Roth in Retirement Plans

The webcast highlights the differences between Pre-tax and Roth deferrals in retirement plans, as well as the differences between In-Plan Roth savings and Roth IRAs. Click Here

The 5-Year to 3-Year U.S. Treasury Spread

This week, the spread between the 3-year U.S. Treasury note and the 5-year note (3s5s curve) “inverted”, with 5-year yields below 3-year yields.  Does an inversion of this part of the yield curve predict a looming recession?  Using daily data, the 3s5s curve has inverted 172 times since 1962!  Smoothing through the daily volatility and using the monthly average of daily curve values, the 3s5s curve has inverted 15 times over the same period.  How many recessions followed?  Just seven downturns. Worse, on average, from the first inversion of the 3s5s curve to the start of a recession, 26 months had elapsed.  A long-leading indicator with a spotty track record, at best.  So if you are following the 3s5s curve as your guide to investment strategy, just…. don’t. 

Source:  Payden&Rygel, Bloomberg, NBER

Markets in Review

Domestic equity markets rallied during the third quarter of 2018, as positive economic data and strong corporate earnings once again helped to offset the impact of rising interest rates and continued trade tensions. The S&P 500 index increased 7.7% during the quarter, its best quarterly gain in nearly 5 years.

Large-cap stocks outperformed their small-cap counterparts during the quarter, with the Russell 1000 index and Russell 2000 index returning 7.4% and 3.6%, respectively. Growth stocks in the Health Care, Technology, Consumer Discretionary, and newly formed Communication Services sectors led the rally, while value stocks in the Materials and Energy sectors were the biggest laggards. Growth-oriented stocks considerably outperformed their value-oriented counterparts across all market-caps.

International equity markets significantly underperformed the U.S. during the third quarter. After a strong second quarter, the U.K. was one of the worst performing markets, as the Bank of England raised base rates and Brexit negotiations appeared to reach an impasse. Despite gains in Latin America, boosted by Brazilian and Mexican markets, the MSCI EM index fell over 1% during the quarter. Markets in China remained volatile as concerns over the escalating trade war with the U.S. and an industrial slowdown continued, leading Emerging Markets lower. Japanese stocks posted solid gains during the quarter, with the MSCI Japan index rising 3.7% as exporters benefited from weakness in the yen. As of September 30, 2018, the S&P 500 index outperformed the rest of the world, as measured by the MSCI ACWI Ex USA index, on an annualized one-, 3-, 5- and 10-year basis.

The Federal Open Market Committee (“FOMC”) lifted its federal funds target rate by 0.25%, to a range of 2.00% to 2.25%, during its September meeting. Current expectations are for one additional increase during 2018, three increases in 2019 and one

in 2020. The U.S. yield curve continued to flatten throughout the quarter, with the yield on the 2-year Treasury rising 0.29% and the yield on the 10-year Treasury rising 0.20%, finishing the quarter at 2.81% and 3.05%, respectively. A risk-on mentality returned to the fixed income market, with the High Yield and Emerging Markets Debt sectors performing the best, while Treasury Inflation Protected Securities (TIPS) and Treasuries provided negative returns.

The initial estimate of third quarter gross domestic product (GDP) came in above market expectations, at 3.5% growth. Consumer data remained very positive during the quarter, with U.S. consumer confidence reaching an 18-year high in September. An increase in consumer spending was the largest contributor to GDP growth, supported by a rebound in inventories. Conversely, a sharp decrease in business investment and a fall in exports were a drag on growth. The global economic expansion continued at a slow but steady pace.

The unemployment rate fell from 4.0% to 3.7% during the third quarter of 2018, reaching its lowest level since December 1969. The labor force participation rate fell slightly, from 62.9% to 62.7%. The U.S. economy added an average of 190,000 jobs per month during the quarter, and wages grew at an annualized rate of 2.8% in September.

The year-over-year headline inflation rate fell from 2.9% to 2.3% during the quarter, with a sharp slowdown in gas prices having the largest impact in September. During the same period, core inflation, which excludes food and energy, fell marginally from 2.3% to 2.2%. The indices for both new and used cars and trucks fell sharply but were partly offset by increased shelter costs.

Hardships Get a Little Easier

Earlier this year, the Bipartisan Budget Act of 2018 was passed by Congress and signed into law.  While this law made several changes that impact retirement plans, one provision changing the rules around hardship distributions is particularly notable. As a result of the act, changes to the hardship distribution rules for 401(k) plans will take effect for the 2019 plan year (e.g., as of January 1, 2019, for calendar year plans). There are three primary changes to the current hardship distribution rules:

  1. Participants will no longer be required to take available plan loans before a hardship distribution is granted.
  2. When a hardship is taken, it is no longer necessary to suspend employee salary deferrals for six months following the withdrawal.
  3. The plan will allow for the distribution of other types of contributions beyond employee salary deferrals and pre-1989 earnings as part of a hardship distribution, including qualified nonelective contributions (QNECs), qualified matching contributions (QMACs), safe harbor contributions, and earnings from all eligible sources (including post 1988 earnings on elective deferrals).

The first and second changes are currently part of the IRS’s requirements for a hardship distribution to meet the safe harbor definition of “necessary to satisfy an immediate and heavy financial need.” If your plan currently uses anything other than the safe harbor definition for hardship distributions, your plan participants may not take advantage of these new regulations.  To adopt these new hardship rules, you’ll need to ensure that:

  • You confirm with your document provider whether you use the safe harbor definition for hardship distributions.
  • Your hardship distribution procedures are updated to reflect the changes.
  • All necessary administrative changes are being implemented by the plan record keepers.
  • You address the language of your plan document for any necessary amendments.

What if you sponsor a 403(b) plan? While the Treasury regulations for a hardship withdrawal under 401(k) and 403(b) regulations have the same meaning, further clarification concerning the latter is still needed from the IRS. While applying the new hardship rules to both types may have been Congress’ intent, the law itself does not currently extend to 403(b) plans. Many are hoping for a technical correction bill to address 403(b) plans and issues such as salary deferral suspension for hardships late in the year. The Treasury Secretary still has until early 2019 to modify the current 401(k) regulations to reflect the new hardship distribution rules.

Come 2019, a general certainty is plan sponsors may incorporate softer hardship distribution rules into their plans, policies, and procedures due to changes made under the Bipartisan Budget Act of 2018.

Helping Hands

One of the most prevalent and difficult challenges for many twenty somethings these days is the repayment of their, often substantial, student loan debt. Statistics show that the average college graduate with a bachelor’s degree left school in 2016 with $28,446 in student loan debt.  While paying off this mountain of debt is certainly a difficult task on its own, doing so and contributing toward retirement can be a seemingly insurmountable challenge. But, there’s hope. A recent private letter ruling made public by the IRS in August takes aim at alleviating some of this burden for the participant while doubling as an added tax benefit to the plan sponsor.

In August, the IRS issued the private letter ruling to Abbott Laboratories which allowed its employees, who qualified for the company’s 401(k) Plan, to receive a full matching contribution if they were to contribute at least 2% of their pay toward reducing their student loan debt.  The IRS ruled that the contributions would be allowed even if the employees weren’t contributing any portion of their pay to the plan. Abbott stated that the change to the plan responds to the financial challenges facing their young employees.  The change gives free retirement money for the student loan borrower and a tax benefit for the employer.

While this is fantastic news for employees that can’t afford to contribute because of student loan debt, the lingering question is “Is it legal?”. After all, a private ruling does not constitute tax law and, at the moment, the letter only applies to one Chicago company. However, Abbott isn’t the only employer to adopt this type of program.  Financial giant, Prudential Retirement, started offering a similar program in 2016.  Until the IRS issue expands guidance, employers wishing to implement student-aid based contributions should contact their TPA or legal counsel to understand any potential liability.