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The Bond Vigilantes Sing Don’t Cry for Me Argentina

By:  Steven L. Yamshon, Ph.D., Managing Principal

James Carville, President Clinton’s political consultant said at the time when Clinton was President, “I used to think that if there was reincarnation, I wanted to come back as the president or the pope or as a .400 baseball hitter. But now I would like to come back as the bond market. You can intimidate everybody.” 

Back in the early 1980’s, bond investors were a force to be reckoned with and these “bond vigilantes” took matters into their own hands when the government was fiscally irresponsible, selling bonds en masse, pushing up interest rates sharply higher and forcing the government to get serious. What is a bond vigilante and why does it matter? The truth is any bond investor is a potential member of this esteemed group. Investors who purchase fixed income products such as bonds want a positive real return on their investment. The real return is the return after inflation, and this is what counts, because it is what your money buys. Inflation erodes your purchasing power.

When the Great Financial Crisis occurred in 2008, the Federal Reserve (the “Fed”) had to use all the tools at their disposal to keep the economy from sliding into a depression. Lowering interest rates is just one tool at their disposal and the Fed lowered interest rates close to zero. To keep interest rates near zero, the Fed implemented a never-tried-before technique called Quantitative Easing (“QE”). Without getting too technical, this operation is called money printing and is equivalent to dropping money from helicopters. In 2008, the Fed had to do this to save the economy.  In 2020, the Fed did it again because of the COVID-19 pandemic but at greater speed and intensity. Most likely, this was an overkill, and we believe it will lead to a sustained level of higher trend inflation.

Where are the bond vigilantes? After all they have been in hibernation for a long time. There is one reason and one reason only. Inflation was low until now. However, the U.S. economy may be at a pivotal turning point. If history is any guide the bond vigilantes will most likely wake up in the next several years. In the 1930-1950 period, inflation spiked because of dollar devaluation during the 1930’s and to finance World War II (Chart 1). During this period the Federal Reserve accommodated fiscal spending by their massive power of the printing press.

Chart 1: Inflation (1930-2021)

When President Lyndon B. Johnson wanted to eliminate poverty and pay for the Vietnam War, known as “guns and butter,” he did so without raising taxes. This set off a stagflation period that lasted from 1969 to 1985 and only ended when Federal Reserve Chairman Paul Volcker raised interest rates to 20% (Chart 2). Volcker had no choice. He had to stamp out inflation and the bond vigilantes forced his hand.

Chart 2: Interest Rates (1970-2021)

By mid-decade, we believe the bond vigilantes will come out of their long-lasting sleep because the U.S. fiscal position will become unsustainable. The budget deficit, and trade balance of payments is exploding upwards. The major reason why the United States is not in the same situation as Buenos Aires, Argentina, is because the U.S. Dollar is the global reserve currency, but that exclusivity is eroding.

At some point investors here and abroad will say “enough is enough” and want increased compensation for the risk of holding U.S. government debt. That is when the bond vigilantes will awaken from the dead like the rise of the Phoenix and sing “Don’t Cry for Me Argentina”.

Disclosure: BFSG does not make any representations or warranties as to the accuracy, timeliness, suitability, completeness, or relevance of any information prepared by any unaffiliated third party, whether linked to BFSG’s web site or blog or incorporated herein and takes no responsibility for any such content. All such information is provided solely for convenience purposes only and all users thereof should be guided accordingly. Please see important disclosure information here.

The Economy is Tapering Ahead of the Fed

Source: J.P. Morgan Asset Management, Guide to the Market

By:  Thomas Steffanci, PhD, Senior Portfolio Manager

The July minutes of the Federal Reserve’s (the “Fed”) latest policy meeting were released on August 18th to the hue and cry of Wall Street pundits about the Fed making plans to pull back the pace of their monthly bond purchases before the end of the year.

The ongoing assumption has been that the Fed’s tapering would begin next year and be spread throughout 2022. The stock market reaction was swift and sharp as the Dow Jones Industrial Average fell nearly 2% in two days as expectations swirled that the first rise in the Federal Funds rate may be similarly pushed forward to next year, rather than in the prevailing opinion to 2023.

Now so far, the Fed has not disclosed any timetable of either of those two events. Several members of the Federal Open Market Committee (FOMC) have made public comments about a timetable which on balance has called for an early start to tapering and a year-end 2022 first increase in the Federal Funds rate. These members have touted the strength of the economy as rationale for their views.

Why is all this important? Because current, real time, economic data are indicating a sharp slowing of the economy, especially in retail and home sales, along with continued declines in consumer buying intentions and homebuyer expectations. And survey data show consumers now expect a more negative economic impact from Covid than they have for the past several months. Covid-sensitive spending in restaurants, air travel and hotels has weakened further in August. Higher frequency indicators of consumer activity such as daily credit card spending have flat-lined since mid-July.

There is an historical irony in all of this. In past cycles, the Fed was behind the curve in reacting to rising inflation accompanying above trend economic growth, raising interest rates sharply and too late, precipitating a credit crunch and a recession, or a tightening policy in anticipation of rising inflation which did not occur (2017-2018).  What may be unfolding here is much the same thing.

If market signals are correct on the growth slowdown, which the Fed’s econometric models fail to pick up, they would wind up behind the curve by beginning to reduce their bond purchases too early, raising false expectations that current conditions cited above are mere transitory data points. They are likely not…the economy is tapering toward an identifiable growth slowdown in the months ahead, putting the Fed’s 7% estimate for 2021 GDP growth in serious jeopardy. The lesson is that the Fed will need to be more cautious in their plans for the speed and timing of their tapering plans.

What would be the market impact? As market signals become reflected in hard data, expectations of a Fed policy reset could elevate equity prices, raise commodity prices, and keep bond yields low. As 2022 is an off-year election, inflation would not be a policy problem in an economy that downshifts to trend growth, and any political resistance turns to congressional job preservation.

Chart Source: FactSet, Federal Reserve, J.P. Morgan Investment Bank, J.P. Morgan Asset Management. As of August 20, 2021.

*The end balance sheet forecast assumes the Federal Reserve maintains its current pace of purchases of Treasuries and MBS through December 2021 as suggested in the June 2021 FOMC meeting. **Loans include liquidity and credit extended through corporate credit facilities established in March 2020. Other includes primary, secondary and seasonal loans, repurchase agreements, foreign currency reserves and maiden lane securities. ***QE4 is ongoing and the expansion figures are as of the most recent Wednesday close as reported by the Federal Reserve.

Disclosure: BFSG does not make any representations or warranties as to the accuracy, timeliness, suitability, completeness, or relevance of any information prepared by any unaffiliated third party, whether linked to BFSG’s web site or blog or incorporated herein and takes no responsibility for any such content. All such information is provided solely for convenience purposes only and all users thereof should be guided accordingly. Please see important disclosure information here.

Upcoming Compliance Deadlines

September 2021

15th: Required contribution to Money Purchase Pension Plans, Target Benefit Pension Plans, and Defined Benefit Plans.

15th: Contribution deadline for deducting 2020 employer contributions for those sponsors who filed a tax extension for Partnership or S-Corporation returns for the March 15, 2021 deadline.

30th: Deadline for certification of the Annual Funding Target Attainment Percentage (AFTAP) for Defined Benefit Plans for the 2021 plan year.

October 2021

15th: Extended due date for the filing of Form 5500 and Form 8955.

15th: Due date for 2021 PBGC Comprehensive Premium Filing for Defined Benefit Plans.

15th: Contribution deadline for deducting 2020 employer contributions for those sponsors who filed a tax extension for C-Corporation or Sole-Proprietor returns for the April 15, 2021 deadline.

Safe Harbor: A Cure For Your Testing Headaches

A crucial requirement for 401(k) plans is that the plan must be designed so it does not unfairly favor highly compensated employees (HCEs) or key employees (such as owners) over non-highly compensated employees (NHCEs). To satisfy this requirement, the IRS requires that plans pass certain nondiscrimination tests each plan year. These tests analyze the rate at which HCE and key employees benefit from the plan in comparison to NHCEs. Failed tests can result in costly corrections, such as refunds to HCEs and key employees or additional company contributions. Luckily for plan sponsors, there is a plan design option – a safe harbor feature, that allows companies to avoid most of these nondiscrimination tests.

To be considered safe harbor and take advantage of the benefits afforded to safe harbor plans, there are several requirements that must be satisfied. Below we will take a look at the key characteristics of a safe harbor plan.

The plan must include one of the following types of contributions. The chosen formula is written in the plan document, and with the exception of HCEs, must be provided to all eligible employees each plan year. Please note that additional options, not covered here, are provided for plans that include certain automatic enrollment features.

  • Safe Harbor Match: With this option, the company makes a matching contribution only to those employees who choose to make salary deferral contributions. There are two types of safe harbor matching contributions:
    • Basic Safe Harbor Match: The company matches 100% of the first 3% of each employee’s contribution, plus 50% of the next 2%.
    • Enhanced Safe Harbor Match: Must be at least as favorable as the basic match. A common formula is a 100% match on the first 4% of deferred compensation.
  • Safe Harbor Nonelective: With this option, the company contributes at least 3% of pay for all eligible employees, regardless of whether the employee chooses to contribute to the plan.

Unlike company profit sharing or discretionary match contributions, safe harbor contributions must be 100% vested immediately. In addition, the contribution must be provided to all eligible employees, even those who did not work a minimum number of hours during the plan year or who are not employed on the last day of the plan year.

In most cases, an annual safe harbor notice must be distributed to plan participants within a reasonable period before the start of each plan year. This is generally considered to be at least 30 days (and no more than 90 days) before the beginning of each plan year. For new participants, the notice should be provided no more than 90 days before the employee becomes eligible and no later than the employee’s date of eligibility. The safe harbor notice informs eligible employees of certain plan features, including the type of safe harbor contribution provided under the plan.

If all safe harbor requirements have been satisfied for a plan year, the following nondiscrimination tests can be avoided:

  • Actual Deferral Percentage (ADP): The ADP test compares the elective deferrals (both pre-tax and Roth deferrals, but not catch-up contributions) of the HCEs and NHCEs. A failed ADP must be corrected by refunding HCE contributions and/or making additional company contributions to NHCEs.
  • Actual Contribution Percentage (ACP): The ACP test compares the matching and after-tax contributions of the HCEs and NHCEs. A failed ACP must be corrected by refunding HCE contributions and/or making additional company contributions to NHCEs.
  • Top Heavy Test: The top heavy test compares the total account balances of key employees and non-key employees. If the total key employee balance exceeds 60% of total plan assets, an additional company contribution of at least 3% of pay may be required for all non-key employees. It is important to note that a plan will lose its top heavy exemption if company contributions, in addition to the safe harbor contribution, are made for a plan year (e.g., profit sharing or discretionary matching contributions).

So, how do you know if a safe harbor plan is a good fit for your company? As discussed above, the primary benefit of a safe harbor plan is automatic passage of certain annual nondiscrimination tests. If your plan typically fails these tests, resulting in refunds or reduced contributions to HCEs and key employees, your company may benefit from a safe harbor feature. Predictable annual contributions also provide a great incentive for employees to save for their retirement. However, if you do not currently offer an annual match or profit sharing contribution to your employees, a safe harbor formula may significantly impact your company’s budget. Except for a few limited exceptions, safe harbor contributions cannot be removed during the plan year, so it’s important that a company is able to fund these required contributions. As with all things qualified plan related, the key is working with an experienced service provider who can design a plan to suit your company’s needs!

Missing Participants: Ready or Not, Here I Come!

Most plan sponsors can relate to the trials and tribulations of having missing participants in their retirement plan. At times, it may feel like you are on the losing end of an intense game of hide-and-seek. Your opponents, the missing participants, may not have intended to pick the best hiding spots, but in many cases, they have surely succeeded. Now you are tasked with tracking them down and upping your game to avoid this scenario in the future.

So, what are missing participants, exactly? Missing participants are former employees who left an account balance in a retirement plan and did not keep their contact information up to date. In addition, they may no longer actively manage their accounts. There are a few factors that have led to an increase in the number of missing participants in retirement plans over the years. Unlike the generations of our parents and/or grandparents, employees do not typically work their entire career with one firm anymore. Another contributing factor is the mobilization of the workforce. The ability to work remotely has mobilized employees even more these days. Some have chosen to relocate across the country while others find themselves living in a new locale every few months. Many of us can relate to this, especially over the past 18 months. With these two factors alone, it can be difficult to keep track of plan participants once they leave your firm.

It is important to develop procedures to ensure contact information is up to date and to illustrate the proactive measures employed in this effort. Whatever steps you implement, you should relay to employees and participants why keeping these details current is important and how it can affect them. Ask any employee if they would be okay with losing track of their retirement account – the answer would probably be a resounding no. A few ideas based on the Department of Labor’s (DOL’s) Best Practices are included below.

  • Annual Review: Have plan participants verify their contact information on file at least annually. This includes addresses, phone numbers, and email addresses. You can also include a review of beneficiaries at this time. Keep in mind this does not only include current employees but terminated or retired participants as well. Also consider making the review part of your company’s exit interview.
  • Mailings: When completing a mailing, provide a form where recipients can update their contact information.
  • Returned Mail: Initiate searches for participants as soon as mail has been returned as undeliverable. This includes mail marked as “return to sender,” “wrong address,” “addressee unknown,” or otherwise.
  • System Log In: If participants regularly log into a system, set a reminder or pop-up directing users to verify their contact information.

Unfortunately, even with the best of plans in place, plan sponsors may still have participants who go missing. So, not only do you need to incorporate procedures for ensuring contact information is up-to-date, but you also need to document procedures for locating participants once they go missing. The DOL provides a list of search methods that should be used to locate missing participants. Some of these methods are included below.

  • Send a notice using certified mail through USPS or a private delivery service with similar tracking features.
  • Check the records of the employer or any related plans of the employer.
  • Send an inquiry to the designated beneficiary or emergency contact of the missing participant.
  • Use free electronic search tools or public record databases.

At some point, most plan sponsors will find themselves with participants who have gone missing. It’s important to remember plan sponsors have a fiduciary responsibility to follow the terms of the plan document and ensure participants are paid out timely. Having a well-documented, organized process which addresses missing participants, along with proof the process is followed, will prove worthwhile.

More information regarding the Department of Labor’s Best Practices can be located on their website.