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Cypen & Cypen
October 24, 2019

Stephen H. Cypen, Esq., Editor

Would you buy a product if you didn’t know its cost? I doubt it. What if overpaying for that product could lead to serious consequences like being sued or postponing retirement? I know you’re not buying then. And yet, I see business owners do something similar all the time. They’ll hire a 401(k) provider without fully understanding their fees. Even when they know that paying excessive 401(k) fees could get them sued or force plan participants - including themselves - to work longer than necessary to afford retirement. If you’re a business owner, you must know how much your 401(k) plan costs because the consequences for paying excessive fees can be steep. Excessive fees reduce 401(k) investment returns unnecessarily – which could dramatically reduce plan participant account balances over time due to the power of compound interest. If this happens, you could be personally liable as a plan fiduciary for restoring participant losses. Not sure how much your 401(k) plan costs? Below are three warning signs your 401(k) provider might be ripping you off.
Your 401(k) plan is “free”
There is no such thing as a free 401(k) plan. This may sound obvious, but I see business owners fall for this claim by some 401(k) providers all the time. In truth, a “free” 401(k) provider is paid “indirect” fees by plan investments. Indirect fees increase fund expense ratios, so they reduce investor returns. They’re usually based on a percentage of assets. Because 401(k) providers are not obligated to disclose their dollar amount in plan fee disclosures or participant benefit statements, indirect fees are commonly considered hidden 401(k) fees. There are two basic types:

  • Revenue sharing - Some mutual fund companies pay the 401(k) providers that use their funds. These payments are called revenue sharing. The two most common types are 12b-1 fees and Sub-Transfer Agency fees (Sub-TA fees).
  • Wrap fees – Variable annuities are basically mutual funds “wrapped” in a thin layer of insurance. The wrap allows insurance companies to add a fee to plan investments. A wrap fee can turn a low-cost index fund into a pricey variable annuity.

I’m not going to lie, it’s generally tough to total indirect fees. That’s why I recommend you avoid them altogether. Doing so is easier to do than ever because a growing number of 401(k) providers now charge “direct” fees – which can be paid from a corporate bank account or allocated among plan participants – only.
You must pick from a “preferred” list of funds
It’s common practice for 401(k) providers to limit your investment options to a shortlist of “preferred” funds. Because there are thousands of investment funds available to 401(k) plans today, this limitation can seem like a godsend. However, the funds on these lists are rarely the best – they’re simply the funds that pay a sufficient amount of revenue sharing to the 401(k) provider. Many of today’s top-performing funds pay no revenue sharing at all – including low-cost index funds and ETFs from Vanguard, Blackrock, Fidelity and Schwab. If your provider does not make these funds available, there is a good chance they are prioritizing their profit ahead of your investment returns.
Your administration fees are mostly asset-based
401(k) plan administration services include asset custody, participant record-keeping, and Third-Party Administration (TPA). Many 401(k) providers charge asset-based fees for these services. The problem? Except for asset custody, the level of administration services delivered by a 401(k) provider scales with employee headcount – not assets. If asset-based 401(k) administration fees outstretch their provider’s level of service, excessive fees are the result. If your plan pays indirect fees, you’re almost certainly paying asset-based administration fees because revenue sharing and wrap payments are usually based on a percentage of assets. To most easily avoid excessive 401(k) fees, I recommend you keep asset-based administration fees to a minimum – no more than 0.10% of assets to cover asset custody.
In my experience, 401(k) fiduciary responsibilities are easy to meet with some basic education and guidance from a qualified 401(k) provider. They are generally common sense and a qualified 401(k) provider will do most of the heavy lifting in meeting your responsibilities. That said, one of the most important responsibilities – avoiding excessive 401(k) fees – is impossible to meet when you don’t know the full cost of your plan. Worried your 401(k) plan is being ripped off? Look for the warning signs. If you see them, there is a good chance you are – or will be as plan assets grow. If you find yourself in that boat, I have a simple recommendation - replace your 401(k) provider with one that charges 100% direct fees that match their level of service. Eric Droblyen, Employee Fiduciary, October 16th, 2019.
As people watched Hurricane Irma rage across their TV screens toward the Florida panhandle in 2017, the Cape Coral Community Emergency Response Team (CERT) prepared for action. The low-lying community is located just south of Fort Myers on Florida’s Gulf Coast and it was time to evacuate. “It’s difficult when we’re surrounded by water and there are only about four good evacuation routes out of the city with 200,000 people,” said Ryan Lamb, Cape Coral’s fire chief. “That can get congested very quickly.” The emergency response team and Cape Coral Fire Department sprang into action to safely evacuate 120,000 residents in the storm’s path and station additional police officers and firefighters around the community. Key to their efforts? Information from the U.S. Census Bureau, including stats gleaned from the most recent census. The team used population maps derived from Census Bureau data to identify distribution points for supplies -- and to send wheelchair-accessible vans to pick up mostly older residents who initially wanted to stay put and ride out the storm. And when the city’s one shelter became overwhelmed, emergency teams used the information to direct people to shelters in other counties. Once the storm passed, the emergency team coordinated with the Federal Emergency Management Agency (FEMA) and Army National Guard to clear debris and start rebuilding. The city suffered $20 million in damages -- a small portion of the estimated $50 billion in damages (pdf) wrought across Florida and other southeastern states by one of the costliest hurricanes in U.S. history. It’s important to know how your responses to the 2020 Census this spring can affect disaster preparedness. Information about how many people live in a town and where they live is critical for emergency response. Data from the census are used to allocate millions of dollars in federal funding each year, including for emergency response services. Statistics from the 2020 Census will provide baseline numbers not only for funding of federal disaster relief, but also preparation, rescue coordination and even locations for new fire stations. “FEMA is now using our resources to identify vulnerable communities,” said Andrew Hait, a survey statistician and economist in the Census Bureau’s Economic Directorate. FEMA’s vulnerability index initially was designed to measure threats of terrorism but, “They’ve expanded its use to include natural disasters,” he said. According to Hait, the vulnerability assessment formula now uses Census Bureau data to identify communities with critical business types, including hospitals, corporate headquarters, and other facilities that render an area more at risk during natural disasters. It can also be used to plan for makeshift shelters and response centers. “A community that has one large regional hospital has a very different vulnerability profile than a community that doesn’t,” Hait said. Cape Coral is racing to keep up with its swelling population. In the past two years, it has opened a new fire station and expanded a two-lane highway into four lanes and two more fire stations are slated to be constructed within the next five years. “As our population continues to change, we need to be mindful of that,so we can continue to provide local service that meets their expectations,” Lamb said. When disaster strikes, people may relocate, either temporarily or permanently. They may stay with relatives or in a hotel. That’s among the challenges the Census Bureau is preparing for when it conducts the 2020 Census. There can be abrupt changes in population, such as in Paradise and Butte County, California, after the devastating Camp Fire in 2018, which have what Hait calls a “cascade effect.” When enough people leave, others follow. Only about 1,000 people live in Paradise today, compared with more than 26,000 before the fire. “The rebuilding process after a major disaster takes a long time,” Hait said. “It’s a massive undertaking and often extends well through many of our business and demographic surveys.” Similar scenarios are playing out across the United States and its territories – in Puerto Rico after Hurricane Maria (2017), North Carolina after Hurricane Florence (2018), Alaska after the 2018 earthquake and in the Midwest after floods earlier this year. In some areas, census takers will interview people, while in others, they can respond to the 2020 Census online, by phone or by mail. Louisiana is still dealing with the effects of a shift in population following the devastation of Hurricane Katrina in 2005. According to Census Bureau data, it was not until 2014 that New Orleans rejoined the list of the nation’s 50 most populous cities, with a population of 384,320. Before Katrina, its population was 494,294. A year later, it had dropped to 230,172. The Census Bureau tracks and produces timely local data critical to emergency planning, preparedness, and recovery efforts by event on census.gov. Every September, the Department of Homeland Security recognizes National Preparedness Month by promoting programming and sharing resources to remind families and communities of the importance of disaster and emergency planning. The 2019 theme is “Prepared, Not Scared.” It’s important for people to remember that a key to disaster prep is responding to the 2020 Census, which can lead to more effective and efficient emergency response times and rescue operations, and allocation of funds for rebuilding communities. America Counts Staff, October 15, 2019.
In this article, we begin with a review of the interest rates used for plan funding – 25-year average Highway and Transportation Funding Act (HATFA), 24-month average, and one-month spot rates – reflecting the significant declines this year. We then consider the short- and medium-term effect of those declines on sponsor funding requirements. We conclude with a brief review of the effect of those declines on the calculation of PBGC premiums, financial disclosure, and “real life.”
Interest rates as of October 2019
Two charts provide a picture of what funding looked like at the beginning of the year and how it has changed through mid-October 2019. Chart 1 compares historical and projected (1) 25-year average HATFA, (2) 24-month average, and (3) spot rates for a typical pension plan, reflecting changes in market interest rates through the beginning of 2019, with spot rates projected forward at 1/1/2019 levels. Chart 2 does the same thing, only it carries interest rates forward to 10/11/2019 and then projects rates forward at those levels.
Minimum funding – HATFA until 2028
How has the minimum funding outlook changed since the beginning of the year? As of 1/1, assuming no further change in interest rates, we were projecting that market interest rates would be higher than HATFA rates by 2023, stabilizing (for our “typical plan”) at about 4.4%. Since the beginning of the year, rates have gone down more than 100 basis points. At this level, HATFA rates will continue to apply until 2028. For sponsors concerned about ERISA minimum funding demands, that is bad news. Here are the minimum funding basics if this new environment persists:
Until (on our projections) 2028, HATFA rates will be the rates used to value liabilities for ERISA minimum funding purposes. Those rates currently equal 90% of a trailing 25-year average of rates. During the period 2019-2020, HATFA rates will go down marginally as more “low interest rate” years are added to the 25-year average. During the period 2021-2024, HATFA rates will then (per the statute) be reduced to 85% of the 25-year average (in 2021), 80% (in 2022), 75% (in 2023), and finally 70% (in 2024). After 2024, and (on our projections) until 2028, our typical plan’s effective discount rate will be 70% of the HATFA 25-year average – around 3.7% in 2024, declining to 3.1% by 2030. After 2028, market rates would exceed 70% of the HATFA 25-year average, stabilizing at around 3.3%, and would thereafter apply for ERISA minimum funding purposes. Thus, the changes resulting from the huge 2019 decline in interest rates will not be felt for ERISA minimum funding purposes until 2023 – the year in which, prior to the decline, we were predicting that market rates would exceed HATFA rates. If rates remain at current levels, for the period from 2023 on, sponsors will have to fund based on liabilities calculated using much lower discount rates than we had projected at the beginning of the year. This will matter both for what we have called “funding regime one” – the base rules for the minimum a sponsor must contribute – and for “funding regime two” – the set of limitations on design and administration that are triggered when plan funding falls below 80%/60%. We want to emphasize that our projections here are simple and are most useful as an illustration of the consequences of 2019 interest rate declines. We are assuming that future interest rates will be the same as present rates. If, as some expect, interest rates go back up, the minimum funding picture will improve. If, as others expect, they go down further, it will get worse.
PBGC premiums – interest rate declines will increase 2020 PBGC variable-rate premiums
As noted above, the recent decline in interest rates will not affect ERISA minimum funding until 2023 (at the earliest and depending on each plan’s own funding situation). In this context, the primary statutory driver of funding decisions for many sponsors is likely to be PBGC variable-rate premiums. The 2020 variable-rate premium (generally) equals 4.5% of a plan’s unfunded vested benefits (UVBs), measured based on either year-end 2019 spot rates or 24-month average rates. In either case, for 2020, (unless rates move up significantly before year-end and assuming, e.g., no additional contributions) a plan’s UVBs and its variable-rate premium will be higher – in many cases significantly higher. We review the technicalities of the measurement of UVBs in detail in our article Interest rates 2019 – measuring UVBs for variable-rate premiums. And we discuss strategies for reducing variable-rate premiums that sponsors may wish consider in our recent article Interest rates 2019 – managing funding and PBGC variable-rate premiums in a volatile interest rate environment.
Financial disclosure – interest rate declines will increase liabilities and expense
We’re not going to review the effect of interest rate declines on financial disclosure in detail. We simply observe that declines in market interest rates, if they persist through year-end, will show up on year-end 2019 balance sheets (liabilities for a typical plan could increase 20% this year, although assets have done pretty well this year too). Barring accelerated recognition, however, the near-term impact on the income statement will, as always, be muted.
Real life – contributions vs. investment returns
After working through (1) what the statute makes sponsors do and (2) what FASB makes issuers do, it is generally useful to consider (3) what in real life the sponsor will have to do. In that regard (and staying brief) we note:
In the long run (and unless the sponsor liquidates in bankruptcy), the sponsor will have to contribute enough to its DB plan to pay all benefits and overhead costs. That cost will be affected (positively or negatively) by net returns on the plan’s asset portfolio. Speaking very broadly, declines in interest rates are associated with increases in the value of assets on the books and declines in future returns. Latitude in funding – e.g., HATFA relief – allows the sponsor to delay making plan contributions with the prospect of earning its way (via asset returns) to improved funding. Funding relief carries with it, however, a tax, assessed at more or less current market interest rates, on underfunding – the PBGC variable-rate premium. In this context, sponsors will want to consider (among other things) the following variables in making funding decisions:
(1) their overall cash strategy,
(2) the cost of PBGC variable-rate premiums,
(3) the long-run cost of the plan,
(4) any financial disclosure statement risks/concerns they may have, and (5) their plan investment strategy.
Finally, we note that a further extension of HATFA relief, in 2019 or 2020, is a possibility. October Three, October 15, 2019.
Retirement is often romanticized as a time for pursuing personal interests, traveling the globe, or starting an encore career, but for many married couples who are forced to redefine their relationship overnight, it can also be a time of stress. First of all, transitioning from work life can bring about depression that can affect personal relationships. Beyond that, there can be issues with:

“Very often, married couples ignore the potential challenges of retirement and say, ‘Oh, I know how to do leisure very well,’ but when leisure becomes one-third to one-quarter of your life, it’s a different story,” said Sara Yogev, Ph.D., a clinical psychologist and couples therapist near Chicago, Illinois. “Even couples that get along well need to find a new homeostasis in retirement for the time they spend together and apart, as well as the other domains of their life, like the division of housework.” But some marriages don’t survive the retirement transition. Indeed, divorce rates among aging seniors, also known as “gray divorce,” have roughly doubled over the last 25 years, according to a Pew Research Center analysis of 2015 Census Bureau data. For every 1,000 married persons aged 50 or older in 2015, 10 divorced, up from five in 1990, a trend led by demographic shifts. “During their young adulthood, baby boomers had unprecedented levels of divorce,” the Pew Research Center report found. “Their marital instability earlier in life is contributing to the rising divorce rate among adults ages 50 and older today, since remarriages tend to be less stable than first marriages.” While the divorce rate is lower among older adults who have been married long term, a significant share of gray divorces do occur among couples who have been married for 30 years or more. Among all surveyed adults aged 50 or older who had divorced in the prior 12 months, about one third (34 percent) had been in their prior marriage for at least 30 years and 12 percent had been married for 40 years or more. For more information read here. Shelly Gigante, Mass Mutual, October 11, 2019.
Illinois should consolidate the 649 downstate and suburban police and fire pension plans into two new funds, a task force recommended to Gov. J.B. Pritzker in a report Thursday. The Pension Consolidation Feasibility Task Force, which was created by Mr. Pritzker and consists of financial professionals, former elected officials and representatives from municipalities and labor unions, recommends consolidating the assets of the plans because doing so would generate investment returns far beyond the annualized 2% the report says the plans achieved in the past 10 years due to their small sizes. According to the report, Illinois has the second highest number of local pension systems and the ninth fewest assets per any system in the United States. Of the total 649 plans potentially affected by consolidation, 424 plans, or 65.3%, have less than $20 million in assets each. Overall, the 649 plans have a total of $14.3 billion in assets, and the task force notes that consolidation would generate a collective $820 million to $2.5 billion in investment returns over the next five years. The task force recommends the creation of two new funds: One for municipal police beneficiaries and one for municipal fire beneficiaries. Each fund would be governed by a board with equal employer and employee representation, and each municipal pension plan would maintain an individual and separate account within the consolidated funds so plans' assets and liabilities are not adversely shifted. The task force recommends establishing trusts separate from the state treasury. Non-hazardous municipal and school district employees in Illinois outside of Chicago are part of the $42.8 billion Illinois Municipal Retirement Fund, Oak Brook, created in 1939. The report also cited IMRF's funding ratio of 90.4%, nearly 50 percentage points above the next best-funded state plan, as a reason for police and fire pension plan consolidation. The task force includes former IMRF executive director Louis Kosiba. Rob Kozlowski, Pensions & Investments, October 10, 2019.
Social Security is a big part of retirement income planning for employees. The Social Security Administration has announced that Social Security and Supplemental Security Income (SSI) benefits for nearly 69 million Americans will get a cost of living adjustment (COLA) of 1.6% in 2020. The COLA will begin with benefits payable to more than 63 million Social Security beneficiaries in January 2020. The COLA adjustment for the eight million SSI beneficiaries will begin on December 31, 2019. Social Security is a big part of retirement income planning for employees, as it is estimated that Social Security will represent 40% of the average Americans replacement income. Cost of living increases, claiming age, marital status and work history all complicate Social Security claiming strategies. The administration says the Social Security Act ties the annual COLA to the increase in the Consumer Price Index, as determined by the Department of Labor’s Bureau of Labor Statistics. Based on that increase, the maximum amount of earnings subject to the Social Security tax will increase from $132,900 to $137,700. People will be able to view their COLA notice online through their my Social Security account; they can create or access this at: www.socialsecurity.gov/myaccount. Information about Medicare changes for 2020, when announced, will be available at: www.medicare.gov. Lee Barney, Planadviser, October 10, 2019.
I recently came across a fascinating paper from the Board of Governors of the Federal Reserve that investigated the financial situation of public pension plans in the US and their reaction to low interest rates. In three simple charts this paper clearly demonstrated the dire straits public pension funds are in. Let’s first take a look at the official funding ratios (the ratio of assets relative to the present value of future liabilities) of the 100 or so public pension plans in their sample. In 2001, the average funding ratio was close to 100% but despite the strong returns of stock markets and declining yields in Treasuries that boosted returns on all fixed income asset classes the average funding ratio declined to about 70% in 2016. And these are only the official funding ratios. Currently, generally accepted accounting standards require pension fund liabilities to be discounted by a discount rate derived from the asset mix of the pension fund. But why the risk and timing of liabilities should be related to the risk and timing of equity returns, for example, is anyone’s guess. It makes no sense to use equity returns as input into the discount rate for pension fund liabilities. Instead, as practically every pension fund expert in the world has pointed out by now, one should use discount rates that reflect the risk and timing uncertainty of the liabilities of the pension fund. Unfortunately, these data are not publicly available but in the paper the researchers made an effort to estimate the true funding ratio of the public pension funds in their sample. And the results are disastrous. The average funding ratio is more likely around 40% than 70%! In most countries, private pension funds with such massive underfunding would be forced to either restructure or close. Yet, thanks to some simple accounting tricks, the true level of underfunding has been covered up for years. One of the tricks to use to keep funding ratios high is to keep expected returns for risky assets, such as equities high because that will allow the pension fund to discount liabilities at a higher discount rate. And despite a ten-year equity bull market and steadily declining Treasury yields, the expected returns of public pension funds remain stable at 8% per year. Every investor knows that expected returns vary over time, depending on the valuation of the assets today. But public pension funds seem to be oblivious of that fact. Of course, they aren’t. They know full well that their expected returns are too high at the moment and that their true funding ratios are lower than their published numbers. But they can’t say that out loud because that would start a discussion about who is going to fund the gap. And in the case of public pension funds the answer to that question is very simple: it’s taxpayers. So instead of owning up to the problem, politicians and trustees of public pension plans rather kick the can down the road and assume unrealistically high expected returns and discount rates for liabilities. And to achieve these high returns, they have to reach for yield, particularly in the fixed income space where current yields are extremely low. No wonder, bank loans, high yield and private debt are so popular with pension funds these days. Klement on Investing, October 8, 2019.
Even if you're on the right track, you'll get run over if you just sit there.
If you want to lift yourself up, lift up someone else. - Booker T. Washington
On this day in 1929, "Black Thursday", start of stock market crash, Dow Jones down 12.8%.

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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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