Managing the financial risk associated with pension obligations has become a high priority for many organizations in the current economic environment. The good news is that the recently enacted funding stabilization law, the Moving Ahead for Progress in the 21st Century Act (MAP-21), is helping to mitigate significant short-term cash contributions to pension plans.
Further, the enactment of MAP-21 provides an incentive for plan sponsors to manage pension plans to full funding while concurrently reducing risk.
Leading pension consultants are currently recommending that employers “derisk” their pension plans within a time they specify via a “glide path” investment strategy. For example, based on a plan’s objectives, the consultant recommends a derisking strategy consisting of a series of proposed Estimated De-Risking Funding Ratio triggers.
Each trigger is set to a proposed asset-allocation target with gradually lower-risk allocations between liability hedging assets and growth assets consistent with the time horizon and risk preferences of the plan sponsor.
Ironically, this risk-reduction strategy relies on liability-hedging assets such as swaps and other derivative security products regarded as relatively risky by framers of the Dodd-Frank Act, under which such derivatives are heavily regulated.
Before the development of derisking solutions, plans subject to the Employee Retirement Income Security Act (and investment vehicles in which such plans invest) regularly engaged in swap transactions to hedge against market risks. Swaps also help pension-plan sponsors reduce volatility and make funding obligations more predictable.
For example, many sponsors of defined-benefit plans believe the ability to hedge interest-rate risk by using an interest-rate swap is critical to the management of plan risk. Accordingly, an important part of Dodd-Frank is to protect ERISA plans by identifying them as “Special Entities” with respect to which swap dealers (SDs) and major swap participants (MSPs) owe certain special duties.
Generally, under Dodd-Frank, an SD acting as an adviser to a Special Entity must act in the best interests of that entity. Under regulations issued by the Commodity Futures Trading Commission (CFTC), however, an SD that merely makes a recommendation to a Special Entity is an “adviser.”
Under Dodd-Frank, an SD acting as a mere counterparty (not as an adviser) also has obligations to a Special Entity. Specifically, under Section 731 of the act, employee-benefit plans as defined in Section 3 of ERISA are classified as “Special Entities” and SDs, and MSPs transacting with them must adhere to an additional set of standards enumerated under the Dodd-Frank Act.
Specifically, Dodd-Frank requires an SD or MSP that “offers to enter or enters into a swap” with a Special Entity to have a “reasonable basis” to believe that the Special Entity has an independent representative that:
(I) has sufficient knowledge to evaluate the transaction and risks;
(II) is not subject to a statutory disqualification;
(III) is independent of the SD or MSP;
(IV) undertakes a duty to act in the best interests of the counterparty it represents;
(V) makes appropriate disclosures;
(VI) will provide written representations to the Special Entity regarding fair pricing and the appropriateness of the transaction; and
(VII) in the case of employee-benefit plans subject to ERISA is a fiduciary as defined in section 3 of that act and discloses to the Special Entity in writing the capacity in which the SD is acting.
Complying with those requirements shouldn’t be an additional burden, since they generally parallel the fiduciary requirements set forth in ERISA and strict participant and plan service–provider fee-disclosure requirements set forth in Department of Labor (DoL) regulations.
For example, Item I above requires the independent representative (e.g., members of the sponsor’s pension committee who serve as a plan’s named fiduciary) to have enough knowledge to evaluate the transaction and its risks. ERISA’s fiduciary provisions have provided that protection since the law’s inception. Indeed, an ERISA fiduciary lacking the requisite knowledge must obtain to comply with ERISA’s “prudent expert rule” requiring that a fiduciary discharge his or her duties with the same care, skill, and diligence as a prudent man “acting in a like capacity and familiar with such matters would use in the conduct of an enterprise of a like character and with like aims.” (Emphasis added.)
Item II prevents transactions with representatives subject to statutory disqualification. ERISA prohibits persons from serving as fiduciaries if they have been convicted of, among other things, a felony or any crime described in the Investment Company Act of 1940. The act proscribes felonies and misdemeanors involving the purchase or sale of any security. Thus, Item II’s safeguard is also one firmly built into ERISA.
Item III calls for independence from the SD or MSP. That safeguard is unnecessary, given ERISA’s prohibition of self-interested acts by a fiduciary, and of a fiduciary’s representation of those with interests adverse to the plan.
Item IV requires that the representative act in the Special Entity’s best interest. An ERISA fiduciary must act with an “eye single” to the interests of the plan’s participants and beneficiaries.
The ERISA duty of prudence requires diversification of the plan’s investments, adherence to the documents and instruments governing the plan, and ongoing attention to the plan’s conformity with the law. Moreover, ERISA fiduciaries are prohibited from dealing with plan assets in their own interests, and will be held personally liable for any breach of their duties. It’s therefore abundantly clear that Item IV should be met since an ERISA fiduciary must act in the plan’s best interest.
Item V requires that the representative make appropriate disclosures to the ERISA plan investor. Transparency is required by the ERISA statute and its regulatory provisions. For example, the DoL has issued regulations that require plan fiduciaries to identify and disclose fee and other investment information to participants and even describe the form in which the required information may be disclosed.
Item VI requires written representations to be made regarding the transaction’s fair pricing and appropriateness. An ERISA fiduciary has a duty to defray reasonable expenses and act with the same diligence as one familiar with such matters.
Representations of an investment’s price and fees are required by those ERISA provisions, and DoL regulations require disclosure of direct and indirect compensation of plan-service providers and potential conflicts of interest. Complying with these regulations is essential to qualify for the statutory exemption for services under ERISA and to avoid characterization of the service provider’s contract or arrangement as a prohibited transaction. Such a characterization would result in the imposition of excise taxes on the service provider and employer plan sponsor and could represent a potential breach of fiduciary-duty liabilities by the employer plan sponsor.
Further, consideration of an investment’s appropriateness with respect to the plan’s needs is mandatory. Lacking it, the fiduciary would fail to exercise his or her duties diligently and in accordance with the documents and instruments governing the plan.
Further, the CFTC has issued final regulations under Dodd-Frank that specifically provide that the CFTC and DoL are in agreement that the ERISA fiduciary concerns of ERISA-subject plans and SDs have been “addressed appropriately” by the agencies. The rules also provide that the final regulations, together with any regulations issued by the DoL, should not adversely affect ERISA-subject plans and SDs.
Since many plan sponsors use master trusts to fund their pension plans, it is important to note that the final regulations also specifically provide that the definition of “Special Entity” under Dodd-Frank includes a master trust holding the assets of more than one plan sponsored by a single employer or group of related employers.
But the CFTC indicates that a SD or MSP would not fail to comply with the CFTC regulations with respect to an ERISA plan if it complies with the requirements with respect to the master trust that holds the assets of the ERISA plans.
According to the CFTC, any individual ERISA plan within the master trust would not receive any additional protection if the SD or MSP had to separately comply with respect to each additional plan.
The good news for plan sponsors is that the CFTC Dodd-Frank final regulations exempt collective investment vehicles from complying with these regulations. In the preamble to the final regulations, the CFTC provides that “the Commission has determined as a matter of statutory interpretation . . . that the definition of Special Entity does not include collective investment vehicles that have Special Entity Participants.” Accordingly, if you purchase a derisking solution, make sure it uses derivative transactions through a collective investment vehicle and that the pension-plan trust only holds shares in such vehicles and does not enter directly into a derivative swap transaction.
If your plan does directly hold derivatives, the Dodd-Frank regulations require that “Special Entities” such as pension plans have an “independent representative” who monitors compliance with the Section 731(h)(5) “Business Conduct Standards for Swap Dealers as Counterparties to Special Entities.”
It is very hard for an “independent representative” like a pension-plan committee to deal with that requirement. Accordingly, I recommend that the “independent representative” should not be the pension committee but the master trustee. The derisking package you are buying from the investment consultant, however, is cleared through the master trustee and therefore there needs to be coordination between the consultant and trustee about achieving compliance with the regulations.
Also, although pension plans are exempt from being a “commodity pool operator” under CFTC Regulation 4.5, 401(k) plans now must file for an exemption under National Futures Association Rule 45, and you need to tell employees that you are exempt from being a CPO.
The CFTC also wants to know who is using derivatives, and you need to apply for a CFTC Interim Compliant Identifier for all your plans. That is normally handled by the trustee or the investment consultant.
Jeff Mamorsky is co-chair of the global benefits practice at law firm Greenberg Traurig.