Compliance December 21, 2017

Tax Bill Affects IRA Conversions, Loans, 529s, NQDC Plans

The bill does not impact tax breaks for retirement savings, either by lowering the amount people can contribute or requiring some or all of the money to be invested as a Roth 401(k).

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The tax bill currently awaiting President Trump’s signature does not fundamentally change the tax breaks retirement plan participants receive, according to a law alert that The Wagner Law Group issued.

However, the Tax Cuts and Jobs Act does make some changes to Employee Retirement Income Security Act (ERISA) plans, including 529 college savings plans, and nonqualified deferred compensation (NQDC) plans. The tax bill will continue to allow taxpayers to recharacterize contributions made to a Roth individual retirement account (IRA) as contributions to a traditional IRA, as long as it is done before the due date of the taxpayer’s income tax return, including any extension. Importantly, this will not apply to the reverse situation, where an investor would take traditional IRA contributions and then recharacterize them as Roth.

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Currently, if an employee has taken out a loan from their retirement plan and has an outstanding balance when leaving the company, they have up to 60 days to roll over the outstanding loan balance to an IRA to avoid having the loans treated as taxable distributions. The tax bill extends this rollover period to the due date for filing their tax returns.

College savings plans are now amended to permit 529 account owners to take a $10,000 distribution each year and apply it not just to college expenses but also to public, private or religious elementary or secondary schools. The tax bill also permits rollovers from a 529 plan to an ABLE program, which is a tax-favored savings program for disabled individuals, as long as that program is owned by the designated beneficiary or a member of his or her family.

With respect to nonqualified deferred compensation (NQDC) plans, the bill modifies the definition of a “covered employee” at a publicly traded company, for whom an annual deduction up to $1 million applies. A covered employee includes the principal executive officer and principal financial officer, as well as the next three highly compensated employees, during the tax year. Furthermore, if an individual was a covered employee at a company in a taxable year after December 31, 2016, they will be considered to be a covered employee for all future years.

The bill also extends the application of this NDQC feature to include all foreign companies publicly traded through American depository receipts (ADRs) as well as certain types of large organizations that are not publicly traded, such as large private C or S companies. The bill eliminates commission and performance-based exclusions.

A tax-exempt organization will be subject to a 21% excise tax on any payment in excess of $1 million paid to its highest paid employees, and any excess parachute payment. An excess parachute payment is redefined as one exceeding three times the average annualized compensation for the five years preceding separation of service. With regard to transfer of employer stock to an employee in connection with their performance, the employee can defer,  for income tax purposes, the income attributable to the stock, but this must be done no later than 30 days after the stock is vested or becomes transferable, whichever comes first.

Offering additional commentary, the tax and accounting division of Thomson Reuters notes that the legislation allows 401(k) plans and other eligible retirement plans to help victims of federally declared major disasters occurring in 2016 by allowing “qualified 2016 disaster distributions” of up to $100,000 per individual prior to January 1, 2018. Such distributions are not subject to the 10% additional tax on early withdrawals.

Professor Jamie Hopkins, co-director of the retirement income program at the American College of Financial Services in Bryn Mawr, Pennsylvania, notes that while the 401(k) savings cap and Rothification of accounts did not end up in the final bill, neither did any additional measures to help Americans to save more for retirement. She says the removal of recharacterication of IRAs to Roth IRAs will discourage people from investing in Roth IRAs, since recharacterizations allowed them to undo conversions.

However, Tim Slavin, senior vice president at Broadridge, sees a number of positives for retirement plan participants. Most notably, he says, lowering the tax brackets for middle- and lower-income Americans could go a long way to motivate people who are not currently contributing to their 401(k) plan to sign up, or for those who are already in the plan, to increase their contributions. He also likes the flexibility being added to 529 plans. He thinks the new provisions will increase ownership and assets in 529 plans.

And the extension of time people are being given to repay outstanding loans without having the distribution being treated as taxable income is another improvement Slavin applauds. As he notes, “There are a lot of loans out there.”

Compliance December 21, 2017

ESG Investing Goes Under the Microscope in CalPERS Debate

In a series of sharply written, dueling reports, experts from the American Council for Capital Formation and CalPERS debate the proper role of environmentally and socially conscious investments—and whether the massive public pension fund has grown too political in its actions.

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While many in the wider retirement planning industry have rightly been focused on the final stages of the GOP tax cut legislation, George Michael Gerstein, ERISA council with Stradley Ronon, has been following another important story.

As he tells PLANADVISER, there is a hot debate going on between the lobbying and advocacy organization known as the American Council for Capital Formation (ACCF) and the California public employee’s pension fund known as CalPERS. Readers will likely know of CalPERS as one of the largest public pension funds in the world, but for its part, the ACCF has had an active history in Washington dating back to its first advocacy effort in support of the Revenue Act of 1978, which cut capital gains taxes.

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The debate involves the proper use of environmental, social and governance (ESG) investments within the context of institutional tax-qualified retirement investing. While ERISA attorneys and asset managers broadly agree that ESG is rapidly becoming a cornerstone issue for defined contribution (DC) and defined benefit (DB) plan sponsors—and most other categories of institutional investors for that matter—the ACCF says there is evidence that the leaders of CalPERS are not adhering to the federal government’s strict rules putting limits on the use of non-financial factors when investing employees’ tax-qualified retirement assets.

The whole saga started when the American Council for Capital Formation (ACCF) published a sharply written report alleging that, as the group puts it, “CalPERS has prioritized relatively poor performing Environmental, Social and Governance [ESG] investments at the expense of other investments more likely to optimize returns,” and for the sake of politics no less. ACCF summarizes its charges as follows: “The board uses its size and its beneficiaries’ money to wage war on companies not aligned with its political views, and influences other large institutions and influential proxy advisory firms to fall in line alongside it—or run the risk of losing out in billions of dollars in annual fees and business transactions.”

ACCF seeks to tie a drop in plan health at CalPERs to greater use of ESG: “Over the past ten years, CalPERS has increased its ESG investing and activism while converting a $3 billion pension surplus in 2007 to a $138 billion deficit today … This performance lag comes as the value of the S&P 500 index has increased by more than 275 percent over the past eight years. CalPERS’s environmental-related investments comprised four of its nine worst performing private equity funds last year, accounting for more than $600 million in committed capital.”

There is considerable detail in the ACCF report digging into these allegations, but they all more or less turn on the notion that the CalPERS leadership has prioritized the symbolism of committing to ESG investments over the fiduciary duty to pursue the most financially prudent course with employee dollars. According to ACCF writers, “none of the system’s leaders put their own money into environmental investments … Yet large passive funds such as BlackRock, State Street and Vanguard—which manage trillions in pension fund and 401(k) dollars—are being influenced to support these political initiatives.”

Naturally CalPERS rejects these accusations, and the fund’s board put out its own analysis responding directly to the ACCF. The CalPERS analysis charges that ACCF’s report fails to tell the whole story of CalPERS’ use of ESG. They also suggest ACCF fundamentally misrepresents what ESG investing programs can be. 

“ACCF cites four environmental investments as proxies to feebly argue its anti-ESG message. They’re correct—these private equity funds haven’t done well,” CalPERS writes. “But here’s the context that was willfully ignored: These are just four funds totaling about $600 million out of about 240 in a $26.4 billion private equity portfolio. And this: Private equity earned 13.9 percent last fiscal year, 11.5 percent for the preceding five-year period, and 11.3 for the preceding 20-year period. In fact, our private equity program has produced higher returns for the CalPERS fund than any other asset classes. ACCF’s analysis of the poor performance of five public solar companies falls victim to the same dismal logic. At nearly half of the entire CalPERS fund, our public market holdings represent the vast majority of all listed global companies—around 10,000—and largely follows a passive, index-like investing approach. We don’t stock pick or try to time the market. What we do pick is a long-term investing strategy—with a 50- to 60-year horizon—and we stick to it.”

CalPERS also takes some digs at ACCF’s objectivity on this matter, or alleged lack thereof: “As MarketWatch notes, ACCF is funded in part by the Koch Brothers and energy companies like Exxon, Chevron, and Occidental [all of which, by the way, we own]. That’s why it’s not surprising that one of its four recommendations is that public pension funds insist that outside managers not vote for proposals that require additional disclosures beyond those mandated by regulatory authorities. That tired and tortured argument really means this: ACCF wants us to act like the index funds we invest in—passive and silent.”

Continuing the debate, ACCF has now responded with yet another analysis (the third in this process), suggesting the initial CalPERS response, too, fails to acknowledge key facts. Readers will have to review all three publications and draw their own conclusions, but offering his take on the back-and-forth, Gerstein says there are some potentially important lessons to be abstracted here for the future of ESG in the retirement planning industry, both in the public and private markets.

“Fiduciaries of plans of all sizes and types who are thinking of moving into utilizing more ESG investments should take note of how this debate unfolds,” Gerstein says. “I think to some degree this argument shows the good will amongst some members of the public and political class is not enough, from a fiduciary standpoint, to justify on its own the use of ESG investments. Fiduciaries must be able to explain and clearly articulate why the investments they choose are consistent with their fiduciary duties to pursue strong financial performance.”

Gerstein observes that under the new rules established late in the Obama administration, ESG investments are absolutely fair game and there is an important acknowledgement that ESG factors do directly impact financial performance of mutual funds. But it also must not be imagined that the Obama administration gave plan fiduciaries free reign to ignore negative drags on performance, whether the source of the drag is related to ESG methodology or any other source.

At a high level, Gerstein is certainly to be counted among the general advocates of ESG-minded investing, suggesting this ongoing debate is “important and healthy.” He suggests ESG is, unfairly, still “associated with this idea that it is pure political activism, without a tangible tie to improved investing performance.”

“The truth about ESG today is something quite different,” he concludes.  “There is very clear reporting from many highly respected sources that shows challenges like climate change, resource scarcity, political instability and the like, will be very impactful to the future performance of long-term investments that are being made and debated today. ESG investing can actually be a primary part of the analysis because it can affect the actual performance, but this analysis must be objective and it must put participant’s financial benefit first.”

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