Client Service December 19, 2018

Mercer Recommends Areas of Focus for DB Plans in 2019

According to Mercer, developing a “journey plan” that outlines the strategic policy choices to move a plan to its ultimate destination is a step many plan sponsors have undertaken.

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Most defined benefit (DB) plan sponsors enjoyed significant funded status improvements in the first three quarters of 2018. According to Mercer, the continued bull market, coupled with a significant rise in discount rates, drove up the aggregate funded ratio of pension plan sponsors in the S&P 1500 from 84% to 92% by the end of September—the highest level in the past five years.

However, the beginning of the fourth quarter reminded plan sponsors of the potential equity volatility inherent to plan funded status performance and continued equity risk moving forward, including concerns of a potentially less accommodative Federal Reserve. Mercer says this highlights the question, “When is the right time to bank on funded status improvements?”

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In its “Top 10 Defined Benefit Areas of Focus for 2019,” Mercer suggests that whether a DB plan has a formal glide path in place or not, plan sponsors should take a fresh look at their current situation and risk posture and consider monitoring funded status more frequently to ensure opportunities are not missed; reviewing the plan situation to determine or reconfirm the plan sponsor’s ultimate intended destination for the plan and the conditions that should drive changes in the structure of the investment portfolio or to initiate a transfer of plan obligations and risk off balance sheet (in part or in full); and putting the appropriate governance in place so plan sponsors can move quickly to take advantage of market opportunities as they are presented.

According to Mercer, developing a “journey plan” that outlines the strategic policy choices to move a plan to its ultimate destination is a step many plan sponsors have undertaken. The three primary elements of a journey plan are investments, funding and risk transfer strategies (for some plans, plan design may also be an option). Mercer says it is important that these strategies are coordinated where appropriate, for example by linking the investment policy with planned risk transfer activity, to manage cost and risk. As another example, where the journey plan calls for annuitizing a portion of the liability, adjusting the investment policy to account for financing the transaction by transferring assets-in-kind can reduce premium costs.

Mercer also suggests DB plan sponsors assess pension risk transfer strategies. It notes that there are emerging solutions gaining increased attention for 2019. For one, while organizations may pay lump sums to terminated, vested participants, plan sponsors can structure a transaction to offer lump sums to active employees with frozen benefits, although Mercer notes this is slightly more complex. The firm notes that such an offer can shed liability, reduce Pension Benefit Guaranty Corporation (PBGC) premiums and allow employees to roll their lump sum into their defined contribution (DC) plan, though the cost may not always be attractive. Other strategies to consider for 2019 are to implement a pension buy-in—the plan sponsor purchases an annuity as an asset that it holds and which provides cash flows to pay benefits—rather than a pension buy-out, and a full plan termination, which settles all liabilities through a combination of lump sums and annuity buyouts.

If plan sponsors are currently navigating the plan termination process, Mercer says it is time to focus on the investment risk hedging strategy and critical drivers of termination costs, such as the plan’s lump sum stability and look-back periods and the impact that the lump sum rate-lock date will have on the total plan termination liability duration. Mercer offers details about changes to contemplate for a plan’s liability hedging portfolio, as well as considerations for bond capacity, re-evaluating growth portfolio construction and alternatives, and managing the growth portfolio’s liquidity along a plan’s glide path.

Looking ahead to possibly more volatile market activity, Mercer notes that protection strategies always reduce return as they reduce risk if the strategy is held for a long period. “The key to options, and most protection strategies, is to use them when there is something in particular to protect against, and it can’t be the same thing everyone else wants to protect against. An option strategy to protect a portfolio from a loss prior to a planned buyout or lump sum can be effective, as might an interest rate strategy that takes in a premium for accepting the risk of buying bonds after rates rise,” the firm says.

Finally, Mercer recommends assessing opportunities to improve investment governance. “Understanding why plan sponsors have made the decision to shift to the OCIO [outsourced chief investment officer] approach, and whether these decision drivers are applicable to your organization, is critical,” it says.
Compliance December 19, 2018

After Grace Period, SEC Share Class Disclosure Investigations Begin

Attorneys warn the “other shoe has dropped” in the SEC’s special Share Class Disclosure Initiative—and RIAs that did not self-report potential 12b-1 fee disclosure violations are now being investigated.

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In February of this year, the U.S. Securities and Exchange Commission’s Division of Enforcement announced a special “Share Class Selection Disclosure Initiative,” under which registered investment advisers (RIAs) could self-report and correct previous failures to disclose the selection of mutual fund share classes that paid a Rule 12b-1 fee when a lower-cost share class for the same fund was available to clients.

In a new legal alert shared by Eversheds Sutherland, attorneys warn the “other shoe has dropped,” and SEC investigators are now following up with firms that didn’t self-report under the share class initiative by the June deadline. They say the SEC seems to be targeting firms that it thinks should likely have self-reported potential violations but did not.

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As the Eversheds Sutherland attorneys point out, in announcing this initiative, SEC enforcement staff pledged that if RIAs accurately self-reported violations and promptly returned money to harmed clients, then it would recommend favorable settlement terms with no civil penalty for any resulting enforcement action against the self-reporting RIA. On the other hand, if RIAs didn’t self-report, then SEC enforcement staff would recommend “violations and remedies beyond those described in the initiative, including penalties that could be greater than those imposed in past cases involving similar disclosure failures.”

Eversheds Sutherland attorneys warn, beginning last week, SEC enforcement staff started sending request letters to firms that didn’t self-report “but perhaps should have.” The request letters largely mirror the 12b-1 disclosure issues set forth in the initiative, the attorneys say, but the letters expand on the SEC’s initial review with regard to two key areas.

“First, the SEC has expanded the relevant time period, going back to 2013,” the attorneys note. “Second, the SEC’s request covers not just 12b-1 fees, but also revenue sharing, including requesting all agreements concerning revenue sharing payments and data regarding each mutual fund that made revenue sharing payments due to the share class in which the advisory client assets were held.”

The attorneys warn that, assuming SEC enforcement believes a firm’s disclosures were inadequate, investigators may focus on the following additional issues: “Why the firm didn’t self-report; why the firm’s conduct resulted in inadequate disclosures; and any subsequent remedial efforts taken by the firm.” As described in the initiative announcement, SEC enforcement actions will likely allege fraudulent disclosures, breach of fiduciary duty and best execution failures.

“If firms have not received enforcement’s requests, they may, nonetheless, want to assess the issues being investigated,” the Eversheds Sutherland attorneys recommend.

The choice to forego self-disclosure

According to attorneys with the Wagner Law Group, some advisory practices may have had reason to forego this “carrot and stick” opportunity to self-report potential violations of fee disclosure and fiduciary standards. While the term “amnesty” used by SEC staff in describing the initiative conjured up an image of full forgiveness, the Wagner attorneys warn that any voluntary remediation program of this nature is not without its own risks.

“For one thing, it is not actually mandatory to self-report, although dual registered firms must consider their FINRA reporting obligations under FINRA Rule 4530(b),” the Wagner attorneys note. “Missteps in crafting a correction can increase a firm’s legal and reputational risk. Cease and desist orders carry their own consequences.”

The attorneys urge advisers to be cautious even as they do the right thing: “The goal of correcting past violations is to make injured parties whole, prevent recurrence and avoid increased scrutiny by regulatory authorities. Remedial efforts generally, and the decision whether to participate in the Share Class Disclosure Initiative, require a thoughtful, well-documented and careful review by the investment adviser.”

Because this initiative covers only eligible individual advisers, the attorneys warn, other individuals associated with the same firm do not actually have assurance that they will be offered similar terms for their role in any self-reported violations.

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