Open Architecture

Nicholas Zaiko

Investment Consultant

Bridgebay Financial, Inc.

www.bridgebay.com

As fiduciaries, plan sponsors must act for the sole benefit of their plan's participants. Decisions born of the need for corporate convenience may lead to less-than ideal arrangements or investment options for plan participants. Sponsors need to evaluate whether the convenience of one-stop shopping is worth the potential fiduciary risk of foregoing open architecture.

The conventional wisdom regarding bundled service providers is that the convenience offered by an all-in-one solution is particularly attractive to smaller 401k plan sponsors who might not have the scale or staffing necessary to administer the plan in-house. These types of companies are typically spread thin already, with many individuals wearing many hats. Tight resources tend to push plan sponsors to make the easy choice of working with bundled service solutions. These service providers come in several forms. They can be a broker, a mutual fund firm, a payroll processor or an insurance company.

Truly open architecture goes well beyond the simple ability to add non-proprietary funds to a plan's line-up. In a open architecture, all of the service providers are either unbundled or entirely separate entities. The goal of open architecture is to have the flexibility to monitor and trade out each individual component, independent of the other services with a minimal amount of disruption to the plan. The primary service providers to a typical DC plan include the recordkeeper, investment or fund managers, custodian or trustee, plan investment consultant, managed account provider, and the education/communications provider. Ideally, each of these service providers is a separate, unaffiliated entity without any vested interest in the actions of any of the other providers.

The key is to then take a "best-of-breed" approach and select only the best recordkeeper, TPA, mutual funds and investment consultant. A recent study which compiled the characteristics of an ideal 401k plan supported this approach and demonstrated that such plans do not use bundled providers. By managing each component individually, the sponsor maintains the flexibility to replace any element that may suffer from poorer or declining quality service without disturbing any of the other services. The modular nature and the ability to use best-in-class providers are the major strengths of open architecture.

In contrast, bundled service providers typically rely on investment products to drive revenues, making other peripheral services an afterthought and generally a loss leader. Ancillary services such as plan administration and recordkeeping tend to suffer when pushing investment products is the primary source of revenue.

Additionally, by obscuring the actual cost for each service in the bundled fee, such providers make it difficult to accurately benchmark total plan fees. Independent providers bring with them a built-in check-and-balance mechanism regarding the quality and fees of other service providers. Though many bundled providers may tout the benefits of the "economies-of-scale" that come with their arrangements, the inherent conflicts of interest may actually result in higher fees than a truly open architecture solution.

In recent years we have seen numerous lawsuits brought against plan sponsors for various breaches of fiduciary duty. In 2011 we witnessed the result of the high-profile class action suit against Walmart for breach of duty regarding the investment choices in the 401k plan. The plaintiffs discovered that het plan's bundled service provider had placed high-fee funds into the plan and the broker was receiving trailing commissions for having placed those funds in the plan.

The mere fact that it took plan participants so long to discover the breach of fiduciary duty indicates how well high fees can be hidden within the bundled arrangement. 2012 promises to be a year of greater disclosure and transparency on behalf of bundled service providers. The new fee disclosure requirements outlined under sections 408(b)(2) for provider to plan sponsor disclosures and 404(a) of the Employee Retirement Income Security Act (ERISA) offer to shed light on the bundled service provider. This has the potential to reshape the bundled provider industry and reinvigorate plan sponsors' interest in pursuing open architecture.

While a bundled solution may work for plans of a relatively small size, the modular and best-in-class approach afforded plan sponsors by using open architecture and the potential for lower, more competitive fees must not be ignored.

Selecting and Monitoring Fiduciary Advisors

Nicholas Zaiko

Investment Consultant

Bridgebay Financial, Inc.

www.bridgebay.com

Effective December 27, 2011, the Department of Labor's Employee Benefits Security Administration (EBSA) issued its final rule regarding the provision of investment advice to participants in individual account plans, such as 401(k) and 403(b) plans, and beneficiaries of individual retirement accounts. The final rule affects plan sponsors, fiduciaries, participants, and beneficiaries of participant-directed retirement plans. Essentially, the rule enables providers of investment advice acting as fiduciary advisers to offer investment guidance to participants provided certain conditions set forth in the regulations are satisfied.

The Need for Advice

Recent studies have indicated that participants who receive professional investment advice consistently outperform those who go it alone. Constructing a proper asset allocation is key to the long-term success of any retirement strategy and most participants are ill-equipped to make such a potentially life-altering decision on their own. The DOL's new participant investment advice regulation attempts to offer participants another means of achieving their retirement goals.

Not all investment advice that has been provided in the past has been impartial or in the participant’s best interest. Sometimes there have been conflicts of interest unknown to the plan sponsor. In selecting a fiduciary advisor the plan sponsor still retains fiduciary responsibility in selecting the form of investment advice they offer to their participants.

Best Fit

There are numerous factors to consider when selecting a fiduciary adviser to a plan. The last few years have seen dramatic growth in the independent investment consulting industry and with the passage of the new regulation, more solutions are sure to follow. The first step is to determine what type of investment advisory service is the best fit for the plan participants. Traditionally, plans have relied on an eligible investment advice arrangement ("EIAA") through a fiduciary adviser to help employees make informed investment decisions, but this is no longer the only available option.

Third-Party Advice

Web-based investment guidance services and managed accounts offered through an independent, third party are increasingly popular options. These firms are unaffiliated with any of the plan’s fund providers or managers. According to the new regulation, their methodology for building an asset allocation must not be in any way impacted by the funds selected. In other words, they must not have a vested interest in or receive any additional financial benefit from using one fund over another. The methodology must be fund and share class neutral. In order to determine the best option for their participants, plan sponsors should conduct a thorough analysis based on their company's demographics and plan objectives.

Identifying Fiduciaries

Another important factor which is often overlooked in selecting a fiduciary adviser is determining exactly who can act as a fiduciary adviser. Many brokers may offer investment advice to participants but most are protected by regulations from taking on fiduciary liability. In many cases, if the adviser is not receiving compensation directly from the act of offering advice, they are not considered a fiduciary under the current law. Eligible fiduciaries generally come in four categories: a registered investment adviser (RIA), an advisor for a bank providing services through the trust department, an insurance company representative and a representative of a registered broker-dealer. Plan sponsors should check with the fiduciary adviser to confirm their status as an eligible fiduciary to the plan and receive confirmation in writing that they are acting as a fiduciary.

Establish Evaluation Criteria

The next step in selecting a fiduciary advisor is for the plan sponsor to establish objective criteria for evaluating an adviser that fits the needs of its participants. The retirement plan committee is responsible for creating a documented checklist that can then be used to evaluate fiduciary advisers. Some general criteria should focus on identifying any potential conflicts of interest, fee and compensation arrangements that may cause the adviser to pressure participants into less appropriate products. The firm’s experience and depth of services in providing fiduciary advice and specifically the qualifications of the professionals providing the advice are important. Checking for any disciplinary actions against the fiduciary adviser or the firm should be conducted at the onset and on an annual basis for any potential change in status.

The fiduciary adviser’s professional credentials and investment experience are critical. Many large firms may be impressive marquee names yet the individuals providing the advice may be junior, less skilled advisers than small boutique firms whose advisers may be highly experienced professionals providing high caliber advice.

Ongoing Monitoring

Once a suitable fiduciary adviser has been selected, it is important that the sponsor establish a process for ongoing monitoring of the adviser. Best practices dictate that a plan sponsor review their plan's fiduciary adviser at least once a year. There are a multitude of factors to consider, but a prudent approach would include a deep dive of the adviser and documenting their process. This would include confirming that all required documentation and notifications were provided. Another factor to consider would be determining whether the adviser is actually complying with the new participant investment advice regulation.

Revisiting the relative cost of the investment advice program in relation to participant adoption and utilization is a prudent way to quantify the value added by the fiduciary adviser. If participant adoption is relatively low compared to the cost, perhaps more education is required or the plan sponsor may want to scale back on the services offered . A thorough review should also include inquiring into and following up with participant comments and feedback. Any participant complaints should be addressed immediately. Participant feedback, whether positive or negative is a good way to stay ahead of any potential fiduciary liability issues. Fine-tuning the plan based on participant comments may lead to increased participation rates, if done in a prudent way. Updating the firm’s and fiduciary adviser’s status for any disciplinary actions should be part of the annual evaluation.

The most important fiduciary benefit of conducting this due diligence review is documenting the decision making process and the results. Comprehensive documentation of the information collected to render decisions that impact the plan is the best way to protect the plan sponsor from fiduciary liability. While investment returns may go up and down, a detailed accounting of the due diligence process is the plan sponsors' greatest asset. An annual review of the plan's fiduciary adviser will go a long way to fulfilling a plan sponsor's fiduciary duty.

Conclusion

Most participants lack the skill, training or time to construct a disciplined, asset allocated, long-term investment strategy. Short-term trends often lead them to make mistakes and risk their long-term success. Individual investors are driven by emotion, causing them to make the same investment mistakes over and over. The DOL's new participant investment advice regulation attempts to offer participants another means of achieving their retirement goals. Plan fiduciaries are responsible for evaluating and understanding the advice options they offer to their participants. Realizing the plan sponsor's role in delivering this essential service is an important fiduciary duty. Establishing a defined strategy for implementing participant investment advice is key to fulfilling a plan sponsor's fiduciary obligations.

Stable-Value Funds

Linda Ruiz-Zaiko

Investment Consultant

Bridgebay Financial, Inc.

www.bridgebay.com

Stable-value funds have played an integral role in employer retirement plans and have evolved, growing in complexity and structure. Despite issuer downgrades and constraints on wrap capacity, demand for stable-value funds continues to be strong as participants seek safety from the volatility of equity markets. This article examines the unique characteristics of stable-value funds and identifies the benefits and potential downsides of this in-vestment strategy.

Until the financial crisis, stable-value funds were considered a conservative investment option, being a hybrid asset class that produced bond-like returns while seeking to maintain a stable principal value. The advent of the financial crisis exposed several structural weaknesses and caused numerous detrimental plan events that negatively impacted these funds.

Today, stable-value fund providers face countless challenges including limited wrap capacity, restrictive investment guidelines, higher wrap fees and exceptionally low yields.

Background

Prior to the financial crisis, banks and insurance companies considered wrap insurance contracts to be a highly desirable source of revenue. Competition for this coveted market rapidly grew, resulting in increasingly thin wrap fees or insurance premiums as wrap providers took on increased risks by insuring a broader range of riskier asset classes without differentiating for potential risk/returns. The plan sponsor benefited from the low fees and excellent yields with perceived principal protection.

During the financial crisis, the prices of the underlying assets dropped dramatically (yields on bonds rose sharply) causing market-to-book ratios for many stable-value portfolios to plunge below 100%. Contractually, wrap providers insure the difference between the market and book value of a plan and have to step in to provide capital when the market value is significantly below book value.

What is a Stable-Value Fund?

Today’s stable-value fund is typically a high-quality, diversified portfolio of fixed income in-vestments that includes U.S. Treasury and Agency securities, corporate bonds, asset-backed and mortgage-backed securities held in commingled bond trusts or mutual funds.

Another variation of the stable-value fund is the synthetic GIC (guaranteed investment contract) which consists of a fixed-income portfolio and a wrap contract issued by a bank or insurance company that guarantees the principal.

Stable-value funds generally are available as separately managed accounts or commingled funds.

Separately managed accounts are comprised solely of the assets of a specific DC plan managed to their unique investment guidelines. No other plan assets are in the account. Commingled funds, similar to mutual funds, combine the assets of multiple unrelated DC plans in one fund. There are restrictions that apply to the fund's liquidity provision called the "equity wash rule" or competing fund rule that forbids any redemption out of the stable-value fund into a "competing" fund such as a money market fund or a short-duration bond fund (typically less than 3.5 year duration). Long duration bond funds and equity funds are considered noncompeting funds and money must stay at least 90 days.

Book Value Accounting

Stable-value funds seek to maintain a $1 per unit price. Interest is credited to the account. These funds use book-value accounting to smooth out any difference in market values and provide a stable net asset value (NAV).

A successful stable-value fund relies on having well-capitalized and financially sound wrap providers, close tracking of the market-to-book value ratio and reasonable cash flows to insure liquidity and participant withdrawals without principal loss.

Participant directed withdrawals from the stable-value fund are made at book-value rather than market value. This works well for the fund when the market values are higher than the book values but is problematic when market values fall below book values. When the market-to-book value ratio drops below 100%, the wrap provider insurance may be triggered to pay out the participant at book value or principal.

During the turbulent financial crisis, the market value of the underlying securities in many stable-value funds fell below the book value triggering the guarantees.

Wrap Provider Exposure

Stable-value funds have unique structural risks that differ from fixed income bond funds. The fund's reliance and exposure to wrap providers can be quantified as the difference between book value and market value of the underlying investments. As the market-to-book value ratio falls below 100% the risk to the wrap provider grows because the provider is required to make up the difference in order to provide liquidity.

Employer-Initiated Event Risk

Event risk arises when the market value is below the book value and a plan level or employer-initiated event other than a termination occurs. During the crisis, layoffs, mergers, divestitures, plan changes and bankruptcies triggered "plan events". Many contracts enable wrap providers to pay participants less than the book value (principal) at redemption when employer-initiated events occur.

This plan level event risk was significant in separately managed stable-value funds that were dedicated to a single plan. Commingled stable-value funds that pool the investments of multiple, unrelated plans fared better.

Stable-value funds have been widely used yet not fully understood as to how various events are treated by book value guarantee providers (wrap providers). Even some of the retirement plan consultants advising DC plans on the fund selections were not well versed on the wrap provider covenants until the plan was notified of a potential violation.

Employer-initiated events can lead to payments to participants at market value, which during recent times of stress, have been below book value.

Fortunately, plan sponsors are now generally more discerning of the creditworthiness and financial strength of the wrap provider while historically, fees had been the most significant criteria for selection.

Insurance Costs Rising

table-value portfolios have been traditionally insured by insurance companies. As a result of poor fixed income performance and pricing, heightened market volatility, and increased capital requirements, many wrap providers have raised fees, tightened portfolio requirements or exited the market altogether.

New wrap capacity entering the market consists of insurance companies that are charging 2-3 times the fees previously charged. Wrap insurers are also requiring that their asset management services be used as part of the stable-value program in order to gain access to wrap capacity.

Many wrap providers have exited the market because the margins are too thin or they lack sufficient capital or resources to maintain this exposure. Issuer downgrades, constraints on wrap capacity, and low fees are limiting the availability of stable-value funds.

Regulatory Impact

New regulations present new and ongoing challenges to the stable-value market. The financial crisis triggered bank regulatory reforms with the introduction of Basel III and Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank) in July, 2010.

These regulations have prompted bank wrap providers to re-evaluate the market and reduce their wrap insurance exposure. As some banks have exited the wrap business, a number of insurers have re-entered the market.

Declining yields exacerbated by higher expenses and wrap fees make these complex and less transparent investments less desirable in the current market environment.

Conclusion

Plan sponsors that have a stable-value fund option in their DC plan should understand the structure of this investment option, new developments in the wrap issuer market and the risks associated with this perceived "safe" option. A review of the stable-value documentation should focus on under-standing what events may trigger a violation of the wrap agreements, causing a potential market value adjustment (loss). Any clauses that could impair the coverage provided by wrap providers should be understood. Enhanced, timely re-porting and transparency to the underlying investments for quarterly reviews should be available to the plan sponsor to ensure consistent due diligence.

Plan sponsors should re-evaluate the stable-value option within the plan's current fund line-up to determine if it still meets the needs of the plan's participants. A short bond fund that provides current income, minimal principal volatility and the flexibility to transfer money may offer a less complex and more transparent investment alternative for a plan sponsor to monitor.

Design Trends in QDIAs After the Financial Meltdown

Presented at the Association for Financial Professionals (AFP) National Conference in Boston, MA

This session covers the evolving trends in target-date funds, risk-based asset allocation, balanced accounts, managed accounts and other QDIAs. Hear insights on QDIA issues and DoL regulations. Are providers changing their products in response to these regulatory initiatives? Have plan sponsor perceptions of QDIAs shifted?   Learn what elements of these solutions pose the greatest challenge for plan sponsors and their participants.

Presented by:

Patrick Baumann

Assistant Treasurer

Harris Corporation

Linda Ruiz-Zaiko

President

Bridgebay®

Ashish Gandhi

Product Mgr. DC Solutions

Northern Trust

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