Across the country, public employee retirement systems are investing in companies that privatize public employee jobs. Such investments lead to reduced working hours and often job losses for current employees.  Although, in some circumstances, pension fund participants and beneficiaries may benefit from these investments, their actual economic interests might also be harmed by them, once the negative jobs impact is taken into account. But that impact is almost never taken into account. That’s because under the ascendant view of the fiduciary duty of loyalty, pension trustees owe their allegiance to the fund first, rather than to the fund’s participants and beneficiaries. Notwithstanding the fact that ERISA and state pension codes command trustees to invest, “solely in the interests of participants and beneficiaries and for the exclusive purpose of providing benefits,” the United States Department of Labor declared in 2008 that the plain text of the quoted language means that the interests of the plan come first.  Under this view, plan trustees should de facto ignore the potentially negative jobs impact of privatizing investments because that impact harms plan members, and not, purportedly, the plan itself. Thus, in the name of the duty of loyalty, the actual economic interests of plan members in plan investments are subverted to the interests of the plan itself (or, at a minimum, to an unduly constrained version of the plan’s interests that excludes lost employer and employee contributions). As a result, public pension plans make investments that harm the economic interests of their members. This turns the duty of loyalty on its head.
Posts Tagged ‘Retirement plans’
These are uncertain times for our nation’s investors and for those who issue and sell investment products, including variable insurance. A positive sign is that assets in variable annuities, at almost $1.6 trillion, remain near their all-time high.  In addition, the retirement income solutions offered by the industry are designed to address the needs of the many investors moving toward retirement in today’s uncertain market environment. However, there are significant challenges facing the business, particularly those presented by the persistent low interest rate environment and by volatile equity markets both here and abroad.
The Division has observed the industry undertaking several initiatives to address these challenges and curtail risk exposure in the contracts being offered. In addition, some insurers have chosen to exit the business. An industry on solid financial footing is important for investors, who rely on insurers’ ability to pay promised benefits. At the same time, some contract changes are not good for investors. For example, many recent changes have reduced benefits for new investors. Other changes have limited the ability of existing contract owners to make additional payments into their contracts in order to take advantage of the benefits of those contracts.
In our paper, An Experiment on Mutual Fund Fees in Retirement Investing, we report the results of a new experiment studying the impact of mutual fund fees on consumer investment decisions. The importance of fees to overall investor returns, especially in the context of long-term investing like retirement accounts, is frequently overlooked. Morningstar’s Director of Mutual Fund Research recently observed, “If there’s anything in the whole world of mutual funds that you can take to the bank, it’s that expense ratios help you make a better decision.” But there is evidence that many investors are paying high fees. One study estimates that in 2007 alone, retail investors paid $206 million more in S&P index fund expenses than they would have paid had all investments been in the lowest-fee funds.
Why are investors willing to pay high fees? Are existing fee levels the result of robust market competition or do market failures or investor biases limit market discipline? In his recent Jones v. Harris opinion, Judge Easterbrook took the efficient market position, concluding that market forces will lead investors to reject funds that charge excessive fees in favor of more fairly-priced alternatives. Under this view, investors will only pay higher fees when those fees are justified. Judge Posner countered, in dissent, with an empirical question: do high fees really affect investor behavior? A growing collection of evidence suggests that Judge Posner’s skepticism is well-founded; in the market for mutual funds, uninformed investors do not appear able or willing to distinguish between cheap and expensive funds.
On March 31, 2012, the U.S. District Court for the Western District of Missouri awarded plaintiffs more than $35 million in a class action suit over certain breaches of duty related to 401(k) plan expenses.
The case was brought on behalf of participants in two 401(k) plans sponsored by a major manufacturer of power and automation equipment with operations in around 100 countries and more than 135,000 employees.
In Tussey v. ABB, Inc.,  the District Court held that ABB, Inc. and its benefit and investment committees (collectively, “ABB”) violated their fiduciary duties to the plans when they failed to monitor record-keeping costs, failed to negotiate rebates from investment companies on the plans’ investment platform, selected mutual fund share classes that were more expensive than necessary, and replaced a mutual fund with a fund offered by an affiliate of the record keeper for the plans. In addition, the District Court found that the employer and its benefits committee violated their fiduciary duties to the plans by agreeing to pay the record keeper above market record-keeping fees in order to subsidize other corporate services provided to the employer by the record keeper, such as payroll and record keeping for other employee benefit plans.
In the past decade, numerous lawsuits have been brought under ERISA against the fiduciaries and sponsors of 401(k) and other defined contribution retirement plans. Many of these lawsuits have been pled as class actions on behalf of all or many participants of the plan. The most common lawsuits have involved declines in the value of employer stock offered in the plans and allegations that decisions to maintain employer stock in the plans were imprudent. There have also been some lawsuits over other investment options, as well as lawsuits over the management of collateral from securities lending programs run by plan trustees. Another substantial category of litigation has involved allegations of excessive fees. Many of these cases, both investments and fees, have also involved allegedly inadequate disclosure of information to plan participants.
Economic analysis plays an important role in many of these cases. The purpose of this paper is to discuss some of the important economic issues that arise in ERISA litigation, both in establishing liability and in calculating damages.
In the paper, Seeking Safety: The Relation Between CEO Inside Debt Holdings and the Riskiness of Firm Investment and Financial Policies, forthcoming in the Journal of Financial Economics, we investigate whether CEOs with large inside debt holdings protect the value of their holdings by implementing less risky investment and financial policies. The recent near-collapse of global financial markets led to renewed scrutiny of executive compensation practices by journalists, academicians, politicians, and regulators. Much of the scrutiny focused on alleged excesses in the compensation packages of the executives deemed (at least partially) responsible for the economic turmoil (e.g., Karaian, 2008; Rappeport, 2008; McCann, 2009). However, the financial crisis also highlighted the vulnerability of certain components of firm-specific executive wealth during times of financial distress as several prominent chief executive officers (CEOs) surrendered significant portions of their inside debt holdings (pension benefits and/or deferred compensation) when their firms failed during the crisis. Inside debt holdings are at risk because they generally represent unsecured and unfunded liabilities of the firm, rendering these executive holdings sensitive to default risk similar to that faced by other outside creditors (Sundaram and Yermack, 2007; Edmans and Liu, 2011).
In the paper, Do Pension-Related Business Ties Influence Mutual Fund Proxy Voting? Evidence from Shareholder Proposals on Executive Compensation, which can be found in a forthcoming issue of the Journal of Financial and Quantitative Analysis, we examine the relation between mutual fund votes on shareholder executive compensation proposals and pension-related business ties between fund families and the firms. Mutual funds have a fiduciary responsibility to act in the interests of their shareholders. Shareholder proposals provide one mechanism via which mutual funds can influence firm policies to benefit shareholders. However, mutual funds benefit when they receive pension fund business from firms, which creates a potential conflict of interest that creates an incentive for fund managers to support firm management and to vote against shareholder proposals. Rationally, fund families should trade off the economic benefit of self-interested voting against possible economic losses related to lower portfolio returns, damaged reputations, or potential lawsuits. Shareholder proposals that relate to executive compensation provide an excellent arena in which to examine the influence of pension-related business ties, since these proposals can directly affect the pay and benefits of managers with influence over which fund families receive pension business.
In our paper, How Do Pensions Affect Corporate Capital Structure Decisions?, which was recently accepted for publication in the Review of Financial Studies, we investigate the importance of pension contributions as a source of tax shields and their effect on companies’ marginal tax rates, and whether companies treat pension liabilities as a substitute for debt financing. To date, the bulk of capital structure research has focused on explaining the leverage choice as it is reported on the balance sheet. Yet companies have sizable assets and liabilities that do not appear anywhere on the balance sheet, the largest of which relates to corporate pension plans.
We study all publicly traded firms on Compustat from 1991 to 2003. About a fourth of these firms have defined benefit pension plans. For some companies, the magnitude of pension assets and liabilities is substantial. On average, pension plan assets are 16.4% of the book value of assets recorded on the balance sheet and represent 62% of the market value of the firm’s equity, though there is considerable variation across firms.
My recent article “The Trilateral Dilemma in Financial Regulation” analyzes a practice — which I label the trilateral dilemma — existing in many different sections of the financial services industry, including mortgage lending, retirement savings, investment management, insurance brokering and banking services. The practice arises in the context of a consumer seeking the recommendation of a financial adviser for the purpose of choosing financial products and services. With surprising frequency, these advisers receive side payments or other forms of compensation from the firms that provide the product or service the advisers recommend. Many times these payments are not clearly disclosed to the consumers; often they are entirely secret.
In the article I describe how trilateral dilemmas have arisen in many different sections of the financial services industry. I then review the many different regulatory strategies that legislatures, courts and regulatory bodies have employed to address the problem. The modal regulatory response is the imposition of some sort of fiduciary duty on the financial advisor along with a generalized disclosure to consumers affected by the transaction. I then discuss a range of recurring analytical issues that arise in policy debates over trilateral dilemmas in a variety of settings, and I also evaluate the possibility that side payments and other forms of indirect compensation may in fact be an efficient or at least innocuous means of financing the cost of distributing financial products and services. The article concludes with some thoughts about the implications of my analysis for devising regulatory responses and for the role that consumer education might play in helping consumers work through these difficulties.
The article is available here.
One specific — and highly controversial — example of the trilateral dilemma in the real estate context involves the payment of yield spread premiums by lending institutions to mortgage brokers for steering consumers towards particular loans. In a recent article entitled “Kickbacks or Compensation: The Case of Yield Spread Premiums“, Laurie Burlingame and I present an empirical study of approximately 3,000 mortgage financings of a major lending institution operating on a nationwide basis through both a network of independent mortgage brokers and some direct lending. The data for this study was obtained through discovery in litigation that was subsequently settled. The study offers a number of insights into the impact of yield spread premiums of mortgage broker compensation and borrower costs. In particular, the study suggests that for transactions involving yield spread premiums, mortgage brokers received substantially more compensation than they did in transactions without yield spread premiums. This estimated difference in mortgage broker compensation is statistically significant and robust to a variety of formulations.
Industry representatives have long argued that yield spread premiums are not harmful to consumers because these payments are recouped through lower direct payments to mortgage brokers. However, our analysis suggests that this claim is baseless, at least with respect to sample included in our database. With a high degree of statistical confidence and using multiple formulations, we can reject the proposition that consumers fully recoup the cost of yield spread premiums. Our best estimate is that consumers get less than 35 cents of value for every dollar of yield spread premiums, a very bad deal for consumers.
The article also provides evidence that the payment of yield spread premiums may allow mortgage brokers to engage in price discrimination among borrowers. The evidence suggests that yield spread premiums are not simply another form of mortgage broker compensation, but rather a unique form of compensation that allows mortgage brokers to extract excessive payments from many consumers. The article concludes with a discussion of the implications of the study, areas for regulatory focus, and proposals for regulatory reform.
The article is available here.