March Toward Socialism: What It Means for the Pension Indus. (A0043645)

CFDD ADVISOR CONFERENCE

THE MARCH TO SOCIALISM: WHAT IT MEANS FOR THE PENSION INDUSTRY

October 2010

by: Marcia S. Wagner, Esq. The Wagner Law Group A Professional Corporation 99 Summer Street, 13th Floor Boston, MA 02110 Tel: (617) 357-5200 Fax: (617) 357-5250 www.erisa-lawyers.com

The Wagner Law Group – Specializing in ERISA, Employee Benefits and Executive Compensation Law

2 THE MARCH TO SOCIALISM: WHAT IT MEANS FOR THE PENSION INDUSTRY

I. Introduction

The title of this program “The March to Socialism: Effects on the Pension Industry” should be renamed the “March to Statism”. It is the increased involvement of the government, without any end in sight, that can lead to significant problems in our industry and in our society.

This presentation will focus on what socialism/statism in the pension industry means, how it is evolving and what we must all do to survive.

The main premise of this presentation is that our society needs a strong private pension system – it is the only proven way that pension systems can work. Socialism in the pension industry leads to collapse – look no further than Western Europe (e.g., Greece) and many of our state governments.

II. The Premise & Proof

Many state defined benefit pension plans are severely underfunded. Illinois has racked up a staggering $78 billion pension liability. New Jersey has a $46 billion pension gap. The state of California’s real unfunded pension debt may be as high as $500 billion, as reported in a study released by Stanford University (commissioned by Gov. Arnold Schwarzenegger).

On top of the underfunding problem, states are struggling to find room in their annual budgets to meet their annual funding obligations. For example, the Illinois General Assembly was able to pass its budget, but hit a snag over plans to make the pension contribution. The House passed a plan to borrow the $4 billion needed to make the pension payment for fiscal year 2011, but the plan didn’t come to a vote in the Senate. Illinois could skip the payment this year, forcing the five public employee pension systems to sell assets and lose out on money earned from interest. Other states, including New Jersey and California, are skipping or deferring their scheduled pension contributions.

Benefits are defined under state law, so the underfunding is not supposed to have an impact on employees and pensioners. However, as reported by The Wall Street Journal, according to Northwestern University (Kellogg School of Management) economist Joshua Rauh, at least seven states are heading toward crushing crises – of the magnitude that would require U.S. bailouts in the next decade – from one cause: state pension liabilities. In some state constitutions, promised pension benefits to state and local government workers take a higher priority than general obligation bonds. Rauh, with the University of Chicago’s Robert Novy- Marx, previously estimated that state pension liabilities stood at $3 trillion at the end of 2008, compared to $1 trillion in other forms of debt. Even if pension funds received 8% annual returns, many large states would run so short – without any overhaul today – that raising state taxes to make up for it would be insufficient. (Illinois, for instance, would run out of money in its three primary pension funds by 2018. In the years after, the payments owed to existing state workers would be $14 billion, or more than half of the total revenue Illinois projects in 2010.) Other state pension funds expected to dry up by 2020: Louisiana, New Jersey, Connecticut, Indiana, Oklahoma and Hawaii. By 2030, 31 states could be in similar trouble, Rauh reports. He says the ultimate cost of a federal rescue could top $1 trillion. Although state benefits are not actually guaranteed by the federal government (or the PBGC), allowing state plans to go bankrupt would not be a viable political option.

Socialism in the pension industry – specifically pension benefit formulae established through the political process with heavy union involvement – leads inexorably, to over-promises, over-commitment and unwillingness on the part of plan participants to give up, without severe struggle, “earned” pensions. Governments, by definition, do not have to live with the fiscal restraints that private businesses must. They can increase taxes or, at the federal level, literally print money – hence the scourge of over-commitment. Without significant efforts at fiscal restraint, e.g., ending pay-to-play arrangements and cronyism, implementing better accounting standards, negotiating with plan participants for lower benefits prospectively and smaller cost of living adjustments, switching to DC from DB arrangements, eliminating the ability to “spike” benefits by increasing compensation at the end of a career – state pension liabilities will force states into a Hobbesian choice of providing needed services or paying benefits. Thus, without some adult thinking and flexibility, we all could be heading into dangerous terrain.

III. The Effects On Private Pension System In Facing Increased Governmental Intervention

Since the state of the public pension plans is so bleak, the “savior” of the U.S. pension system is our private pension system – which is imperfect – but nonetheless robust and creative. However, the private system is facing threats of increasing governmental intervention, legislation and regulation. This leads to the following observations regarding the inherent dangers of statism:

1. The proliferation of highly complex, nearly impossible to comply-with regulations is the ideal seed-bed for the growth of arbitrary power, which can and often does lead to unjust outcomes (note the cash balance determination letter debacle), and if carried to extremes, can lead to statist tyranny.

2. In the hands of a negatively-motivated bureaucrat, some subsection of a paragraph of an article from some obscure federal regulation can be just as lethal to citizens’ rights as a rubberized truncheon in the hands of a rogue cop. Even if the correct result ultimately is obtained at a higher bureaucratic level or in court, the costs and burdens of obtaining “justice” can be overwhelming for mid-size and small businesses, and might be rationally foregone. Justice foregone is justice denied.

3. Socialized medicine, also known as health care reform, will significantly affect the pension industry. In my view, despite the absence of a public plan, health insurers will abandon both (i) the health insurance exchanges and (ii) the group insurance marketplace. This will eventually lead to a public plan by default. The public plan will then lead to the demise of the group insurance brokerage industry. Brokers from the welfare benefit industry will soon realize they have little or no ability to make a decent living in a socialized medical state. They

2 will gravitate to the pension industry, be fierce competition and lower profit margins for RIAs, IARs and registered representatives.

4. One of the hallmarks of socialism or statism is rewarding and encouraging whistleblowers. It is interesting to note that a significant part of the recent Form 5500 Schedule C and the 408(b)(2) regulations provides exemptive relief for plan sponsors who “whistle blow” on their financial advisors and providers. Expect more such “relief” as state powers grow.

5. In most statist governments, there is a real blurring of the lines between “incentives” and “mandates”. This is clearly the case with the proposed automatic IRAs, “private” pension plans which, for the first time in American history, would be mandatory. The automatic IRAs are the descendants of the Social Security Plus concept that emerged during the Social Security reform debate during the Bush Administration. The notable difference is that the Social Security Plus accounts (ERSA, RSA and LSA) would have been voluntary while the automatic IRAs would be mandatory.

Senator Jeff Bingaman (D-NM) introduced the Automatic IRA Act legislation in the Senate on August 6, 2010. In the first year after enactment, employers with 100 or more employees would be subject to the automatic IRA requirement. It would apply to employers with 50 or more employees in the second year, and employers with at least 25 employees in the third year. In the fourth year and beyond, any employer with 10 or more employees would be subject to the automatic IRA requirement. On August 10, 2010, Richard Neal (D-MA), chairman of the Subcommittee on Select Revenue Measures of the Ways and Means Committee, introduced the Automatic IRA Act of 2010 during the House of Representatives’ rare mid-recess session held on that day. The House version of the bill is similar to the Senate bill, with a few exceptions.

Employers that already maintain a qualified retirement plan would be exempt from the automatic IRA requirement. However, if the plan does not cover employees in a division, subsidiary or other major business unit, the employer would have to provide automatic IRAs to the excluded employees.

The Senate bill has the following features:

 Employees have the choice of contributing to either a traditional pre-tax IRA or Roth (post-tax) IRA. If no choice is made, Roth IRA accounts are the default vehicle.

 The bill sets the default contribution at 3% of compensation. Employees can raise or lower their contribution percentage, or can opt out entirely from the program.

 Investment firms are not be required to accept automatic IRA accounts. An employer can select an IRA provider to which all automatic IRA contributions will be sent, using a central online resource developed by the Treasury Department.

 All Automatic IRAs will offer the same three standardized investment options (to be developed by Treasury and DOL): (1) a principal preservation fund, or a special, new Treasury Retirement Bond (“R Bond”); (2) a life-cycle or other blended The Wagner Law Group – Specializing in ERISA, Employee Benefits and Executive Compensation Law

3 investment option; and (3) an alternative investment option with a somewhat higher concentration in equities than the life-cycle or other blended investment option.

 The investment options must be based on low-cost investments, which may include index funds.

There are three issues that are problematic with – or should at least be vigorously debated concerning – automatic IRAs.

First and foremost, should the federal government be in the position of mandating employer-sponsored pension plans? I think not. Employers can be incentivized by tax deductions, tax deferred growth on pension assets, etc. – but a mandatory private pension scheme goes too far astray from the mores of a capitalistic society.

Second, I fear this could be the beginning of the government making public our private pension system. To reduce the deficit, the government may well offer business, in exchange for a guaranteed rate of return, no fiduciary liability, no nondiscrimination testing, and no plan maintenance or governmental filings (irresistible!); plan sponsors could “voluntarily” transfer their defined contribution plan assets to the federal government, which would pay pensions; and payroll taxes would be increased, akin to elective deferrals, to increase plan participants’ account balances with the government – the concept would be like Automatic IRAs on steroids. The recent financial crisis can be used as apparently good fodder for the “wisdom” of this idea.

Third, I am concerned about the “safe harbor” investment known as the “R Bond.” This is, apparently, a new governmental issuance of debt specifically for pension plans. Why is this needed? Will this compete with mutual fund money market funds or insurance company stable value products? Is this the beginning of attempts to reduce the deficit by “incentivizing” people to invest in a new type of government debt?

6. The final observation regarding the potential effects of our march to socialism or statism is that to finance European-type socialism or statism, the United States might consider imposing a VAT, or reduce or eliminate corporate deductions for pension contributions and the tax exempt growth on pension trust assets. This could effectively kill the private pension industry.

IV. What Can and Should the Private Pension Industry Do to Solve the Problem?

1. Realize that this is a real existential battle. To survive, the highly balkanized pension industry must do that which is has never done: speak with one clear, clarion voice and get highly involved politically and in lobbying.

2. The industry must create, sooner rather than later, a set of core principles on which all in the industry can agree – e.g., the importance, primacy and superiority of a private pension system, opposition to any new “public option” pension system and opposition to the government creating a “safe harbor” for retirement plan investment in governmental debt.

4 3. The industry must support changes that maintain and increase the integrity of and public faith in the pension system, such as: supporting transparency of fees, disclosing and mitigating the ill-effects of potential conflicts of interest, supporting efforts to assist plan participants in becoming financially literate, including what participants need, in annual income, to retire.

V. What Can and Should Advisors and Plan Vendors Do?

Know the rules of the game, have good contracts, have a good ERISA lawyer, have a good BD and RIA platform. Document everything, and make best practices your shield. Understand fully that the DOL (and soon the IRS and PBGC) could make your clients into your enemies with “whistle blowing” safe harbors for them, but not for you. Be careful, smart and up on the law. And, above all, try to add real value to your clients and your profession.

Financial advisors should become actively involved not only in securities trade association but benefits trade associations.

Best practices, honesty, integrity, effort and hard work are the best antidotes to any form of governmental overreaching which, I believe, our government is engaging in “for the greater good”.

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