Report to Faculty Council on the. Proposed Changes to the BU 403(b) Retirement Savings Plan

Transcription

1 Report to Faculty Council on the Proposed Changes to the BU 403(b) Retirement Savings Plan March 3, 2018 Submitted by the Compensation and Benefits Committee Don Smith, QST and Committee Chair Joel Brandwine, CFA Rich Feeley, SPH Kelly Pesanelli, Sargent Stephanie Oberhaus, MED Jim Hamilton, MED

2 Background Representatives from Aon Hewitt, the University s retirement plan investment consultant, proposed some significant changes to our 403(b) plan at the October 27, 2017 meeting of the Benefits Advisory Committee. Don Smith, as Chair of the Compensation and Benefits Committee, is a member of that Board and was present at this meeting. Marty Howard, who is the chair of the BU Retirement Plan Investment Committee, then presented the Aon Hewitt analysis at the Executive Council meeting on November 28, These two presentations resulted in the charge to the Compensation and Benefits Committee from the Executive Council to make a recommendations to Faculty Council based on the three choices below: (A) Maintain the status quo regarding our two record-keepers, Fidelity and TIAA, and the current investment options. (B) Freeze TIAA in that all new savings are directed to the investment options available through Fidelity. (C) Transition from the TIAA Traditional Retirement Annuity to TIAA Traditional Retirement Choice and freeze further investments in the CREF Stock Account and CREF Money Market Account. Ultimately, the final decision among these choices will be made by the BU Retirement Plan Investment Committee. Nevertheless, we appreciate the opportunity to offer our recommendation on an issue that is of such importance to faculty and staff. Recommendation The Compensation and Benefits Committee recommends choice (A), that we maintain the status quo with regard to TIAA. We further recommend that TIAA Traditional Retirement Choice be added to our annuity offerings. If that is not possible, we recommend that the Investment Committee consider transitioning from the Traditional Retirement Annuity to Retirement Choice. The remainder of this report explains our recommendation.

3 The Threat of a Class-Action Lawsuit Aon Hewitt s proposal that we consider either freezing new investments with TIAA entirely, or at least the CREF Stock and Money Market Accounts, includes reference to the class-action lawsuits that have been filed against several large, private universities since August 2016: Yale, Columbia, Cornell, Duke, Emory, Johns Hopkins, Penn, USC, MIT, NYU, Northwestern, Vanderbilt, Chicago, Princeton, Washington, Brown, and, most recently, Georgetown. These class-action lawsuits, which have been filed by two law firms, are quite similar in content. Aon Hewitt summarized the allegations below which were made against the university retirement plans: 1. Using multiple administrative record-keepers leads to duplicative, excessive, or unreasonable fees. 2. Assessing record-keeping fees based upon a percentage of a participant s balance rather than as a fixed recordkeeping fee. 3. Offering too many investment options, which undermines the ability to negotiate lower fees and leads to investor confusion and paralysis. 4. Retaining poorly performing investment options, specifically mentioning CREF Stock for underperformance relative to its stated benchmark and TIAA Traditional Annuity for its redemption restrictions and penalties. 5. Failing to conduct a competitive bidding process to ensure record-keeping expenses are reasonable for the services rendered. The concern raised by Aon Hewitt is that our current plan shares some of these aforementioned allegations. With regards to the first concern, BU currently has two record-keepers, Fidelity and TIAA. Fidelity charges plan participants a fixed fee of $61 per year. TIAA, however, charges a fee based on the account balance. Aon Hewitt estimates that the average fee per participant in 2017 was $86. The third and fifth allegations have already been addressed by the University s Retirement Plan Investment Committee by consolidating the investment menu and conducting a competitive bidding process in BU offers the investment options (TIAA Traditional Annuity and CREF Stock) mentioned in the fourth allegation within our tiered investment structure. The first tier is the Vanguard Target Date funds; the second tier is a set of 15 mutual funds, some actively managed and some

4 tracking an index; the third tier is the TIAA annuities; and the fourth is a Fidelity brokerage account for self-directed investments. Our reading of the lawsuits identifies a sixth common allegation: offering investor (or retail) share classes of mutual funds instead of institutional shares. The expenses collected by the fund are significantly higher for the investor class than the institutional class. For example, the NYU suit reveals that participants had access to the Vanguard Emerging Markets Stock Index Fund charging 33 basis points (0.33%) instead of the institutional class at 10 basis points. This difference in expenses matters because the investments are otherwise identical. Fortunately, our retirement plan does not suffer from this problem. Our target date and mutual funds are the lower-fee institutional shares with only one exception (Vanguard Federal Money Market Fund Investor Shares). The University s Retirement Plan Investment Committee is diligent about negotiating for lower fees on our behalf. For instance, it has just been announced that effective February 12, 2018 we are moving from Vanguard Institutional Index Fund Institutional Shares having a 3 basis-point expense ratio to a share class which has only 2 basis points. There was no mention of subsequent judicial rulings on these class-action lawsuits at the Aon Hewitt presentation in October. However, we believe that some of these rulings are pertinent in this discussion: On August 25, 2017 Judge Katherine Forrest of the Southern District of New York dismissed five of the seven counts in the NYU case, including the too many investment options and investor vs. institutional share classes claims. However, she allowed the excessive record-keeping fees and poorly performing investments (CREF Stock which we offer and TIAA Real Estate which we do not offer) claims to proceed. (Pension & Benefits Daily, August 28, 2017). On September 21, 2017 Judge Gene Pratter of the Eastern District of Pennsylvania completely dismissed the case against Penn. She rejected all the allegations identified by Aon Hewitt and our committee. (Pension & Benefits Daily, September 21, 2017). Recent news regarding the class-action lawsuits reveals that that the NYU case is scheduled to go to trial in April And on February 28, 2018, Georgetown became the latest university to be sued for all of the above allegations. Our conclusion is that it is not possible to determine whether changing our retirement plan s TIAA-CREF offerings, that is, adopting choice (B) or (C), will decrease the probability of a classaction suit being filed against us. The lawsuit against Vanderbilt is a worthy case to review. They were in the initial wave of filings in August Previously, in April 2015, they made major changes to their retirement savings plan eliminating over 100 mutual fund options, freezing TIAA, and going to a single record-

5 keeper (Fidelity). These actions did not deter a class-action lawsuit. On January 5, 2018, Judge Waverly Crenshaw of the Middle District of Tennessee allowed the case to proceed, dismissing only the too many investment options claim. (Pension & Benefits Daily, January 8, 2018). It is the committee s opinion that, if BU is eventually sued, the plaintiffs will be unable to show deficiencies in the quality of our current 403(b) plan and its management, which we believe to be outstanding. Our tiered investment structure directs participants first to the Vanguard Target Date Funds, which are the appropriate options for many faculty and staff. Those who want more direct involvement in their 403(b) investments can then choose among our core mutual funds and TIAA annuity products. This is a well-thought out scheme that justifiably entails that we maintain two record-keepers. Moreover, the Retirement Plan Investment Committee ensures that we have access to the lower-fee institutional mutual fund shares. TIAA s Record-Keeping Expenses and Service Concern about TIAA s record-keeping expenses and service were raised at the Benefits Advisory Committee meeting in October and at Executive Council in November. Our committee has conducted an informal assessment by speaking with colleagues in informal settings and faculty meetings. While we admittedly have a small and unrepresentative sample, some patterns have been observed. The two examples below would most likely shine true if a much larger and more representative survey of faculty and staff is conducted: Faculty have no idea how much they pay annually for record-keeping at TIAA or Fidelity. Faculty are not bothered when told that Fidelity has a fixed annual fee of $61 and TIAA a fee that depends on the account balance and averages around $86. Faculty have mixed reactions to the concern that TIAA charges an asset-based fee while Fidelity s fee is fixed. Some believe that a flat fee is appropriate because the cost of recordkeeping does not depend on the number of zeros in the account. Some think that it is fair that older faculty nearing retirement and having more in their accounts pay a higher fee because they are more likely to be using the (free) services such as the wealth advisors available to participants at both TIAA and Fidelity. Experiences with the wealth advisors are also mixed. Positive comments about both recordkeepers include they produced a very nice, slick-looking report for us and my spouse was relieved to hear that we will have enough funds in retirement. A former associate dean remarked, I ve had meetings with both representatives from TIAA and Fidelity and wasn t impressed with either one. Another faculty member complained, I had a meeting with a senior person at Fidelity and all he talked about was that I should transfer over my funds from TIAA.

6 Our conclusion from this limited assessment is that there is no groundswell of support from faculty to make a major change to our 403(b) plan based on record-keeping expenses and experiences with service. However, the Benefits Office might want to commission a comprehensive survey on these issues. The CREF Stock Account The performance of the CREF Stock Account relative to its benchmark is central to this discussion. The representatives from Aon Hewitt reported at the October meeting of the Benefits Advisory Committee that their rating for CREF Stock is sell/consider contract terms. That conclusion is based on the review of CREF Stock conducted by Aon Hewitt in February The report on this review, which was made available to the committee, includes the statement below which discusses the investment process used by CREF Stock s management team: The process incorporates various underlying internally managed strategies including active quantitative, passive index, and active fundamental. Overall, there are over 60 separate underlying strategies that form the CREF Stock Account. The senior portfolio management team is charged with allocating capital to the underlying portfolio managers, establishing risk parameters, and tactical investment decisions. Overall, we believe the strategy is too focused on mitigating risk through diversification. This emphasis has impacted the strategy s ability to produce excess return for clients over any substantial length of time. Aon Hewitt arrived at their overall rating by considering several factors. CREF Stock was deemed to be average in the business, investment staff, risk management, and terms and conditions categories and weak in investment process and performance analysis. Clearly, the latter two categories dominated the conclusion, which was we recommend the termination of client investments in this product. There are two contrasting assessments of the performance of the CREF Stock Account that were not were not raised at the October presentation to the Benefits Advisory Committee. One is from Aon Hewitt itself. The consultancy provides quarterly reports to the Retirement Plan Investment Committee on the performance of the options included in our 403(b) plan. The report for the third quarter of 2017 was made available to the committee. A key part at the beginning of this report is a Watch List on the average performance of each of our investment options over the previous three years. This performance is summarized on a pass/fail basis. CREF Stock was given a pass rating as of 12/31/16, 3/31/17, 6/30/17, and 9/30/17 after the February 2016 formal review. We note that the Fidelity Low-Priced stock

7 fund, which is one of our core mutual funds within our tiered structure, received a fail rating on each of those dates. The other contrasting assessment comes from Morningstar, which is the industry standard for mutual fund ratings. Morningstar gives the CREF Stock Account five stars, its highest rating. Notably, our core mutual funds in the second tier of investment option structure, have just three or four stars. As Morningstar does not give ratings to target date funds, CREF Stock currently has the highest rating of all our investment options. The divergence of opinion between Aon Hewitt and Morningstar is surprising. Most likely it is because CREF Stock is such a unique equity fund. Most mutual funds are either actively or passively managed. If the former, the goal is to outperform some identified benchmark. If the latter, the goal is to simply track a designated stock index like the S&P 500. However, CREF Stock is a diversified portfolio of both active and passive investment strategies. Table A demonstrates the nature of the CREF Stock Account by comparing its performance to an equally weighted portfolio of our core equity mutual funds. Morningstar provides a simple, transparent measure of return by assuming an initial investment of $10,000 one, three, and five years ago. We collected this data for March 7, For example, $10,000 placed in the Vanguard Institutional Index Fund one year ago would have grown to $11,710. That amount invested five years ago would have grown to $19,611. The average for the ten equity funds, four of which are passively managed to track an index and six of which are actively managed, grew to $17,423 after five years. The results for CREF Stock are similar--$17,340. The comparison of expense ratios also shows that CREF Stock acts like a fund of funds. The average for the four index funds is 0.08%; the average for the six actively managed funds is 0.66%. Combined, the overall average is 0.43%, compared to 0.32% for CREF Stock. The investor in CREF Stock essentially holds a diversified set of actively and passively managed mutual funds. This unique structure makes it difficult for CREF Stock to be evaluated by comparison to a benchmark, even a self-designated one. This is not the case for most mutual funds. For example, a passively managed fund that benchmarks the S&P 500 aims to minimize its tracking error. The manager must weigh the transaction costs to mimic daily movements in the S&P 500 and holding and trading only a subset of the stocks that comprise the index. On the other hand, an actively managed fund that benchmarks the S&P 500 will use its fundamental analysis of companies and industries to intentionally overweight and underweight chosen sectors. In each case, there is a strong and clear connection between management decisions and the benchmark. Therefore, performance relative to the benchmark is a reasonable test for quality. The CREF Stock Account has used a composite benchmark to address its atypical structure 70% of the Russell 3000 Index, which measures the performance of the broad U.S. stock market, and 30% of MSCI All Country World ex USA Investable Market Index, which measures

8 the performance of small-, mid- and large-cap stocks in 46 developed and emerging markets throughout the world, excluding the United States. The TIAA Annual Report dated December 21, 2017 shows these results for CREF Stock relative to this composite benchmark: 1y Total Return 5y Average Return 10y Average Return CREF Stock 23.43% 12.69% 6.44% Composite Benchmark 23.13% 13.07% 6.71% These results support the Aon Hewitt view in February 2016 that CREF Stock had been underperforming its benchmark for several years as well as the more recent pass grades in its quarterly reports to the Retirement Plan Investment Committee. The problem, however, is that this composite benchmark is not necessarily a good representation of a portfolio of passively and actively managed funds like CREF Stock because there is no clear link between the benchmark and the decisions by managers of the 60 separate strategies. The Annual Report notes that: On December 15, 2017, the Morningstar Aggressive Target Risk Index was added as an additional broad-based securities market index for the CREF Stock Account. The returns of this index are appropriate for comparison purposes because they reflect a multi-asset class exposure that is similar to the Stock Account. Perhaps going forward this additional benchmark will allow for better performance assessment. Our conclusion is that the CREF Stock Account should be maintained as one of our investment options. It offers faculty and staff a unique opportunity to invest in equities. We do not believe that Aon Hewitt has made the case to terminate investment in this fund, especially given its recent performance and five-star rating from Morningstar. The CREF Money Market Account At the October presentation, the Aon Hewitt representatives reported that the CREF Money Market Account received a qualified rating from them. They stated that the existing fee of 0.23% is more than double the category average of 0.11% and that the existence of a fee claw-back provision further tempers the Account s ongoing performance. The performance report to the Retirement Plan Investment Committee for the third quarter of 2017 further reinforced this conclusion. The Money Market Account got a fail grade as of 12/31/16, 3/31/17, 6/30/17, and 9/30/17. The issue of the claw-back provision arises because of the historically low interest rates we have seen in the market since the financial crisis of The fund itself invests in shortterm U.S. government securities. The returns on these have been lower than administrative costs, resulting in a negative rate of return to investors in the fund if nothing was done. Most mutual fund families instead pay a zero rate of return and essentially absorb the net negative

9 result and spread that expense contemporaneously across the other funds. Apparently, TIAA has chosen a different method of repayment the claw back provision means that investors in the Money Market Account alone will have to accept lower returns until the previous losses are recouped. Table B reports the Morningstar results as of March 7, 2018 for $10,000 investments in the Vanguard Federal Money Market Fund and the CREF Money Market Account. The low growth rates for both reflect the historically low money market interest rates of recent years. The Vanguard Fund outperforms CREF over 1-year and 3-year horizons and underperforms over five years after expenses. The Morningstar expense data is consistent with that reported by Aon Hewitt. Money market funds serve as companions to equity accounts to allow investors to engage in market timing. Expecting falling equity prices, the investor might choose to move funds temporarily to a money market fund that maintains a constant share value. Our recommendation is that the CREF Money Market Account be maintained within the TIAA annuities tier of our investment option structure. TIAA Traditional Annuities The TIAA Traditional Retirement Annuity Accounts are insurance contracts and are fundamentally different than investments in mutual funds. The Traditional Retirement Annuity contact goes back to 1918 and many financial planners would say that it is a valuable core component to a typical retirement savings plan. Investments in the annuity during the accumulation phase prior to retirement earn a guaranteed crediting rate that is set periodically, subject to some minimum rate, based on current financial market conditions and general interest rates. At retirement, the annuity converts to a guaranteed monthly income for the participant s remaining lifetime or for a set term at a somewhat higher amount. The Aon Hewitt presentation in October 2017 included these concerns about the TIAA Traditional Retirement Annuity (RA): A lack of benefit responsiveness in the individual RA contract creates a significant challenge of BU s Fiduciary Committee and meaningful illiquidity of participant-directed transactions. The perceived value of the 3.0% minimum guarantee during accumulation is greater than its intrinsic value in most market scenarios. Benefit responsiveness is a technical matter in financial contracts. We understand that it is a term used to describe investments that guarantee contract value (or book value) even when

10 the fair market value of the underlying assets is more or less than contract value. 1 This seems to be a desirable attribute for an investment and the lack of benefit responsiveness to be problem. However, the Aon Hewitt quarterly report to the Retirement Plan Investment Committee indicates that our 403(b) plan has both benefit responsive and non-benefit responsive holdings in TIAA Traditional Annuities. As of September 30, 2017, we had $144,542,821 in the former and $489,774,856 in the latter. It also reports that the performance of the non-benefit responsive annuities has been consistently higher than the benefit responsive contracts, 3.8% compared to 3.2% over the last 10 years, and that both have been performing significantly better than their benchmark, the Hueler Stable Value Index which grew at 2.5% per year over that time. Frankly, the committee does not have enough information to opine on the apparent trade-off between benefit responsiveness and the performance of the annuity. The second bullet point in the Aon Hewitt presentation about the intrinsic value of the 3% minimum crediting rate for the Traditional Retirement Annuity is interesting. Intrinsic value is a term used in the valuation of option contracts. The minimum crediting rate is essentially an option. It is an interest rate floor that becomes in the money when market interest rates would otherwise drive the crediting rate below 3%. Investors pay for the option by accepting a lower crediting rate than if there were no such floor. Aon Hewitt contends that investors in the Traditional Retirement Annuity (RA) are effectively paying too much for the 3% minimum, pointing out that there have been only two months since September 2007 that the floor rate was binding. That explains why they give another TIAA annuity, the Traditional Retirement Choice (RC), an above average rating while RA garners only an average rating. In effect, an investor in the RC annuity buys a less expensive interest rate option. Therefore it has a higher crediting rate than the RA annuity, 0.20% higher on average and 0.25% as of 9/30/17 (4.25% for RC and 4.00% for RA). However, instead of having a 3% minimum, the minimum is reset annually and ranges between 1% and 3%. RC also has more generous liquidity terms than RA. Whereas funds in RA can only be withdrawn in 10 annual installments without paying a surrender change, funds in RC can be withdrawn in 84 monthly installments. We conclude that the TIAA Traditional Retirement Annuity should not be frozen because it is a worthy investment for many faculty and staff. Moreover, we suggest that the Retirement Plan Investment Committee consider adding the Retirement Choice account to our offerings within the TIAA annuity products tier in our investment structure. 1

11 Table A: Equity Investment Performance as of March 7, 2018 Core Equity Mutual Funds Management Type Ticker Expenses Growth 1 Year Growth 3 Years Growth 5 Years Vanguard Institutional Index Fund Passive VINIX 0.04% 11,710 14,010 19,611 Vanguard Extended Market Passive VIEIX 0.06% 11,563 13,185 18,389 Vanguard Total International Stock Passive VTSNX 0.09% 12,094 12,402 13,728 Vanguard FTSE Social Index Passive VFTNX 0.12% 11,852 14,011 20,482 Fidelity Contrafund Class K Active FCNKX 0.65% 13,028 15,111 21,549 Fidelity Low-Priced Stock Class K Active FLPKX 0.58% 11,754 12,995 17,893 DFA US Small Cap Active DFSTX 0.37% 11,093 13,274 18,169 Causeway International Value Active CIVIX 0.89% 11,798 11,572 13,730 Harding Loevner Global Equity Active HLMVX 0.93% 12,635 14,302 17,880 DFA Emerging Markets Core Equity Active DFCEX 0.53% 12,707 13,193 12,797 Average of 10 Funds 0.43% 12,023 13,406 17,423 CREF Stock Account R3 Passive & Active QCSTIX 0.32% 11,852 13,345 17,340

12 Table B: Money Market Performance as of March 7, 2018 Core Mutual Fund Options Ticker Expenses Growth 1Y Growth 3Y Growth 5Y Vanguard Federal Money Market Fund VMFXX 0.11% 10,096 10,139 10,142 CREF Money Market Account QCMMIX 0.23% 10,061 10,078 10,263