The Markets June 29, 2010

Feature:Qualified Success?

For QDIAs, no news is good news, though changes loom.
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The news about qualified default investment alternatives (QDIAs) in 2009 was that there really was no news. The market volatility of the fourth quarter of 2008 did not have much impact on QDIAs, says Stephen Utkus, Head of Vanguard’s Center for Retirement Research in Malvern, Pennsylvania. Few sponsors reconsidered QDIA choices, he says, because retirement plan committees understand portfolios decline sharply in a bear market. Instead, their reaction to the market was to stick with their choices because the portfolios still made sense.

The economic downturn, however, did expose some flaws in QDIAs, particularly the most popular QDIA choice, target-date funds. Because a number of target-date funds—notably those designated for participants planning to retire in 2010—were heavily weighted in equities, participants close to retirement saw steep declines in their account balances late in 2008.

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“Target-date funds are neither the problem nor the solution to making sure people have enough income in retirement,” says Jamie Kalamarides, Vice President of Retirement Solutions at Prudential Financial in Hartford, Connecticut. While target-date funds currently reign supreme in the QDIA realm, Kalamarides sees a future migration to other products that offer downside market protection prior to retirement and income guarantees. This is going to get increased focus in coming years, he predicts, with both the Internal Revenue Service and Treasury interested in providing this protection to participants.

Yet, while the economic downturn did not lead to sponsors changing their QDIA selections, it has led to a number of debates. Utkus notes that there is an ongoing debate as to whether QDIA funds, whether target-date funds or other QDIAs, should be managed actively or passively.

There is also a policy debate as to whether participants understand how their QDIA funds work, says Utkus, and at least an inference that sponsors should do more to ensure they understand. Many believe that the Department of Labor (DoL) will issue guidelines or a checklist of what plan sponsors should consider but, almost by definition, participants are in QDIAs by default, notes Utkus. How much disclosure can be effective to a participant who did not even take the time to sign up for his 401(k)?

There also has been a debate on glide paths, how the shifts in asset allocation take place over time. There is a political debate, says Utkus, that glide paths are too risky. The overwhelming consensus of retirement plan committees is that they are not, he says. In contrast to sentiments in the political realm, there has been no big shift away from equity exposure at retirement in the marketplace, says Utkus. Committees realize that, when participants retire, they are going to live for decades and need a balanced portfolio, he says. Committees also take into account that participants have Social Security and other assets, he adds.

 

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Another debate since the financial crisis lies in the appropriateness of target-date funds as the QDIA of choice. Some believe that, while target-date funds are appropriate and adequate for accumulating assets before retirement, they do a poor job of providing steady, reliable retirement income. “They’re good at getting people to retirement, not through retirement,” says Kalamarides.

Additionally, while target-date funds take into account time horizon, they do not take into account risk, says Kalamarides. The wild market fluctuations of the fourth quarter of 2008 demonstrated that participants, he says, often could not handle volatility.

That said, target-date funds are here to stay, acknowledges Kalamarides, but target-date funds will evolve from just being accumulation solutions to including guarantees. That way, he says, the risk of having a bad year just before retirement or outliving assets will be mitigated.

There is an increased awareness by large-plan sponsors not just about time horizons, but also risk tolerance, says Kalamarides. He predicts that, in 2010, large-plan sponsors will begin adopting next-generation QDIA products with guarantees. The trend will shift from accumulation solutions to QDIAs that take over longevity risk, he says.

There is also an emerging trend for QDIA pricing now that more plans are moving to automatic enrollment, says Utkus. Three to four years ago, when plans started automatically enrolling workers, there was little money in those default funds, says Utkus. As those assets grow, there will be more and more money in these QDIA funds, and there will be pressure to find lower-cost vehicles, says Utkus. As more money flows into funds, Kalamarides says that plans can graduate into better share classes and get better pricing.

Another emerging QDIA trend is reenrollments. Previously, when participants were reenrolled after fund changes, says Utkus, participants were mapped to similar funds. The new trend, he says, is to map everyone to the QDIA unless they specifically opt out. This could mean even more money in QDIA funds, putting increased downward pressures on fees, he notes.

The long-term question people are discussing now is how to provide participants with adequate lifetime, guaranteed retirement income in a defined contribution universe, says Kalamarides.

“If you’re going to put people on auto-pilot, you don’t just bring them to the point of retirement, but through retirement with guarantees of lifetime income,” Kalamarides says.

 

—Elayne Robertson Demby  

 

 

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SIDEBAR: Investment "Help"?   

It is a long-accepted tenet that most retirement plan participants want—and need—help to make good investment decisions, and a recent study suggests that it makes a difference.

The new report, a collaboration between Hewitt Associates and Financial Engines, titled “Help in Defined Contribution Plans: Is It Working and for Whom?” comes to the unsurprising conclusion that participants who get (investment) “help”—defined in the report as target-date funds, managed accounts, or online advice—are better off than those who do not, in all but the most extreme circumstances (in 2008, the most-conservative allocations, no matter how undiversified or age-inappropriate, did better than more diversified portfolios, according to the report). On average, the median annual return for Help Participants was almost 2% (186 basis points) higher than for Non-Help Participants, net of fees, according to the report.

Additionally, those participants using “Help” have portfolios with risk levels that the ­survey’s authors suggest are both “more appropriate for their retirement horizons and more efficiently allocated among the options in their plan.” Factors contributing to that risk “gap” were the tendency of “non-helped” participants to make no adjustments in their portfolio (or risk level), and a gravitation toward larger holdings in company stock over time. In fact, the survey noted a particular concern—in view of a more limited time to recover from mistakes—that the greatest variability in observed portfolio risk levels was found among retirees and near-retirees not using “Help.”

On average, across the more than 400,000 plan participants represented in the report, about a quarter use at least one of the types of Help offered within their 401(k) plans. However, average usage of Help overall varied across the seven plans in the sampling, from a low of 15% to a high of more than 35%.

Of the quarter of participants using Help, 9.8% are invested appropriately in target-date funds (e.g., 95% or more of their balance in that offering—as an interesting side note, of the 75% not using “Help,” 43% have allocated some money to target-dates, but less than 95%. The average portfolio allocation among those participants was 36%), while 9.7% were enrolled in managed accounts, and 5.8% use online advice.

The report looked at participant behavior, portfolio risks, and returns during a particularly volatile period in the markets—January 1, 2006, and December 31, 2008—across a dataset of seven large plans representing more than 400,000 individual participants and more than $20 billion in plan assets.

 

—Nevin E. Adams, JD 

 

This article originally appeared in the April issue of PLANSPONSOR Magazine.

Compliance June 29, 2010

Feature: Down, but Not Out

Populist pressures weigh on nonqualified deferred compensation programs.
Reported by

Shareholder activists have been grousing about executive pay and benefits for years but are getting results now. “Populist pressures to limit executive pay are taking a toll,” says Scott Olsen, a Principal in the HR Services Group at PricewaterhouseCoopers LLP in New York. Executive plans have been under scrutiny for some time but, because of the financial crisis, they are under more scrutiny than ever, and shareholders are flexing their muscle, says James Scannella, a Senior Consultant with Towers Watson in New York. 

Public and shareholder pressure now has led to executive plan redesigns. In the last 24 months, one in three Fortune 500 companies has made changes to executive plans, says Frederick.  

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When changes are made, there have been material changes in the objectives of these programs. “Executive plans are still highly relevant, but play a different role than three years ago,” says Doug Frederick, the Head of Mercer’s Executive Benefits Group in Louisville, Kentucky. For one thing, companies now are creating executive benefits programs that are more “sticky” and give shareholders more rights, says Roberts. Program redesigns also have led to the overall levels of executive benefits going down, says Frederick. Executive benefits had been on a continual upslope for more than a decade, and that seems to have stopped in 2008 to 2009, confirms Scannella. 

One notable trend in the redesigns is to make executive benefits be more restorative and less supplemental, says ­Frederick. Firms still are providing executives with plans that compensate for Internal Revenue Code qualified plan limits, he says, but true SERPs, where executives get benefits above and beyond the rank and file, are less popular. In 2009 and 2010, says Scannella, the trend was for companies to freeze or terminate SERPs.  

Additionally, as firms freeze and terminate qualified defined benefit plans, they are doing so for executives as well, adds Frederick. Eight out of 10 Fortune 500 plans that changed their qualified defined benefit plan changed the executive defined benefit plan as well, he says.  

There also have been a lot of changes in the way equity grants are made to exec­utives, says David Roberts, Head of Equity Plan Services at Bank of America Merrill Lynch in Scottsdale, Arizona. Previously, stock options and restrictive stock were the types of equity most often granted. The new trend is to grant restricted units tied to a performance factor, he says, such as stock price growth in relation to peers. Equity grants also have longer vesting periods, moving from a typical three-year period to one that is now five to seven years long. 

Perhaps one of the biggest changes has been to the methodology for determining executive pay and benefits. Setting executive compensation only in relation to peers has lost favor. Previously, says Olsen, the primary driver of executive pay packages was peer group/benchmarking. This, however, was criticized as creating the so-called “Lake Wobegon” effect of spiraling executive compensation. Now, peer group/benchmarking is lower down in overall consideration, says Olsen. The new way, he says, is to look at pay and benefits more holistically and determine how a compensation program fits the overall goals of the company.  

Historically, agrees Frederick, the primary analysis was whether a package was defensible in relation to peer group or industry pay. Now, he says, other factors are being heavily considered, including whether the compensation is internally defensible. 

 

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One reason for the changes is shareholder pressure. Shareholder opinions are being communicated to management, and compensation committees now look for the valid business purpose to providing the benefit, says Scannella. If there is no valid business purpose, he says, the discussion then turns to whether it should be continued.  

Shareholders want more alignment between their interests and executives’, says Olsen. Shareholders, he says, believe retirement programs provide no real incentives, and want programs that provide guaranteed and fixed-income compensation abandoned. 

While shareholders are exerting pressures to rein in executive pay programs, employees exert even more curbing pressure. Rank and file now can see when benefits are structured differently for executives because of the 2006 disclosure rules, says Olsen. The new attitude in setting executive compensation, says Frederick, is that executives should lead by example, so executive pay has to be internally defensible. For example, when qualified defined benefits are being frozen or terminated, it now is viewed as inappropriate to maintain nonqualified defined benefit plans for executives. In these difficult times, it is realized now that you cannot ask people to take a cut in pay if executives are not sharing in the pain, adds Frederick.  

Repercussions from section 409A’s passage continue to ripple through the industry as well. Because section 409A complicated administration, there has been a tremendous move to outsourcing nonqualified deferred compensation (NQDC) plans, says Roberts. The consequences of violating the rules can be severe, he notes, so companies now want administration of these plans in the hands of administrators with subject matter experts. Expect that the movement to outsource administration of executive benefits will gain ground in coming years, adds Scannella.  

Executive pay also is still feeling the aftershocks of the 2006 requirements for proxy disclosure of executive pay and benefits. The disclosure rules have led to anything doing with contractual severance payments or change of control payments moving in the direction of being less favorable to executives, says Olsen. 

In 2010, expect a continued whittling away of executive perks, says Scannella, with shareholders continuing to play a role in the shaping of executive pay and benefits. For example, he says, executive tax gross-ups on change of control benefits are coming under intense shareholder scrutiny now. If an executive contract comes up for renewal and contains a gross-up, institutional shareholders are likely to vote out the compensation committee.  

In addition, although they have lost favor in recent years, expect to see more NDQC plans. In the last few years, because of regulatory pressures and lack of interest, voluntary deferred compensation plans lost favor, says Olsen, but there may be a comeback in the next few years because of possible tax hikes. Olsen says he has seen several clients that already are taking a new look at voluntary plans. Firms also are exploring mandatory deferred compensation plans with matches tied to performance, he says.  

You will see continued innovation in the design of executive compensation in the next few years, says Roberts. As the rules change, there will be changes in the way packages are structured. With more scrutiny and disclosure, there will be more innovation in how these packages are designed, he says.  

However, disclosures will be at the forefront of any executive plan redesign. “No one wants to be in the news regarding abnormal executive pay packages, so everyone is rushing to the middle,” says Roberts. “No one wants to be the poster child for executive compensation that is viewed to be egregious.”  

 

This article originally appeared in the April issue of PLANSPONSOR magazine. 

 

 

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