Economic Review 4Q 2014

Nicholas Zaiko, CIMA®

Senior Consultant

Bridgebay Financial, Inc.

www.bridgebay.com

Of the major global economies, the US continues to be one of the strongest with the end of QE in October, 2014 and the prospect for the Fed to raise rates in mid-2015.  As the Fed normalizes interest rates in 2015, the USD should strengthen.  On a relative basis, the US economy is stronger than others such as Europe which is now in recession.  Japan is also technically in recession.  Since mid-2014, commodity prices have been under pressure and risk asset spreads widened during the quarter.   

US banks have strong liquidity and good asset quality.  With expected higher interest rates, bank net interest margins will increase.  If these factors hold up, financials should continue to be a well performing sector.

Event risk as a result of shareholder activism, financial engineering and limited growth is beginning to impact certain sectors.  The energy sector has continued to weaken since mid-2014. 

Geopolitical risks remained elevated during 4Q2014 and are expected to linger throughout 2015.  The quarter ended with increased volatility in December, 2014.  Further volatility and uncertainty is expected through 2015 as the Fed begins to raise rates. The release of better than expected US economic data also reinforced the fear that the Fed will begin raising rates.

Falling oil and commodity prices were the dominant theme during 4Q2014.  Lower yields, falling inflation and flattening of the yield curve for maturities greater than 5 years all contributed to poor performance across risk sectors.

Yields on securities in the 1-5 year part of the yield curve rose in December and spreads widened in response to increasing Fed Funds Rate expectations. 

U.S. Federal Reserve

The Federal Open Market Committee (FOMC) minutes (December 16-17, 2014) increased expectations that interest rate hikes will begin in June 2015 as the unemployment rate continues to fall, consumer confidence grows and core inflation falls.  Fed officials also noted the geopolitical and economic risks globally.  The FOMC noted that the international situation could represent some downside risks to US economic and employment activity. Key concerns include deflationary pressures abroad.  The US dollar has surged as the ECB has aggressively eased.  Negative interest rates in Europe, oil price collapse and geopolitical tensions have spurred capital flows to the US seeking safety in US Treasuries.    

At its December meeting, the FOMC updated its economic projections and interest rate forecasts. For 2015, the committee maintained its GDP forecasts, but lowered its unemployment rate and inflation projections. Because it reduced its inflation expectations, the committee lowered its 2015 rate expectations, although Fed Chair Janet Yellen continued to advise that mid-2015 would be an appropriate time to raise interest rates.

Additional guidance is expected from the Fed’s meetings on January 27-28 and March 17-18, 2015. Several top Fed officials expect that they will start raising rates by mid-2015.  The Fed predicts that the US economy may grow at 2.6% - 3% in 2015.  The unemployment rate is expected to fall to 5.2%-5.3%. CPI in 2015 is expected at 1.0%- 1.6% which is below the 2% Fed target. 

Geopolitical tensions in Ukraine and Syria, fears of Ebola spreading and plunging oil prices are creating investor anxiety and will continue to generate market volatility resulting in continued flows to U.S. Treasuries as a safe haven.  

U.S. Interest Rates

The Fed ended its asset purchase program in October, 2014.  Federal-funds futures (CME data), reflect a 23% probability that the Fed will raise rates at the June 2015 meeting.  The probability of a rate increase in July 2015 is 48%.  Investors see a 56% chance of a rate increase by September and an 84% chance by December 2015.

For now, the Fed Funds target range remains at 0%-0.25%.  LIBOR yields ended the year slightly higher with three-month Libor at 0.255% and the one-year at 0.628%.

U.S. Treasury bill yields rose heading into year-end.  Three-month yields ended the month at 0.04% and six-month yields at 0.12%.

During the quarter the U.S. Treasury yield curve between two- and five-year maturities flattened significantly, by 21 basis points (bps), with the yield of the two-year note increasing 10 bps to 0.67% and the yield of the five-year note decreasing 11 bps to 1.65%. 

The U.S. Treasury market was volatile during the quarter as early in the quarter, risk aversion briefly drove yields down (prices up) with the 10-year U.S. Treasury (UST) hitting 1.87%.  Yield spreads widened with plummeting oil prices and heightened geopolitical risks, largely ignoring strong U.S. GDP and economic data.  The plunge in oil prices helped consumer spending and consumer confidence but created volatility in the markets.  Yield spreads widened on oil-dependent industries and countries. 

Inflation

Headline inflation fell as energy prices plunged, while core inflation measures held steady. The Consumer Price Index (CPI) slid 0.13% per month on average, down from an average decline of 0.01% in the third quarter. The Personal Consumption Expenditures (PCE) Index fell 0.06% per month in Q4, below the 0.04% Q3 average. Core inflation estimates, which exclude food and energy, were more resilient, with Core CPI up 0.14% on average, from 0.08% in the prior quarter, and core PCE up 0.09%, just below the 0.10% Q3 average.

Jobs and Unemployment

Employers added 2.95 million jobs in 2014 yet the US Labor-force participation rate was only 62.7% in December. 

Nonfarm payrolls rose a seasonally adjusted 252,000 in December.  The unemployment rate decline to 5.6% is attributed to people that stopped looking for jobs. Once people leave the workforce, they are no longer counted as unemployed.  About 8.7 million Americans have not been able to find work.  Wages were stagnant with average hourly earnings for private-sector workers at $24.57 and the average workweek held steady at 34.6 hours in December. Over the past year, hourly earnings are up a mere 1.7%, barely ahead of inflation’s 1.3% rate.  

Personal Income

Consumer spending rose 0.4% per month on average in October and November, up from its 0.3% monthly average in Q3. Aided by strong auto sales, retail sales improved, climbing 0.6% on average in October and November. Consumer confidence uniformly strengthened in the fourth quarter. The University of Michigan consumer survey rose to 89.8 in the fourth quarter from 83.0 and the Conference Board measure of consumer confidence increased to 93.6 from 90.9. Both measures are at post-recession highs.

Manufacturing

Manufacturing indices were marginally better in the fourth quarter, although they softened going into December.

The national ISM survey averaged 57.7 in Q4, up slightly from 57.6 in the prior quarter.  Regional surveys were mixed in the fourth quarter:  the Chicago and Philadelphia surveys improved while New York, Dallas and Richmond softened.

Housing

Housing indicators were mixed in Q4. In October and November, new home sales averaged a seasonally adjusted annual rate of 442,000, up from 434,000 in Q3; housing starts averaged an annualized rate of 1.037 million in October and November, up from 1.03 million, and building permits averaged 1.072 million, up from 1.03 million. Less strong were existing home sales, which averaged an annualized rate of 5.09 million, down from 5.12 million in Q3, and the pending home sales index, which averaged 104.4, down from 105.3. 

Plan Design: In-Plan Roth Conversion

Nicholas Zaiko, CIMA®

Investment Consultant

Bridgebay Financial, Inc.

www.bridgebay.com

The In-Plan Roth Conversion provision is a plan feature introduced by the American Taxpayer Relief Act (ATRA) in January, 2013 that permits participants to convert pre-tax balances that are vested to after-tax Roth balances within the plan.  Expanding in-plan Roth contributions may prove to be a powerful tool for plan participants and a welcome enhancement to plan sponsors' retirement offerings.

IRS Notice 2013-74 dramatically increases participants' ability to convert pre-tax savings into after-tax Roth retirement savings by expanding the pool of eligible assets. 

Pre-Tax

Traditional DC plans such as 401(k), 403(b) and government 457(b) plans allow participants to make pre-tax deferrals to their plan.  These contributions reduce their current tax liability but ultimately, the withdrawals taken during retirement are taxed at regular income tax rates. 

After-Tax

With Roth versions of 401(k), 403(b) and 457(b) plans, participants contribute after-tax amounts that will be taxed in the year of their contribution, however,  withdrawals  will be tax-free.  In-Plan Roth rollovers enable participants to convert pre-tax retirement amounts into an after-tax account (Roth), paying taxes in the year of the conversion.

New IRS Guidance

On December 11, 2013 the IRS issued Notice 2013-74 which expands  the previously limited in-plan Roth conversion option to all vested amounts under eligible plans.  The new rule also allows amounts that are not yet eligible for distribution.

Plan sponsors are not required to offer in-plan Roth conversions to their participants.  Plan sponsors may limit the types of vested pre-tax contributions  to be converted (employer/employee), may  designate the frequency of elective conversions and may choose to discontinue the conversion program, as long as it is done in an equitable manner.

In-Plan Roth Conversion Process

A participant can make an in-plan Roth conversion by transferring assets from a non-Roth account into a designated Roth account within their retirement plan.   The amount transferred from pre-tax to after-tax becomes taxable in the year of the conversion. 

The participant is paying taxes up-front on its converted balances so that in the qualified distributions taken by the participant during retirement may not be taxed.   Essentially, the participant is paying taxes today to avoid paying taxes in the future.  According to the tax law, both the cumulative contributions and any accumulated earnings are both tax-free when withdrawn by the participant in a qualified distribution.  In order to qualify for tax-free status, among other criteria, the assets must be held in the Roth account for at least five years prior to distribution.

Eligible Pre-Tax Amounts

Prior to the new regulations, the only amounts in a pre-tax retirement plan that were eligible for Roth conversion were amounts that were otherwise distributable under tax law.  The new expansion of eligible amounts now covers all vested assets within a pre-tax plan including those that were previously excluded from conversion.

The Notice clarifies that plan sponsors may decide and restrict the types of vested contributions eligible for conversion within their own plan.  The frequency of conversions is also left to the discretion of the plan sponsor.  The plan sponsor must ensure, however, that any restrictions that are implemented do not  disproportionately favor highly compensated employee.

Tax Considerations

The guidance specifically identifies in-plan Roth conversion amounts as not being subject to income tax withholding.  This means that when a participant converts a pre-tax amount to an after-tax Roth amount, the income tax withholding for the year will be insufficient to cover their annual tax liability.  The conversion will trigger an increase in tax liability and the Notice warns that employees who choose to partake in the in-plan Roth conversion either increase their withholding rates or make estimated tax payments to cover the additional income tax liability

Administrative Considerations

Despite characterizing Roth conversions as in-plan "rollovers" from non-Roth to Roth accounts, the new law does not require plan administrators to provide Code section 402(f) notices regarding the tax implications of rollover distributions to participants who choose the make in-plan Roth conversions of non-distributable amounts.

Distribution Restrictions

Any amounts with specific distribution restrictions that are selected for conversion from pre-tax to after-tax Roth amounts will retain those same restrictions after the completion of the conversion.  The IRS suggests that for the simplicity of recordkeeping purposes, plan sponsors simply exclude those amounts with distribution restrictions from the amounts eligible for conversion.  Again, the Notice leaves the determination of eligible assets entirely up to the plan sponsor.  This would eliminate the need to track different converted amounts with different distribution restrictions, dramatically simplifying recordkeeping.

Qualified Roth Distributions

Several requirements must be met for Roth distributions to be considered qualified and therefore tax-free.  Primary among these criteria is the five-year period for qualification.  A qualified distribution must come from a Roth account made more than five taxable years after the first year the participant contributed to the Roth account.  In order to calculate the five-year period, the IRS has stated that if an in-plan Roth conversion is a participant’s first contribution to a Roth account in the plan, the five-taxable-year period begins on the first day of the taxable year in which the in-plan Roth conversion was made.

Converted Excess Contributions and Deferrals

In some cases, contributions and deferrals may later be determined to be in excess of limits.  Excess contributions may occur under the Internal Revenue Code (IRC) nondiscrimination rules.  Excess deferrals may occur under the IRC individual deferral limit.  If any converted amounts are  determined to be in excess, those amounts must be distributed from the Roth account.  This includes amounts that were previously designated non-distributable at the time of the in-plan Roth conversion.

Amending the Plan Document

In order to offer in-plan Roth conversions plan sponsors must amend their plan document before the end of the first calendar year in which they choose to add the feature.  For safe harbor plans with mid-calendar year-ends, the IRS allows for such plans to implement in-plan Roth conversions immediately. 

Conclusion

The Internal Revenue Service (IRS) recently issued guidance on the new legislation that could significantly expand the use of in-plan Roth rollovers in defined contribution (DC) plans.  Plan sponsors have the opportunity to offer expanded in-plan Roth conversions and should seriously evaluate the feature in light of their plan demographics, income levels and tax brackets before deciding to add this feature.

QDIAs Offer Fiduciary Protection

Barbara E. Williams, CFA

Managing Director

Bridgebay Financial, Inc.

www.bridgebay.com

The Pension Protection Act (PPA) of 2006 introduced the qualified default investment alternative (QDIA) as a safe harbor investment. The final QDIA regulation issued in October 2007 was followed by a DOL fact sheet and Field Assistance Bulletin (FAB) No. 2008-03 in April 2008.

At that time the DOL issued regulations to guide plan sponsors in the selection of appropriate default investments for the employer defined contribution plan.  QDIAs generally apply to any participant that is enrolled in the retirement plan and has not made an investment choice or has not made an “affirmative investment” selection.  QDIAs are most frequently used to default employees under automatic enrollment. 

The DOL designated the types of investments that qualify as QDIAs which include age-based asset allocation funds (target-date funds), risk-based asset allocation funds, managed accounts and balanced funds. The DOL regulation did not include stable value funds, GICs and money market funds as QDIAs.

Since the DOL’s QDIA regulation, most plan sponsors have designated a QDIA for their defined contribution plan’s automatic enrollment default investment.  Target-date funds have become the most popular QDIA choice by plan sponsors. 

Target Date Retirement Funds - Tips for ERISA Plan Fiduciaries

In February, 2013 the Department of Labor’s EBSA released a fiduciary guidance for plan sponsors to establish a process for evaluating, selecting, and monitoring target-date funds. QDIA options should be evaluated for  transparency, overall performance, risk management, fees and participant understanding. 

The publication highlights that plan fiduciaries should: 

1.  Establish a process to compare and select TDFs against peer groups and benchmarks

2.  Develop a periodic review process to ensure performance and soundness

3.  Understand the glide path, asset classes and underlying investments  

4.  Evaluate expenses for reasonableness

5.  Consider custom or non-proprietary TDFs as alternatives  

6.  Develop effective employee communications specific to TDFs

7.  Use independent, third party resources to evaluate TDFs

8.  Document the decision making process

Safe Harbor Conditions for QDIAs 

The QDIA regulation offers a safe harbor for plan sponsors seeking legal protection from fiduciary liability for enrolled participants that do not make an investment selection.  The QDIA regulation, however, still requires that fiduciaries prudently select and monitor QDIAs. 

Plan sponsors must meet certain conditions in order to benefit from safe harbor protections:

•        Participant balances must be invested in the plan’s designated QDIA

•        Participants must have been given an opportunity to make an investment decision and decided not to make a selection

•        Participants must be notified in advance of the initial QDIA investment, followed by annual notifications

•        The notice should include an investment prospectus

•        Participants must be able to change out of their QDIA investment, at least quarterly or comparable, into other investments in the plan

•        Participants must be able to opt-out of the plan and/or the QDIA without incurring high fees or penalties 

ERISA Section 404(c) Safe Harbor

•        Compliance with ERISA Section 404(c) may relieve plan fiduciaries of liability for investment losses from a participant that exercises control over assets in their account.  The plan must offer a broad range of investment choices and the participant must be able to exercise control in their accounts.  

•        Default investments that qualify as QDIAs can also provide plan sponsor protection under ERISA Section 404(c).  Under this safe harbor, the plan sponsor is not liable for investment losses by the participant as long as the plan sponsor has made the appropriate QDIA notifications, provided opportunity for opt-out, and conducted a due diligence in the selection and monitoring of the QDIA for the plan.  

•        Plan sponsors select a QDIA so that they may have a fiduciary safe harbor when they default participants to the investment option and use auto-enrollment to increase plan participation. 

•        Plan sponsors tend to select a QDIA in conjunction with automatic enrollment when their participants do not make their own investment selection.  

•        The QDIA affords fiduciary protection to the plan sponsor in the designation of a default option, however, the fiduciary is still responsible for the investments' due diligence, understanding, selecting, monitoring the funds and fees of the QDIA investments. 

Conclusion

Surprisingly, given the safe harbor available to plan fiduciaries by including a QDIA in the plan and relying on the 404(c) safe harbor, there are still some plan sponsors that have not updated their plans and are inadvertently foregoing the safe harbor protections available to them.  Amazingly, there are still plan sponsors that may not be aware of the advantages and fiduciary relief offered by using QDIAs.  There is still a strong need for fiduciary education for plan sponsors. 

Plan sponsors that were prompt to adopt a QDIA for their plans are now re-evaluating the QDIA they had originally selected to ensure that the choice is still appropriate for the plan.  A QDIA review entails the same level of investment due diligence applied to other investment choices in the plan's fund line-up.