BNA Pension and Benefits Blog

This posting comes in from a different perspective - that of the benefit plan auditor.  Since the reporting season for the calendar 2005 plan year is pretty much over, I thought it might be valuable to go over some of the problems that cropped up this year on such audits.  After nearly 30 years of doing these audits, one would think that the audit requirement would be pretty well understood by now and the season would flow very smoothly.   I shouldn’t be saying that the season is “pretty much over.”  It should be just plain over.

Such was not the case this year.  At an AICPA committee meeting last week,  practice leaders from some of the nation’s largest CPA firms agreed that there were more Forms 5500 filed without audit reports this year than any year that they could recall.  Surprisingly, in early October 2006, all were receiving requests for proposals for calendar 2005 or earlier plan audits.

What is up with this? 

First, the plan audit process is a lot more complicated than it used to be and over the next several years, plan sponsors are going to find it even more complex.  Today the complexities arise from paperless systems, HIPAA and other privacy considerations, mergers and acquisition activity, service providers' desire to protect what they see as their proprietary interests and changing investment arrangements.  This has resulted in many audit firms leaving the business of doing plan audits or, at least, culling their client lists.  That means that many plans are changing auditors unexpectedly and, often, late in the game.  Hence, we have the problem with too many incomplete filings this year.

But that is not the only reason.  There were simply a lot of problems this year.  I wanted to take advantage of this space to give the readers some free advice on working with their benefit plan auditor.

1. Arrange a meeting with your plan auditor in the next couple weeks to plan next year’s audit.
2. Review problem areas from the prior plan year and what can be done to eliminate them.  Common problem areas this year included:
   1. Plan documents that did not conform to the plan’s operation.  This seems to be a trend as more and more sponsors shift to prototype or volume submitter plans.  Those nuances of plan operations that were embedded in their individually designed plans persist in operation, but were omitted from the restated version of the plan.
   2. Operational defects:  Though annoying to discover, wouldn’t you rather know now that your system has omitted eligible employees, enrolled ineligible, used the wrong definition of compensation or any one of the hundreds of things that can go wrong with the plan’s operations?  Remember, an audit is based upon sampling, so there is no assurance that all operational defects will be identified.  Just be grateful for the ability to promptly address those items that are discovered.
   3. Privacy and confidentiality agreements:  The auditor is obligated by ERISA to follow generally accepted auditing standards.  That means the auditor must look at statistically valid samples of the operating data of the plan.  The terms under which the auditor is granted access to this information should be set as soon as possible with all parties responsible for the plan’s operations.  Once set, such terms should remain in place until there is a change in the parties involved or a change in the law. 
   4. Plan combinations:  It is a simple thing for an auditor to audit a rollover.  But, when an entire population is entering a plan with all of the history associated with the prior plan, the plan sponsor’s duties increase and so do the auditor’s.  So, talk about any such activity during a planning session.
   5. System changes:  Because of the paperless environment, auditors rely heavily on the controls built into electronic systems, so make sure you advise your auditor of any such changes. 
   6. Hard to value assets:  ERISA requires that plan assets and liabilities be reported at fair value.  For plans that invest in publicly traded vehicles that is not a problem.  But, recently plans have again started investing in arrangements for which there is no active market – real estate partnerships, hedge funds, etc.
   7. Late deposits:  This has been an irritant in the audit process for nearly a decade now.  What does it mean for funds to be deposited as “of the earliest date on which such contributions can reasonably be segregated from the employer's general assets?” If I had to pick the two worst areas of audit controversy, it would be the privacy or confidentiality agreements for welfare plan audits and timeliness of deposits for 401(k) plans.  In this latter case, the sponsor needs to recognize that the auditor is required by GAAS to look at related party transactions and to reach some conclusions on their status as exempt or not.  Further, there is no materiality standard for the ERISA schedule of non-exempt transactions.  I can confidently tell you that auditors don’t like doing this piece of the work any more than the sponsor enjoys hearing about it. 
      
      Different audit firms have different approaches to this area.  In all cases, the audit files need to include evidence which supports the conclusion that deposits are or are not made on time.  This standard varies from the standard the auditor is allowed to apply on tax matters.  There the auditor is merely instructed to take action in the event something comes to his or her attention.  With regard to prohibited transactions, the auditor is required to make specific inquiries and draw specific conclusions. 
3. Keep the communication lines open on plan amendments, government audits or inquiries, system changes, addition of new service providers, etc.  I realize that it is an audit, but don't try to bury stuff just to see if the auditor can find it.  Please.
4. Agree upon a schedule of what data will be required and when.

I recognize that when you look at many of the problem areas for the year, it appears that the auditor has an adversarial relationship with the sponsor.  That is not intentional.  It is grounded in the fact  that ERISA requires that the audit be conducted for the benefit of the participants and beneficiaries.  The auditor should simply be living up to their arrangement letter.

When my oldest child was about 13 years old, he asked me to explain what I did for a living.  I told him I was an ERISA twit.  We then spent some quality time on the Internet, so he could understand what ERISA was and a bit about what I did.  Since he was in the mood to actually like me at that time - he found my name on the Internet, after all, giving me immediate credibility - he decided that terminology was demeaning.  About 2 weeks later, he came back with the term ERISACRAT and I have since been reveling in it. 

To me, an ERISACRAT is someone who takes the concept of the law very seriously, to work towards Employee Retirement Income Security.   I hope that I am, in fact, an ERISACRAT or at least on the way to becoming one.

I put the question out to the audience - do you like the term?  Probably not too catchy, won't show up on any late night talk show.  But, who would you nominate as an ERISACRAT?

The first name that comes to my mind is the late chair of the BNA Pension and Benefits Advisory Board - Michael Gordon.  He was a brilliant and generous man and a huge asset to the benefits community.  Clearly since he contributed to the writing of ERISA, he deserves the title.

The second name that comes to mind doesn't actually have a name.  Somewhere back in 1979, someone decided to eliminate Form EBS-1 - a 30+ page compliance nightmare.  Had that filing requirement persisted people would have simply thrown in the towel on sponsoring any benefit plans.  So - thanks to you, anonymous ERISACRAT.

I realize this does not have the jazz of "ERISA hottie" but the exercise might trigger some interesting and colorful nominees, so have at it.

The general direction given to those of us in the position of being a guest commentator for a week on this new blog was to “write about something that interests you”.  I’m not sure Sarah’s directions would quite encompass my interest in how well the Bears are doing this year and pondering how long this glorious winning streak will last as well as what the post-season will bring—so I will not write about what really is of interest to me—although I’m sure if I did, there would be a lot of interesting comments and other points of view expressed.  So let’s look for something else of interest.

Company stock is always fun, so let’s go there.

We seem to be near the end of the “stock drop” litigation explosion, which has given many plan sponsors heartburn, even if they were not involved in litigation.  Much has been written and discussed as to what steps should be taken to avoid or minimize potential exposure to the issues and many plan sponsors have made changes to their plans and/or committee structures.  But before they can catch their breath, along comes the new kid on the block—the Pension Protection Act of 2006.

The PPA has provisions focused on 401(k) plans which have a company stock option as part of their structure and adds new diversification requirements along with mandated information notices to participants addressing the benefits of diversification of their plan accounts.

Since company stock has had a long history in retirement plans, one would assume plan sponsors will not retreat wholesale from continuing to provide the option, especially since there are financial benefits to making matching contributions in company stock, but will the option stay the same?  Will plan sponsors comply and continue the option in their 401(k) plans?  Will plan sponsors reconsider continuing the option? Or will the option be continued in a different form—such as moving it to a stand alone ESOP—in order to keep certain restrictions on diversification?  If it is moved, will the fact that it was once part of a 401(k) plan have any taint?

A small focus, but seemingly one with a potential for attracting a great deal of interest.  What thoughts, dear reader, do you have?

Today the Ninth Circuit decided Glanton v. AdvancePCS  Inc. http://caselaw.lp.findlaw.com/data2/circs/9th/0415328p.pdf

Plaintiff participants sued the Plan's Pharmacy benefits management company (PBM) saying the PBM was buying prescriptions for less than it was selling them to the plan and the PBM was making an inappropriate bundle.  The court held that while defendant PBM was a fiduciary, plaintiffs had no Article III constitutional standing to bring the claim. 

Interestingly, the court never mentions either 502(a)(2) or (a)(3) of ERISA - the two possible bases for ERISA standing.  However, the court, by implication, appears to reject both bases as conferring Art. III standing.

First, the court notes that if plaintiffs are successful, the money will go to the plan. The plan, in turn, may lower the co-pays and deductibles for plaintiffs, redounding directly to the benefit of the participants & beneficiaries, or it may reduce employer contributions.  However, for a benefit from the litigation to depend on the acts of an independent third party is not sufficient to confer Art. III standing because it is insufficient evidence of the required "harm." I presume this is the discussion of the (a)(3) claim.

Here's the really interesting part.  As for the stealth (a)(2) claim, the court held that the plaintiffs don't have standing to sue on behalf of the Plan because, while the Plan has suffered harm, the plaintiffs have not.  For example, sayeth the court, in Kayes v. Pacific Lumber, where plaintiffs sued saying the fiduciary's selection of an annuity provider resulted in a reduction of the plaintiffs' annuities, there was a sufficient allegation of the participant's direct harm.  Not so here, as the plaintiffs cannot show a direct harm to themselves.

This is, of course, a completely new twist on representational standing under (a)(2).  Not only must the Plan suffer harm, but the plan participant who seeks to recover on behalf of the plan must have suffered direct harm because of the plan's harm.  So let's say that a plan fiduciary steals some of the DB's plan money.  If a participant sues on behalf of the plan to recover it, the defendants will argue, under Glanton, that the participant's benefit has not been reduced because of the theft (after all, not only is there the good ol' PBGC, but there's the employer who now has to contribute more in light of the theft) (Shades of Harley v 3M).

The court noted that "associational" standing worked only one way - that the association may sometimes represent the individual.  However, it did not work the other way, the individual may not represent the association.  But this entirely misses the 502(a)(2) point.

Here, the plan clearly suffered an injury.  Are the fiduciaries of the plan the only ones allowed to sue to redress that loss if there is no individual participant or beneficiary who is directly (as is true in most cases) affected by the loss?

Tell me why this isn't a good idea

a. There should be National Health Insurance to cover basic insurance for everyone; employed, unemployed, uninsured and people like me. Employers would contribute to it based on a percent of payroll. There would be no problems with adverse selection or horrible bookkeeping problems about who's in and who's out, since this National Plan would cover everyone for these "basic" needs. It is a policy choice as to how far basic coverage should go. But suppose we use current Medicare as a base.

b. Employers may also provide "wrap around" policies in addition to the Basic policy. Like Medicare supplements (or private retirement plans supplementing social security), they can be as stingy or as generous as the employer desires. These wrap around policies could be self-insured or be provided by insurance companies. The policy would pay supplemental coverages (supplemental charges above what the National Plan determines to be "average" (see below), long term/catastrophic care, additional days of hospital stays, dental, dog and cat medical, whatever). In this way, the private industry can continue to provide benefits on a less than universal basis, and can play their exclusion and denial games, yet the right to fundamental basic medical care will not be diminished.

c. This is the part I like the best. Under this Plan, when you go to the doctor that doctor has to tell you (a) what services are covered under the National Plan and which are not (e.g., experimental, beyond the basics, etc.); and (b) how much more, as a percentage, that doctor will charge over that allowed by the National Plan. So, for example, the doctor may say "I will be charging you 10% more than what the National Plan pays me" and that will be a binding commitment. It has the following charms: (1) Doctors, not patients, have the expertise to know this information; (2) Doctors, not patients, have the expertise (and resources) to challenge the National Plan on determinations they believe are incorrect.

If a doctor finds that the National Plan will only pay $100 for a procedure but the doctor feels $150 is appropriate, all he has to do is tell patients, "I will charge you 50% more than the National Plan." If other of the doctor's charges are identical to that paid by the National Plan the doctor will simply average it out and tell people "I charge 5% more than the National Plan." The doctor cannot say that a particular procedure, test, exam, etc. will cost x% more -- the percentage must apply to all services supplied by that doctor to that patient. In this way the patient can doctor shop and compare apples with apples; the doctor can determine her own fees (within a narrow range) by using a multiplier of the National Plan; and disputes as to what the National Plan should pay can be resolved between those with the expertise and knowledge.

Presently the payor says $100 is reasonable, the doctor says the payor is full of it and that $150 is reasonable, and the patient winds up losing $50 and having no idea of who's right -- or any simple means of finding out. No wonder people are mad as hell and just won't take it anymore. I think this has the elements everyone needs. People are happy because they'll at least have guaranteed access to basic medical care; employers/employees are happy because they can have greater coverage than the basic plan; patients are happy because they will have a pretty good idea going into the doctor as to how much it's going to cost them. More important, there aren't going to be any surprises like "pre existing condition" and "we don't cover that" and "we only pay 50 cents for that procedure."

So whaddya think?

Is The "Abuse of Discretion" Standard of Review Worth the Candle?

I am an ERISA benefits plaintiff's lawyer. This "note" is not intended to be objective. It is supposed to stimulate discussion.

In 1989, the Supreme Court told us in Firestone v. Bruch that if a plan provided that a fiduciary's benefits decision was given deferential review by the plan documents, so too must a court reviewing the benefits denial. The Court described the standard of review as one for "abuse of discretion" though the term is used interchangeably with "arbitrary and capricious." The Court found the basis for this in trust law, that if a trust instrument gave a trustee discretionary powers, a court must defer to the trustees decision unless it was unreasonable. Even before Firestone, all the Circuits were usually applying an abuse of discretion standard of review as part of ERISA's baptism or, perhaps more aptly, its bris.

There are two views: (a) it doesn't matter which standard of review applies as all judges are intellectual softies and if a judge believes a claimant should be paid, the claimant will be paid; (b) the standard of review is usually the most important issue, oft outcome determinative, in benefits litigation. Rush Prudential v. Moran, 536 U.S. 355, 384 (2002)(referring to deferential review as "highly prized" by benefit plans).

Those who hold that it matters little, seem to litigate the issue the most. Plaintiffs have several arrows in their quivers for attacking the standard: e.g., (a) is the discretion granting language in the appropriate documents and, if so, is it sufficient to grant discretion? (b) if the language is in an insurance policy, has that language been approved by the State Department of Insurance - and does the state have any business regulating this? (c) is the person/entity that was granted discretion the same as the person/entity that exercised it? (d) was the decision within the scope of the discretion granted? and, finally, the Big Doozie - (e) was the decision maker acting under a conflict of interest?

Each one of these issues presents its own discovery challenges. Of course, plans contend that denials must be considered only in the context of the administrative record so that discovery is irrelevant. Plaintiffs, and most courts, hold that while the underlying benefits decision is limited to the administrative record, questions regarding these issues are subject to discovery. For example, recently an en banc panel of the Ninth Circuit in Abatie v. Alta Life & Health Ins. Co., 458 F. 3d 955 (9th Cir. 2006) held that the following issues (and these only relate to the issue of conflict) were to be resolved by the trial court: (a) what outside interests did the decision-maker have? (b) what were its motives? (c) what was the "nature, extent and effect" of the conflict on the decision making process; (d) has there been a parsimonious claims granting history? (e) have there been repeated claim denials to deserving claimants that were against the weight of the evidence? In fact, Abatie recommended that decision-makers affirmatively come forward with evidence to show that its decision was not affected by any conflict. The tail has now become the dog. The whole purpose of deferential review was supposed to be streamlined, efficient and cost effective litigation. Now those defending deferential review find themselves in major, drawn out and costly litigation, even with the most minor claim, over the proper standard of review. At the same time, insurance companies report that they pay between 80 and 90% of all claims. So, putting aside the claims that would easily lose under even the de novo standard of review, aren't we talking about just a few percentage of cases? It seems to me that these cases would be more effectively and efficiently tried under the de novo standard of review.

So, whaddya think?

The PPA has some interesting cash balance provisions, including a prohibition on cash balance plans whose interest credits exceed market rates of return.  The reason for this prohibition is clear enough: if an interest credit is higher than investment returns available in the market, the interest rate will favor younger plan participants, since they will have the benefit of the above-market rate for a longer period of time than older plan participants.  Or put another way, a compensation credit that will grow in synch with an above-market interest rate will have a higher present value for a younger employee than for an older employee, assuming, as we should, that present value will be determined with a market discount rate.   

This raises the question of what a market interest rate of return is. Suppose a plan provides that interest credits will reflect the return on an equity index, and if we like, a rather risky equity interest that might pay spectacular returns if things go well.  Suppose further that the cash balance plan says that your account will be credited with positive returns, but not negative returns.  In years of negative return, your account will still grow, but only to reflect new compensation credits. 

Is this a market rate of return?  Well no, you get the possibility of spectacular returns only if you are willing to shoulder the corresponding risks, which include loss.

But can a plan offer such an interest credit?  Possibly yes: the PPA says that a plan shall not be treated as failing to meet the market-rate interest credit requirement “merely because the plan provides for a reasonable minimum guaranteed rate of return or for a rate of return that is equal to the greater of a fixed or variable rate of return.”

So let’s put into our plan that interest credits are equal to the greater of our equity index or 1%.  If such an investment option were available on the market, I would certainly like to invest in it. 

I suppose that Treasury regulations might try to put a stop to this, focusing on the word “merely” and regard the above arrangement as abusive and thus not providing a market interest rate.  This would seem to be a stretch under the language of the PPA.  And what if the equity index were a standard market index, say the Willshire 5000.  Presumably this would not be abusive, but the problem is still there: anyone would love to invest in an instrument that gives you the full upside of an index but insulates you against any market declines.  Perhaps this can be fixed in regulations, but as I said, I think the language of the statute might make a regulatory fix a bit problematic.

It should also be said that the PPA says that an interest rate shall in no event result in the account balance or similar amount being less than the aggregate amount of pay credits.  So the statute actually makes it illegal to provide a true market rate of interest if the rate is pegged to any index that can go negative, since a participant’s losses are capped at the prior investment gains on a participant’s account.  In the real world, of course, your initial capital (in cash balance plans, the compensation credits) would also be at risk.

The drafters of the statute had a sensible idea about market rates of interest, but then wrote rules that are in effect conceptually incoherent. 

Now where is this likely to lead to problems?  I think primarily with cash balance plans adopted by small firms, where most of the rank-and-file employees will have a relatively short period of plan participation.  Here, the owners are likely to enjoy the favorable interest rate for a long period of time, while rank-and-file participants may not. (And you can probably exclude from cash balance participation those rank-and-file employees who are likely to have long periods of participation.) 

Section 415 of course puts some limits on how large a benefit an owner can get by defining interest credits in a way that provides the possibility of high returns but protects against the full impact of the possibility of losses.  But I also suspect that the next legislative push on cash balance plans will include proposals to allow cash balance plans to choose whether to be subject to either the defined benefit or defined contribution section 415 limit.  And if this happens, the planning possibilities for cash balance plans in small firms are perhaps not limitless, but getting there. 

By the way, does anyone think that any large or medium-sized businesses that do not already have cash balance plans are going to adopt new cash balance plans (or convert existing traditional defined benefit plans into cash balance plans)?  I don’t.  I just don’t see what benefits cash balance plans offer such firms over true defined contribution plans.

On the other hand, I do think there will be interest in new cash balance plans by small, owner-dominated firms, where cash balance plans already seem to offer some interesting planning possibilities.  But that is another blog for another time.  

Dana Muir, a professor at University of Michigan’s business school, has co-authored an interesting article on the use of the efficient market hypothesis in two areas, one of which relates to ERISA retirement plans that hold employer stock.  (The other part of the article, which was written Cindy Schipani, looks at EMH in the context of shareholder appraisal cases.  Its interesting, but it is not ERISA, so barely warrants a reading by the ERISAphiles reading this blog.) 

In the ERISA side of the article, Professor Muir is interested in what happens in plans—usually 401(k) plans—that are holding employer stock, and in the normal scheme of things would be purchasing more employer stock, when continuing to hold the stock, and certainly to continue to purchase it, is, at least arguably, imprudent.  And Professor Muir is particularly concerned with the responsibilities/plight of a directed trustee, whose directions are to continue to hold and to continue to buy.  When should the directed trustee ignore those directions because they are in violation of the statute?  Since one of  ERISA’s statutory commands to fiduciaries is to act prudently, presumably the fiduciary should refuse to honor the directions to purchase employer stock and should consider selling at least some of the employer stock if the fiduciary believes, or should believe, that the stock (at least if held in large amounts) is not a prudent investment for the plan.

This is an issue of multiple dimensions and extraordinary complexity.  Professor Muir is interested in several aspects of that issue, but her portion of the article is focused on the Department of Labor’s 2004 field assistance bulletin (FAB 2004-03) on when directred trustees may satisfy their fiduciary responsibilities simply by following the directions given to them.  The FAB indicates that under EMH, the price of securities reflects all known public information about the securities (this is the semi-strong version of EMH, since it does not assume that the price reflects nonpublic information), and thus that directed trustees generally have no duty to second-guess directions, since the directions are to purchase the securities at the “correct” price.  The only exceptions that the FAB recognizes from this generally free pass to uncritically follow directions are when the directed trustee has nonpublic information or when public information calls into “serious question a company’s viability as a going concern,” or perhaps when there is public information that shows that the company, its officers or directors have been formally charged by state or Federal regulators with financial irregularities. 

The reason for these exceptions (except the one dealing with a fiduciary who has nonpublic information) is not entirely apparent from the FAB, but might be either that in such situations the market cannot accurately gauge the value of the stock (but why that would be so is itself not clear if you believe in the version of EMH that DOL apparently believes in), that a company that may lack viability as a going concern is not (at least in large concentrations) a suitable investment for a retirement plan, even given that Congress has generally exempted investments in employer stock from ERISA’s diversification requirement, or that the directions—which likely come from individual employed or related to the plan sponsor—may be polluted by the dishonesty of the individuals who are engaging in financial chicanery.

Professor Muir is concerned that the FAB, which purports to be based on EMH, reflects a primitive view of EMH and ignores the substantial economic work that claims EMH is not nearly so robust as the DOL apparently believes.  (That word, robust, has become a trendy adjective; it may be a bit overused these days.)  In fact, as Professor Muir notes, not all publicly traded securities always trade in an efficient market.  Research has shown that, for example, market noise, behavioral departures from economically rational behavior, short-selling in certain markets, can result in temporarily inefficient markets.  Indeed, as Professor Muir notes, “in other contexts, courts and policy makers are far more skeptical of the robustness of EMH than is the DOL.”   Professor Muir observes that in Delaware, for example, in appraisal cases, courts consider whether the market for a particular security appears efficient. 

How we construct a meaningful legal standard for directed trustees out of all this is of course not simple, and there are various competing policy considerations.  But the Department of Labor suggests that the issue is easy to resolve because of the DOL’s naive and dated understanding of EMH.

Professor Muir points out that courts, unfortunately, have given considerable weight to the views reflected in the FAB.  Another interesting question, which I know Professor Muir is concerned about from conversations with her, is why the Department’s views were presented in an FAB rather than in a regulation project, which would have been subject to public comment. 

The article, which will be in Michigan Law Review in June of next year, is easily worth the time and cost to download and read it.  It is on SSRN, and you can get there by following the links from Professor Muir’s biography page:  http://www.bus.umich.edu/FacultyBios/FacultyBio.asp?id=000279015.  Or you can probably call her for a copy.

In the interest of full disclosure, I am a big fan of Professor Muir’s work.

The ERISA Advisory Counsel has devoted one of its study projects this year to issues surrounding the prohibited transaction rules and hedge funds (and also cross-trading).  The basic problem, as the study group has framed it, is that the Department of Labor's plan asset regulations characterize the underlying assets of a hedge fund as plan asssets if immediately after the most recent aquisition of any equity interest in the fund, more than 25% of the equity is held by benefit plan investors.  (This is a slight but for our purposes irrelevant simplification of the actual rule.)  So significant investments by plan investors make the otherwise largely unregulated hedge funds subject to ERISA regulation.  Being subject to ERISA regulation can make it difficult for a hedge fund to operate, particularly in complying with the prohibited transaction rules.  (It should be said, contrary to the belief of some, that the plan asset regulations do not use the term "hedge fund.")

The study group held two days of testimony.  The first day was largely given over to representatives of groups that favor changing the plan asset regulations in a way that would allow more plan investors to hold interests in a hedge fund without the hedge fund being subject to ERISA regulation.  (The Pension Protection Act of 2006 has already softened the impact of the plan asset regulations, but retains the 25% threshold, although with a more limited definition of plan investor.)  The witnesses argued that hedge funds can be an acceptable plan investment, that the regulations' treatment of hedge funds was different than its treatment of certain venture capital and real estate asset pools, that hedge funds were subject to state law and federal securities fraud laws, and that the plan-asset regulations were promulgated almost two decades ago and that there has been a sea change in the investment universe since then. 

On the second day of testimony, there were at least two witnesses who were somewhat skeptical of the desirability of changing the plan asset regulations to accommodate greater plan investments in hedge funds.  Ironically, the second day of testimony occurred on the day after Amaranth announced it had lost three billion dollars of its investors' money.  I was one of the skeptical witnesses.  (Damon Silvers was another.)

I thought I would use this blog to expand the audience for my testimony from the advisory council members and the few outside attendees to the perhaps the slightly larger and only slightly overlapping world of readers of this blog.  I stipped the testimony of its first paragraph (the one saying how I am the author of articles and books and teach at the University of Alabama and am a visiting professor at Vermont Law School), but reproduce the rest of my testimony below (including a few paragraphs on the other topic the study group was looking at: cross-trading).  Although the hedge fund issue has a number of interesting aspects, I am particularly interested in thoughts about what plans, if any, should be investing in hedge funds, and when and for what purpose.

Anyway, here is the testimony (double-spaced no less):

I appreciate the opportunity to testify before you today on the important topics that this work group is studying: the plan asset regulations, and particularly how they affect the ability of employee benefit plans to participate as investors in hedge funds; and cross-trading.  It is also always a pleasure to testify before the advisory council, something that I think is especially true for those of us who are advisory board alumni   

            I should mention up front that my comments today are my own and in no way reflect the views of the University of Alabama, which I should add has won, although not in convincing fashion, its first three football games of the season. 

Vermont Law School does not have a football team, but it does have its own wonderful tradition of

stunning fall foliage. 

            I mentioned that it is a pleasure, as an advisory council alum, to offer you my comments today.  But it is even more of a pleasure to appear before you with an opportunity to play the role of Old Testament prophet, railing against the abandonment of the first and second of ERISA’s fiduciary commandments:

            First, honor the principle that where there is an opportunity for fiduciaries or parties-in-interest to exploit a conflict of interest, some will do so; and

            Second, recognize, always, that some fiduciaries will do really dumb stuff unless the law makes it really hard to do really dumb stuff.

            These two commandments lead me to conclusions about each of the topics you are studying today:

            On cross-trading, there is room for a thoughtful expansion of the ability of investment professionals dealing with plan assets to use cross-trading to benefit the plans, but generally speaking, only for large plans that have the resources and sophistication to protect their interests;

            On the plan asset regulations, do not change one iota of the current plan asset regulations to accommodate ERISA plan investment in hedge funds.  And I don’t say this just because Amaranth, the hedge fund, might be worth less today than Amaranth, the cereal I had for breakfast this morning.  I say it because it is not a good idea, at least not now, to tinker with the regulations, especially since the Pension Protection Act has already done some tinkering and we should give that tinkering time to cure. 

            Let me begin with some general observations about ERISA fiduciary law and ERISA investing—not the most common ideas, such as ERISA’s adoption of modern portfolio theory, and in particular, the benefits of diversification and the notion of total portfolio design as the proper context for judging prudence.  Those ideas are generally understood by sophisticated ERISA practitioners and scholars and have already been invoked by some of the other witnesses that have appeared before you.

            But one idea that is too infrequently articulated and often not fully appreciated is that with employee benefit plans, it is better to have rules that protect most plans against the possibility of large loss than rules that accommodate speculative or even innovative investment strategies that might produce above-market gains for some plans.  Departures from this principle can be disastrous for the participants in employee benefit plans.

            Another important idea that is sometimes overlooked, and that has some congruence with the “large loss” concern, is that ERISA plans come in varying sizes and ERISA fiduciaries and service providers with varying degrees of sophistication.  Rules that might be good with respect to one type of plan (a large plan, for example, utilizing the investment skills of highly regarded and experienced professionals) may not be good with respect to another type of plan (a small plan, for example,. that does not have easy access to sophisticated investment advice).

            With those two principles in mind, I am almost ready to turn to the topics at hand.  But I want to make one additional preliminary point: my thoughts on the plan asset regulations reflect not only ERISA concerns, but also some general concerns about hedge funds and investment markets generally.

1.  Cross-Trading

            Let me begin with cross-trading.  Cross-trading has obvious advantages to ERISA plans: it can reduce trading expenses.  It is, of course, true that over the last several years increased competition, industry innovation, and a DOL-supported fiduciary focus on plan expenses, have substantially lowered trading costs for plans.  So today there is less low-hanging fruit to be harvested through the use of cross-trading. But having said that, cross-trading, subject to appropriate regulatory constraints, can still save some plans money.

            But cross-trading has costs as well.  Let me mention three obvious costs:

            1.  Cross-trading can result in a favorable price to one party at the expense of another.

            2.  Cross-trading can result in investment managers causing a plan to sell or purchase assets in order to facilitate a trade with another plan, rather than to advance the plan’s own investment strategies.

            3.  Cross-trading can delay consummation of buy or sell transactions and thus lose the benefit of the market price at the time the buy/sell decision was made by the plan fiduciary.

            Obviously, practices that implicate the first two costs would be illegal under ERISA’s general fiduciary rules, but the general fiduciary rules are not as strong a deterrent to such practices as the prohibited transaction rules. 

            Large plans are equipped to protect themselves from illegal costs and to minimize the overall costs of cross-trading.  I suspect that many small plans are not in such a position.  Thus, any liberalization of cross-trading should create two regulatory regimes, one for larger plans, and one for smaller plans.  The regime for smaller plans should reflect likely aggregate gains and losses for small plans on the whole: better to impose modest additional costs on those small plans that have the ability to protect themselves from improper or unnecessary cross-trading costs than to impose such costs on plans that cannot protect themselves.  (Perhaps to cross-trade for smaller plans, an entity facilitating the cross-trades should be required to hire one or more independent fiduciaries to monitor its practices.)

            In addition, those professionals that facilitate cross-trading for plans should be required to provide client plans information about cross-trading on a regular basis, to allow the appropriate plan fiduciaries to monitor actual practice to ensure that the benefits exceed the costs.                       

2.  The Plan Asset Regulations and Hedge Funds

            I am skeptical that this is the appropriate time to revisit the interaction between the plan asset regulations and hedge funds.  For one thing, we have just seen yet another hedge fund absorb yet another spectacular loss in a moment’s time.  For another, Congress itself just liberalized the plan asset regulations in a way that will increase the opportunities for ERISA plans to invest in hedge funds. Given this, prudence alone dictates that we wait a decent interval before expanding still further the invitation for hedge funds to pursue ERISA plan investors.  Lets wait to see what happens from Congress’s liberalization before yet still further liberalization.

            Here are some reflections on why the 25% plan investor threshold should not, at least at this time, be increased.  (Indeed, I think a compelling case could be made to reduce rather than increase the threshold.)

            1.  I am skeptical of hedge funds as suitable investments for most investors, in part because of their lack of transparency, which is related to their immutability to the normal registration and disclosure rules applicable to most other securities.  To me, a hedge fund is a magic box: put your money in one end and out the other end comes dollar after dollar.  It is true that some funds have claimed spectacular returns, but other funds have lost almost unfathomable amounts of money. And I suspect—and this is only conjecture—that some of the large gains earned by some funds have come from two sources:

            First, the normal rules of chance—if you make large bets, you will win some of the time but over the long haul you will also lose some of the time.  Today’s winners look great, but two years from now they might not.  This was certainly the case for Long Term Capital Management and Amaranth. 

            Second, from inflated valuations of illiquid properties held by some hedge funds.  This may be the next great scandal waiting to happen, when we learn that many hedge funds did not generate mega returns after all.  Without more regulation, we cannot be certain that some of the amazing rates of return on investment have not been mere paper returns. This may be the hedge fund equivalent of cooking the books.

            2.  Hedge funds might, as some of your earlier witnesses have suggested, offer risk/return characteristics that can improve a plan’s overall portfolio.  This may be true, but if so, it is probably true only for, or primarily for, large defined benefit plans.  Any change in rules that applies to plans generally will inevitably result in the assets of smaller plans finding their way into some hedge funds. 

            3.  To paraphrase W. P. Kinsella, if more plan capital can be invested in hedge funds, there will be more hedge funds.  And if there are more hedge funds, there will be more lower-quality hedge funds, including some that are run by people who are not Nobel Prize laureates and perhaps some that are run by people spiritually linked to Tony Soprano.  And as certain as night follows day, these funds will end up with the assets of some employee benefit plans.  Moreover, a proliferation of hedge funds may have an unpredictable effect on capital markets, as they attract more capital away from more traditional investments.

            4.  One might have special concerns about so-called fund of funds, which is an umbrella fund that then purchases interests in actual hedge funds.  As I understand it, the appeal of hedge funds is that they offer unique investment strategies that can help plans hedge certain types of risk or that promise to provide high returns at low risk (now there’s a concept for you).  Given this, it is hard to see how a fund of funds would ever be a prudent investment.  Presumably, a hedge fund is a good investment if the particular fund fits the particularized needs of a particular plan’s portfolio.  A fund of funds is not a particular fund, and its appropriateness to a portfolio, and its value, will be extremely hard to assess.  Plus, funds of funds subject plans to two sets of fees and expenses.  Yet some of these funds already attract ERISA capital, and if the plan asset regulations are made more flexible they will attract still more ERISA capital.

            5.   Some witnesses have likened hedge funds to other “alternative” investments, i.e., real estate and venture capital pools.  But there is an important distinction between these investment vehicles and hedge funds: we know that these pooled investments are investing in real things: actual businesses or actual real property, not exotic swaps and large bets on currency fluctuations or the size of tiny expected spreads between related indexes.  Investors know what they are investing in with real estate and venture capital, at least more or less.  With hedge funds, investors know less and have less ability to judge the bona fides of a particular investment strategy, especially where the strategy is “proprietary” and not fully disclosed.     

            Indeed, plans may often find that their investments in a hedge fund are merely investments in the purported genius of its individual managers, a dangerous investment strategy.  And other plans may find that they are simply chasing last year’s spectacular returns.

            (It is also important to observe that venture capital pools are not exempt from the plan-asset regulations unless the pool is in fact actively involved in the management of at least one of the businesses in which the pool has invested.)

            6.  More hedge funds will mean more capital diverted from clearly productive use to bets on what will happen to the spread between March and April heating oil futures contracts.  This may not be a good trend to encourage by opening wider the ERISA doors to hedge fund investments.

            7.  Although this point may have been obliquely made in some of the earlier points, many small plans simply do not have the sophistication to evaluate hedge fund offerings; they will be the prey of the marketers of the lower quality funds that will almost certainly be released into the marketplace if the plan asset regulations are relaxed.

            8.  The current administration has championed defined benefit funding policies that would subtly encourage plans to develop portfolios in which assets more closely match plan liabilities, i.e., portfolios that are rich in secure fixed income securities that match the duration of plan liabilities and thus substantially tamp down interest-rate risk.  Inviting new plan investment in hedge funds seems curiously inconsistent with this policy.

            9.  For those hedge funds that are subject to ERISA, ERISA shines the most regulatory light on what are otherwise fairly secretive investment vehicles.  For those who believe in either transparency, or on the strongest constraints on the behavior of those who handle the retirement savings of other people, dimming that regulatory light may be problematic.       

            10.  Hedge funds may offer spectacular returns but sometimes return spectacular losses.  To return to one of my original points: for pension plans, it is better to have a rule that prevents some plans from experiencing devastating losses, even if it freezes the ability of a few plans to chase spectacular returns.  This is not to say that high-income investors should stay away from hedge funds; only that pension plans, which cannot afford large losses, should generally stay away from hedge funds.

3.  Conclusion

            There is always pressure to weaken ERISA’s fiduciary rules, to believe that the better angels of our nature are sufficient, in and of themselves, to restrain the self-interest of those who are entrusted to manage the retirement savings of other people.  We tend, as we look back at those wise men and women who drafted ERISA’s elaborate fiduciary protections (both in Congress and in the Executive branch), to think that they just didn’t realize that strict and sometimes unyielding constraints on fiduciary behavior has costs to plans.  But of course they realized this.  But they also realized that weaker, more flexible rules have costs as well. 

            In 1974, and in the early part of ERISA’s regulatory history, they determined that those latter costs were too high for an enterprise that is attempting to ensure adequate retirement savings for millions of working men and women.  Evolution is a slow process and human nature has not, so far as I can discern, evolved to a more angelic level since 1974, at least in the worlds of finance, investment management, and business.  The judgments made in ERISA’s early days were not, of course, perfect, and we should enjoy the freedom today to adjust them when we are certain that the benefits of adjustment outweigh the costs of adjustment.  But that freedom should be leavened with a heavy responsibility, and the responsibility is to make sure that we know that those benefits outweigh those costs. 

           Making it easier for fiduciaries to engage in cross-trading of the assets of plans that have the ability to protect themselves from the costs of cross-trading is consistent with that responsibility.  Making it easier for ERISA plans to invest in hedge funds, or put another way, weakening the protections that ERISA plans enjoy when they invest in hedge funds, is not consistent with that responsibility.

While I wasn't paying much attention, on July 19 the U.S. Supreme Court entered a short order, without opinion, denying Texas and several other would-be co-plaintiff states leave to file a complaint challenging the constitutionality of part of the Medicare Prescription Drug, Improvement, and Modernization Act of 2003 (MMA). Texas v. Leavitt, No. 135 Orig. (U.S.) (15 HLR 735, 6/22/06). The part of the MMA under attack is embedded in the program familiar to even the lay public, and more so to the elderly, as Part D of Medicare.

What was (and still remains) in issue is a common so-called "clawback" provision -- in Part D, one requiring the States to pay to the federal government the money that they now save under their Medicaid programs because of Medicare's funding the drug benefit costs of "dual [Medicare/Medicaid] eligibles" which would otherwise remain the States' burden.

The fiscal stakes are enormous. We are talking, of course, about a prescription drug program which, before it became law, carried a 10-year (2004-2013) estimated cost of almost $400 billion.  Afterward, in a well publicized flap, involving accusations that the then head of the CMMS had suppressed higher cost estimates of CMMS's own actuaries, Congress bitched and moaned about having been deliberately misled, and some members who had supported the bill openly declared they would have voted against it, in numbers possibly sufficient to defeat the bill, had the higher cost projection been revealed to them.

With the passage of the lead time for implementation on January 1 of this year, and considering drug price trends generally during this period, later 10-year (2006-2015) cost estimates for Part D rose in stages to a federal number of $1 trillion or more -- gross before the estimatedl hundreds of billions which the States would be billed and either pay or have offset against receivables from Washington under the clawback provisions in question.

In the context of these magnitudes up in the stratosphere, announcements of fresh estimates of other cost savings in the billions of dollars have passed for very good news. Thus, early this year, the CMS took pride in the claimed results of private-market competition in holding down drug costs, dropping previously expected spending in 2004 and 2005 and bringing the expected net cost to the federal government in 2006 to be $30.5 billion, 20% less than earlier estimated. By the new reckoning, the estimated 10-year cost -- presumably, now dealing with the less scary net numbers after clawbacks -- has been lowered from $737 billion to $678 billion, a decrease of 8%.  (In navigating through these numbers, I absolve from blame any misunderstandings on my part of the factually detailed attention Robert Pear of the New York Times has especially given to Part D program implementation and finance.  See especially Robert Pear, In Medicare Maze, Some Get Tangled in Two Drug Plans, N.Y. Times, 3/01/06.)

However, the reality is that dollar numbers that cease to evoke dread in Washington can bring on panic attacks in state capitols. In a declaration filed in the HHS Secretary's opposition brief to the States' initial motion to file in Texas v. Leavitt, a (now) CMS actuary laid out estimates making clear the size of the chunks of change subject to clawbacks against the plaintiff States.  Pursuant to the applicable law in 42 U.S.C. § 1396u-5(c), he calculated for the lead plaintiff, Texas, its 2006 liability of $261 million to send back to the federal government from the roughly $10.3 billion the State was estimated to receive this year in federal Medicaid payments -- in effect, an "adjustment" of 2.5% from gross to net.

From a federal advocate's standpoint, advising the Supreme Court that the State is complaining about having to repay HHS "only" 2.5% of the more than $10 billion of Medicaid assistance HHS sends to Austin is to make a telling point that the case merits are not substantial enough for the Court to deviate from its more routine practice of letting its non-exclusive original jurisdiction cases start out in the federal trial courts. (Beyond that, Texas is far from the threatened "irreparable injury" to the State that it pled as part of a preliminary injunction motion it filed with its proffered complaint.) From the perspective of a State governor and its chief fiscal officers, having to budget for and ask the State legislature to appropriate $261 million, or roughly a quarter-billion more than it otherwise would, to give Washington relief from perceived excesses of federally conceived and created social programs is to give offense to some attributes of state "sovereignty": the state's reserved powers under the Tenth Amendment as well as other "federalism" principles derived from it.

Go to the poorest State among Texas's co-plaintiffs, Maine, and the dollars involved invite the same gut reaction.  HHS is slated to render Maine $1.58 billion of Medicaid program aid this year, from which it is estimated it will recoup, one way or the other, via payment or offset, $39 million under the clawback rule. That is a 2.5% adjustment from gross to net, the same as in Texas.  Again, though, another $39 million to be raised from Maine taxpayers under compulsion of federal law has a  different feel to it in Augusta than in D.C.

The Supreme Court's orders of June 19 disposing of the case had an odd structure to them. First, the Court denied the plaintiff States' motion to leave to file its bill of complaint.  Second, after so declining to take jurisdiction, the Court then denied the States' motion for a preliminary injunction, as opposed to dismissing it, outright or as moot. So was the matter disposed of, seemingly with short shrift, as the Court's conference on the case (and dozens of others) was held but days earlier. Can the Court's denial of the States' motion for preliminary injunction be seen as a form of message to the lower courts that the case, if refiled, does not merit any preliminary relief to stop a program as large and meaningful as Part D of Medicare is to Medicare's 41 million enrollees and 6 million fully-covered "dual eligibles"?  Legally speaking, certainly not.

However, the plaintiff States, and their friends in other States which filed supporting amici briefs in the Supreme Court, have to date not tipped their hand on whether and when at least some of them will repair to, say, the District Court in D.C. to attack the constitutionality of the clawback provisions anew, on the same or added grounds they invoked in the High Court. As recently as yesterday (October 5), your blogger spoke with a reliable official source in Austin, who gave every indication that deliberations among certain of the States were still taking place and an upshot is not close at hand.