Cypen & Cypen
APRIL 19, 2007
Stephen H. Cypen, Esq., Editor
1. RISING CONCERNS PROMPT DEFINED BENEFIT PLANS TO EXPLORE NEW INVESTMENT APPROACHES:
A new comprehensive study of large corporate and public defined benefit plans conducted by Pyramis Global Advisors found that against a backdrop of significant regulatory and accounting changes in 2006, many plans are considering new investment strategies to help them deliver on their obligations to employees. The fifth annual defined benefit survey addressed issues with chief investment officers, treasurers and executive directors at more than 200 of the largest DB plans in the United States. The survey showed public DB plans are beginning to wrestle with new rules from the Government Accounting Standards Board, which, for the first time, will require them to account for future health-care liabilities. Chief among the rising concerns regarding costs are increasing life expectancies (for example, new mortality assumptions) and rise in health-care costs. The majority of public DB plans estimate their health care liability (other post-employment benefits, “OPEB”) to be more than $1 Billion. This situation has prompted them to focus more on investment performance, with 53% naming a low-return environment as their biggest concern. These new liabilities likely will need to be pre-funded, putting further stress on the system, another motivation for public DB plans to expand their universe to investment options. In addition, the survey found that many plans were considering new ways of engineering their portfolios. For example, survey results found that more than 80% of large DB plans are either using or considering portable alpha programs. And, for the first time ever, asset allocation to international equities for public DB plans actually exceeded asset allocation to international equities for corporate DB plans! Public and corporate DB plans share a common need to find and employ new investment strategies and are loosening many of the historical constraints they have been under. They are interested in non-traditional strategies to help meet their return targets in a low-yielding, single-digit return environment.
2. AN INVESTOR GUIDE TO THE STOCK OPTION TIMING SCANDAL:
Institutional Shareholders Services has issued an Investor Guide to the Stock Option Timing Scandal. Although the paper was published/revised July 2006, in terms of background and implications for shareholders, it is still timely. For years, institutional investors have complained about the excessive pay packages received by top executives at underperforming U.S. companies. In many cases, shareholders have trouble tracking what was happening because of inadequate corporate disclosure of equity incentives, retirement benefits, perks and change-in-control payments. About fifteen months ago, the U.S. Securities and Exchange Commission unveiled a set of new pay disclosure rules. The proposal was hailed as a positive step to improve transparency and underscore the duty of directors to ensure that corporate assets are used wisely. However, this sense of optimism faded after a Wall Street Journal questioned the timing of stock option grants at six companies. Within weeks, the SEC and federal prosecutors were scrutinizing option grants at dozens of technology and health care companies. More than fifty firms subsequently disclosed criminal, regulatory or internal investigations into whether they had backdated or otherwise manipulated the timing of stock option grants to maximize compensation for senior executives. As the number of companies under scrutiny has continued to grow, institutional investors are increasingly concerned, asking questions and urging regulators to take action. To help investors understand the issues raised by option timing, ISS prepared this guide, which details how the scandal developed and how shareholders and companies have responded. It can be accessed at http://www.issproxy.com/pdf/OptionTiming.pdf.
3. AMERICA CELEBRATES TAX FREEDOM DAY:
Tax Freedom Day® will arrive on April 30 this year, the 120th day of 2007. That date means Americans will work four months of the year, from January 1 to April 30, before they have earned enough money to pay this year’s tax obligations at the federal, state and local levels. Americans work a significant number of days each year to pay for things other than government, but nothing else is so expensive: they will work for food, clothing and housing a combined 105 days. Since 1986, taxes have cost more than these basic necessities. In fact, Americans will work longer to afford federal taxes alone (79 days) than they will to afford housing (62 days). Although government is by far the most expensive thing Americans buy, there is one category of spending that has grown faster than taxes -- health care. The number of days Americans work to pay for medical service jumped from 29 days in 1982 to 52 this year, a 23-day increase in 25 years, almost an extra day of work each year. Of course, the growing cost of health care is in part due to the growth of Medicare and Medicaid, which are funded by taxes. Ultimately, Americans get more taxes and more expensive medical care. As taxes and health care have absorbed more of the nation’s income, the category that has taken the biggest hit is savings, which has plummeted from 35 days in 1982 to negative 4 days this year. Tax Freedom Day® has arrived later each year for four years running.
4. BUILDING THE FOUNDATIONS FOR NEW RETIREMENT SYSTEMS:
From PRNewswire we learn that the Society of Actuaries, in conjunction with its Pension Section Council, has released “Building the Foundations for New Retirement Systems,” a report that examines retirement systems models against needs, risks and roles of all stakeholders contributing to and benefitting from the current systems. This report is the first comprehensive one stemming from SOA’s Retirement 20/20 initiative, a project that brings together, for the first time, key stakeholders with an interest in developing new retirement systems. Participants, who included pension actuaries, corporate benefits managers, attorneys, public policy advocates and academics, developed six major themes they say will need to be addressed in designing new retirement systems:
5. BABY BOOMERS ARE RIPPING UP THE RETIREMENT RULE BOOK:
Baby Boomers (those born between 1946 and 1964) are changing the face of retirement. It remains to be seen, however, exactly what form that change will take, according to a piece in the International Foundation of Employee Benefits Plan’s Benefits & Compensation Digest. Marketers and anthropologists often label subgroups to help define a phenomenon, such as “empty nesters.” In ten years, “career extenders,” “later-life balancers” and “second stagers” may well be in the vernacular. Developing in tandem will be new classes and forms of retirement benefits. Many, somewhat ironically, will aim to prolong the very act of retiring -- to the satisfaction of employee and employer alike. The article explains how and why this shift is happening.
6. WHAT’S RIGHT WITH PUBLIC PENSIONS:
Writing in governing.com, Girard Miller, who usually rags on public sector defined benefit systems, tells what’s right with public pensions. First, a defined benefit pension is the more certain way to assure retirement security. Studies have already shown that workers in the private sector are not saving enough in their 401(k) and other personal retirement accounts to provide for sufficient replacement income upon retirement. A pension plan does that by providing a formula assuring long-term employees that they will generally receive 60%-80% of their final compensation through a pension often supplemented by Social Security, regardless of swings in the stock market. For employees who go the distance of a long career, it’s hard to beat. Second, most of the largest state pension plans are more investment-efficient than defined contribution plans. They retain experts to allocate their assets, and invest their money with lower fees than those that individuals must pay for mutual funds in defined contribution plans. Although pension trustees do make investment mistakes, their long-term performance usually exceeds that of many individual employees who tend to buy high and sell low, chasing past performance or trading impulsively. Third, and perhaps most important, a pension plan absorbs longevity risk. People are living longer, which means more retirees will outlive their modest savings. That will especially be a problem for defined contribution plan retirees. Statistically, half of us outlive our average life expectancy. Retirees in pension plans may not leave much to their estates, but at least they still receive a check into their 90s if they outlive the averages. If a modest cost-of-living adjustment is prudently built into the plan design, pensioners can avoid eating cat food in their final years. On the last point, one of the great contributions that public pension systems can make to society is to offer a pension-purchase option to retirees in defined contribution and deferred compensation plans. Although life insurance companies will hate it, the fact is that public plans can provide annuity-like pensions to governmental retirees with actuarial investment returns far superior to the private sector. Public pension plans can afford to underwrite the actuarial risk of stock market volatility across generations. For example, a conservative police officer could trade his individual 457 account balance for a supplemental life pension at fair actuarial rates, and not worry about investing his money in stocks or bonds or buying a lower-yielding annuity from an insurance company. One more constructive suggestion for public pension plans: offer nationwide portability and transferability between public employers. If a traffic engineer or teacher relocates to a similar public service job in another state, why not offer reciprocal benefits and a transfer of service credits? A multi-state cost-sharing agreement would be necessary, but certainly astute state retirement plan administrators can figure this one out. Intrastate reciprocity is a no-brainer. Retirement plan portability would maximize talent in the public service and emphasize careers over location. The author is past Chief Executive Officer of ICMA Retirement Corp.
7. NEW LABOR DEPARTMENT RULES ALLOW QDROS ISSUED AFTER PARTICIPANT’S DEATH:
Our readers from the private pension sector may be interested to know that the Department of Labor has issued a new regulation, effective April 6, 2007, which clarifies certain issues relating to domestic relations orders under the Employee Retirement Income Security Act of 1974. According to a memo from Seyfarth Shaw, the new regulations allow a valid QDRO to be issued even after the participant has died. Private plan administrators will need to change their QDRO procedures to the extent that they are inconsistent with the new regulations. The new regulations address two specific issues. One, subsequent QDROs: a domestic relations order may be treated as a QDRO even when the order is issued after or revises another DRO or QDRO. Two, timing: the regulations further provide that a DRO does not fail to be QDRO solely because of when it is issued; specifically, the guidance clarifies that post-death domestic relations orders will not fail to be treated as QDROs simply because the participant has died before a final DRO was issued.
8. MUTUAL FUNDS LAG BY 250 BASIS POINTS:
An article in Pensions & Investments says that U.S. retirement plans deliver far more bang for the buck in their domestic equity portfolios than do similarly managed U.S. equity mutual funds. While that finding is not new, the size of how much individual investors give up in agency costs is a stunning 250 basis points per year, according to a recent paper. The paper represents the first time that the cost difference between mutual funds and pension portfolios’ separate accounts in the U.S. has been translated to performance terms. These hidden agency costs raise concerns about using mutual funds in individual retirement programs, such as individual retirement accounts. The research also generates concern on the Bush administration proposal to privatize Social Security. That proposal, which would allow individuals to invest a portion of their Social Security savings, was a key plank in the first term of President George W. Bush’s administration, but subsequently was shelved. Considering that neither U.S. defined benefit nor defined contribution plans were able to beat their benchmarks after costs, mutual fund investors are getting a return substantially below the market. Only agency costs can explain the additional 1% of negative return mutual funds experienced after stripping out the 1.5% in upfront costs. Agency costs are charged in addition to upfront management fees and are incurred by intermediaries such as money managers, but passed on to investors. They often include “hidden” expenses such as portfolio turnover and dealing charges.
9. SEC CHAIRMAN ADDRESSES MUTUAL FUND DIRECTORS FORUM:
And speaking of mutual fund charges, U.S. Securities and Exchange Commission Chairman Christopher Cox recently addressed the Mutual Fund Directors Forum Seventh Annual Policy Conference. When the SEC adopted Rule 12b-1 more than a quarter century ago, the premise was that 12b-1 plans would be relatively short lived. The idea was that 12b-1 fees could be used to solve the specific distribution problems, as they arose. And indeed, in the early going, that was the experience: no-load funds used 12b-1 fees of 25 basis points or less to offset the cost of advertising, of printing and mailing prospectuses, and of printing and mailing sales literature. All of this was consistent with the Commission’s purposes in adopting the rule, at a time when nurturing mutual fund growth was an SEC priority. Specifically, the Commission’s action came at a time of net redemptions. There was a very real concern that if funds were not permitted to use at least a small portion of their assets to facilitate distribution, many of them might not survive. Very quickly, however, 12b-1 plans came to be used for other reasons. Most notably, instead of paying for distribution, they became a substitute for front-end loads. In this way, more substantial sales loads could be collected while the fund could still advertise itself to investors as “no load.” The transformation of the 12b-1 fee from a distribution subsidy to a sales load in drag is now so nearly complete that the primary purpose to which the $11 Billion in 12b-1 fees last year were put was to compensate brokers. Another way that 12b-1 fees have veered away from their conceptual basis as distribution subsidies has been using them to pay for administrative expenses in connection with existing fund shareholders. Even some funds that are closed to new investors continue to collect 12b-1 fees. So it is that today, by far the lion’s share of mutual funds’ 12b-1 fees is used for these two purposes. Back in 1980, the Commission noted in its adopting release that the Commission and staff would monitor the rule’s operation closely. And if experience suggested that the rule’s restrictions on the use of fund assets were insufficiently strict, the Commission made it clear it would be prepared to act to remedy the situation. Now, with nearly three decades of experience under its belt, and with today’s uses of 12b-1 fees barely recognizable in light of the rule’s original purpose, it is high time for a thorough re-evaluation. The considerable distance that 12b-1 fees have strayed from the rule’s paradigm is not just occasion for the Commission to take a hard look at current practices. It is also a reason for independent directors to take a fresh look at the way this use of investors’ funds has evolved. Thus, rule 12b-1 is an issue the Commission will address this year. And as it does so, the Commission will have the interest and concerns of independent directors, whose responsibilities and sensitivities to the fund’s investors are thought to be particularly acute, uppermost in its mind.
10. FLORIDA STATUTE THAT PROHIBITS EMPLOYER ORGANIZATION FROM SOLICITING PUBLIC EMPLOYEES DURING WORKING HOURS IS CONSTITUTIONAL:
Section 447.509, Florida Statutes, provides that employer organizations, their members, agents, representatives or any persons acting on their behalf are prohibited from soliciting public employees during working hours of any employee who is involved in the solicitation. City firefighters were trying to organize the City’s firefighters for purpose of collective bargaining. They were fired for violating Section 447.509(1)(a), Florida Statutes. They filed suit against the City, seeking declaratory and injunctive relief, principally contending that the statute is facially unconstitutional. They raised several separate grounds: vagueness; overbreadth; infringement on the right of free speech, equal protection and privacy; right to bargain collectively articulated in the Florida Constitution; right to freedom of association; right to petition for redress of grievances ; and right of access to public records and meetings. The trial court addressed all issues and rejected them. On appeal, the court affirmed, agreeing with the trial court’s disposition of each claim and with its conclusion that Section 447.509, Florida Statutes, is not unconstitutional. Menegat v. City of Apopka, 32 Fla. L. Weekly D965 (Fla. 5th DCA, April 13, 2007).
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