed regulations, that has not been heard with this regulatory effort to date.

Still beyond prediction is whether – if regulations closely resembling this take effect – advisors that would fall under a broadened fiduciary definition will maintain existing business models with variable compensation, given the disclosure, contractual and prudence stipulations that would be required.  Will some advisors move to fixed or levelized compensation models?  Will some decline working with small balance investors altogether?


Much, much more to come!

Friday, March 20, 2015

“March Madness” an Apt Name for Fiduciary Regulations Battle


Perhaps it’s fitting that the country is in the period we’ve come to know as “March Madness.”  As even casual sports fans know, the term refers to the NCAA men’s and women’s college basketball tournaments.  It’s a time when basketball junkies are filling in the brackets for their friendly “it’s not really gambling” office pools, scratching their heads over the prospects of teams they’ve never heard of, and getting caught up in a fever that is the college sports equivalent of the Super Bowl. 
In the retirement industry we are generating a little March madness of our own.  I’m not aware that any Las Vegas bookmakers are establishing odds, but the players in this contest are definitely serious about the outcome.  No one will be cutting down basketball nets, or pulling a “Champions” T-shirt over their uniform when it’s over.  But without a doubt, one side or the other will see itself as the winner if it prevails. 

The contest in our industry is the battle over the Department of Labor’s proposal for defining “fiduciary” in the context of retirement plan accounts and IRAs.  In question is: under what circumstances will a financial advisor, investment advisor, or broker, be considered a fiduciary, with all of the responsibilities and the duty of care that entails?  

We have seen these same opposing forces arrayed against one another on this stage before.  In October of 2010, DOL’s Employee Benefits Security Administration (EBSA) issued proposed fiduciary definition regulations.  This guidance expanded the fiduciary definition beyond the so-called “five-part test” that has been in effect for some 40 years.  Certain advising relationships that might not have been considered “fiduciary” under the old regulations, now would be. 

The regulations applied to advising IRA owners as well as qualified plan participants, and to situations where participants might be rolling over assets from employer plans to IRAs.  Under much criticism for this expanded application, EBSA withdrew the proposed regulations in September of 2011, promising to perform a more robust economic study of the impact of these rules and to review the issues raised by public comments on the original proposed regulations.  Some cynically suggested that the decision to withdraw the controversial proposal and to re-propose it a later date was motivated by presidential and general election year politics, a time when regulatory red tape is always in the crosshairs of one party or another.
Fast-forward to today, and the oft-promised (threatened?) and several-times-postponed reincarnation of EBSA’s fiduciary regulations has now left that office.  The regulations now reside with the federal Office of Management and Budget (OMB), where such guidance typically resides for up to 90 days for “fly-specking” before eventual release. 

It seems almost as if we’re still in the midst of an election campaign, so visible, caustic and politically-charged are the energies and commentary being poured into support – or opposition – to the anticipated regulations.  The match-to-the-tinder seems to have been the Obama administration’s release in late February of a report entitled The Effects of Conflicted Investment Advice on Retirement Savings.  As is now widely known, the report contends that many retirement savers suffer substantial financial losses due to advisor conflicts of interest.  It is significant that these anticipated regulations are now widely being referred to as the “conflicted advice” regulations, a name that unquestionably is more charged than “fiduciary definition” regulations.  “Politically charged” would not be putting it too strongly. 
There have been numerous salvos fired by members of Congress in the direction of Labor Secretary Thomas Perez, including letters from the House Committee on Education and the Workforce, and the Senate Health, Education, Labor and Pensions (HELP) Committee, expressing concern that the anticipated regulations will lead to advisors abandoning many investors with small accounts, and that the EBSA regulations may conflict with fiduciary regulations that the Dodd-Frank Wall Street Reform and Investor Protection Act charged the Securities and Exchange Commission (SEC) with drafting.  These committee letters pointedly ask for proof that EBSA has attempted to coordinate its regulations with the SEC.    A bill, the Retail Investors Protection Act, has been introduced in the House that would require EBSA to defer issuing fiduciary regulations until the SEC acts first.  Meanwhile, Secretary Perez has said emphatically that these regulations will be issued.

Not all lawmakers are challenging the administration and EBSA on the advisability of EBSA going forward with release of its fiduciary definition regulations.  Elizabeth Warren, widely expected to be in the running for a nomination to the Democratic Party presidential ticket in 2016, recently used the forum of a Senate Special Committee on Aging hearing to reinforce the administration’s message that advisor conflicts of interest are hurting Americans’ retirement preparedness. 
Apart from the vigorous sparring among administration policymakers and Washington lawmakers, there are numerous pro and con analyses and opinion pieces appearing almost daily in industry and general media.  It appears that the all-too-brief calm between election cycle storms that we’ve come to expect may not be a reality this time.  Instead it’s “game on” for what could be one of the defining regulatory actions of the Obama administration – or not!

Monday, March 16, 2015

Does Retirement Saving Cost, or Pay?


February will likely be remembered in our industry for a seismic response to the Obama administration’s launch of a campaign to generate support for regulations governing fiduciary behavior in the advising of retirement savers.  We certainly have our own thoughts on the matter, as we have expressed in the past and most likely will again. 
For that reason, some may have overlooked the release by the Congressional Research Service (CRS) of a report on the largest individual income tax breaks for fiscal year 2015, which CRS has historically described as “tax costs.”  This is something the CRS has been doing for many, many years, but it is especially relevant at a time when those in Congress and in commerce have their eyes on possible major tax reform.  There is virtually no way to substantially lower individual and corporate tax rates without cutting into some of these tax provisions that now save citizens billions in federal taxes each year.  “Cutting into,” in plain terms, could potentially mean reducing the benefits of some – or all – of these and other individual tax breaks.

The lineup in this top-five roster of so-called tax costs is projected to be as follows for the 2015 fiscal year:  1) home mortgage interest deduction, $74.8 billion; 2) state and local tax deduction, $59.2 billion; 3) charitable giving deduction, $45.6 billion; 4) state and local real estate tax deduction, $34 billion; and 5) retirement savings deduction, $18.3 billion. 
It is a bit like stepping through a mine field to make comparative judgments about the value or importance of federally-delivered benefits, whether it is an entitlement like a social welfare program, or a tax break like a deduction for a Traditional IRA contribution.  Each has its advocates, and credible arguments can be made for many of these benefits.  Favoring one while questioning another exposes a person to accusations of partisanship.  But it’s part of our responsibility as citizens to make value judgments, and grapple with issues where there may not be answers written in black or white, or answers that will be universally popular. 

It is not my intention to step on any toes, but I do happen to feel that there are differences in the relative importance to our society of some of these tax benefits.  Differences, too, in which actually result in a loss of tax revenue.  One of the true “sacred cows” in American tax law is the home mortgage interest deduction for one’s principal residence.  We are generally allowed to reduce our taxable income by this amount of interest paid when we file our individual income tax returns.  This is especially beneficial in the early years of home mortgage payments, when a high proportion of that payment represents interest, and a much lesser proportion represents principal. 
Many, if not most, Americans grow up with the admirable goal and expectation of owning a home.  For some, the tax benefit of a mortgage interest deduction might be a deal-breaker when it comes to when – or whether – they will become home owners.  To date though, I haven't seen anything that would show that this would be the case for a majority of citizens.  Certainly the housing industry, and the associated professions of real estate broker, mortgage banker, contractor, insurance provider and numerous others, benefit from robust activity in home buying. 

But are tax incentives that make home ownership easier for an increment of Americans more important than preparing us for security in retirement?    A value judgment to be sure but one that at some point will likely have to be made.  The annual “tax cost” estimated by CRS for home mortgage interest deductions is four times the estimated cost in lost revenue as a result of IRA deductions and contributions to employers’ retirement plans.  Furthermore, citizens who reduce their taxable income via the home mortgage interest deduction do not pay this tax benefit back to the U.S. Treasury at some future time.  Contrast this with deductible IRA contributions and pre-tax amounts deferred into 401(k) plans which are eventually taxed when a retiree withdraws them for financial support in retirement.  Contrary to the way these retirement benefits are often characterized, they are not a permanent “cost” to the federal tax revenue stream.  Again, I do not mean to imply this tax benefit does not serve a valuable benefit but rather want to point out that comparing this to retirement benefits, is not an apples to apples comparison.
Next after the home mortgage interest deduction as a tax cost are deductions for state and local non-business taxes paid.  This amount is three times the so-called annual tax cost for retirement contributions, and is never recovered.  Charitable giving comes next on CRS’s list, and is almost two-and-one-half times the retirement number.  I have no quarrel with the importance to our society of tax incentives for charitable giving and in fact strongly believe they serve an important purpose.  But perhaps we should not impede the average American’s ability to provide for their own security in retirement – helping to insulate them from the need to rely on social programs – by reducing their tax incentives for saving, in order to deliver maximum tax benefits for charitable giving.

The same can be said for CRS’s #4 cost, from deductions for state and local real estate taxes paid.  This is twice as large as the price tag for retirement saving incentives.  Like the others, it too is a permanent tax loss, whereas most retirement saving pours back its tax “cost” when amounts are taken from these savings arrangements and included in income.
The administration’s fiduciary campaign cited at the start of this blog has been criticized for a lack of perspective.  Perspective is also needed when lawmakers consider the relationship between an imagined cost of retirement tax benefits, and the real and painful costs of having a retiree population unprepared for that stage of life.

Monday, March 2, 2015

Where Are We Bound in 2015-16?


The turn of the New Year can be a time to start fresh, which is why so many people make New Year’s resolutions, vowing to change some behavior, or in some way live differently than in the past.  On a less personal level, for workers and most businesses, it’s the start of a new tax year, and of course a time to begin reckoning with the tax year just ended. 
For those we’ve sent to Washington, D.C., to govern us, it’s an opportunity to regroup and take a fresh look at priorities for the coming session.  This year, 2015, is a pivotal one, with the seating of new senators and congressmen and the start of the final Congress with President Obama at the helm.  The dynamics have changed, of course, with both the House of Representatives and Senate controlled by the Republican Party, mirroring the potentially adversarial scenario faced by Mr. Obama’s two immediate predecessors, President Bush and President Clinton. 

Because of this shift in the balance of power on Capitol Hill, there has been lot of uncertainty over how the 114th Congress and the President will interact, and how they will be able – or not – to govern in the roughly 22 months until the 2016 presidential and congressional elections.  The Republicans now hold 247 seats in the House and 54 in the Senate, an advantage that party has not enjoyed since the 71st Congress of 1929-1931.  To start this year, the early indications are an ongoing inability to interact seems to be continuing.
One thing that did not change with the 2014 elections is the leadership of the federal agencies with oversight over tax-favored savings arrangements, such as employer-sponsored retirement plans, IRAs, Health Savings Accounts, Coverdell Education Savings Accounts, and the like.  This means that the power within these agencies has not shifted as a result of the elections, and the philosophies that might be reflected in their guidance are unlikely to be different during the next biennium. 

Having said that, however, there’s no denying that the ultimate leaders of such agencies as the Department of Labor and the Treasury Department – both cabinet functions – are political appointees.  Whether desirable or not, pressure sometimes finds its way down from the very top, through the cabinet members, and ultimately to the ranks where guidance is written and issued.  Many believe, for example, that the Department of Labor’s highly unpopular fiduciary definition guidance was first withdrawn – and then subsequently kept on hold – for political reasons in the presidential election year of 2012, and through 2014.  It now appears that at the end of this administration, a strong push to issue this guidance is at hand.
But the intersection of presidential power and regulatory action can work both ways.  Prior to the 2012 and 2014 election the White House had reason to temper aggressive regulatory actions, for fear of election losses.  That is less a concern, at least at the presidential level, since our president cannot run again for reelection.  Perhaps because of this, we have already seen bold – some would say excessively bold – moves taken by executive action.  The last two years of a president’s term are sometimes the period in which the country’s top leader seeks to leave his stamp on the nation, and it could be so with regulatory actions that are favored by the current administration.  The proposed fiduciary regulation may be a good example of this. 

One consideration that could temper aggressive executive and regulatory activism in the next two years is a weighing of the odds for the 2016 election, with the obvious concern that unresponsive or uncompromising regulatory action could weigh against Democratic candidates in both congressional and presidential elections.
Despite the difficulty of governing with a divided, polarized government, one bright spot for the coming Congress is the elevation of Senator Orrin Hatch (R-UT) to chairmanship of the Senate Finance Committee.  Sen. Hatch has substantial credentials when it comes to retirement issues, and his committee plays a key role where retirement savings-related legislation is concerned.  In the last session of Congress Sen. Hatch introduced the Safe Annuity for Employee Retirement (SAFE) Act, and it will be one of his priorities in the 114th Congress.

But don’t let that title fool you; the bill is not only, or primarily, about annuities.  Yes, the legislation advocates that retirees have access to investment options that can provide lifetime income.  In that respect it reflects the philosophy of the current qualifying longevity annuity contract (QLAC) regulations.  For example, dating back to 2013, Sen. Hatch’s bill mirrored these regulations in limiting to 25% the use of retirement assets to purchase qualifying deferred annuities.  The objective of both Sen. Hatch’s legislation and the current QLAC regulations is to enable what policy makers and lawmakers have long advocated – investment planning that takes into account guaranteed lifetime income options.  Such options are not the entire answer, but can be part of the formula in the retirement security equation.
But Sen. Hatch’s bill goes way beyond the annuity dimension.  It encourages greater use of automatic enrollment and automatic escalation of contributions in deferral-type plans.  It simplifies plan testing, reporting and disclosure.  It enhances the popular and successful 401(k) safe harbor plan, enhances the portability of lifetime income options from employer plans to IRAs, and offers numerous other positive – some might say overdue – retirement savings enhancements.

Whether these exact provisions are embraced, or refined, or in some form eventually become law, is of course uncertain.  In the current political environment an odds-maker would probably not give ANY legislation a high probability of success.  But if legislation such as this fails it won’t be for lack of vision and effort.  Sen. Hatch seems to have “the right stuff” to lead on the retirement savings front.  Whether others will have the good sense to follow is, of course, another question.

Thursday, January 15, 2015

Let’s Help Participants Invest With Knowledge, Not Ignorance


One of the ways we understand and manage the world we live and work in is through statistical analysis.  We use it to determine worker efficiency and productivity, company profitability, marketing effectiveness, and many other things.  In our field, it’s also used to measure retirement saving behavior and worker decision making, among other things. 
A recent study compiled by the mutual fund industry-serving Investment Company Institute (ICI) contained something both revealing and disturbing about the saving behavior of participants in defined contribution retirement plans.  For illustration purposes several bar graphs from the study ICI Survey of DC Plan Recordkeepers are reproduced below.  They compare the years 2008 through 2013. 



If anyone needs a reminder, 2008 was the year when the stock market took a bungee-jump dive that reflected an economy as close to a second Great Depression as most of us ever want to see.  Fear of a financial meltdown gripped the country, and government and private industry together looked for ways to shore up the battered economy and restore some semblance of confidence.
Uncertainty and fear generated by business failures, wage stagnation, job losses, and securities market declines of as much as 40% were eventually reflected in retirement plan participant behavior.   Not necessarily informed or wise behavior, however. 

Perhaps most understandable of plan participant behaviors is “withdrawals,” including both in-service and hardship withdrawals.  In 2008 these were taken by a larger percentage of participants than in any subsequent year through 2013.  The incidence of withdrawals in 2008 was more than 10 percent higher than any other survey year.  The study does not specifically claim that this higher distribution rate was due to job loss, wage or salary cuts, a decline in value of other participant assets, or any specific factor.  But hard times and withdrawal of retirement assets often go hand-in-hand.
Similar to increased distribution activity in its retirement security implications is ceasing contributions.  This, too, occurred at a higher rate in 2008 than any other year through 2013.  Many also ceased contributing in the following year, 2009, when the ugly economic realities of the recession were continuing to manifest themselves.  As with withdrawal motivators, such factors as job loss, wage or salary cuts, or a decline in value of home or other participant assets – even just the fear of potential economic adversity – may have contributed to participants stopping contributions. 

There are a couple of other measures of participant behavior that might not alarm others as much as they alarm me.  To me they reflect participants lacking an understanding of informed investment behavior.  It concerns the changing of allocations in participants’ existing account balances and their new contributions. 
There will always be allocation changes, and should be, as participants age and – we hope – become more adept investors.  But in 2008 the rate of investment reallocation in existing accounts was 28 percent greater than the average from 2009 through 2013.  For new contributions, 2008 reallocation changes were 32 percent greater than the 2009-2013 average.  Anecdotal evidence tells us that most of these reallocations went to more conservative investments, such as cash-equivalents like money market funds, or guaranteed investments. 

Participants who exited from equity investments when they were at their lowest ebb in 2008 or 2009 essentially “locked in” their losses.  Those who held on and rode the wave back to where the markets are today in all probability recovered their losses.  Some may have seen the opportunity that a severe market decline can offer, and not only held on, but continued or even accelerated their contributions to historically solid – but temporarily depressed – investments.  They are the real winners. 
The point of this dialogue is that far too many plan participants – when faced with a market reversal – behave like poorly trained soldiers confronting their first battle.  Rather than hunkering down and preparing to weather the siege of a market decline, they panic, cast off their good judgment and head for the imagined security of a non-volatile investment.  Some may never again move back into the types of investments that have the potential to generate real long-term growth. 

Of course, some participants may be in that near-retirement stage where they should be in conservative investments.  But that’s not an excuse for the many who are in early or mid-career and have a long time horizon to retirement.  We need to do a better job of educating all participants so that investment decisions are driven by knowledge and reason, not ignorance and fear. 

Friday, December 12, 2014

Some Roth is Good; “More” May Not Be


One of the “grand old men” of the U.S. Senate in the modern era was William Roth, the late lawmaker from Delaware.  Senator Roth championed tax-advantaged retirement savings options to assist American workers in preparing for a secure retirement.  The Roth IRA, provisions for which were enacted in 1997 and became effective in 1998, was named for him as a tribute to this legacy. 
The chief characteristic that distinguishes the Roth IRA from the familiar Traditional IRA is the absence of a current-year tax deduction, while offering the potential for tax-free earnings in the future.  This benefit is earned after a five-year period, and when the taxpayer satisfies one of several other qualifying conditions, which include reaching age 59 ½, making a first home purchase, becoming disabled, or upon death.  Fast-forward to today, and we see an expansion of this concept to include “designated Roth contributions” in 401(k), 403(b) and governmental 457(b) plans.  This option allows the deferral contributions withheld from employees’ paychecks to be treated in the same way as Roth IRA contributions.  There is no current-year benefit in the form of an exclusion from taxable income, but there is similar potential for tax-free earnings after five years.  “Tax-free” earnings is a benefit available almost nowhere else.

In addition, not only can contributions of a Roth nature be made, but existing pre-tax balances in Traditional IRAs and employer-sponsored retirement plans can be remade and given Roth status by a process called “conversion,” or “in-plan Roth rollover” in the case of employer plans.  When that happens – when these pre-tax assets are converted to after-tax amounts – tax revenues are generated, but the new Roth assets begin generating earnings that could eventually be tax-free.
The driving force behind the Roth concept in IRAs and deferral-type employer plans was not some Santa Clause-like generosity on the part of senators and congressmen.  The motivation was the effect that these contributions had – or didn’t have, to be more accurate – on the federal budget process.  Congress typically tallies up or “scores” the tax consequences of a bill within a five or 10-year time horizon, or “window.”  Tax deductions or tax exclusions result in an on-paper loss of federal tax revenue, and can complicate budgeting.   But when retirement saving is done on an after-tax basis like the Roth concept represents, immediate tax revenues appear undiminished, and can be assigned by Congress to other uses. 

Magnifying this effect, the conversion of pre-tax IRA or employer plan amounts to Roth status actually generates new tax revenue in the year the transaction occurs.  This has been used as a tax-generating device by Congress on more than one occasion.  The Tax Increase Prevention and Reconciliation Act (TIPRA) was signed into law in 2006.  In order to generate more tax revenue Congress opened wide the door to conversions, eliminating – beginning in 2010 – the $100,000 taxpayer income ceiling for Roth IRA conversion eligibility.  Furthermore, Congress offered an attractive incentive to complete a conversion.  The taxation of conversions executed in 2010 could be split equally in 2011 and 2012, the objective being to drive additional tax revenue into those years to offset other budget items. 
The Roth concept also figures heavily in proposals for future tax reforms.  Outgoing House Ways and Means Committee Chairman Dave Camp has laid out the most comprehensive tax reform proposal to date, one of whose stated purpose is to reduce individual and corporate tax rates.  To “pay for” these reduced tax rates, many existing tax deductions and exclusions could be reduced, or eliminated.  For example, Camp recommends eliminating the tax deduction and all future contributions to Traditional IRAs, and allowing all taxpayers – even those of highest incomes – to make Roth IRA contributions instead.  Rep. Camp also proposes allowing Roth-style contributions to SIMPLE IRAs, and requiring large employers sponsoring 401(k)-type plans to limit pre-tax deferrals to half the statutory limit. 

The goal of this proposal is to drive more saving into Roth arrangements, and thereby greatly limit taxpayer deductions or exclusions from current-year taxation.  The upside for taxpayers, and there certainly is one, is potential tax-free earnings in the future – after meeting the previously-described conditions for qualified distributions. The downside for the federal budget is a significant reduction in future tax revenues.  While tax reduction is a definite public good in many ways, there are certain national needs for generating tax revenue, well beyond various entitlements that may – or may not – be prudent spending.  National defense, Social Security, transportation infrastructure, science and technology, education and certain other expenditures, may be necessary to keep our nation strong and competitive.  These, by their nature, are funded through taxes, whether we like it or not.  Eliminating or reducing a significant source of these future revenues is concerning and may be a case of "kicking the can" down the road and leaving it for someone else to solve potential future shortfalls. 
Some Roth in the mix of retirement savings options is definitely a good thing.  But it’s also important for lawmakers to be forward-thinking enough to consider future needs for fair and necessary taxation, rather than focus only on short-term solutions to our federal budget dilemma.