Developing structures to facilitate long term saving has been core to David C. John’s work for four decades. As well as co-developing a low cost product wrapper now being adopted by states across the US, John, who is senior strategic policy advisor at the AARP Public Policy Institute, has been influential in the debate on US decumulation. With a new president in the White House who is not intent on stifling responsible investment strategies and an emerging master trust-like pension structure taking its first steps in the US corporate space, John is optimistic about the prospects for retirement workplace provision.
President Joe Biden has already signalled his support for the Paris Accords. So to what extent will a Biden presidency change the rules of the game for ESG?
“We already know that Biden is making a 180 degree turn from what Trump did as far as climate change. He’s made it very clear that climate is one of his top priorities. So that’s definitely going to change the focus. We have a new secretary of Labor [Biden has nominated Marty Walsh, Mayor of Boston]. The first thing they’re going to do is look at the final ESG rules that the former Department of Labor put in place that were designed to discourage investment in ESG.”
Former US president Donald Trump’s administration had put in place a rule that was widely seen as restricting investment by 401k workplace pension default funds in assets adopting ESG or responsible investment strategies. Republicans said the rules were designed to clarify implementation of fiduciary duty under The Employee Retirement Income Security Act 1974 (ERISA), which establishes minimum standards for US workplace pensions, although critics argued they created a millstone round the neck of effective stewardship.
Early drafts of the rules included requirements to calculate the economic impact of every vote on proxy ballots, including votes for or against directors, to approve independent auditors as well as say-on-pay and shareholder proposals, which critics said made such stewardship activity unworkable. US SIF research found 96 of asset managers and investment advisers were opposed to the original rules, as were 97 per cent of investor organisations, multi-employer plans and trade unions and 91 per cent of financial services providers. As a Washington insider of four decades John sees the ERISA restrictions on voting activity as a result of lobbying by a wide range of business interests.
“It wasn’t just oil and coal. It was a matter of a large number of companies themselves trying to limit the influence of activist investors. So yes, there are environmental issues, but there are also labour issues. There may be foreign policy issues – why are you investing in country X, which takes this approach to human rights? So it was a distinct effort to try to squelch activists.” Final rules published in October 2020 watered down these proposals, but still left in a requirement for fiduciaries to make investment choices purely on the basis of financial factors. The rule says fiduciaries can use non-pecuniary factors as a tie- breaker in the rare event that alternatives are equally balanced.
John says: “So, yes, there is a new direction. The question is going to be, is this [Walsh’s] number one item? The reality is that removing this regulation is going to take time.
Among UK pensions professionals, the basic principle that ESG investing improves member outcomes and returns over the long term has become a mainstream view – voices questioning this view have receded significantly over the last two or three years. So where is the US pensions industry in terms of accepting the role of ESG as central and fundamental to the entire investment process?
John says: “Substantially lower. We have a couple of structural issues to deal with. For a 401k or an individual retirement account (IRA) atmosphere the investments must be structured in a way that they have a certain amount of liquidity with a daily valuation.
“One of the things the Trump people also did was to make it easier for DC plans to invest a certain amount of assets in hedge fund or other types of illiquid assets – but they obviously did not include ESG in that at the time. If the Biden people put it as a priority, they could put in a certain amount of illiquid assets in addition to the stocks and the bonds.
“The other consideration that comes into play here is that when you have an auto enrolment situation, and auto enrolment is voluntary in the US, as is the whole providing of retirement assets, so much of the judging of fund choice is done on the basis of fees. There was a Supreme Court decision that required plan actuaries for DC schemes to consider fees on a regular basis. And in many cases, rather than looking at return net of fees, what they are looking at is actual fee charges.
“Given the fact that hedge funds and basically any illiquid or less liquid investment is going to have a higher fee structure, you’re going to have to get through that screen,” he says.
The QDIA – Qualifying Default Investment Arrangement – is a requirement on auto-enrolment schemes, allows for three types of scheme – target date funds, managed funds (typically 60/40 split), and liquidity funds. This may allow a broader range of assets in future, such as infrastructure, but this is still some way off, says John.
While UK regulation is driving schemes towards spending more on ESG investments, albeit within a charge cap, the US’s more litigious approach is pushing in the other direction.
“We have a couple of law firms that have made a fair amount of money initiating class action lawsuits, charging that the fees or the investments are too expensive,” he says. “So one of the things that we are hoping to see more of as we look into the whole question of ESG is the ability to look at return net of fees rather than just the level of the fees.”
As in the UK, the US employer-sponsored pensions system has evolved more through chance than planning. DB plans grew after World War Two, while the DC system flourished in the 60s, covering mostly larger companies and professional firms.
“As was the case in the UK, retirement assets were part of the estate in the case of a corporate bankruptcy. When car firm Studebaker went out of business in the 60s, it took the workers’ pensions with it,” says John. “That led to the institution of ERISA in 1974. Firms were finding the cost of providing a DB scheme was higher than they expected. Here comes a genius law firm which discovers a section called 401(k) in the tax code, which allows a supplementary saving system for upper income management. That tiny pin prick loophole has grown to the size of an auto tunnel.”
Around the same time Congress introduced the ‘IRA’ which originally stood for Individual Retirement Arrangement, but is now the Individual Retirement Account.
While 401k plans cover most people in big organisations, for the rest of the American working age population the situation is reminiscent of the UK pre-auto enrolment.
“We still have about 50 percent of the workforce and these are predominantly smaller companies, companies with high turnover and companies that employ younger people, women, minorities, lower income workers that do not offer anything,” he says.
To address this gap, 15 years ago John developed, in partnership with J. Mark Iwry, the Automatic IRA, a small business retirement savings program that has been adopted by several states for firms that do not sponsor any other form of retirement savings or pension plan. Oregon, Illinois and California are the first states to adopt the plan, with 10 other states looking to bring them on stream.
Only employee contributions are deducted and paid into what is a state sponsored entity with a single set of providers. Employees have the right to opt out if they want to.
Employer contributions into these arrangements are not possible. “Politically, the only way we could get this passed was because the IRA structure technically is an individual savings vehicle. And as a result, employers are not only not required to contribute, they’re not allowed to,” he says.
So is there political pressure for something more akin to the UK style of auto enrolment where there is an employer contribution?
“There is. For instance, [US Secretary to the Treasury] Janet Yellen in her confirmation hearing listed this as one of her priorities. And during the Obama years, the budget that was issued by the Obama administration every year included a ‘nationwide auto-IRA’. It’s just that the political will to pass it was not there. And the political even now is going to be hugely difficult. We can’t get people to wear masks, much less to actually contribute to a pension.”
The reality is, the US already has a stronger state-administered pension base for its people than the UK, so has less need for a private pension top-up. 2018 data shows the UK’s net replacement rate second only amongst OECD members to South Africa, standing at an average of 28.4 per cent of pre-retirement earnings, compared to 49.4 per cent for the US.
That is not to say there is not demand for greater DC coverage amongst hundreds of thousands of small American businesses. This demand is partly being held back, says John, by two factors – set-up costs and concern over regulatory burden.
“As a result, the Auto IRA, the smaller, simpler version, is actually much more attractive,” he says.
A poll in Oregon found that 80 percent of employers who use the auto IRA did not experience any additional costs.
“So what is actually more likely, if we can get it through Congress, is that we would have a system where the smallest employers would use the Auto IRA. The next tier up, the medium sized employer, would use the PEP, something that’s akin to the UK master trust. And then bigger firms will use the individual 401k.
PEPs – Pooled Employer Plans – are just weeks old, introduced through the SECURE Act 2019, and legally possible since January 1st this year. They allow two or more completely unrelated employers to pool assets, governance and other services and functionality, through a single structure.
PEPs are expected to hoover up employer-sponsored plans in the same way master trusts are in the UK. Aon predicts more than half of employers’ schemes will switch to PEPs by 2030.
As everywhere in countries with significant DC systems, decumulation is one of the thornier challenges the US is attempting to untangle. John argues a US system that automatically enrols the member, automatically escalates their contributions through their working life and determines their investment strategy should do more than leave people to figure out decumulation for themselves. He is a co- author of a proposal to include trial annuities as a default withdrawal choice in 401(k)- type plans.
He says: “The big debate here is do you put something like an annuity in place, whether it’s immediate or deferred, in the investment structure. Annuities are wildly unpopular in the US – we’ve done surveys where we can describe what an annuity is and people love it, but as soon as we use the word annuity, they hate it.”
The decumulation conundrum seems to remain a challenge for DC systems everywhere. But with so many other initiatives coming to the fore, US workplace pensions look set for positive growth for the coming years.
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