Friday, January 8, 2016

Economic Review 4Q 2015


Nicholas Zaiko, CIMA®

Investment Consultant
Bridgebay Financial, Inc.
 
US Federal Reserve
On December 16, 2015 the Federal Reserve raised the Fed Funds rate target range to 0.25% - 0.50%.   The low interest rate environment has been in place for several years at the 0.0% - 0.25% range.

Fed policymakers concluded the benefits of the zero interest rate policy were being outweighed by the costs, specifically the misallocation of capital into riskier and higher-yielding sectors.

The FOMC stated that the pace of rate increases will be gradual and monetary policy will remain highly accommodative.  Expectations are that there will be 3 – 4 additional rate hikes in 2016. 

Given the turmoil in the markets so far in January 2016, fewer rate hikes may actually occur, but the Fed is still indicating 3 to 4 rate hikes. Fed funds futures contracts show that traders expect the central bank to raise rates at least twice in 2016, and are reducing bets on a third hike by December, 2016.

At the September 17, 2015 FOMC meeting, the Fed had cited global financial and economic developments that could impact and restrain US economic growth and keep inflation low.  This may delay further hikes. 

Reverse Repo Program (Fed RRP)
The Fed raised the overall cap on the overnight Fed New York (Fed NY) RRP to $2 trillion from $300 billion. The Fed NY RRP is an important policy tool for managing the fed funds rate floor, now 0.25%, and meeting money market fund demand.  Without sufficient RRP there would be potential disruptions in repo, securities lending, T-bills and other funding operations. The sizeable increase in RRP provided funding market stability. 

FOMC Forecast for Fed Funds
The FOMC’s forecasted average Fed Funds rate for 2016 is 1.375%.  The forecast average for 2017 was reduced to 2.375% and 2018’s forecast average was revised to 3.25%.  The longer run average remains unchanged at 3.5%. 

Employment
The US economy created around 292,000 net new jobs in December or 257,000 private payroll jobs, exceeding the 252,000 increase in November that was stronger than previously estimated.  The unemployment rate held at a seven-year low of 5%.  Some analysts, however, noted that many of the December jobs were part-time delivering no wage growth.

China
Investors focused on volatility in Chinese markets after the country sought to quell losses in equities and stabilize its currency. Fresh concern that China’s slowdown will hamper global growth has emerged again.  Policy makers are struggling to revive an economy that’s the world’s biggest user of resources. China Securities Regulatory Commission announced the suspension of a new stock circuit- breaker that forced local exchanges to shut for the second day in the first week of January. The move added to worry that policy makers are struggling with how to contain the months-long turmoil in its financial markets.

Global Growth
The World Bank cut its global economic growth forecast for 2016, saying the weak performance of major emerging market economies will hamper activity overall, as will anemic showings from developed countries such as the United States.

In the U.S., economic growth should increase slightly, from an estimated 2.5% in 2015 to 2.6% in 2016, with rising employment, wage growth and consumer spending countered by lagging capital investment and manufacturing.

Oil and High Yield bonds
Oil prices fell to 12-year low for a fourth day last week, lurching again to 12-year lows as new financial market turmoil in China brought a $32 per barrel price for the commodity.  Recently, oil’s close below $30 a barrel heightened fears of disinflation fueling concern that junk-rated energy producers won’t be able to stay solvent.  A collapse in commodity prices has been the main driver for high-yield’s setback since September and there may be some defaults in energy-related credits.

Junk Bond Selloff
The high yield market sell-off was sparked by declining oil prices and concerns about energy and commodity companies. The closure of a Third Avenue bond mutual fund sparked a wider sell-off in the credit market.  Several high yield bond ETFs were hit with major redemptions as a result of the junk bond selloff. 

Inflation
Headline consumer prices remained flat in November, in line with consensus expectations, pulled lower by declining oil and food prices. Headline inflation is now up 0.5% from November 2014, while the energy index is down 14.7% in the same time. Core CPI inflation increased to 2.0% year over year growth and improved by 0.1% month over month.

With the drag from energy prices expected to fade in early 2016, headline inflation should also move closer to the Fed's 2.0% mandate in the medium term.

Manufacturing
In October, the Institute for Supply Management (ISM) reported that the U.S. manufacturing sector fell to 50.1, slightly above 50, the level between expansion/contraction.  This is a sign that the strong US Dollar and tepid overseas demand is weighing on manufacturers.

Corporates
corporate issuance returned to the market in January with over $19 billion in supply.  For 2016, economists are expecting corporate issuance to exceed $1.1 trillion, which would be in-line with 2015’s supply.

While investors cope with the turbulence sparked by China, another source of consternation is looming as the corporate earnings season begins.  Investors will begin to contend with another expected decline in corporate earnings.

During the quarter, investment-grade corporate bonds underperformed Treasuries and agencies amid the risk-off environment and credit spreads widened.  Treasury prices were volatile on speculation that China will continue to sell U.S. debt to raise cash to defend its currency and support its stock market.  Corporate profits are expected to slow due to falling energy prices and a high U.S. dollar.

During 2015, investment grade corporates issuance was 17% higher than 2014 with $1.33 trillion in new supply.  US corporate issuance in 2016 is expected to be as high as the acquiring companies in M&A deals continue to issue investment grade debt. 

Credit Quality
Recently there has been a noticeable deterioration in credit quality as newly announced M&A transactions are leading to high corporate debt issuance by the acquiring companies.  These companies in turn are being downgraded by the ratings agencies although the overall credit quality is expected to improve over the next 18 months.  Issuance related to the M&A activity is especially pronounced in the below investment grade bond market. 

U.S. corporate defaults hit a four-year high for below investment grade bonds that increased from 2.1% to 2.5% in 3Q2015.   Investment grade bonds have also seen a downward trend in credit ratings. 

Interest Rates
Market sentiment has become cautious with heightened market volatility rising over the last 3 months.  The rate hike by the Fed was basically priced into the market.  The shorter-end of the yield curve has seen spread widening in anticipation of the Fed action.  During the quarter, the yield curve continued to flatten in December as rates on the 2-yr and 5-yr both climbed 12 bps for the period. The yield on the 10-yr rose 6 bps during the month, while the 30-yr rose 4 bps.

Negative market sentiment is not being driven by the Fed, but by the collapse of oil and commodity prices.  The OPEC meeting in mid-December did not resolve the supply glut. 

Banks that are lending to the energy sector or holding leveraged loans on their books may also have some credit problems on their books.  If lending to the weak high yield oil sector is stopped, some of those issuers may have liquidity problems. 

Higher quality, energy-related names may come under short-term pressure and their bonds will have spread widening.  Australian banks and some Canadian banks may be impacted if they have substantial loans to the energy and commodity-related industries. 

Third Avenue Focused Credit Fund froze redemptions and Stone Lion Capital Partners LP, a distressed-debt specialist, stopped redemptions on its credit hedge funds due to falling commodity and junk-bond prices in December.

Although the portfolio is all investment grade, our cautious view is that we may be entering into a period of credit spread widening, and overreaction by the ratings agencies, being quick to downgrade credits.  The pace of credit downgrades has been accelerating over the last few months.  

U.S. short-term and long-term rates are rising in contrast with other countries where rates are falling.  The USD is expected to continue strengthening against other currencies.

Liquidity
Liquidity in the US bond market has changed dramatically from the period before the financial crisis.  Historically, broker-dealers carried securities inventories on their balance sheets and were willing to make markets in securities and take market risk.  The change in making markets, and the record corporate issuances and low interest rate environment have made it difficult for broker-dealers to make markets and inventory securities.  Fixed income trading has become less liquid. 

Fixed income investors face longer holding periods than they would have considered in the past.  Lower turnover strategies have a lower impact on transaction costs on portfolio especially when there are changes in market liquidity.  Trading now requires a more deliberate approach to minimize transaction costs.  Conversely, there are attractive prices for buyers when there are forced sellers in the market. 

The liquidity in fixed income markets has changed across all sectors including Treasuries.  The ability to trade in large blocks has changed.  Primary dealers that purchase directly from the Fed have been buying fewer Treasures and volume has fallen.  The size of the Treasury market has doubled since 2008.  US and foreign investors have purchased a higher percentage of Treasuries sold by the Fed than the dealer community. 

Monday, December 14, 2015

Benchmarking Defined Contribution Plan Fees


Nicholas Zaiko, CIMA®
Investment Consultant
Bridgebay Financial, Inc.

This article focuses on Defined Contribution (DC) plans such as 401(k) and ERISA-covered 403(b) plans.  The most recent round of legislation has largely focused on increasing transparency regarding the fees charged for these plans by all of the various service providers.  The Department of Labor (DOL) has addressed this issue through increased regulatory disclosure requirements under sections 408(b)(2) for provider to plan sponsor disclosures and 404(a) of the Employee Retirement Income Security Act (ERISA) for plan sponsor to participant disclosures.  These full fee transparency measures were implemented in 2012.    

Some of the unfavorable judgments against plan sponsors stemming from "excessive fee" litigations over the last few years have demonstrated the regulatory and legal reasons to benchmark and document the "reasonableness" of DC plan fees.

Types of Plan Services
Fee structures and arrangements differ from plan to plan in the defined contribution marketplace.  Retirement service providers maintain a multitude of fee arrangements to pay for plan services.  The services that DC plans tend to obtain can be broken down into essentially three major categories.  Those categories are investment management, plan administration and investment or financial consulting to the retirement committee and participants. 

Recordkeeping Services
A variety a service providers may perform recordkeeping services including insurance companies , mutual fund companies, third party administrators (TPAs) or banks.  The services include compliance testing, plan and participant communication, earnings adjustments, posting payroll contributions, plan payments, educational materials and various regulatory requirements.  Each plan is unique and plan sponsors may choose from various levels of recordkeeping service.

A competitive fee review should include: fee re-negotiation with the current service provider, review of plan fees by an independent, retirement plan consultant or a complete vendor search through a request for proposal (RFP).

Fee Arrangements
There are a wide array of fee arrangements to pay for the numerous services used by 401(k) and 403(b) plans.  Administrative service fees, which cover recordkeeping, education, compliance and other administrative functions of the plan, can be charged to the employer, the participant account or directly to the plan itself.  Additionally, these fees can be assessed as variable or fixed costs and  in several different ways including as a percentage of total plan assets, per plan fees or per participant fees.

Asset-Based Fees
Revenue-sharing fees such as asset-based 12b-1 fees, shareholder servicing fees or administrative servicing fees can also be used to pay for some or all of the recordkeeping and administrative services.

Asset-based fees are typically charged by the investment manager and are quoted as a percentage of assets.  Participant fees may vary from person to person depending on the expense ratios of the funds they choose to invest in and the portion of their total amount that they choose to allocate to each selected fund.  The asset management fees make up the majority of the plan's total cost.

Investment options are offered in a variety of vehicles including mutual funds, commingled trusts, separate accounts and insurance products.  In addition to these types of arrangements, some plans may offer company stock or self-directed brokerage windows as investment options.  The fees on each of these options will vary with the share class, asset class, active or passive management and investment vehicle structure.  In certain situations, some of the asset-based fees may also be used to cover some participant services in addition to asset management.  These fees typically cover the investment management, distribution or service fees, and any other fees for the investment option such as custodial, legal recordkeeping and operating expenses.

The various services and all of their associated fees can be structured in a myriad of ways depending on the needs of each plan sponsor.  Several different scenarios may be considered when plan sponsors negotiate for services with their retirement service providers.  Some of the factors considered when negotiating include the number and types of investment options (active vs. passively managed funds), fund fee structures, proprietary vs. non-proprietary investments, and the depth of participant communications and education services  to be provided.

All-In Fee Breakdown
On average, the majority of fees go towards investment management, with a smaller portion going to cover the cost of recordkeeping and administration.  Recordkeeping and administrative fees can be charged directly to the plan sponsor on a per participant basis or may be asset-based.  Administrative fees are used to cover plan audits, 5500 reporting and compliance testing for the plan.

Investment management fees are typically based on asset size and are charged by mutual funds, commingled funds or separate accounts.  These fees may also include a revenue sharing component which pays for compliance testing, plan audit, form 5500 reporting, trustee fees, legal services and other administrative expenses.

Included in the investment expense is the external investment consultant or financial advisor to the plan.  These consultants are typically hired by the plan sponsor to guide the plan design, fund search and selection process and assist with other advisory services.  Many service providers offer their own investment consultants that may tend to select proprietary investment funds or share classes of nonproprietary funds with attractive revenue sharing for the recordkeeper.  In order to avoid potential conflicts of interest, best-practices dictate that the plan consultant be independent of the recordkeeper and asset management.   

Investment fees represent the majority of the plan's expenses.  This trend has steadily grown over the last few years.  As assets accumulate and grow, the investment management component of the all-in fee will also expand.  This portion of the fee will increase in rising markets as total dollar expenses for asset-based management fees grow.  This partially explains the overall increase in plan fees.  It is imperative that plan sponsors monitor the increase in absolute fees charged and periodically re-negotiate with the providers for fee reductions.

Economies of Scale
All-in fees, as compared to total plan assets may vary greatly especially between plans of dramatically different sizes.  Plan fees are heavily dependent upon the total plan size, which determines the ability to access institutional level share classes which typically carry lower fees.  Periodically, plan sponsors should revisit the share classes of selected funds and negotiate reduced fees as plan assets increase.

Factors Affecting Fees
Numerous variables affect any particular plan's all-in fees.  Some of the major factors include total plan size, number of participants, average account balance, participant contribution rates, and levels of participant services and communication.  Larger plans tend to benefit from economies of scale which lead to lower fees.  As a percentage of assets, plans with larger average balances and larger numbers of participants pay lower investment fees.  Plans with smaller total assets typically have smaller average account balances than larger plans, which contributes to the higher relative fees as a percentage of assets for smaller plans.  Additionally, studies have indicated that plans with more participants have lower all-in fees than plans with fewer participants. 

The correlation between large plan size and lower total fees is largely a function of the interaction between the variable and fixed costs associated with the plans.  The specific service provided and the fee arrangement with the service provider dictates whether the fee is variable or fixed.  While fixed costs remain fairly flat, variable rate costs, such as per participant or asset based charges vary as the plan grows or shrinks.  Variable costs include investment management expenses while plan audit fees, document services and regulatory filing expenses would be examples of fixed rate costs.  As the defined contribution industry has matured and become the primary retirement savings vehicle, variable costs have increased while fixed costs have decreased as a percentage of total plan costs.

Conclusion
Defined contribution plans have evolved dramatically since their creation and now represent the majority of Americans' retirement savings.  Along with this colossal growth has come a renewed sense of scrutiny, especially in the wake of the financial crisis and market turbulence of late.  Fiduciaries need to make the extra effort to properly asses the fees associated with their defined contribution plans and ensure that they are competitive and appropriate for the level of services the plans receive.  The increase in "excessive fees" litigation brought against plan sponsors over the last few years has made benchmarking and periodic fee reviews all the more important for prudent fiduciaries. 

Monday, November 16, 2015

Best Practices in Benchmarking 403(b) Plans


Barbara Williams, CFA
Managing Director
Bridgebay Financial, Inc.

This article addresses some of the best practices in benchmarking 403(b) plans as a guide for plan sponsors.

Periodic benchmarking of your 403(b) plan is a normal due diligence process that should be conducted by an independent retirement plan advisor or consultant that is well-informed and has experience working with multiple service providers.  This broad experience allows the third-party advisor to properly benchmark your plan against other plans and service providers in the defined contribution market, namely, ERISA-covered and non-ERISA plans. 

The Department of Labor (DoL) has signaled that such a review should be conducted every 3-5 years.  Plan sponsors should conduct a request for information (RFI) through an independent retirement plan consultant to benchmark plan services, fees and administration as a best-practice and document good fiduciary practices.  Refreshing plan features and services assists nonprofit retirement plan sponsors who are dedicated to their participants' ability to have positive retirement outcomes.

Ideally, the independent retirement plan advisor conducting the benchmarking study should not be associated or affiliated with the current or prospective plan provider.  Also, the advisor should not have any conflict of interest or be able to benefit financially from selecting or recommending any specific provider. 

A critical element of the benchmarking process is proper and thorough documentation.  The evaluation criteria must be specifically defined in order to unequivocally demonstrate that an impartial, balanced, and comprehensive review was conducted and that the final decision is rational, defensible and free of any potential conflicts of interest.  Such documentation will definitively exhibit the prudent process for the DoL and demonstrate that the chosen solution was for the benefit of the plan participants. 

The due diligence process should incorporate a review of the recordkeeper's financial strength, delivery of services, plan compliance, reporting services, plan sponsor services, participant services including education, quality of investment choices and fees.  Fortunately, recently mandated disclosure requirements now enable the plan sponsor to receive better information and greater transparency concerning services and total costs.

Investments
On the investment side, many plans rely on the recordkeeper's affiliated investment team to provide investment reviews quarterly.  From a fiduciary perspective, it is also a best-practice to conduct a deep-dive of the investments using an independent third-party investment consultant at least annually to provide an impartial review of the quality, diversification and cost of the investments.  By conducting an annual deep benchmarking review of the plan by an independent consultant the sponsor can still benefit from the recordkeeper's quarterly investment input while also enhancing fund, plan and provider oversight.  This third-party perspective is a tremendous fiduciary benefit that the plan recordkeeper simply cannot provide.

Multiple Providers
When compared to 401(k) plans and other defined contribution plans, 403(b) plans offer many more investment options to their participants on average.  Typically, when multiple vendors are used, many of the investment options are redundant and may not necessarily be best-in-class.  This redundancy in investment options can lead to participant confusion, inertia, poor asset allocation and higher costs for participants.  The use of multiple providers can present complications when trying to evaluate a particular 403(b) plan with regards to its peers. 

Nonprofit plan sponsors with multiple providers with different investments and embedded costs may require retaining an experienced retirement plan consultant to streamline the plan.  Many 403(b) sponsors find it advantageous to move to a single provider with an efficient cost structure and investment offerings that best benefits the participants. 

Understanding Plan Fees
The implementation of 408(b)2 in 2012 represented a major step in assisting plan sponsors in understanding plan fees, re-negotiating those fees and gaining a better understanding of the costs associated with the services being provided.  In many cases, providers have updated the services and expanded their platforms to better serve their clients in an effort to retain existing business.  All of these developments are positive for the discerning 403(b) plan sponsor.

Enhancing Plan Features
There are numerous features in plan design that sponsors can employ to increase the success of their plan and participants' retirement outcomes.  Some key design features include auto-enrollment of current and new employees, auto-deferral, auto-deferral increase, and selection of a Qualified Default Investment Alternative (QDIA).  Providing enhanced participant information on projected retirement savings and income replacement by retirement age are also important participant incentives to increase the success of the 403(b) plan.

The current trend is to de-emphasize participant education and focus on plan design features that optimize participation, asset allocation, and maximize deferrals.

Planning for the Future
When using independent third-party consultants, it is important that the retirement plan adviser have specific experience in an ERISA environment, even if the 403(b) plan is non-ERISA.  This experience and background will ensure that the plan sponsor is attaining the highest standard of prudent care and is implementing best practices.  The advisor should be able to draw from the practices of a wide range of providers so that if the plan services are determined to be limited, outdated, or overpriced, the advisor will be able to recommend better solutions.

Retirement plans offered at different nonprofit organizations are at different stages of development.  Advisors that are familiar with more evolved retirement plans can "see the future" and are able to lay out a blueprint for success.

Many qualified retirement plan advisors that have historically advised 401(k) plans can contribute significantly to 403(b) plan sponsors.  Their expertise and fiduciary knowledge gained from operating in a ERISA world can benefit nonprofit organizations that are now progressing into an ERISA fiduciary environment.  An advisor well-versed in ERISA standards can effectively apply that same level of due diligence, prudence and fiduciary standards to the 403(b) plan of a nonprofit organization. 

Conclusion
Fiduciary oversight of a 403(b) plan has become a challenging role for many plan sponsors, especially if their administrative responsibilities are still burdened with multiple vendors.  Periodic plan benchmarking is a critical function for all plan fiduciaries, regardless of the retirement plan type or size.  Benchmarking helps plan sponsors upgrade plan services, plan design and participant services at a competitive price.