Client Service March 15, 2018

DISRUPTION: Insider Service and Strategy Talk With PGIM

In an exclusive interview with PLANADVISER, PGIM Head of Institutional Defined Contribution Josh Cohen offers some guidance to advisers speaking with plan sponsors about litigation, fiduciary risk and progressive plan design.
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It has been just about eight months since Josh Cohen, formerly at Russell Investments, took on the role of head of institutional defined contribution (DC) plan business for PGIM, the investment management wing of Prudential Financial.

Describing the move from Russell to PGIM, Cohen says the job is actually pretty similar, despite the somewhat different focuses of the large financial services organizations.

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“Working with plan sponsors and their consultants, and bringing thought leadership and strategic advice has remained very familiar and similar across the organizations,” he explained. “I think that speaks to the similar ways that companies in this space are trying to get ahead and be strategic about client service and growth.”

At PGIM, Cohen now gets “even more unique insights to work with,” given that he can look across all the different segments of Prudential Financial. For starters, being associated with a top-10 recordkeeper with several million participants gives him a new view into how participants behave and what drives their behavior. A big part of the new gig, as Cohen put it, is to “grab insights from all across the organization and then help to build those into real solutions.”

“I think it’s becoming increasingly clear to everyone in the DC plan industry that the DC plan solutions of tomorrow are going to cross over the traditional lines of investments, design, administration and guaranteed income solutions,” Cohen suggest.

A decade out from PPA, much more work is needed

Asked to step back and describe the DC plan industry’s development over the last decade, Cohen pointed out academic research still shows only 57% of plans are automatically enrolling new hires, and most commonly they still use a default rate of 3%.  

“We talk so much about how important automatic enrollment is, and how important it is to set people up with 6% or even 10% deferrals to get them on the right track,” Cohen pointed out. “And so it can be eye opening to pause and look at the academic research and see that the Pension Protection Act has brought about some tremendous strides, but to realize we’re still quite far away from having a totally rationalized DC plan environment in the U.S.”

As readers will likely know, historically it has been the larger end of the DC plan market where the best practices have taken hold earlier. But there has been a historical legacy even in this market segment of using lower match rates of 2% or 3%, driven in part by past regulations, but also by the notion that, as Cohen framed it, “We need to start folks off lower so we don’t scare them away.”

“Today, there is a greater recognition that we need to take into account the fact that employees are thirsting for guidance from their employer, and they won’t run away from higher default rates,” Cohen said. “At PGIM, something we are doing is pushing this idea of ‘individual retirement income liability’ within plan designs. It’s not just about deferring 6% or 10% for the sake of deferring 6% or 10%. Even a simple analysis shows these are the levels at which most individuals are going to have to save, at the very least, to have any chance at all of meeting their own retirement income liability through DC plans.”

Cohen agreed there is not one specific deferral rate to point to that is the right rate for everyone, but that being said, the proper rate for a given individual is very likely higher than 3%.

“Even if you factor in a 2% or 3% employer match, it’s just not going to be enough to get folks to meet their liability,” Cohen warned. “Through our research, we estimate that 57% of employees are somewhat or very stressed about their financial situation, but only 30% admit to being distracted at work about their finances. This is a problem for employers and employees alike. You can see it in the workplace around you that financial hardship and distractions really do have an impact on employers and on their bottom line.”

Previous Prudential research shows, for each individual who cannot retire at the traditional age of 65, the cost averages an extra $50,000 a year, representing the difference between the salary and benefits of an older worker and hiring a younger person. The annual cost across a workforce is an additional 1.0% to 1.5% a year. Considering a company with 3,000 employees and workforce costs of $200 million, a one-year delay in the average retirement age would cost the firm between $2 million and $3 million.

“Helping to solve this problem is a big initiative for us,” Cohen said. “We see very clearly the need to find new ways to get employers to think about the big picture of workforce management, vis-à-vis, the retirement and benefits programming. I think it is really important for DC plan sponsors not just to worry about features such as the default rate or the default investment. It also has to be about outcomes, because a more retirement ready work force is not just good for the participants, but also for the company.”

Litigation threat has delayed progress

Cohen went on to describe another factor at play here that has complicated the effort to broadly improve DC plans in the United States.

“On the litigation threat, we are stressing that minimizing any and all perceived fiduciary concerns should not be the sole basis of the decisions being made within DC plans,” Cohen said. “This may seem counterintuitive, but doing so could potentially put participants at risk of failing to meet their goals, arguably creating more legal risk by violating one’s fiduciary duty in thinking more of the sponsors’ risks than the participants’ best interest.”

Cohen asked readers to consider that, since 2006, there have been over 120 class action lawsuits filed related to fees, and while many have settled, very few judgements have actually been issued against sponsors.

“Even so, litigation risk often does deter plan sponsors’ willingness to implement innovative investment or administration solutions for their DC plans,” Cohen noted. “This includes adding diversified asset classes or having a thoughtful mix of active and passive funds, for which PGIM advocates strongly. In fact, where plan sponsors have selected an entirely passively-managed menu, our surveys show as many as a quarter did so because they are easier for a fiduciary to monitor and nearly the same number did so to alleviate threat of litigation.”

This is problematic because the fiduciary obligation in fact require sponsors to do what is in the best interest for participants, and not simply offer basic, passive investment options that are easier to oversee. In other words, fees are critical to consider, but the Employee Retirement Income Security Act (ERISA) requires that costs be “reasonable,” and not necessarily the lowest. Also, documentation of deliberation and decisionmaking by the retirement plan committee or the dedicated investment committee is crucial.

Promoting the language of ‘individual retirement income liability’

Turning to his expectations for progress—or not—on these and other challenging issues, Cohen suggested a broad new perspective is needed, one that focuses more on the notion of “individual retirement income liability.”

“As all of these issues play out, ultimately we must keep in mind that DC plan participants will need ongoing help in managing a variety of risks, notably market, inflation, and longevity risks,” Cohen said. “Longevity risk, the risk of outliving one’s money, is linked to all risks retirement savers experience and thus, the most critical to manage.”

Individual participants in DC plans will always face the structural disadvantage of not being able to pool their mortality risks. In addition, growing life expectancies due to healthier lifestyles and advancements in medicine require that investment earnings keep pace. Further, demographers have often underestimated life expectancy. For example, an American born in 1940 was expected to live on average until 63; current life expectancy for that 1940 cohort is now known to be well over 75.

“These mortality improvements, while positive from a lifestyle perspective, leave participants in a difficult position to manage through these risks on their own,” Cohen warned. “Insurance-related solutions can be of significant help to bolster private savings and Social Security. These products have the ability to better pool mortality risk, reduce market volatility, and protect against inflation, but of course they come with unique complexities that need to be carefully considered.”

Cohen believes sponsors should be aggressive and truly help participants solve these challenges, even with expectations that some participants may intend to leave the plan upon retirement.

“Doing so will require addressing a variety of questions,” Cohen said. “Will the retirement income solutions be offered in-plan or out-of-plan? Should it be guaranteed or not? If in-plan, is the product offered on a standalone basis or part of an existing investment option like a target-date fund? If income is guaranteed, is the rate the guarantee is based on fixed or variable? Is it portable?”

For insurance-related products, fiduciary and cost concerns continue to weigh on sponsors, but increased protection from regulators around insurer selection will likely lead to greater adoption.

“While we understand the process can be overwhelming, sponsors and their advisers should determine the appropriateness of various solutions, particularly given the growing role of DC plans in retirement savings,” Cohen concluded. “The reality is that there is likely not a single one-size-fits-all solution, and retirees will need access to a variety of products and services that meet their specific objectives and situation. A good first step sponsors can take is communicating to participants in terms of projected future retirement income, away from the focus on account balances.”

Compliance March 5, 2018

FINRA Rep Monitoring Rule Change Could Trigger RIA Compensation Renegotiation

The regulator is reassessing its requirements for RIAs to monitor the outside business activities of their reps; one experts argues it is likely that, if the final rule reflects the proposed rule, many plan advisers who serve plans through an independent RIA (as opposed to the broker/dealer’s “corporate” RIA) will seek to renegotiate their compensation arrangements relating to their independent RIA revenue.
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A new proposed rule published by the Financial Industry Regulatory Authority (FINRA) would replace FINRA Rules 3270 and 3280 and is, according to FINRA leadership, intended to reduce unnecessary burdens while strengthening investor protections relating to advisers’ outside business activities.

Advisers and other financial industry practitioners are invited to share comments with FINRA through April 27, 2018. Comments must be submitted through one of the following methods: Emailing comments to pubcom@finra.org; or mailing comments in hard copy to Jennifer Piorko Mitchell, Office of the Corporate Secretary, FINRA, 1735 K Street NW, Washington, DC, 20006-1506.

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By way of background, the announcement comes after FINRA launched what is described as “a retrospective review of its outside business activities and private securities transactions rules to assess their effectiveness and efficiency.”

As FINRA explains, these rules serve important goals—they seek to protect the investing public when a member’s registered or associated persons engage in potentially problematic activities that are unknown to the member but could be perceived by the investing public as part of the member’s business. An ancillary benefit, FINRA argues, is that the rules protect the member from resulting reputational and litigation risks.

The retrospective rule review confirmed the continuing importance of rules relating to outside activities, FINRA says, but also indicated that the current rules, as well as related guidance, “could benefit from changes to better align the investor protection goals with the current regulatory landscape and business practices.”

In particular, FINRA received significant feedback on “members’ obligations with respect to the investment advisory activities of their registered persons.” Consistent with a number of recommendations by stakeholders during the retrospective review, FINRA is proposing a single streamlined rule to address the outside business activities of registered persons.

Here’s how FINRA explains the streamlined approach: “The proposed rule would require registered persons to provide their members with prior written notice of a broad range of outside activities, while imposing on members a responsibility to perform a reasonable risk assessment of a narrower set of activities that are investment related, allowing members to focus on outside activities that are most likely to raise investor protection concerns.”

Perhaps the most substantive change, FINRA says, is that the proposed rule also would generally exclude a registered person’s “personal investments,” sometimes referred to as “buying away,” and work performed on behalf of a member’s affiliates. Moreover, the proposed rule would not impose supervisory and recordkeeping obligations for most other outside activities, including investment advisory activities at an unaffiliated third-party investment adviser. At the same time, the proposal would hold a member responsible for approved activities that could not take place but for the registered person’s association with a member.

FINRA provides some examples to explain the spirit and general scope of the new rule as currently envisioned:

  • When selling private placements away from the FINRA member, for example, this situation would be subject to the proposed rule, potentially to the fullest extent. In other words, such selling activity would require prior notice by the registered person and a risk assessment by the member. If the member disapproves the activity, it has no further obligation. If the member approves the activity, the activity becomes part of the member’s business and must be supervised and recorded as such.
  • When a rep engages in activities at a third-party investment advisory shop, this situation would also be subject to the proposed rule, but in an intermediate manner. In this situation, prior notice by the registered person and risk assessment by the member are required, because the activities here are investment related and not excluded from the proposed rule, but the member is not required to supervise or keep records of the activities.
  • When a rep engages in non-investment related work, for example car service or seasonal retail, this situation is also subject to the proposed rule, but in a limited manner—a registered person must provide prior notice to the member, but the member is not required to perform a risk assessment of or supervise the activity.
  • When a rep engages in activities at affiliates, for example banking or insurance affiliates of the FINRA member, this situation is generally excluded from the proposed rule. Specifically, the proposed rule excludes activities at affiliates, whether or not investment related, unless those activities would require registration as a broker or dealer if not for the person’s association with a member.
  • When a rep engages in personal investing activity, or “buying away,” this is excluded from the proposed rule, but potentially subject to other rules (e.g., FINRA Rule 3210) or firm-imposed notice requirements.

Offering some further analysis and explanation, FINRA officials note that a majority of stakeholders that provided feedback during the retrospective review believed that the scope of activities subject to the outside business activities rule, Rule 3270, should be narrowed.

“On the other hand, a significant minority of stakeholders favored the rule’s current notice requirement to ensure that registered persons report a broad range of outside activities to their employing firms,” FINRA admits. “Moreover, a number of stakeholders believed that notice of private securities transactions under Rule 3280 should not be narrowed. The proposed rule takes a balanced approach that would ensure that members are apprised of their registered persons’ outside activities, while tailoring members’ responsibilities to those activities that are most likely to raise investor protection concerns.”

The explanation continues: “To that end, FINRA is proposing a single rule that would require registered persons to provide their firms with prior written notice for all investment-related or other business activities outside the scope of their relationship with the member. The proposed rule would require that a registered person include in the notice a description of the proposed activity and the registered person’s proposed role therein, and that the registered person update the notice in the event of a material change to the activity. With respect to investment related activities only, a registered person would be required to receive prior written approval from the member before participating in the activity.”

The rule would define “investment-related” as “pertaining to securities, commodities, banking, insurance, or real estate (including, but not limited to, acting as or being associated with a broker-dealer, issuer, investment company, investment adviser, futures sponsor, bank, or savings association).” This definition is also used for purposes of the Uniform Application for Securities Industry Registration or Transfer (Form U4) and would better harmonize the Form U4 reporting requirements and the notice obligations under FINRA rules, an issue frequently raised during the retrospective review.

Also important, the concept of “business activity” would be similar to current Rule 3270, with minor clarifying changes, and would be defined in the rule as acting as an employee, independent contractor, sole proprietor, officer, director or partner of another person; or receiving compensation, or having the reasonable expectation of compensation, from any other person as a result of the activity.

“Similar to current Rule 3270, the proposed rule would apply only to the outside activities of registered persons. It would not apply to the activities of members’ non-registered associated persons because the risk of potential conflicts is more prevalent with regard to registered persons,” FINRA concludes. “However, the proposed rule would not preclude members from instituting policies and procedures relating to the outside activities of associated persons more broadly.”

Rule change could trigger compensation relegations

Asked to interpret the possible outcomes of such a rule change, Jason Roberts, CEO of the Pension Resource Institute, says it is likely that, if the final rule reflects the basic tenants of the proposed rule, many plan advisers who serve plans through an independent registered investment adviser [RIA] (as opposed to the broker/dealer’s “corporate” RIA) will seek to renegotiate their compensation arrangements relating to their independent RIA revenue.

“Currently, many broker/dealers charge a ‘haircut’ for supervising and, in some cases, facilitating select compliance-related functions related to the adviser’s role in the independent RIA,” Roberts notes. “The proposed test for the required risk assessment, which the B/D must perform before approving the outside, investment-related business activity, should allow many independent investment adviser representatives (IARs) to argue that their institutional plan clients are sufficiently distinguishable from their individual clients (who may also be clients of the B/D) such that they may not be required to be supervised by the B/D.”

For those who successfully make the case, Roberts argues, they should be able to eliminate or lower the haircut charged by the B/D, at least to the extent it was previously imposed for supervisory purposes.

“In other words, if the plans have no relationship with the B/D, other than the fact that their independent RIA plan adviser happens to work with individual clients through an unaffiliated B/D, then it would be hard for the B/D to argue that the adviser’s services would negatively impact the B/D’s customers or the investing public,” Roberts says. “It will also allow more plan advisers to serve plans in a discretionary, aka 3(38), capacity. The current rules (specifically, 3280) require B/Ds to supervise their registered reps’ business when the rep, who is acting as an IAR for an independent RIA, places trades for the client with any firm (i.e., an unaffiliated recordkeeper or custodian) other than their B/D. Notably, the language below is not included in the proposed rule that would replace FINRA Rule 3280: ‘If the member approves a person’s participation [that relates to the rep placing trades with firms other than his/her B/D], the transaction shall be recorded on the books and records of the [B/D] and the member shall supervise the person’s participation in the transaction as if the transaction were executed on behalf of the member.’”

According to Roberts, this rule has been the chief impediment for a significant percentage of plan advisers that would like to offer discretionary, investment-related services to their plan clients.

“If this condition no longer applies, then we can expect to see a marked shift in the marketplace as we see plan sponsors increasingly looking to outsource fiduciary functions,” Roberts concludes. “I would strongly encourage advisers to conduct their own risk assessments before taking action in response to changes emanating from a final rule.”

In some cases, Roberts says, the independent RIA is more reliant than it may first appear on compliance-related support provided by their B/D.

“Also, adding discretionary, ERISA fiduciary services requires new agreements, disclosures, policies/procedures, E&O coverage, etc.,” he explains. “I expect we will also see B/Ds, which currently derive a significant amount of revenue from these supervisory/haircut arrangements, moving to expand the scope of retirement plan-related compliance and practice management resources they offer to independent RIAs. We have a number of member firms that are already doing this and more that are evaluating how best to support plan advisers generally.”

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