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Plan investments – Hard to value assets

Jun 12, 2009

The 2008 ERISA Advisory Council published a "Report On Hard To Value Assets And Target Date Funds." These are discrete issues although they are, in some situations, linked.

The issue of hard to value assets (HVAs) has been getting considerable attention. There are efforts by both the accounting community (see our article FASB finalizes rules for financial reporting of DB plan assets) and, largely informally, by the Department of Labor (DOL), to push sponsors to get "better" valuations of these assets. But many sponsors are confused as to what are their obligations with respect to HVAs. Quoting the Advisory Council report:

Plan sponsors and their fiduciaries are now placed in a dilemma. It has been widely advertised that failure to properly value assets will place them in breach of their fiduciary duties, yet in view of the Council, there has not been sufficient guidance issued to assist them in understanding the scope of those responsibilities.

In this article we begin with a discussion of some of the fundamental issues HVAs raise. We then discuss DOL regulatory and enforcement efforts. We conclude with a discussion of the Advisory Council's recommendations.

Preliminary issues

Let's start by defining the term "hard to value asset." The instructions to Form 5500 state: "Examples of assets that may not have a readily determinable value on an established market … include real estate, nonpublicly traded securities, shares in a limited partnership, and collectibles." We would add that HVAs are fundamentally characterized by what is absent – a reliable market price. There is clearly a continuum of "hardness to value" – generic office space in a financially stable downtown business center is probably less-hard to value than the assets in a boutique emerging markets limited partnership.

Problems presented

Obviously, hard to value assets present a problem – it's difficult to come up with a value for them. It's worth considering the ramifications of that problem before we turn to how sponsors and regulators are grappling with it. So, here's a list (in no particular order):

Because these assets are, by definition, hard to value, coming up with a "good" ("transparent" or reliable) value for them is difficult. And, in reality, however rigorous the process – for instance, a third party full due-diligence on-site audit – given the thin and non-transparent market for HVAs, you often cannot come up with a reliable number, i.e., what you'd get if you sold the asset tomorrow (to a "willing buyer," or to anybody).

Coming up with any value for a hard to value asset can be expensive. If it were inexpensive, the asset wouldn't be "hard" to value. And some sort of judgment must be made about whether that expense outweighs the value the HVA may produce.

In this context, the question should be considered: if you cannot come up with a reliable value for an asset, or if the expense of valuation outweighs its utility, is this an appropriate asset for a pension investment (which is an investment of someone else's money)? Are the returns available from these fundamentally non-transparent investments worth the uncertainty they bring? Just how much is transparency worth?

Does part of the value of HVAs derive from the fact that they are hard to value? That is, if values were made transparent, would returns go down? For instance, an element of the hedge fund model (at least for some hedge funds) is limited information regarding the assets of the fund.

HVAs – defined benefit plans vs. defined contribution plans

This HVA issue is worth its own section. The issue HVAs present is fundamentally different for defined benefit (DB) plans and defined contribution (DC) plans.

In a DB plan, so long as the sponsor is not insolvent, the fact that an HVA is worth less than what it is being carried at on the books is only the sponsor's problem. Only the sponsor will have to make up the difference. If the HVA is worth more than it is being carried at, then arguably it may also be the Treasury's problem, because the employer may be getting a deduction for contributions it would not get if the asset were "properly" valued. If the sponsor is a solvency risk, then the issue of valuation is also a problem for the Pension Benefit Guaranty Corporation (PBGC) and plan participants. But, generally and with respect to an ongoing DB plan, year-to-year mistakes in valuation can be fixed (e.g., by additional contributions) over time.

Valuations are much more immediate and critical in an account-based, DC plan. In that sort of plan, you need a reliable valuation so that you can properly treat in-flows and out-flows to the plan's funds. Obvious example: if you have a bad under-valuation, a participant taking a distribution will be under-paid. Thus, there is a much higher premium on transparency in DC plans. And that premium on transparency accounts (at least partly) for why you don't typically see HVAs in DC plans.

But – with the move towards "DB-ization" of DC plans – some sponsors and providers are considering whether it may be possible to add DB investment strategies, especially the use of HVAs, to DC plans in order to improve returns. As we have discussed in the past, DC asset performance overall lags DB performance by (at least) 100 basis points, and at least part of that lag may be attributed to the more limited DC investment set (e.g., generally excluding HVAs).

It's hard to imagine a sponsor offering as an investment option a boutique emerging markets limited partnership. But with the emergence of target date funds as a "core" DC investment strategy, imbedding a boutique emerging markets limited partnership in a target date fund's portfolio seems a possible strategy. If you ignore the fact that, as money flows in and out of the target date fund (daily? monthly? yearly?) you are going to need to strike a reliable value, which is not plausible

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Part of the problem that many sponsors have with the efforts of regulators in this area is that many of these first order issues are being ignored. Judging by the ERISA Advisory Council report and informal reports we hear about DOL regional office initiatives, it appears that DOL is focused on two issues: first, the value provided by the plan administrator on the plan's Form 5500; and second, plan fiduciaries' general prudence obligation with respect to plan investments. Let's consider those issues.

Form 5500

Schedule H (Financial Information) to the Form 5500 provides for an asset and liability statement describing the "current value" of plan assets. Related instructions define current value as "fair market value where available. Otherwise, it means the fair value as determined in good faith under the terms of the plan by a trustee or a named fiduciary, assuming an orderly liquidation at time of the determination."

According to the instructions, the plan administrator must specify:

[T]he fair market value of the assets … whose value was not readily determinable on an established market and which were not valued by an independent third-party appraiser in the plan year. Generally, as it relates to these questions, an appraisal by an independent third party is an evaluation of the value of an asset prepared by an individual or firm who knows how to judge the value of such assets and does not have an ongoing relationship with the plan or plan fiduciaries except for preparing the appraisals.

but

Although the current value of plan assets must be determined each year, there is no requirement that the assets (other than certain nonpublicly traded employer securities held in ESOPs) be valued every year by independent third-party appraisers. 

Whatever all of this means, it is probably not as rigorous as the new valuation rules under generally applicable accounting principles (GAAP), e.g., FAS 157, and we believe it's fair to say there is some uncertainty about exactly what kind of value must be provided on the 5500.

The issue of what sort of value must be provided with respect to the 5500 is further clouded by the fact that, as a general matter, a plan administrator must submit, with the 5500, a set of audited financials. (These financials are the financials of the plan, not to be confused with company financials, in which information about, e.g., plan assets is also reported.) In the ordinary course, those financials would have to present, per generally accepted accounting principles, assets at "fair value." But ERISA's limited scope audit exemption allows a plan administrator to rely on the "certification" of value by, e.g., a bank trustee or custodian.

We, at least, find these rules somewhat confusing. As the council stated: "The Council discussions revealed confusion revolving around which plan fiduciary has the actual responsibility for the good faith determination to satisfy Form 5500 requirements. … [A]lthough plan fiduciaries may be able to outsource the process of valuation and the auditor reviews such process whether done by the fiduciary or an external party, there is confusion as to who bears the ultimate fiduciary responsibility if the valuation is incorrect."

All of which points to the fact that the 5500 reporting rules are kind of an odd place to make policy about how to value HVAs, how much to spend on the valuation effort and whether HVAs are appropriate for pension plans generally.

General fiduciary obligation

An area where the discussion of the appropriateness/inappropriateness of pension plan investment in HVAs would seem more apt is ERISA's general fiduciary obligations. And testimony on this point at the ERISA Advisory Council hearings by DOL officials seems realistic (if somewhat abstract). Quoting from the Advisory Council's report:

According to [DOL Director of Regulations and Interpretations for the Employee Benefits Security Administration (EBSA) Robert Doyle], investments in [HVAs] are subject to [ERISA requirements that fiduciaries act prudently and solely in the interest of plan participants] in the same manner as any other plan investment. Therefore, concerning [HVAs], Mr. Doyle stated that a fiduciary's analysis, as part of a prudent due diligence process, would include, but not be limited to, how the investment fits in the plan's investment portfolio; the role of the investment in the plan's portfolio; and the plan's exposure to losses, for example, is the investment subject to extreme price fluctuations and a high degree of leverage? … [DOL guidance] generally states that a fiduciary must give appropriate consideration to the role of the investment in the plan's portfolio, as well as, as above stated, how the investment will impact the portfolio relative to the funding objectives of the plan.

Bottom line: plan fiduciaries must understand the financial "significance" of any asset, including HVAs. And, with respect to HVAs, part of that significance is the fact that they are not transparent. To say "We didn't understand how this asset (on which we just sustained significant losses) worked," is to invite fiduciary liability.

Enforcement

Testimony before the Advisory Council gave some insight as to what DOL is doing to monitor compliance with these standards (such as they are).

Virginia Smith, Director of Enforcement for the EBSA…detailed … that there are currently several active regional enforcement projects that involve HVAs, and that the review about a [p]lan’s asset valuation process is part of the standard enforcement review procedure.

Scott C. Albert, Chief, Division of Reporting Compliance of EBSA's Office of the Chief Accountant [noted that his office] is examining what plan administrators are doing regarding properly valued alternative investments.

On a regional basis, the EBSA’s Boston Regional Office on July 1, 2008 (the "Boston letter"), recently issued a letter which stated in relevant part:

"It is incumbent upon the Plan Administrator to establish a process to evaluate the fair market value of any “hard-to-value assets” held by the plan. Such a process will include a complete understanding of the underlying investments and the fund’s investment strategy. In addition, the Plan Administrator must have a thorough knowledge of the general partner’s valuation methodology to assure it comports with the fund’s written valuation provisions and reflects fair market value. A process which merely uses the general partner’s established value for all funds without additional analysis may not insure that the alternative investments are valued at fair market value."

The letter goes on to threaten legal action, absent compliance with certain requirements set forth in the letter.

So, clearly, there are widespread efforts by the DOL to get sponsors (or somebody – consider the confusion noted by the Advisory Council as to who is responsible for valuations) to improve HVA valuation methods. It's our impression that most of these efforts center on values provided on the Form 5500 and related audited financials, which as we noted is not the most powerful area for compelling change. Thus, exactly what the potential legal action would look like and how it would play out is not entirely clear. And much of DOL's activity in this area has a "jawboning" quality.

Council recommendations

After surveying the issues, the Advisory Council made the following recommendation:

The Department of Labor should issue guidance which addresses the complex nature and distinct characteristics of Hard to Value Assets. This guidance should define Hard To Value assets and describe the ERISA obligations when selecting, valuing, accounting for, monitoring and disclosing/reporting these assets. The Department should coordinate its issuance of the guidance on Hard To Value Assets utilizing resources such as recent accounting pronouncements by the SEC on fair value rules, the General Accounting Office report, the AICPA, the Department of the Treasury Blueprint for a Modernized Financial Regulatory Structure from March 2008 ("The Paulson Report"), and the 2006 ERISA Advisory Council’s Report on Prudent Investment Process.

It's not clear (as of this date) what efforts DOL intends to make to provide guidance and relieve sponsors of the "dilemma" the Council identified, that is, that (to repeat) "It has been widely advertised that failure to properly value assets will place them in breach of their fiduciary duties, yet in view of the Council, there has not been sufficient guidance issued to assist them in understanding the scope of those responsibilities."

Bigger picture

Federal regulatory efforts parallel efforts by the accounting community to get sponsors to provide more information about plan assets. We noted the recent completion by FASB of its DB plan assets project. There is (although still more or less "underground") some controversy over the extent to which FAS 157 rules apply to plans generally and, perhaps most controversially, to defined contribution plans. And there are efforts in the IASB pension accounting project that touch on these issues.

In the end, all of these efforts (including those of the DOL) are aimed at two strategic issues. First, with respect to DB plans, getting everyone – the sponsor, investors, the PBGC and participants – a better handle on the risks presented by the assets (most critically, because of the transparency difficulties, HVAs) backing up the pension promise. And second, with respect to DC plans, challenging the viability of fundamentally non-transparent assets held in account-based plans that depend on regular, accurate valuations.

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We will continue to follow these issues as they develop.