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The Department of Labor awakens

At President Obama’s urging, the US Department of Labor (DOL) has proposed a new regulation condoning state-sponsored private sector retirement programs. The proposed DOL regulation extends to such state-run programs principles already applicable to private employers’ payroll deduction IRA arrangements. If properly structured, payroll deduction IRA arrangements avoid coverage under the Employee Retirement Income Security Act of 1974 (ERISA) and the employers implementing such arrangements dodge status as ERISA sponsors and fiduciaries. Similarly, a state-sponsored private sector retirement savings program following the DOL’s proposed regulatory guidance will, in the DOL’s judgment, fall outside the coverage of ERISA.

As enacted by California and Illinois, such plans require private sector employers who do not offer their employees 401(k) or other retirement plans to participate in the state savings program. Some hail the DOL’s proposed regulation for state-sponsored private sector retirement plans as facilitating potentially useful arrangements to encourage needed retirement savings. Others denounce the DOL regulation for succoring state-sponsored plans which will unfairly compete against the retirement savings arrangements offered to private employers by private sector pension providers.

I suggest an additional perspective: The proposed DOL regulation, if finalized in its current form, will undermine California’s current statute which uses formula-based, cash balance-style accounts for the Golden State’s private sector retirement savings program. The DOL’s proposed regulation requires that participants in state-sponsored retirement savings programs possess the same unrestricted right to withdraw their retirement savings as IRA participants possess. This unrestricted right of withdrawal will create the possibility of a “run on the bank” if the assets in the proposed California state retirement plan are insufficient to pay larger formula-based claims established by the California statute.

A true IRA continuously adjusts on a dollar-for-dollar basis for investment gains and losses as they occur. In contrast, cash balance accounts do not reflect investment gains and losses as such gains arise and as such losses accrue. Rather, a participant’s formula-style, cash balance account is a theoretical construct which is credited with the participant’s cumulative contributions augmented by an assumed rate of interest regardless of actual investment performance. The California Secure Choice Retirement Savings Trust Act in its current form provides for the California private sector savings retirement plan to use such formula-based cash balance accounts.

As a statutory matter, cash balance accounts (whatever their benefits as a matter of retirement policy) do not qualify as IRAs under the Internal Revenue Code. These theoretical accounts do not receive or reflect actual investment gains and losses but, rather, are governed by formulas based on interest rate assumptions which may or may not prove true in practice.

The California statute uses the cash balance format. Thus, the accounts to be established under the California plan will not qualify under the Internal Revenue Code as true IRAs, which must be adjusted to reflect actual investment gains and losses.

Moreover, the right of withdrawal required by the proposed DOL regulation now undermines California’s cash balance format in practice. The unrestricted right of withdrawal required by that regulation can encourage a “run on the bank” when participants’ entitlements in their formula-based cash balance accounts exceed the resources available to pay the larger promised amounts.

To see this possibility, suppose that the California retirement savings plan is up and running under the current statute and that a particular participant in the plan has an account balance of $10,000. This formula-derived total reflects the participant’s cumulative contributions withheld by her employer plus interest accumulated at the presumed rates assumed by the board administering the California plan.

Let us further suppose a decline in the value of the assets held by the California trust which invests the plan’s resources. Suppose, in particular, that the pro rata trust assets supporting this participant’s account decline to $9,000. Finally, let us further assume that this participant, unsettled by this stock market decline, understands that the State of California by law does not guarantee her formula-based retirement entitlement of $10,000. Consequently, she elects to protect her financial interests by withdrawing the full $10,000 pursuant to her withdrawal right required by the proposed DOL regulation.

If this were a true IRA, the participant would only be able to withdraw $9,000, the current value of the trust assets allocable to her account. However, under the California statute as it now reads, this participant would be entitled to the full $10,000 determined by formula even though the pro rata share of the trust assets allocable to her notional account come to only $9,000.

Suppose now that other participants, seeing the trust’s assets decline and watching this first participant withdraw her formula-based account balance, emulate her and protectively withdraw their respective account balances as well to guard against the California trust’s potential insolvency. In this scenario, a “run on the bank” starts because participants’ claims under their cash balance accounts are determined by formula, not by actual (potentially smaller) asset values.

The drafters of the California statute were evidently aware of this kind of possibility. Hence, under the California statute, the California trust can purchase insurance to guarantee participants’ formula-derived account balances. It is, however, not inevitable that such insurance will be obtained at affordable rates nor is it assured that such insurance will be kept in force. It is, moreover, not foreordained that such insurance, even if purchased, will prevent a “run on the bank” when total formula-based account balances exceed the actual investment values in the California trust funding those theoretical accounts. An insurance company’s guarantee is only as good as the insurer’s solvency or, perhaps more precisely, the perception of that solvency.

Even before the proposed DOL regulation was announced, the California statute required amendment to replace the statute’s formula-based cash balance accounts which do not qualify as true IRAs under the Internal Revenue Code with investment-based accounts which do. By mandating that participants must have unrestricted rights of withdrawal, the proposed regulation now creates the possibility that the California statute’s formula-based accounts will trigger a “run on the bank” when trust assets are less than the total claims represented by those cash balance accounts. If the California legislature undertakes the second vote necessary to effectuate the Golden State’s private sector retirement savings plan, the legislature should emulate the decision of the Illinois general assembly, should jettison the formula-based cash balance accounts now established by the California statute, and should make the retirement savings accounts of the California plan true IRAs which directly receive and reflect investment gains and losses as they occur.

Image Credit: “San Francisco” by Kārlis Dambrāns. CC BY 2.o via Flickr.

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