white paper: a plan sponsor's guide to retirement plan investments

PLAN SPONSOR’S GUIDE TORETIREMENT PLAN INVESTMENTS


PLAN SPONSOR’S GUIDE TO RETIREMENT PLAN INVESTMENTS | PAGE 1

As the sponsor of a retirement plan, you, or someone you appoint, will be responsible for making important decisions involving plan assets. Understanding the different terms, risks and attributes of plan investments is vital regardless of the role you play in determining how the plan’s assets are invested. Investments may range from exchange-traded instruments, the terms of which are typically clear and transparent, to private company equity securities, which can be difficult to value. Plan assets may also include more complex instruments such as derivative financial instruments and insurance products such as annuities. In many plans, more complex and structured instruments may be used to manage the overall risk that may exist in a portfolio.

Each instrument’s terms and the conditions, particularly those that pertain to underlying risk exposure, redemption features and terms that impact investment liquidity, should be closely considered. By understanding the terms and conditions for all investments in a plan’s portfolio, you may avoid unwanted surprises during an audit of your retirement plan by your auditors, the regulators or upon liquidation of these investments.

Reporting Requirements

Reporting requirements for ERISA-qualified retirement plans generally include the Form 5500 as well as audited financial statements prepared in accordance with U.S. generally accepted accounting principles (GAAP). Included in these requirements is the accurate reporting of the plan investments. Different terminologies are used for the reporting of investments, including carrying value, fair value, fair market value and contract value. It is critical you understand these terms and how they impact reporting so that you stay in compliance with regulations. Through various laws and regulations, the Department of Labor (DOL) holds the plan sponsor accountable for the accuracy and completeness of the Form 5500. For 5500 reporting purposes, plans are classified as “small” or “large” depending on the number of participants1 they have on the first day of each plan year. In general, large plans, defined as plans with more than 100 participants, require audited financial statements to be included with the Form 5500. Small plans are generally exempt from the requirement for audited financial statements unless the plan holds significant amounts of non-readily marketable investments.2

Through various laws and regulations, the

Department of Labor (DOL) holds the plan

sponsor accountable for the accuracy and

completeness of the Form 5500.



Plan investments are required to be reported at current value

on Form 5500. However, when you submit audited GAAP financial statements with your Form 5500, those financial statements are required to report plan investments at fair value. Generally, current value and fair value will be the same.

The determination of fair value for reporting under GAAP includes several considerations that are detailed in FASB ASC 820. Fair value for an exchange-traded instrument is relatively straight forward, as market observable information is available. However, for instruments that are not exchange-traded, such as private company equity securities, fixed-income debt securities, stable value funds, guaranteed investment contracts (GICs) and other investment contracts, consideration of the requirements of ASC 820 are necessary. As a general rule, ASC 820 requires the use of market observable data when available, which means the determination of fair value includes a process for determining if market observable data exists, and the extent to which it should be used. In order to evaluate and apply the requirements of ASC 820, plan sponsors and administrators need to understand the terms and conditions of each investment held by the plan and how those terms impact fair value.

It is recommended plan sponsors document the process to determine and verify the reported values of the plan’s assets and related disclosures as regulators and auditors typically examine those calculations during an audit.

Retirement Plan Investment Types

The types of investments are as diverse as the investment strategies and the goals of the plans themselves. Fixed-interest funds provide a guaranteed rate of return; self-directed brokerage accounts allow participants to choose the types of investments held in their individual account; mutual funds in-clude a diverse portfolio of assets offered at a lower price than could be created by an individual and exchange-traded funds are pooled investment fund vehicles that trade like stocks.

Investments not listed on national exchanges or over-the-counter markets are more difficult to value and often referred to as “alternative” investments. Defined benefit retirement plan investments tend to rely more on alternative investments due to their investment goals and strategies for matching benefits and liquidity with expected benefit payments.

TYPES OF INVESTMENTS

Common retirement plan investments include the following:

n Exchange-traded equity securities (common stocks and exchange-traded funds, ETFs)

n Mutual funds n Fixed-income debt securities (highly rated and speculative)n Common/collective trust funds and pooled separate

accountsn Stable value investments, GICs, insurance contracts, annuitiesn Investment and hedge fundsn Derivative instruments (options, swaps, credit wrappers, etc.)



Alternative investments are the most difficult to value as market observable information is generally not available. Each investment may also have very specific terms and conditions. The terms and conditions are critical to understanding the plan’s liquidity options. In certain instances, pooled investment vehicles may be reported at the Net Asset Value (NAV) as a practical expedient to fair value. NAV equals the total fair value of the pooled investment vehicle’s assets divided by the total number of units outstanding for the fund. Though the fair value for such investments may often differ from the NAV due to restrictions on redemption or other liquidity features, GAAP allows the NAV to be used as fair value for qualifying investments.

Common types of alternative investments include:

Common/Collective Trust Funds and Pooled Separate Accounts: Though they look and function much like a mutual fund, pooled separate accounts (PSAs) and common/collective trusts (CCTs) are not registered with the Securities and Exchange Commission (SEC). PSAs and CCTs may invest in various securities and alternative investments such as mutual funds and marketable securities as well as hedge funds and private equity funds. They often hold cash as well because the funds’ fees are deducted from the fund value versus charged to the other investors, and cash needs to be available to provide liquidity for redemptions. The fair value for these investments is generally determined using the NAV as a practical expedient, however, if the plan anticipates disposal of the investment at an amount other than the NAV, the fair value must be determined using traditional methods, which would consider the plan’s anticipated proceeds from the disposal of the investment. Plan sponsors and administrators should ensure a process is developed to monitor the NAV of such investments, including understanding how the NAV is developed and obtaining audited financial statements from the pooled investment fund.



Stable Value Investments: These types of investments primarily include GICs, synthetic GICs and PSAs and CCTs that invest in a GIC. The unit of account for these investments is the investment contract itself, thus, the fair value must consider all of the contractual terms and conditions. A traditional GIC typically consists of a contract between the plan and the issuer in which the plan holds an interest in the general assets of the issuer. However, the investment return of the contract may be indexed to a certain set of specific assets or a fixed rate of return. Repayment of the principal and the guaranteed interest rate are from the issuer’s general assets, thus, the creditworthiness of the issuer can be a significant input to the fair value of the contract. The fair value is also impacted by the liquidity features of the contract as well as how the crediting interest rate compares to market rates for similar investments. If the issuer is a highly rated insurance company, the fair value generally consists of a discounted cash flow model using market observable inputs.

In a synthetic GIC, the return is based on the return of a pool of assets that is owned by the plan. The contract also includes a third-party “wrapper,” which is a derivative instrument designed to provide a guarantee of that contract’s stated interest rate and principal (i.e. if the underlying assets underperform, the counterparty to the wrapper will make the plan whole). The fair value of a synthetic GIC includes the sum of the fair value of the underlying plan investments plus the fair value of the contract with the third-party service provider, which is typically an insurance company. Obtaining the information to determine the fair value of the components of a synthetic GIC can often be difficult.

Private Equity Funds: Generally organized as partnerships, private equity funds raise capital from qualified investors such as high net-worth individuals, pension funds and financial institutions. Private equity funds tend to include debt securities and various other private securities. Investments in private equity funds usually have a written investment contract or prospectus that details the withdrawal restrictions and other information pertaining to the investment. The NAV may be used as a practical expedient in valuing the investments. Investment values may also reflect a valuation specialist’s report.



Hedge Funds: Using a more aggressive approach than mutual funds, hedge funds employ leverage (e.g., options, futures, swaps and short selling) as part of their investment strategy and offer limited liquidity. They are exempt from the rules and regulations that govern mutual funds.

Real Estate Funds: As the name suggests, these investments exist largely in the real estate market and typically involve the direct purchase of real estate property. If the fund does not qualify for use of the NAV as a practical expedient, the fair value of the underlying assets held in real estate funds can be determined by third-party appraisals, cash flow projections or insurance valuation.

Funds of Funds: When investment companies invest in other investment companies the result is a funds of funds investment structure. Funds of funds can include many tiers of investments and involve offshore structures. If the investments are publicly traded, they can be valued at their fair market prices.

The fair value of these pooled investment vehicles generally will qualify for use of the NAV as a practical expedient to reporting fair value. Determining the fair value disclosures under ASC 820 requires a thorough understanding of the terms and conditions of the investment contract, including the liquidity features. Additionally, plan sponsors and administrators should ensure a process is in place to evaluate the quality and reliability of the NAV provided by the fund. If the NAV is not a reliable source, the plan sponsor may need to design procedures for testing the fair value of the underlying assets held by the fund.

Securities Lending: In exchange for cash or other collateral, the plan may lend securities within its portfolio to a broker to make up the difference from short sales or fail transactions. The collateral received remains a plan investment. Values of securities lending instruments require a close consideration of the fair market values of the assets involved, as the collateral received often depends on the fair market value of the investment’s assets.

TYPE FAIR VALUE DETERMINATION

CCTs and PSAs These investments qualify for use of the NAV (practical expedient) unless the plan anticipates a disposal at an amount other than the NAV.

Stable Value Investments

These types of investments primarily include GICs, synthetic GICs and PSAs and CCTs that invest in a GIC. Fair value must consider investment contract terms and conditions. For synthetic GICs, the fair value is the sum of the fair value of the underlying investments plus the fair value of the contract with the third-party service provider.

Private Equity Funds

Investments in private equity funds qualify for use of the NAV (practical expedient) and may also use information compiled in a valuation specialist’s report.

Hedge Funds If the investments do not qualify for the use of the NAV (practical expedient), the fair value should consider all attributes that would be used to price the interest by independent market participants.

Real Estate Funds

The fair value of the underlying assets can be determined by third-party appraisals, cash flow projections or insurance valuations if they do not qualify for use of the NAV (practical expedient).

Funds of Funds Publicly traded investments rely on fair market value for fair value. Typically, the investments qualify for use of the NAV (practical expedient).

Securities Lending

The fair value includes the fair market value of the assets involved.

Derivative Financial Instruments

Certain derivative instruments may be exchange-traded or valued using observable market data. For complex derivative instruments that do not have market observable data, a valuation specialist is often necessary to determine fair value.



Derivative Financial Instruments: Many plans hold derivative financial instruments, which is a contract whose price is derived from one or more underlyings (e.g., stocks, bonds, commodities, currencies, interest rates, etc.). Such instruments may include forward contracts, futures, options and/or swaps which must be valued and reported in the plan’s financial statements at fair value. The valuation of these instruments is as diverse as the instruments themselves and may range from exchange-traded instruments to complex options without market observable evidence. Generally, a valuation specialist is required for complex derivative instruments that do not have market observable evidence.

Valuing the Investments

The typical services provided by custodians and trustees to retirement plans include providing values that are based on the best information available at the time of the report. If a plan is invested solely in assets with readily determinable fair values, such as mutual funds or marketable securities, the trustee or custodian typically obtains fair values from nationally recognized pricing services such as Interactive Data Corporation (IDC) or Bloomberg. However, in cases where the plan invests in assets without readily determinable fair values, the reported values may be based on the best information available to the trustee and custodian at the time of the report, which may or may not be fair value. Many times the custodian may obtain a value directly from the issues of the investment. To obtain the fair value for alternative investments, a process should be developed to determine the reliability of the evidence obtained and when the use of specialists is needed.

Acceptable valuation techniques used to determine the fair value of an investment include: the market approach, the cost approach and the income approach.

Most retirement plan investments use a market approach, which draws on values from observable transactions and exchanges. The income approach works best for investments that produce cash flows or for which market observable information is not available. This approach uses a valuation model that converts expected cash flows into present amounts (such as a discounted cash flow model). The cost approach is used infrequently as it does not often provide a useful valuation for investments; however, it may be used for certain types of private equity securities. In the case of a start-up, for example, historical cost may be the best value available.



FASB ASC 820 Fair Value Hierarchy

To determine fair value in accordance with GAAP, you must prioritize the inputs used by the various valuation techniques. FASB ASC 820 breaks down valuation methods into three levels based on the availability of market observable evidence used. These inputs and the valuation methodologies used to estimate fair value also represent disclosure requirements required by GAAP, which differ with each level of the fair value measurement hierarchy.

The purpose of this hierarchy is to provide useful information regarding the degree of estimation used to determine the fair value of the various plan investments. It is also used as a disclosure model for financial statements prepared in accordance with GAAP. Following the hierarchy serves as a useful guide for determining which inputs and assumptions are significant to determining the fair value of an investment.

Level 1: Level 1 fair value measurements rely on market observable evidence for the exact security being valued. Determining fair value using Level 1 inputs requires using the current fair market value of the security. Examples of Level 1 fair value measurements include exchange-traded instruments such as common stocks, exchange-traded funds (ETFs) and listed derivatives. Mutual funds that are traded regularly in significant volumes are also generally Level 1 fair value measurements.

Level 2: Similar to Level 1 measurements, Level 2 measurements use observable inputs and rely on data such as the fair market value of similar assets traded on an active market. Also included are investments listed on exchanges that do not trade frequently and assets that rely on pricing models with significant observable inputs (such as interest rates that may be observed for the entirety of the investment life). Examples of Level 2 investments may include GICs, corporate bonds and government bonds.

Investments in which the fair value is reported using the NAV as a practical expedient, such as CCTs, group trusts (103-12 investment entities), PSAs and stable value funds are generally Level 2 fair value measurements unless the redemption or other liquidity features prevent liquidation in less than a 90-day period.



Level 3: Level 3 measurements use significant inputs that are not observable, therefore preparers have to rely on estimates and assumptions to derive significant inputs into a valuation model (for example, expected cash flows for a non-traded instrument). The fair value model should reflect how a typical investor would determine the value of the investment, including risk assessment and pricing models. Level 3 measurements typically include: GICs, private company securities and complex derivative instruments. Investment funds in which redemption is restricted for a period greater than 90 days are classified as Level 3 fair value measurements as well, regardless of the use of the NAV as a practical expedient. Among the required disclosures for Level 3 measurements are purchases and sales, earnings, terms, restrictions, valuation methods and inputs and quantitative disclosures of the unobservable inputs. Additional disclosures apply to plans that are considered to be public entities, such as sensitivity analysis related to the significant unobservable inputs.

Again, in most instances, the fair value of the plan’s investments is reported by the plan’s qualified custodian. Most qualified custodians obtain fair value information through third party sources such as IDC or Bloomberg. However, the responsibility to report the fair value of the investments lies with the plan administrator, thus, each plan should have an individual or committee with processes in place to ensure the fair values reported by the qualified custodian are accurate and can be relied upon. This is particularly significant for plans that hold investments that require fair value measurements using significant unobservable inputs (i.e. Level 3 measurements), but it is also necessary for all plan investments.

The Audit Process

During a full scope audit engagement, audit procedures include the review and validation of the valuation methods used to determine the fair value of the plan investments. This requires a strong understanding of the valuation models used for each type of instrument, as well as all significant inputs used to determine the fair value. An audit validates the models and the significant inputs used. With Level 3 fair value measurements, as the degree of estimation is significant for certain inputs, the audit team may need to use a valuation specialist to assist with the review of the models and inputs. Depending on the complexity and degree of estimation involved in developing the inputs, auditing the fair value of Level 3 fair value measurements can increase audit effort significantly.

The responsibility to report the

fair value of the investments lies

with the plan administrator.

FAIR VALUE HIERARCHY

INVESTMENT TYPE

VALUATION METHOD

Level 1 ETFs and mutual funds

Current market value (closing market price)

Level 2 Some GICs and debt securities, CCTs, PSAs and stable value funds

Use of observable market data such as current market value and interest rates.

Level 3 Private company securities and complex derivatives

Rely on non-observable inputs and often require risk assessments and pricing models



Typically, financial statement audits are performed without any client-imposed scope limitation or other restriction. ERISA is unique in that when certain criteria are met3, it permits plan management to instruct the auditor to limit the scope of testing of investments. This limited scope election must be supported by a certification to both the accuracy and completeness of the plan’s investment information from a qualified entity. Such audits are referred to as “limited scope” audits. Plan management is responsible for determining that the conditions of the limited scope audit exemption have been met.

Plan sponsors should carefully consider each option before selecting an engagement type.

If your plan elects a limited-scope approach to the audit, you should review the contracted level of service of the plan trustee or custodian (i.e., process and procedures for determining the fair value the investments) and assess whether investment values are properly reported based on current or fair value as of the plan’s reporting period. While the qualified custodian may certify that the information on the statement is complete and accurate, the certification does not necessarily mean the values represent current or fair value as required by ERISA and GAAP.

In a limited scope audit, the auditor has no responsibility to test the accuracy or completeness of the investment information certified, including the reported fair values. However, plan sponsors’ responsibilities do not change, and they should still be able to identify how the fair value for each investment is determined, the source of the information used in the fair value measurement and related disclosures required by GAAP. As mentioned above, the models and processes used to determine fair value represent required disclosures in the financial statements that must be included regardless of whether the auditor has been engaged to perform a limited scope or a full scope audit.



Should the plan auditor become aware that the investment information certified is incorrect, the auditor may be required to take certain steps, such as requesting the trustee or custodian to recertify or amend the certification to reflect proper investment values and investment income. The trustee or custodian may have to exclude (“carve out”) such investments and investment income from the certification, which would require full scope audit procedures to be performed for the excluded investment(s). Whether you undergo a full or limited scope audit, your plan sponsor, and in some cases, your investment manager, should meet with the audit team to discuss the terms of the various investments included in the plan’s portfolio.

Your Responsibilities

Ultimately, a plan sponsor is responsible for complete and accurate financial reporting of all plan investments which requires the sponsor to:

n Establish processes for understanding plan investments and the determination of fair value measurements and disclosures

n Select appropriate valuation methodsn Identify and adequately support any significant assumptions

used in preparing a valuationn Ensure that the presentation and disclosure of the fair value

measurements are in accordance with Form 5500 reporting requirements and GAAP.

Endnotes

1 Employees become includable as “participants” on the date the employee becomes eligible to participate—regardless of whether the employee elects to participate. The participant count must include (1) actively participating employees, (2) retired, deceased, or separated employees who still have assets in the plan and (3) all eligible employees who have yet to enroll or have elected not to enter the plan. A special ruling (80/120 Rule) allows plans with between 80 and 120 participants, as of the first day of the plan year, to file the Form 5500 in the same category (“large plan” or “small plan”) as indicated on the prior year’s Form 5500 filing.

2 Small plans are exempt from the audit requirement to the extent that at least 95 percent of their assets are qualifying plan assets. Plans not satisfying this test may still avoid the audit requirement if the total amount of non-qualifying plan assets are covered by an ERISA Section 412 fidelity bond. Small plans seeking to avoid the audit requirement must also make certain required disclosures to plan participants. Qualifying plan assets have been defined to include all assets held by either a bank or other similar financial institution, an insurance company, a registered broker-dealer or any other trustee qualified under section 408 and also includes participant loans and qualifying employer securities under section 408(b)(1).

3 Certification requirements of 29 C.F.R. § 2520.103-5 define the scope of an accountant’s examination and report under ERISA section 103(a)(3)(A) and (C) and 29 C.F.R. § 2520.103-8.



Glossary of Terms and Acronyms

CCTs: Common/collective trusts resemble mutual funds but are not registered with the SEC and are typically issued by financial institutions.

Current Value: (ERISA) section 3(26) defines the term current value as: “fair market value where available and otherwise the fair value as determined in good faith by a trustee or a named fiduciary pursuant to the terms of the plan and in accordance with regulations of the Secretary [of Labor], assuming an orderly liquidation at the time of such determination.” Generally current value and fair value under GAAP are the same.

DOL: Department of Labor

ERISA: Employee Retirement Income Security Act of 1974 includes rules and regulations for employee benefit plans.

ETFs: Exchange-Traded Funds or exchange-traded equity securities.

Fair Value: FASB ASC 820 defines fair value as: “the price that would be received to sell an asset or the price paid to transfer a liability in an orderly transaction between market participants at the measurement date.”

Form 5500: The DOL, the IRS, and the Pension Benefit Guar-anty Corporation jointly developed the Form 5500 in order for employee benefit plans to satisfy annual reporting re-quirements under Title I and Title IV of ERISA and under the Internal Revenue Code, thus, the Form 5500 serves as both a regulatory form as well as a tax filing.

GAAP: U.S. Generally Accepted Accounting Principles

GIC: A Guaranteed Investment Contract consists of a contract with the issuer in which the plan holds an interest in the general assets of the issuer, however, the investment return of the contract may be indexed to a certain set of specific assets or a fixed rate of return.

IDC: Interactive Data Corporation is a nationally recognized pricing service that can help plan custodians determine fair value for various securities.

PSAs: Pooled Separate Accounts resemble mutual funds but are not registered with the SEC and are issued by insurance companies.

NAV: Net Asset Value equals the total fair value of the pooled investment vehicle’s assets divided by the total number of units or interests outstanding for the fund. GAAP allows the NAV to be used as fair value for qualifying investments.

Synthetic GIC: A synthetic Guaranteed Investment Contract in which the return is based on the return of a pool of assets that is owned by the plan. The contract also includes a third-party wrapper that guarantees the contract’s stated interest rate and principal.

Wrapper: A derivative instrument designed to provide a guarantee of a contract’s stated interest rate and principal (i.e. if the underlying assets underperform, the counterparty to the wrapper will make the plan whole).

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