Guest Article

(From the October 23, 2006 issue of Deloitte's Washington Bulletin, a periodic update of legal and regulatory developments relating to Employee Benefits.)

DOL Advisory Opinion on Asset Allocation Strategies for Pension Plans

The convergence of new minimum funding requirements for defined benefit pension plans and new financial accounting standards for reporting liabilities associated with such plans is causing sponsors and fiduciaries to review their plans' investment strategies. Specifically, some are considering deemphasizing equities in favor of fixed-income securities. This would lower expected returns, but also make asset values less volatile -- the latter being an increasingly important objective for plan sponsors. However, can a plan fiduciary take into account the plan sponsor's interests when choosing and implementing an investment strategy without violating the basic ERISA fiduciary directive to act "solely in the interest" of the plan's participants and beneficiaries? New Department of Labor Advisory Opinion 2006-08A (October 3, 2006) provides guidance on that issue.

Setting the Stage ...

According to data compiled by Standard & Poors (S&P), the average asset allocation for pension plans sponsored by S&P 500 companies in 2005 was 61.8 percent equities, 27.6 percent fixed income securities, 3.3 percent real estate, and 7.2 percent "other." The 2004 allocations to equities (64.9 percent), fixed income securities (29.4 percent), and real estate (4.3 percent) were slightly higher, but allocations to "other" (1.8 percent) were substantially lower. (The "other" category includes hedge funds, which usually hold a mix of equities, fixed income securities, and real estate.) Still, equities have been the dominant holding in most pension plans' portfolios for quite some time.

That could change over the next few years as the new minimum funding requirements take effect, beginning in 2008. But the new accounting rules are an even more immediate concern. These new rules are effective for fiscal years ending after December 15, 2006 for publicly traded companies, and for fiscal years ending after June 15, 2007 for all other entities. Together, these new rules could prompt pension plan investment managers to reduce their plans' equity holdings in favor of fixed-income investments.

Specifically, the new accounting rules will require plan sponsors to recognize their plans' funded status as an asset, or liability, on their balance sheets. As a result, even routine fluctuations in plan asset values will affect the plan sponsor's bottom line. This places a premium on stability, and fixed-income securities are more stable than equities.

The new minimum funding requirements for single-employer defined benefit pension plans also favor stability by limiting the "smoothing" of asset values. Additionally, the new rules will require plan sponsors to use a yield curve to value plan liabilities. Because the yield curve results in discount rates that match the duration of a plan's liabilities, it makes sense to use fixed-income securities to similarly align the plan's investments with the expected stream of future benefit payments.

ERISA Fiduciary Issues

Of course, the issue is not whether a particular asset allocation strategy is good for the plan sponsor. Investing pension plan assets is a fiduciary act, and thus must be carried out consistently with ERISA's fiduciary standards. See ERISA ? 3(21)(A). These include acting with prudence, and "solely in the interest of the participants and beneficiaries and ... for the exclusive purpose of ... providing benefits to participants and their beneficiaries ... and ... defraying reasonable expenses of administering the plan." ERISA ? 404(a)(1). In no event can a fiduciary put the plan sponsor's interests above those of the plan's participants and beneficiaries.

Thus, a financial services provider recently asked the Department of Labor (DOL) for guidance on whether it could, as a plan fiduciary, "risk manage" a defined benefit plan's assets "by better matching the risks of a plan's investment portfolio assets with the risks associated with its benefit liabilities, with a goal toward reducing the likelihood that liabilities will rise at a time when the assets decline." One way the financial services provider proposes to do this is "to invest directly in a portfolio of fixed-income securities with a duration of the plan's benefit obligations," although "a variety of approaches may be used in practice."

The focus of this asset allocation strategy would be on "reducing the risk to underfunding to the plan and its participants and beneficiaries by reducing volatility in funding levels." Significantly, the "principal benefit" of this "would be the reduced need for the plan to rely on the plan sponsor to meet its funding obligations, protecting plan participants and beneficiaries in the event of the sponsor's insolvency." However, the financial services provider acknowledges the possibility of "incidental benefits to the plan sponsor from maintaining more consistent funding levels, such as reduced volatility on the sponsor's financial statements and reduced minimum contribution obligations."

The advisory opinion refers to DOL regulations, which provide the prudence standard is satisfied if "(1) the fiduciary making an investment or engaging in an investment course of action has given appropriate consideration to those facts and circumstances that, given the scope of the fiduciary's investment duties, the fiduciary knows or should know is relevant, and (2) the fiduciary acts accordingly." The relevant "facts and circumstances" include,

The advisory opinion continues by explaining the DOL believes "plan fiduciaries have broad discretion in defining investment strategies appropriate to their plans." Furthermore, the DOL "does not believe that there is anything in the statute or the regulations that would limit a plan fiduciary's ability to take into account the risks associated with benefit liabilities or how those risks relate to the portfolio management in designing an investment strategy." As such, the advisory opinion concludes, a fiduciary would not violate its ERISA fiduciary duties solely by implementing "an investment strategy for a plan that takes into account the liability obligations of the plan and the risks associated with such liabilities and results in reduced volatility in the plan's funding requirements."

However, as the advisory opinion points out, whether a particular investment strategy is prudent for a particular plan "depends on all the facts and circumstances involved."

The information in this Washington Bulletin is general in nature only and not intended to provide advice or guidance for specific situations. If you have any questions or need additional information about articles appearing in this or previous versions of Washington Bulletin, please contact: Robert Davis 202.879.3094, Elizabeth Drigotas 202.879.4985, Taina Edlund 202.879.4956, Laura Edwards 202.879.4981, Mike Haberman 202.879.4963, Stephen LaGarde 202.879-5608, Bart Massey 202.220.2104, Laura Morrison 202.879.5653, Martha Priddy Patterson 202.879.5634, Tom Pevarnik 202.879.5314, Carlisle Toppin 202.220.2067, Tom Veal 312.946.2595, Deborah Walker 202.879.4955. Copyright 2006, Deloitte.