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Cypen & Cypen
March 6, 2014

Stephen H. Cypen, Esq., Editor

1. COST-OF-LIVING ADJUSTMENTS: National Association of State Retirement Administrators has issued an Issue Brief dealing with the subject of cost-of-living adjustments, which in some form are provided on most state and local government pensions. The purpose of a COLA is to offset or reduce effects of inflation on retirement income. Considerable variation exists in the way COLAs are designed, and in many cases they are determined or affected by other factors, such as inflation or condition of the plan. COLAs add both value and cost to a pension benefit. Public pension COLAs have received increased attention, as many states look to make adjustments to the cost of benefits amid challenging fiscal conditions and the current low inflationary environment. The issue brief presents a discussion about the purpose of COLAs, the different types of COLAs as provided by government pension plans, and an overview of recent state changes to COLA provisions. The eroding of purchasing power of retirement income can affect sufficiency of retirement benefits, particularly for those who are unable to supplement their income due to disability or advanced age. Social Security beneficiaries are provided an annual COLA to maintain recipients’ purchasing power. Similarly, most state and local governments provide an inflation adjustment to their retiree pension benefits. This benefit is particularly important for those public employees -- including nearly half of public school teachers and most public safety workers -- who do not participate in Social Security. Unlike Social Security, however, state and local retirement systems typically prefund the cost of a COLA over the working life of an employee to be distributed annually over the course of his retired lifetime. The way in which public pension COLAs are calculated and approved varies considerably. In general, COLA types and features are differentiated in the following ways:

  • Automatic vs. Ad hoc.  An overarching distinction among COLAs is whether they are provided automatically or on an ad hoc basis. An ad hoc COLA requires a governing body actively to approve a postretirement benefit increase. By contrast, an automatic COLA occurs without action, and is typically predetermined by a set rate or formula. In some cases, ad hocCOLAs are contingent on other factors, such as a maximum unfunded liability amortization period.
  • Simple vs. Compound.  Another distinction between COLA types is whether the increase is applied in a simple or compound manner. Under a simple COLA arrangement, each year’s benefit increase is calculated based upon the retiree’s original benefit at time of his retirement. Under a compound COLA arrangement, the annual benefit increase is calculated based upon the original benefit as well as any prior benefit increases.
  • Inflation-based.  Many state and local governments provide a post-retirement COLA based on a consumer price index, which is a measure of inflation. Most provisions of this nature restrict the size of adjustment, such as by “one-half of the CPI” but “not to exceed three percent.”
  • Performance-based.  Some public pension plans tie their COLA to the plan’s funding level or investment performance. In one statewide system, for example, the COLA is a range tied to CPI based on the funding level of the plan.
  • Delayed-onset or Minimum Age. Another characteristic contained in some automatic COLAs is to delay its onset, either by a given number of years, or until attainment of a designated age.
  • Limited Benefit Basis. Some retirement systems award a COLA calculated on a portion of a retiree’s annual benefit, rather than the entire amount. For example, one system provides a COLA of three percent applied to only the first $18,000 of benefit.
  • Self-funded Annuity Option. Some state retirement plans offer post-retirement benefit increases through an elective process known as a self-funded annuity account. Under this design, a member effectively self-funds his COLA by choosing to receive a lower monthly benefit in exchange for a fixed rate COLA to be paid annually upon retirement.
  • Reserve Account. Other public retirement systems pay COLAs from a pre-funded reserve account. This method is a variation on the COLA tied to investment performance, since the reserve account is funded with excess investment earnings.

The cost of a COLA predictably depends on the level of the COLA benefit. Such factors as its size; the portion of the benefit to which the COLA applies; whether or not the COLA is paid annually or sporadically; whether the adjustment is simple or compounded; and other features, all affect its cost.

2. EVERYTHING CHANGES FOR THE PENSION WORLD’S “$20 BILLION CLUB”: When UPS and Pfizer filed their 10-K annual reports with SEC, they were the last to do so. The $20 billion club is Russell Investments’ name for 19 of the U.S. listed corporations with the largest defined benefit pension plans, each of which has around $20 billion or more in worldwide pension liabilities. They are the bellwethers of the U.S. defined benefit plan sponsor community. Of course, 2013 was a good year for the $20 billion club, and one which is likely to have a significant effect. The big change is that pension plan funding got stronger in 2013: that was a little bit due to good equity market performance and plan sponsor contributions, and a lot due to increasing interest rates. Looking at the 19 corporations in aggregate, the combined pension deficit fell from $220 billion to $114 billion, the best position in six years. The DB system has been in transition for several years now: from growing to shrinking, from return-seeking to risk averse, from growth-oriented to liability driven. This transition made some policy changes inevitable someday -- and someday is a lot closer now than it was a year ago.

3. SUPPLEMENTAL RETIREMENT PLANS OFFERED BY CITY AND COUNTY GOVERNMENTS: As many local governments have reduced the level of pension benefits they provide to new hires, the importance of boosting savings through supplemental retirement plans has grown. Yet, very little is known about these plans. A new Issue Brief from Center for State & Local Government Excellence examines the structure and terms of supplemental plans offered by 20 cities and counties around the country. (The only one from Florida is Tallahassee.) Four of the local governments in the study do not participate in Social Security; all offer a defined benefit pension plan. Some key findings are:

  • Fifteen of the local government employers offer only one type of plan; all 20 local government employers in the study offer at least one 457 savings plan.
  • Most plans allow loans.
  • Employers match employee contributions in just four plans.
  • Employees need more financial literacy and good information about plans to make optimal decisions when they have more choices to make.
  • More choices for employees may not be better if the quality of the plans, in terms of fees and investment options, is inferior to the quality of a more restricted access model.

More research will need to be undertaken to discover what motivates employees to save more for retirement.

4. MUNNELL SAYS ALL IS NOT FINE WITH PENSION COVERAGE: Alicia Munnell, Director of the Center for Retirement Research at Boston College, is not clear quite why op-eds, articles and conferences are out to show that the employer-sponsored pension system is fine. She suspects that the financial services industry is worried about changes in the favorable tax provisions awarded retirement saving, and have launched a coordinated campaign to show that the private sector is doing a good job in providing retirement income and that reducing the tax subsidy would be a serious mistake. One component of the “all-fine” effort is the contention that coverage is not a serious problem, since about 80% of workers have access to some form of pension. That number is very different from the figure she uses -- namely, that only 42% of private-sector workers aged 25 to 64 participate in an employer-sponsored plan. Both figures are produced by the U.S. Bureau of Labor Statistics. The 80% figure comes from the National Compensation Survey, which is an employer survey that provides comprehensive measures of occupational earnings, employment cost trends, and benefit incidence, and details on benefit provisions. The 42% figure comes from the Current Population Survey, which interviews individuals about their pension coverage and participation. Some differences may exist between the two surveys, but it is helpful to compare apples to apples. First, the 80% figure refers to both the private sector and state and local employers. The percent of state and local workers offered a pension is 99%, so eliminating them for the private sector drops the 80% to 74%. The second issue is full-time versus part-time. The 74% figure refers only to full-time private sector workers. Add in part-time workers and the 74% drops to 64%. The third issue is participation versus access. Only three-quarters of private-sector workers who are offered a plan chose to participate. Thus the National Compensation Survey reports that only 49% of private-sector workers participate in a retirement plan. Yet the 49% participation rate from the National Compensation Survey is not comparable to the 42% from the Current Population Survey. Both numbers refer to the private sector, both include both full-time and part-time workers and both relate to participation rather than access. However, the 42% figure in the Current Population Survey refers to workers age 25-64, whereas the National Compensation Surveyincludes all ages.  Eliminating the age constraint from the Current Population Survey drops the coverage rate from 42% to 37%. Thus, the apples-to-apples comparison is 49% from the employer survey and 37% from the individual survey. Munnell is not sure why the employer survey shows a participation rate for private sector workers that is 12% points higher. But even according to the “all-fine” campaign’s preferred data source, less than half of private sector workers are participating in a plan. That does not sound all fine to Munnell -- or probably to any other informed person.

5. RECENT PENSION REFORM EFFORTS IN FOUR STATES WITH DIVERSE POLITICAL CLIMATES: Pension Politics: Public Employee Retirement System Reform in Four States by Patrick McGuinn provides actionable policy recommendations for those states that are looking to enact such reforms. He examines recent reform efforts in four states with diverse political climates. Two of the states (Utah and Rhode Island) succeeded in passing significant structural changes to their pension systems, while the others (New Jersey and Illinois) enacted more limited, less innovative changes. The author highlights what activities have and have not been successful in producing meaningful reform, and details a number of recommendations for other states seeking to successfully improve their underfunded pension systems. Key recommendations include:

  • Avoid turning pension reform into an ideological issue. Do not allow the conversation around pension reform to devolve into a business versus regular dynamic. Reform leaders must stop blaming unions for pension issues, but rather focus on the numbers and the need to put the system on a sustainable path.
  • States need a credible and visible reform champion. Given the contentious nature of pension reform, credibility, visibility, and skill of the messenger is very important.
  • Reform advocates must gather and disseminate accurate data, and clearly communicate the reality of their state’s pension liability. Updated and unbiased information about the status of the pension fund and its projected future health, based on realistic actuarial assumptions, must be collected and disseminated. 
  • Demonstrate pensions’ impact on taxes and other state spending priorities. Reform leaders need to translate the budget data around pensions into opportunity costs to make it clear what impact of not making pension changes will be on the provision of public services.
  • Sell benefits of pension reform to state workers. Pension changes should be framed as ultimately in the best interests of pension participants relative to the consequences of pension plans getting to the point where they cannot meet their obligations.
  • Anticipate and plan for legal challenges. The U.S. constitution and  many state constitutions gives a high level of legal protection to contracts, which can open the door to court challenges to pension reform. Reformers need to be strategic in designing reforms that can survive inevitable legal challenges.

Patrick McGuinn is Associate Professor and Chair, Department of Political Science, Drew University.

6. BEYOND DIVERSIFICATION -- THE PERVASIVE PROBLEM OF EXCESSIVE FEES AND “DOMINATED FUNDS” IN 401(K) PLANS:Ian Ayres, Yale Law School, has co-authored a paper that again stirs the pot.  Notwithstanding ERISA’s fiduciary requirements, a wide range of plan administrators establishes investment menus with options that predictably lead to substantial underperformance of retirement portfolios. Utilizing data from more than 3,000 401(k) plans with more than $120 billion in assets, the paper provides evidence that fees lead to an average loss of 86 basis points in excess of low cost index funds. In 16% of analyzed plans, the paper finds that, for a young worker, the fees charged in excess of an index fund entirely consume the tax benefit of investing in a 401(k) plan. The authors also document a wide array of “dominated” menu fund options where costs of fees in holding the fund so outweigh the benefits of additional diversification that rational investors would not invest in these assets. Approximately 52% of plans have menus offering at least one dominated fund. In the plans that offer dominated funds, dominated funds hold 11.5% of plan assets, and these dominated investments tend to be outperformed annually by their low cost menu alternatives by more than 60 basis points. The authors argue that existing fiduciary duty law (aided by improved rule-making by the Department of Labor) can be used to challenge plans that imprudently expose investors to risk of excess fees. In particular, the authors argue that (i) evidence of excessive fees can be powerful evidence of an imprudent fiduciary process and (ii) fiduciaries act imprudently if they included dominated option in their menus, even if plan participants have other offerings with which to construct prudent retirement portfolios. But because heightened fiduciary duty reforms are unlikely by themselves to solve the problem of excess fees and dominated funds, the authors also propose three additional structural reforms: first, they recommend that the requirements for default fund allocations be enhanced to assure that the default investment is reasonably low cost. Second, they recommend that the Department of Labor designate certain plans as “high cost”, and mandate that participants in these plans be given the option to execute in-service rollovers to low-cost plans. Finally, the authors recommend that participants be required to demonstrate a minimum degree of sophistication by passing a DOL-approved test before they be allowed to invest in any funds that would not satisfy the enhanced default requirement. Spoken like a true academician.

7. SECURITIES LITIGATION UNIFORM STANDARDS ACT OF 1998 DOES NOT PRECLUDE PLAINTIFFS’ STATE LAW CLASS ACTIONS: Securities Litigation Uniform Standards Act of 1998 prohibits bringing of large securities class actions based upon statutory or common law of any State in which the plaintiffs allege a misrepresentation or omission of a material fact in connection with purchase or sale of a covered security. The Act defines covered security to include, as relevant in this case, only securities traded on a national exchange. Four sets of plaintiffs filed civil class actions under state law, contending that defendants helped Allen Stanford and his companies perpetrate a Ponzi scheme by falsely representing that uncovered securities (certificates of deposit in Stanford International Bank) that plaintiffs were purchasing were backed by covered securities. The U.S. District Court dismissed each claim under the Act. Although the certificates of deposit were not covered securities, the court concluded the bank's misrepresentation that its holdings in covered securities made investments in its uncovered securities more secure provided the requisite connection (under the Act) between plaintiffs' state law actions and transactions in covered securities. The U.S. Fifth Circuit Court of Appeals reversed, concluding that the falsehoods about the bank's holdings in covered securities were too tangentially related to the fraud to trigger the Act. On certiorari review by the United States Supreme Court, the Circuit Court of Appeals was affirmed: the Act does not preclude plaintiffs' state law class actions. Several factors support the conclusion that the scope of the statutory phrase “misrepresentation or omission of a material fact in connection with purchase or sale of a covered security” does not extend further than misrepresentations that are material to the decision by one or more individuals (other than the fraudster) to purchase or sell a covered security. First, the interpretation is consistent with the Act's basic focus on transactions in covered, not uncovered, securities. Second, the interpretation is supported by the Act's language. Third, the securities cases in which the Supreme Court has found a fraud to be “in connection with” a purchase or sale of a security, under both the Act and the Securities Exchange Act of 1934 (which also uses the phrase “in connection with”), have involved victims who took, who tried to take, who divested themselves of, who tried to divest themselves of, or who maintained an ownership interest in financial instruments that fall within the relevant statutory definition. Fourth, the Supreme Court reads the Act in light of and consistent with the language and purpose of the underlying regulatory statutes that refer to persons engaged in securities transactions that lead to taking or dissolving of ownership interests, which make it illegal to deceive a person when he or she is doing so. Fifth, a broader interpretation of the necessary statutory “connection” would interfere with state efforts to provide remedies for victims of ordinary state law frauds, despite the fact that the Act purposefully seeks to avoid such results by maintaining states' legal authority over matters that are primarily of state concern. Chadbourne & Parke LLP v. Troice, Case Nos. 12-79, 12-86 and 12-88 (U.S. February 26, 2014).

8.  BREAKING THE 4% RULE?: Recent J.P. Morgan research focuses on potential benefits of a dynamic retirement income withdrawal strategy.  Given the unpredictable nature of future expenses and portfolio values throughout retirement, there is mounting evidence that the static withdrawal rules of thumb that may have worked well enough in the past likely do not offer the most efficient use of retirement assets. The 4% rule in particular has faced increased scrutiny, prompted by the prolonged low interest rate environment and the negative impact fixed withdrawals had on shrinking account balances in wake of the 2008 financial crisis. Based on the research, periodically and systematically adjusting withdrawal rates and portfolio asset allocations in response to changes in personal wealth, age, market conditions and lifetime income may significantly enhance the retirement experience, in terms of both the amount of dollars received and retirees’ overall satisfaction with their withdrawals. Retirees can incorporate their unique circumstances and risk profiles when using the dynamic withdrawal strategy to secure their income needs and may better weather the constantly evolving nature of financial markets, including extreme market events. Over the past decade, retirees have been forced to navigate the dual investment challenges of extremely low interest rates and elevated market volatility. Many have relied on the popular 4% rule to draw down their portfolio assets, but this approach, developed in the very different market climate of the 1990s, has increasingly been called into question in terms of providing a truly sustainable retirement income stream. As a result, the rapidly growing number of investors preparing to enter retirement may wish to consider different withdrawal options. Research suggests investors and their financial advisors should look beyond the static rules of the past when seeking to achieve stronger results from retirement income withdrawal strategies. A portfolio based solution using a more robust withdrawal rate framework may help investors better address their retirement funding needs by embedding market risk, longevity risk and evolving personal investment criteria in a way that a cash-flow-based approach simply cannot.  Here are some key findings:

  • Maximizing expected lifetime utility (that is, potential derived satisfaction) serves as a more effective benchmark of retirement withdrawal success than typical measures, such as probability of failure.
  • A dynamic approach to managing withdrawals and asset allocations provides a more effective use of retirement assets than traditional approaches.
  • Age, lifetime income and wealth all provide key insights into how to adjust investors’ withdrawal strategies throughout retirement.

Based on the forgoing analysis, a dynamic withdrawal model may offer substantial advantages to help investors make the most of their assets throughout their retirement years.

9.  SUPREME COURT INTERPRETS SARBANES-OXLEY BROADLY: To safeguard investors in public companies and restore trust in the financial markets following the collapse of Enron Corporation, Congress passed the Sarbanes-Oxley Act of 2002. One of the Act’s provisions protects whistleblowers; at the time relevant here, that provision read “no public company or any contractor or subcontractor of such company, may discharge, demote, suspend, threaten, harass, or discriminate against an employee in the terms and conditions of employment because of whistleblowing activity”. Lawson was a former employee of FMR, a private company that contracted to advise or manage mutual funds. As is common in the industry, the mutual funds served by FMR are public companies with no employees. Lawson alleged that she blew the whistle on putative fraud relating to mutual funds, and, as a consequence, suffered retaliation by FMR. Lawson commenced suit in federal court. Moving to dismiss the suits, FMR argued that Lawson could state no claim under Sarbanes-Oxley, for that provision protects only employees of public companies, not employees of private companies that contract with public companies. On interlocutory appeal from the District Court’s denial of FMR’s motion to dismiss, the First Circuit reversed, concluding that the term “employee” refers only to employees of public companies. On certiorari review by the United States Supreme Court, the judgment was reversed. The Supreme Court concluded that the whistleblower protection includes employees of a public company’s private contractors and subcontractors. This reading is supported by the provision’s plain text. FMR’s textual arguments were unpersuasive. It argued that “an employee” must be read to refer exclusively to public company employees to avoid the absurd result of extending protection to the personal employees of company officers and employees, that is, their housekeepers or gardeners. This concern appears more theoretical than real and, in any event, is outweighed by the compelling arguments opposing FMR’s reading. FMR also urges that its reading is supported by the provision’s statutory headings, but those headings are not meant to take the place of detailed provisions of the text. The Court’s reading fits the aim to ward off another Enron debacle. The legislative record shows that Congress understood that outside professionals bear significant responsibility for reporting fraud to the public companies with which they contract, and that fear of retaliation was the primary deterrent to such reporting by employees of Enron’s contractors. Sarbanes-Oxley contains numerous provisions designed to control the conduct of accountants, auditors, and lawyers who work with public companies, but only the subject provision affords such employees protection from retaliation by their employers for complying with the Act’s reporting requirements. The Court’s reading avoids insulating the entire mutual fund industry from the provisions effect.  Virtually all mutual funds are structured so that they have no employees of their own; they are managed, instead, by independent investment advisors. Accordingly, the narrower construction endorsed by FMR would leave the provision with no application to mutual funds. The Court’s reading, in contrast, protects the employees of investment advisors, who are often the only firsthand witnesses to shareholder fraud involving mutual funds. There is scant evidence that the subject decision will open any floodgates for whistleblowing suits outside the provision’s purposes. Lawson v. MFR LLC, Case No. 12-3 (U.S. March 4, 2014).

10. TOP TWELVE MOST HOMOPHOBIC NATIONS: Here are the Dirty Dozen of Most Homophobic Nations, according to Newsweek:

  • Nigeria. Nigeria is the most homophobic country in the world, with 97% of citizens thinking society should not accept homosexuality. Same-sex couples face up to 14 years in prison for any public display of same-sex affection.
  • Uganda.  The spotlight has been focused on Kampala recently for its anti-LGBT policies. A law recently passed makes homosexuality punishable by up to life in prison.
  • Zimbabwe. President Robert Mugabe has made a crusade out of homophobia -- with widespread public approval.
  • Saudi Arabia. Basing its law on a strict interpretation of Islamic law, the current Saudi regime has made gay sex punishable by death by the lash.
  • India. Thought of as a highly tolerant society, it came as a surprise earlier this year when the country’s highest court reinstated a colonial era law criminalizing gay sex.
  • Honduras. There have been a spate of anti-LGBT hate crimes in recent years. More than 80 LGBT people have been killed in hate crimes since 2009.
  • Jamaica. Sex between men is illegal, hate crimes are alarmingly common and the government seems reluctant to protect gays from violence.
  • Senegal. One of the most anti-gay countries in the world, where 96% of Senegalese think society should not accept homosexuality.
  • Afghanistan. It may no longer be under the rule of the Taliban, but harsh views toward homosexuality remain. It is still news when an Afghan comes out as gay, even from Toronto!
  • Iran. Mahmoud Ahmadinejad, Iran’s last president, famously told Americans: “we don’t have homosexuals in our country like you do.” Homosexuality is illegal in Iran, and can even be punishable by death in certain cases.
  • Lithuania. The Baltic state’s parliament is considering a law similar to Russia’s notorious anti-gay anti-propaganda law. Last year’s second-ever gay pride parade was interrupted by homophobic protesters.
  • Sudan. Homosexuality is punishable by death and even attempts at arranging a homosexual act can lead to a prison sentence.

11. DATING ADS FOR SENIORS: WINNING SMILE: Active grandmother with original teeth seeking a dedicated flosser to share rare steaks, corn on the cob and caramel candy.

12. ADULT TRUTHS: I keep some people's phone numbers in my phone just so I know not to answer when they call.
13. TODAY IN HISTORY: In 1950, Silly Putty invented. (This one is a real stretch.)

14. KEEP THOSE CARDS AND LETTERS COMING: Several readers regularly supply us with suggestions or tips for newsletter items. Please feel free to send us or point us to matters you think would be of interest to our readers. Subject to editorial discretion, we may print them. Rest assured that we will not publish any names as referring sources.

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Items in this Newsletter may be excerpts or summaries of original or secondary source material, and may have been reorganized for clarity and brevity. This Newsletter is general in nature and is not intended to provide specific legal or other advice.

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