March 2017

Inside this issue:


INDEX FUNDS ARE NOT ENTIRELY PASSIVE

One of the largest misconceptions about index funds is that their only distinguishing feature is their fees. It’s not uncommon to hear, “index funds are just holding the stocks or bonds in the index, so we don’t need to pay attention to them.” This assumption, however, is an oversimplification. Many investors don’t realize that all index funds are not created equally.

A key difference between indexes and index funds is that index funds are exactly that – funds. Index funds manage obstacles that indexes themselves don’t face. The largest is that funds actually must transact in securities whereas indexes do not.

As an example, when Standard and Poor’s recently added Coty (COTY) to the S&P 500 Index to replace Diamond Offshore Drilling (DO), S&P simply recalculated the index values based on the closing prices of the securities on the effective date. Index funds that track the S&P 500, however, had to sell out of their positions in DO and purchase COTY, PLUS rebalance the weightings of any remaining securities that were impacted by the change. Trading in these securities exposed the funds to transaction costs such as commissions and market impact. Additionally, funds face the risk that their realized trade prices on the securities may be different than the values used to calculate the index, creating a difference in performance. In this example, the impact of these factors is generally small.

Where the impact is more meaningful is in areas such as fixed income and international equities where liquidity in the securities tends to be significantly lower, there are more securities in the indexes, and changes are more frequent. The Barclays Aggregate Index, for example, has over 8,500 securities in it, with many of them not trading every day. In addition, the index rebalances on a monthly basis, so managers tracking this index must constantly adjust the fund.

Index funds must also efficiently manage flows in and out of the funds, dividends and interest payments, mergers, tax consequences and securities lending – all challenges that the underlying indexes do not face.

Fortunately, most index managers are adept at keeping their funds in-line with their benchmarks, so the impact of these factors on fund performance is generally small – small, but important. Just like active funds, evaluating index funds requires careful analysis beyond fees and should also include performance and risk. The index fund metrics in the Scorecard System™ we use incorporate all of these, providing a complete picture of the factors that produce the most effective index funds.


FINANCIAL WELLNESS INSIGHTS: TOP FINANCIAL GOALS AMONG AMERICAN EMPLOYEES

The majority of employees are concerned with retirement planning. Saving for retirement is the most commonly cited financial goal among employees, coming ahead of many short-term goals, including eliminating debt and creating an emergency fund.¹

In an analysis of data collected from 1,081 employees, Retiremap found that saving for retirement is a goal for the majority, 56 percent, of employees surveyed. The second most popular financial goal, eliminate debt, was chosen by 40 percent of employees.

Employees were asked to choose up to five financial goals from a list of 20, which included a holistic range of family care needs, long-term investment targets and personal aspirations.

Goal #1: Save for Retirement
Saving for retirement is the top goal for employees across all income levels. The relative importance of retirement vis-à-vis other goals varied with income. There is a 7 percentage point difference between saving for retirement and the second most common goal among employees with annual income levels of $0–$49,999. Among those with $125,000 or higher in annual income, there is a 39 percentage point difference.

Goal #2: Eliminate Debt
Forty percent of all employees said that one of their financial goals is to eliminate debt. It is the second most commonly cited goal for employees with less than $125,000 or higher in annual income, eliminating debt was the third most common goal, with 27 percent.

Goal #3: Buy a Home
Thirty-four percent of all employees wanted to be homeowners. Buying a home was more common as a financial goal among those with lower annual incomes, rounding out the top three for employees who made less than $75,000.

Goal #4: Invest Better
Across all employees, investing better was the fourth most commonly cited goal with 30 percent. The desire to invest better correlated with income. It was only in the top three for those with more than $75,000. Investing better was the second most commonly cited goal for those who made $125,000 or higher annually, with 39 percent.

Goal #5: Create an Emergency Fund
Creating an emergency fund was a close fifth, with 29 percent of all employees choosing it as a financial goal. Interestingly, creating an emergency fund varied only slightly between different income ranges, with only a 5 percentage point difference between those who made less than $50,000 and those who made $125,000 or higher.

When probed about financial goals, most employees are aware of the importance of retirement planning. Even with the prevalence of competing goals that have more immediate implications, such as creating an emergency fund and paying off debt, Americans still want to save for retirement. To do so, they need more tools and guidance around how to invest better and make smarter long-term decisions.

¹Based on Retiremap implementation data from 2015. This is an excerpt of Retiremap’s, Financial Wellness Insights, Top Financial Goals Among American Employees, November 2015. Slight modifications were made for compatibility purposes.


NO BENEFICIARY DESIGNATION. WHO GETS THE MONEY?

According to a recent Wall Street Journal article, retirement plans and IRAs account for about 60 percent of the assets of U.S. households investing at least $100,000.¹ Both state and federal laws govern the disposition of these assets, and the results can be complicated, especially when the owner of the account has been divorced and remarried. Therefore, it is important for plan fiduciaries of qualified retirement plans to understand their role regarding beneficiary designations and the regulations that dictate.

Under ERISA and the Internal Revenue Code, in the case of a defined contribution plan that is not subject to the qualified joint and survivor annuity rules², if a participant is married at the time of death, the participant’s spouse is automatically the beneficiary of the participant’s entire account balance under the plan. A participant may designate someone other than his or her spouse as the beneficiary only with the spouse’s notarized consent.

If the owner of a retirement plan account is single when he or she dies, the assets go to the participant’s designated beneficiary, no matter what his or her will states. In addition, the assets will be distributed to the designated beneficiary regardless of any other agreements including even court orders. If the participant fails to designate a beneficiary, the terms of the plan document govern the disposition of the participant’s account. Some plan documents provide that in the absence of a beneficiary designation the participant’s estate is the beneficiary, while others provide for a hierarchy of relatives who are the beneficiaries. Because of the variances in plan documents, it is important that fiduciaries review the terms of their plan document when faced with determining who the beneficiary is in the absence of the participant’s designation.

The beneficiary determination can become complicated when a retirement plan participant divorces. Where retirement benefits are concerned, both the Employee Retirement Income Security Act (ERISA) and the Internal Revenue Code contain provisions requiring plans to follow the orders of state courts overseeing domestic disputes that meet certain requirements. These orders are referred to as “qualified domestic relations orders” (QDROs).

Until recently, the federal courts have failed to adopt a reliable and uniform set of rules for adjudicating disputes among beneficiaries with competing claims. Some courts, adopting a strict reading of ERISA, simply pay the benefit based on the express terms of the plan; while others, with a nod to such concepts of “federal common law,” look to documents extraneous to the plan (e.g., the divorce decree, a waiver, or some other document) to make the call. In Kennedy v. Plan Administrator for DuPont Savings and Investment Plan, the U.S. Supreme Court settled the matter, coming down squarely on the side of the plan document.

The facts in Kennedy are straightforward: A plan participant married and designated his wife as his beneficiary. The plan participant and his wife subsequently divorced. Under the terms of the divorce decree, the participant’s spouse surrendered her claim to any portion of the benefits under the participant’s retirement plan. As sometimes happens, the participant neglected to change his beneficiary designation under the plan to reflect the terms of the divorce. As a result, his ex-spouse remained designated as his retirement plan beneficiary. Upon the death of the participant, the plan administrator, following the terms of the plan document and the beneficiary designation, paid the participant’s account to the ex-spouse. Predictably, the participant’s heir (his daughter in this instance) sued on behalf of the estate. The Supreme Court ruled that under the terms of the plan document, the designated beneficiary receives the participant’s death benefits, and in this case, the ex-wife was the designated beneficiary entitled to the participant’s account.

Another common example occurs following a divorce, when a plan participant designates his or her children as beneficiaries. If the participant later remarries, and dies while married to the second spouse, the second spouse is automatically the participant’s beneficiary unless he or she consents to the participant’s children being designated as the beneficiaries.

There are steps that plans can take to make the beneficiary process less prone to error. For example, a plan document can provide that divorce automatically revokes beneficiary designations with respect to a divorced spouse. It also behooves plans to review their communications materials to help ensure that participants are made aware of the rules that apply to the designation of beneficiaries.

Many plans that have had to deal with issues like these have decided to take inventory of their current beneficiary designations on file and attempt to remediate any deficiencies directly with the participants. Some have also requested their recordkeeper to insert a note in participants’ quarterly statements reminding them to confirm their beneficiary designation is current and accurate. Both are good ideas.

As a plan sponsor you have the best wishes of your participants in mind and helping ensure their beneficiary designations are in order is another way to protect them and help ensure their intentions are carried out. Consider distributing this month’s accompanying participant memo that reminds participants of the importance of keeping their beneficiary designations up to date.

¹Family Feuds: The Battles Over Retirement Accounts
²This commentary addresses only plans that are not subject to the qualified joint survivor annuity (QJSA) rules. Typically, retirement plans are designed not to be subject to the QJSA rules by meeting the following requirements: (1) upon death, 100 percent of the participant’s vested account balance is payable to the surviving spouse; (2) the participant does not elect a life annuity; and (3) the participant’s account balance does not include any assets subject to the QJSA rules, such as a transfer from a money purchase pension plan. Please contact your consultant for questions related to defined benefit pension plans and money purchase pension plans subject to the QJSA rules.

 


No strategy assures a profit or protect against loss.

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing.

For Plan Sponsor use only – Not for use with Participants or the General Public. This information was developed as a general guide to educate plan sponsors, but is not intended as authoritative guidance or tax or legal advice. Each plan has unique requirements, and you should consult your attorney or tax advisor for guidance on your specific situation. In no way does advisor assure that, by using the information provided, plan sponsor will be in compliance with ERISA regulations. 

Montgomery Retirement Plan Advisors does not warrant and is not responsible for errors or omissions in the content of this newsletter.

Montgomery Retirement Plan Advisors offers investment advisory services through Independent Financial Partners, a Registered Investment Advisor. Independent Financial Partners and Montgomery Retirement Plan Advisors are separate entities.

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Montgomery Retirement Plan Advisors offers investment advisory services through Independent Financial Partners, a Registered Investment Advisor. Independent Financial Partners and Montgomery Retirement Plan Advisors are separate entities.