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In Washington, D.C., the debate is just beginning over the merits of extending the option of a workplace retirement savings account to every private-sector worker who doesn’t have already have one. But in Washington State, the debate is already over—or at least tabled.

And in the process of researching their version of a universal workplace plan, Washington State retirement officials learned something: that the private 401(k) industry doesn’t welcome competition from the state.

Back in May 2007, the Department of Retirement Systems in the Evergreen State was assigned to design a retirement program to promote savings among private sector employees. The state came up with three options in its January 2009 report, called Washington Voluntary Accounts: Report to the Legislature.

The three were: a payroll-deduction plan with a single investment, like a Treasury Inflation-Protected bond fund; a similar program, but with a small allocation to stocks; and a state-run 401(k).

Private industry was open to the first two options but nixed the third.

“The people in industry I spoke with were receptive to the our version of an IRA, where the state would specify or create specifications for products but private sector would provide the products,” said Sandy Matheson, then the department’s director. “They’re less receptive to the idea of states competing directly with them by operating these plans.”

Aside from competition, any state-mandated plan was expected to create headaches for small business owners who haven’t computerized their businesses.  “The trouble for small employers is that they’re still on manual payroll,” she told RIJ. “If you’re not automated, that creates more challenges.”

Matheson, a CPA who has since become executive director of the Maine Public Employees Retirement System, also learned that a public-private workplace savings program isn’t likely to work unless it’s very simple.

“The simpler the program, and the easier it is to administer, then the more readily acceptable it tends to be,” she said. “When you build complexity into a program, it may not fit as many people as well. I kept being driven back to a very simple model.”

The state legislature has not acted yet on the recommendations in the January report—in part because the process was interrupted by the global financial crisis. Here are summaries of the options that were presented to them:

A private sector-administered payroll deduction or individual IRA offering a state-specified low-cost, low-cost, single choice, inflation-protected, simple investment. Any financial Institution or eligible broker can administer and offer this product using the state’s name if the product meets the Department’s specifications. The Department will conduct marketing, including Web site referrals to eligible vendors, to encourage low‐risk saving and reduce a market mismatch between the supply and demand for low-cost products.

A private sector-administered payroll deduction or individual IRA offering a state-specified low-risk, single choice inflation-protected and growth investment. This option achieves all of the same benefits as the simple investment option, but could offer a mixture of inflation-protected investments in combination with a smaller amount of stocks. For example, the investment could be a balanced portfolio that consists mostly of principal preservation type assets (e.g.,bonds) with a small amount of equities. The bonds guarantee that, at a minimum, an investor will receive every dollar invested back at its future value, and the stocks offer opportunity for some growth. This option is directed at longer‐term retirement investment.

A state-administered 401(k). The state could administer or partner with private sector providers to offer a 401(k) plan that would be available to private sector businesses. The plan design would be consistent with Internal Revenue Service Regulations and investments could be managed by the Washington State Investment Board. This option would require prior approval by the Internal Revenue Service (IRS) before it could be implemented.

© 2009 RIJ Publishing. All rights reserved.

The details of the auto-IRA/Saver’s Credit proposal are still unclear, as are the kinds of opportunities that it might create for payroll companies, banks, or retirement plan providers. But the basic outline of the plan has taken shape.   

First, the program is voluntary for individual workers—but not necessarily for employers. Companies with at least 10 employees that that do not offer any retirement plan and have been in business at least two years would have to automatically enroll their employees in an IRA—probably a Roth IRA—and start monthly contributions equal to three percent of pay.    

Then there’s the incentive. The next-generation Saver’s Credit would be an updated form of the current Saver’s Credit, now used by about 5.5 million taxpayers. The old version provides a tax credit that accrues only to low- and middle-class workers who pay taxes. The new Saver’s Credit would match 50% (up to $500) of the IRA contributions of low- and middle-income workers whether they owe income taxes or not. 

“There are several models for providing auto IRAs,” said David John of the Heritage Foundation, a co-creator of the auto-IRA/Saver’s Credit concept. “In each case the individual company is the nexus. If a small business has a relationship with a bank, the bank might say, ‘We’ll add the auto-IRA to a full range of other services.’ Or, a small business owner could go onto website and, as with Medicare part D, see a list of all the providers who do business with a firm of that size and location.

“Or a business might belong to a multi-employer plan that uses an ‘Auto-IRA’ fund sponsored by XY insurance company,” he added. “If none of that works, a small business might be assigned to a consortium, and an asset manager could aggregate several thousand employees at several hundred companies.”

Each employee’s contributions to the auto-IRA would be deducted from his or her paycheck and be routed to an IRA custodian via the employer’s payroll system. Contributions would likely be invested in inflation-protected U.S. bonds (a special version of the “I-bonds” now sold to individual investors) or into an account with a target date or target-risk balanced mutual fund or fund-of-funds.

At some point, when their account balances become large enough—this part is still fuzzy—the employees could transfer their IRA assets to any financial services firm they choose. Then they would assume their places in the vast, disorganized and under-informed army of American investors.  

Who might profit from all of this?  Companies who have mastered e-commerce and achieved economies of scale in handling small accounts are expected to latch onto the idea. But it’s not for everyone. “We’ve talked to mutual companies, insurance companies, major banks, to recordkeeping firms and fund administrators, said John. “Some really love it and others say, ‘Who cares?’ 

“It doesn’t break down so much by industry sector as by business model. It takes a business model that’s set up to handle large numbers of customers. A payroll services company might handle the deduction from the paycheck, and forward the money to a funds manager. We’re seeing strong interest there.”

For those interested in the background details, here’s the Tax Policy Institute’s statement on the new plan:

Under current law, low- and middle-income taxpayers may claim a saver’s credit of up to $1,000 ($2,000 for couples) if they contribute to retirement savings plans. The credit equals the credit rate times up to $2,000 of contributions to IRAs, 401(k)s, or certain other retirement accounts by each taxpayer and spouse.

The credit rate for 2008 depends on income and tax filing status as shown in the following table. (For 2009, couples filing jointly must have income below $55,500, heads of household income below $41,625, and other tax filers income below $27,750 to claim any credit.) The credit is not refundable and therefore has limited value for people with little income tax liability.

President Obama proposes to make the saver’s credit refundable as a 50% credit up to $500 per individual (indexed for inflation).  The full credit would go to families with income below $65,000 ($48,750 for heads of household and $32,500 each for singles and married couples filing separately) and would be automatically deposited into the qualified retirement plan or IRA.  The credit would phase out when income exceeds those limits: the maximum credit would be reduced by 5 percent of income over the relevant limit.

The government would effectively pay half the cost of up to $1,000 deposited to a retirement account each year for all eligible households. For example, a family that puts $800 aside in a retirement account would receive a $400 tax credit, lowering the cost of the contribution to $400.

Turning the currently nonrefundable saver’s credit into a refundable credit would encourage low-income households to save more by boosting the effective return to their saving.  Because the credit would go directly into the saver’s retirement account, the default option would augment the amount saved by half and thus further increase the amount saved for retirement. The phase-out of the credit would, however, raise effective marginal tax rates for many middle-income taxpayers with potentially adverse behavioral effects on work effort and saving.

President Obama also proposes to establish automatic enrollment in IRAs and 401(k)s. Currently most employment-based retirement savings plans require workers to make a positive choice to contribute to the plan. The default option is not to contribute.  Under the president’s proposal, employers in business at least two years and with ten or more workers would have to enroll every worker automatically in a workplace pension plan unless the worker opts not to participate.

Employers who do not currently offer retirement plans would have to enroll employees in a direct-deposit IRA account unless the worker opts out. Research has shown that changing from a default opt-in provision to an opt-out provision markedly increases worker participation. The administration suggests that its proposal would increase the savings participation rate for low- and middle-income workers from the current 15 percent level to around 80 percent.

© 2009 RIJ Publishing. All rights reserved.

The blueprint for tighter oversight of the U.S. financial sector that the Obama administration released last week provided for the establishment of an unprecedented Office of National Insurance (ONI) within the Treasury Department.

And while the report did not offer the “optional federal charter” that large insurance companies support as an alternative to state-by-state regulation, it did not rule one out.

The ONI would “gather information, develop expertise, negotiate international agreements, and coordinate policy in the insurance sector,” said the blueprint, officially called “Financial Regulatory Reform, A New Foundation: Rebuilding Financial Supervision and Regulation.”

The recommendation was based on the assumption that the insurance industry is too large and too inter-connected with the rest of the financial system-and too global-for the federal government to leave its regulation up to the individual states.

The 100-page report also for the ONI to “recommend to the Federal Reserve any insurance companies that the [ONI] believes should be supervised as “Tier 1 FHCs.” That is, financial holding companies whose failure could threaten the entire system.

“The current crisis highlighted the lack of expertise within the federal government regarding the insurance industry,” the report said. “While AIG’s main problems were created outside of its traditional insurance business, significant losses arose inside its state-regulated insurance companies as well. 

“Insurance is a major component of the financial system,” the text continued. “In 2008, the insurance industry had $5.7 trillion in assets, compared with $15.8 trillion in the banking sector. There are 2.3 million jobs in the insurance industry, making up almost a third of all financial sector jobs.

“For over 135 years, insurance has primarily been regulated by the states, which has led to a lack of uniformity and reduced competition across state and international boundaries, resulting in inefficiency, reduced product innovation, and higher costs to consumers,” the report said.

Six principles for oversight
Treasury supports the following six principles for insurance regulation, according to the report:

1. Effective systemic risk regulation with respect to insurance. The steps proposed in this report, if enacted, will address systemic risks posed to the financial system by the insurance industry. However, if additional insurance regulation would help to further reduce systemic risk or would increase integration into the new regulatory regime, we will consider those changes.

2. Strong capital standards and an appropriate match between capital allocation and liabilities for all insurance companies. Although the current crisis did not stem from widespread problems in the insurance industry, the crisis did make clear the importance of adequate capital standards and a strong capital position for all financial firms. Any insurance regulatory regime should include strong capital standards and appropriate risk management, including the management of liquidity and duration risk.

3. Meaningful and consistent consumer protection for insurance products and practices. While many states have enacted strong consumer protections in the insurance marketplace, protections vary widely among states. Any new insurance regulatory regime should enhance consumer protections and address any gaps and problems that exist under the current system, including the regulation of producers of insurance. 

4. Increased national uniformity through either a federal charter or effective action by the states. Our current insurance regulatory system is highly fragmented, inconsistent, and inefficient. While some steps have been taken to increase uniformity, they have been insufficient. As a result there remain tremendous differences in regulatory adequacy and consumer protection among the states. Increased consistency in the regulatory treatment of insurance – including strong capital standards and consumer protections – should enhance financial stability, increase economic efficiency and result in real improvements for consumers.

5. Improve and broaden the regulation of insurance companies and affiliates on a consolidated basis, including those affiliates outside of the traditional insurance business. As we saw with respect to AIG, the problems of associated affiliates outside of a consolidated insurance company’s traditional insurance business can grow to threaten the solvency of the underlying insurance company and the economy. Any new regulatory regime must address the current gaps in insurance holding company regulation.

6. International coordination. Improvements to our system of insurance regulation should satisfy existing international frameworks, enhance the international competitiveness of the American insurance industry, and expand opportunities for the insurance industry to export its services.

Comments from interested parties
The National Association of Insurance Commissioners, in a statement from president CEO Theresa (Terri) M. Vaughn, Ph.D., said, “While no one proposal is completely perfect, our initial read of the Administration’s financial overhaul plan seems to reflect what is most important to us: preserving the consumer protections and financial solvency oversight of the historically strong and solid system of state-based insurance regulation.”

American Council of Life Insurers president and CEO Frank Keating said “ACLI therefore appreciates Treasury’s commitment to work towards modernization of insurance regulation based on the principles of national uniformity, efficiency, effective oversight of systemic risk and better international cooperation. The White Paper identifies a federal charter as one possible way to achieve those objectives. ACLI strongly supports an optional federal charter as the only way to achieve them.

In commenting on the report, James Hamilton, a CCH analyst at Wolters Kluwer Law & Business, noted that the recommended Financial Stability Council “would also be able to propose regulations of financial instruments that are designed to look like insurance products, but that in reality are financial products that could present a systemic risk. But the legislation does not preempt state law governing traditional insurance products.”

Fred Joseph, president of the North American Securities Administrators Association, in a statement, praised the fact that the administration was “calling for a council of regulators to assist the Federal Reserve in monitoring risk throughout our financial system; addressing the pressing need for a fiduciary standard of care for broker-dealers providing investment advice and calling for legislation empowering the SEC to prohibit mandatory arbitration clauses in broker-dealer and investment adviser contracts with retail investors.”

© 2009 RIJ Publishing. All rights reserved.

Back in 2006, when the stock market was ramping up and Congress blessed target-date funds (TDFs) as a qualified default investment alternative (QDIA) for 401(k) plans, TDFs seemed to relieve the problem of incoherent or overly-conservative savings habits among plan participants.

These “point-and-shoot” funds-of-funds, whose names always include the approximate year when the participant would retire—2015, for instance—automatically evolved to a higher bond-to-stock ratio over time. A single TDF was said to be all a participant ever needed.

In reality, the solution wasn’t so neat. Some TDFs held high equity allocations well into retirement. Some TDF fund managers drifted from their investment styles. Many participants bought several funds in addition to a TDF, diluting the intended effect.

Worst of all, as a behavioral finance expert told U.S. officials in a hearing last week, many participants mistakenly assumed that a TDF would “magically” allow them to retire comfortably on their target date—no matter how much or how little they saved before then.

The 2008 market crash shattered that illusion, of course. Many 63-year-olds with money in “2010” funds took big losses. Last week, federal officials tried to locate the blame: Was it marketing hype by TDF makers, flawed TDF designs, America’s low financial literacy rate, regulatory lapses-or merely the caprice of the markets?

Judging by testimony from a parade of experts at the joint SEC-Department of Labor hearing/webcast on June 18, the culprit was “all of the above.”

Unintelligent design?
The TDF experts were divided into roughly two camps: those who saw them as a glass half full and those who saw them as a glass half empty.  TDF advocates said the funds were based on sound principles and answered a gaping need in fund plans for a point-and-clink investment technology for average plan participants.

But TDF detractors said the assumption underlying TDFs-that asset allocation could be based entirely on a hypothetical retirement date-was a gimmick that over-simplified and distorted the investment process.  “Age-based rules are unreliable and often perverse,” said Richard O. Michaud of Boston-based New Frontier Investors LLC.

Others agreed the using a single criterion such as age to solve a complicated problem like investing over a lifetime makes no sense. “To say that it is false is an understatement,” said Louis S. Harvey of Dalbar Inc. 

As for the lack of standardization among TDFs with the same target date, some experts viewed that as a flaw and others as a virtue. In practice, every TDF has a different “glide path,” with some reaching their lowest equity allocation in the retirement year (thus minimizing investment risk) and some not reaching it until several years into retirement (thus minimizing longevity risk by maintaining growth potential). For instance, 2015 funds today contain equity exposures ranging from 43% to 83%, according to Standard & Poor’s. 

That sort of disparity has been a cause of confusion among investors but also a sign of innovation among manufacturers. “Variety is a virtue,” said Lori Lucas of Callan Associates.

Because there were no standards, TDF managers could pursue better returns by over-weighing equities and taking on more risk. While this form of style-drift might have looked like a smart strategy and a competitive advantage when stock values were rising, it back-fired when the market tanked.

Financial illiteracy?
Sixty-one percent of plan participants who owned TDFs thought the funds contained an implied guarantee of principal or returns, said Jodi DiCenzo of Behavioral Research Associations in Evanston, Ill., who surveyed plan participants last March. 

“They believed in ‘TDF magic.’ Many thought they would be able to retire on the target date. A significant percentage thought the TDFs offer a guaranteed return ,” she said, asserting that the TDF label contained “implicit advice.”

Participants assumed an implied guarantee for three likely reasons, DiCenzo said, including “excessive optimism” on the part of plan participants, “framing effects” that positioned TDFs as an alternative to riskier solutions, and a “focus on simplicity” that suggested that TDFs did more than simply adjusted asset allocation over time.

DiCenzo seemed to scold the financial services industry for hyping TDFs as a shortcut to success, and for not making their limitations clear in marketing materials.. “There’s no magic in TDFs,” she said. “You can’t invest your way to a secure retirement. You must save.”

Another panelist observed that investors in TDFs also bought other funds, overlooking the idea that a TDF alone was meant to offer adequate diversification and missing the concept that the TDF effect-evolution toward a low-risk asset allocation-would be diluted by the purchase of other funds. “Participants don’t realized that TDFs are funds-of-funds,” said Anne Tuttle of Financial Engines.

Marketing hype and weak regulation?
Fund companies pushed TDFs not because they were good for plan participants, said Richard Michaud, but because they gave investors a reason not to switch funds. Plan record keepers like TDFs, he added, because they were relatively easy to keep track of.

“TDFs simply sales while encouraging people to stay in the same fund until retirement,” he said.

Many TDFs are non-compliant with the regulations of the QDIA, said Dalbar’s Harvey.  TDFs do nothing to limit investor losses, although that is a requirement of a QDIA, and many TDFs charge a fee if an investor exits the fund within 90 days, although that’s not permitted under existing regulations, he said. 

One retirement plan advisor faulted regulators for not making sure that plan participants were aware of TDF shortcomings. “These hearing should have been held five years ago, before the horse was out of the barn,” said David A. Krasnow, of Pension Advisors. 

“We have steered our clients away from the TDF concept,” he said. “It was put out to the masses before it was properly researched. Inadequate oversight has jeopardized Americans’ financial security. People may never be able to retire because they trusted the government.”

It’s unlikely that TDFs will vanish, because their footprint in the defined contribution world has become too large. Invented in 1993 by Barclays Global Investors, they are now manufactured by dozens of fund companies.

More than 60% of employers now use them as a default contribution option. Through Q3 2008, assets in this sector were US$187 billion, up from US$ 115 billion in 2006, according to Standard & Poor’s. Cerulli Associates Inc. recently predicted that TDFs could gather up to $1 trillion in assets by 2012.

© 2009 RIJ Publishing. All rights reserved.