Deferred Compensation Program
Executive Summary
Since 1979, the state of Wyoming has offered public employees an
IRS authorized "457" deferred compensation program. Employees who
decide to participate in this program save for retirement by
deferring compensation for current services and placing the funds
into tax-deferred investment vehicles. At some time in the future,
usually upon retirement, employees receive these funds together
with the earnings generated. Ownership of all deferred
compensation and earnings belongs to the employer until made
available to participants.
By statute, the State Treasurer serves as the program administrator
and chair of the advisory board. Statutes also require the
administrator to contract, upon competitive bidding, with a Wyoming
individual, firm or corporation to serve as program coordinator.
Coordinator responsibilities include enrolling plan participants,
servicing participant accounts, and reporting to the administrator
and the advisory board.
The Legislature authorized the deferred compensation program under
the condition that administrative costs would be absorbed by
participants. Participants can choose from more than 30 investment
options offered by five providers. Providers pay fees to the
Employees' Trust Account which are derived from participant-paid
fees and charges. The administrator uses money in this account to
pay program administration expenses.
Cities, towns, and other political subdivisions can establish their
own deferred compensation programs or join the state's program.
One hundred and six political subdivisions throughout the state
have adopted the plan. Program officials reported plan assets
totaling $129.4 million at the end of fiscal year 1995. The total
deferral for March 1996 was $559,259. If this rate of deferral
remained constant throughout the year, participants would defer an
additional $6.7 million this year.
At the time of our review, there were 2,700 active participants
deferring compensation to the plan. They represent 14 percent of
the estimated 18,700 state and political subdivision employees
eligible to defer.
Finding 1 Better Educational Materials Are Needed To Ensure
Informed Program Participation
We found that opportunities exist to improve the kinds of
information available to employees to allow them to make informed
participation decisions. Participation in deferred compensation
often represents the first investment experience for many public
employees. By their nature, investment materials are technical and
difficult for inexperienced investors to read and understand. We
found educational materials that would introduce the novice
investor to the program and assist the more experienced investor in
managing a portfolio are lacking. We believe program managers
could improve efforts to simplify complex information and produce
useful educational materials.
The administrator has not required the coordinator to increase
educational and marketing efforts for the program. The contract
between the two parties is structured so the coordinator receives
compensation whether employees elect to participate in the program
or not.
Recommendation: The administrator should require the coordinator
to improve educational materials and efforts.
In order to promote employee participation and provide ongoing
communication with participants, the administrator needs to more
clearly define short and long-term expectations for the program.
The administrator can require more effective services from the
coordinator by developing a performance-based contract.
Finding 2 The Administrator Has Not Established An Effective
Investment Monitoring Process
We reviewed the performance of investment options in the deferred
compensation program and found a number of strong investment
options which have produced excellent rates of return for
participating savers. However, we also found that some other
investment choices were poorly rated and have not been producing
competitive long-term earnings, or "yields." This is important
because lower yields decrease participants' investment earnings and
can limit financial independence during retirement.
We found the Wyoming deferred compensation program does not include
a rigorous process to periodically review the performance of
investment alternatives so that poorly performing options can be
eliminated or replaced. Both the administrator and the coordinator
told us they informally review investment literature on a regular
basis. Neither, however, has developed a regular, systematic
process -- such as an annual review of long-term performance -- to
evaluate program investment options based on results and eliminate
poor performers.
Recommendation: The administrator should direct a comprehensive
performance review of investment options to eliminate
underperforming funds.
The administrator, in consultation with the advisory board, should
direct a comprehensive review of all investment options available
through the Wyoming deferred compensation program. Additionally,
to ensure ongoing competitiveness, procedures should be developed
which require periodic reassessment of the program's investment
options at defined intervals.
Finding 3 Effective Controls Are Needed To Contain Administrative
Costs And Participant Fees
Our review revealed a lack of management controls necessary to
minimize program costs and associated participant fees. Under this
program's structure, costs and fees effectively reduce participant
earnings. The administrator and board have not established
controls over program costs, and as a result, these costs have been
escalating. Although fees reduce investment returns, the
administrator and board do not regularly and comprehensively review
participant fees.
Recommendation: The administrator should review program costs and
fees and consider alternatives to increase participant yields.
Administrative expenses, participant-paid fees, and investment
yields are linked; individually and collectively, they affect
participant yields. It is very important that the administrator
exert control over these aspects of the program. The administrator
and the board should take steps to control and reduce
administrative costs. In addition, they should undertake a
comprehensive analysis of participant fees, with a view to reducing
them where possible.
Finding 4 Deficiencies Identified In 1985 Are Unresolved
Eleven years after a legislative study found problems with the
deferred compensation program, we determined there are still
significant weaknesses in these areas. In addition, we identified
other management problems.
We found that board expertise has not been fully used, and the
board tends to ratify decisions already made by the administrator.
Some basic program information, such as participation rates and the
value of program assets, is unreliable. Although statutes require
competitive bidding for coordinator and provider services, the
administrator and board have not incorporated open bidding into
Wyoming's program.
Contract negotiation and oversight have been weak, and contracts
with providers and the coordinator do not contain performance
incentives or cost-control requirements. Contracts with the
largest provider, Nationwide, can be terminated, but under
conditions which appear to favor the provider, not participants.
Several organizations have joined the program even though they may
not technically be eligible. Finally, we found other state
programs have adopted good risk management techniques which, if
adopted in Wyoming, could strengthen the program.
Recommendation: The administrator should develop a plan to
strengthen program accountability.
Deferred compensation participants need tangible assurances that
the program is protecting and maximizing their investments. The
administrator should develop a comprehensive plan for addressing
the program's operational weaknesses, and should submit the plan to
the Management Audit Committee by October 1, 1996. The plan could
also include an analysis of alternate placement options for the
program.
Conclusion
According to retirement planning experts, deferred compensation
plans for state and local employees represent one of the most
beneficial and least expensive benefits available for public
employees. For more than 15 years, such plans have been available
to public employees to help them prepare for retirement and
minimize their dependency on government in their later years.
However, the success of deferred compensation depends on strong
administration, effective employee communication, and responsible
selection of investment options.
We found administrative weaknesses which limit the potential of the
program to help public employees prepare for a secure retirement.
Moreover, solutions to some of these problems have languished for
more than a decade, since they were first identified in a 1985
legislative report. During the intervening years, the program has
not undergone close scrutiny and officials have not resolved
critical shortcomings. With this report, we call for improvements
which are necessary to ensure the quality, cost-effectiveness, and
integrity of this important program.
(Note: Text of the complete report begins below.)
Introduction
A. Scope
W.S. 28-8-107 (b) authorizes the Legislative Service Office to
conduct program evaluations and performance audits. The general
purpose of a program evaluation is to provide a base of knowledge
from which policy makers can make informed decisions.
In February 1996, the Management Audit Committee chose the Wyoming
deferred compensation program as the subject of a review. The
research in this report centered around the following questions:
* Does the deferred compensation program provide employees with
the information they need to make informed investment
decisions?
* Do the program's investment options offer competitive returns?
* Are program administrative costs and fees set and monitored to
provide participants with maximum investment earnings and
benefits?
* Is the extent of program oversight adequate to protect
participant interests?
B. Methodology
This evaluation was conducted according to statutory requirements
and appropriate program evaluation standards and methods. We
conducted our research between March and May 1996.
We reviewed relevant federal and state statutes, rules,
regulations, policies, annual reports, budget documents,
professional literature, board minutes, annual financial audits,
program contracts, other reports and studies, and a variety of
other program documents. In addition, we reviewed program asset
data; participant information extracted from the program's computer
database; and a random sample of 25 individual participant files.
We also attended a Deferred Compensation Advisory Board meeting,
and a new employee orientation meeting to observe the deferred
compensation presentation. We interviewed current and former board
members, program managers, various state officials, program
participants, and investment professionals. Additionally, we
conducted two focus groups with state employees.
Finally, we reviewed materials from other deferred compensation
programs, and conducted a survey of several neighboring state
programs, including Colorado, Montana, Idaho, Utah, South Dakota,
and Nebraska.
C. Acknowledgments
The Legislative Service Office would like to express appreciation
to the individuals who assisted in our research, especially to the
staff at Wyoming Deferred Compensation, Inc., the Wyoming
Treasurer's Office, and members of the Deferred Compensation
Advisory Board.
Background
Americans view retirement as a period of hard-earned independence
and leisure. Retirees typically rely upon three sources of income
in retirement: Social Security, employer-provided pension
benefits, and personal savings. As today's workers approach
retirement in record numbers, however, many may have unrealistic
assumptions about the adequacy of their Social Security and pension
benefits. To the extent possible, workers of even modest means
must assume more responsibility for their retirement incomes.
Retirement savings are no longer just "nice to have." Instead, the
portion of earnings today's workers contribute to their retirement
savings will determine, in large part, the quality of their
retirement years.
Deferred Compensation Programs
Since 1979, the state of Wyoming has offered public employees a
"457" deferred compensation program, giving them an opportunity to
save for retirement. This is one of three deferred compensation
programs authorized by the Internal Revenue Code, the others being
Section 403(b) plans for non-profit organizations and public school
employees, and 401(k) plans for private sector employees.
Participants in these programs find they can minimize their current
income tax liability and dependency on government in their later
years.
Employees who decide to participate in these programs agree to
forgo compensation for current services and place the funds into
tax-deferred investment vehicles. At some time in the future,
usually upon retirement, employees receive these funds together
with the earnings generated. As they receive this income,
participants become responsible for the tax consequences.
Deferred compensation programs benefit employees in two primary
ways. Employees benefit immediately by lowering their taxable
incomes while they are still working. More important, the
program's deferred tax status helps employees build the personal
savings portion of their retirement incomes. Contributions and
earnings can result in larger accumulations of assets than would
the same savings and earnings on an after-tax basis.
Section 457 Plan Requirements
IRS must approve plan documents. To set up a program, employers
must design a plan document that meets the Internal Revenue Code
requirements. If the Internal Revenue Service (IRS) approves the
plan, it issues a private letter ruling regarding eligibility
status. After the Wyoming Legislature authorized a deferred
compensation program in 1977, the State Treasurer and a specially
appointed board spent nearly two years researching and planning a
program to receive IRS approval.
Programs must be unfunded. A basic requirement defining 457
programs is that they must be unfunded. This means ownership of
all deferred compensation and earnings rests with the employer
until made available to participants. To get the tax deferral
benefit offered by 457 plans, employees exchange their rights to
receive current pay for their employer's unsecured promise to pay
them in the future. If the employer should go bankrupt, plan
participants have no greater claims against the employer's assets
than all other general creditors.
Deferrals are limited. Section 457 limits annual maximum deferrals
to no more than 25 percent of gross compensation or $7,500,
whichever is less. This maximum has remained constant since 1979,
and, unlike maximum contributions to 401(k) plans, it is not
indexed for inflation. If participants have not deferred the
maximum allowed in previous years, they may use a "catch-up"
provision to defer up to $15,000 in each of the last three years
before attaining retirement age.
Distributions are limited. Participants cannot obtain loans on
their deferrals. Deferred income and earnings become available
under the following circumstances:
* Retirement, termination, disability, or death.
* Attaining age 70-1/2.
* Facing an unforeseeable emergency.
An Arrangement of Contracts
Since public employers own 457 program assets, they do not hold
them in trust for employees. Plan participants cannot hold their
employers liable for losses incurred in the investment of deferred
compensation. Plan administrators have only the responsibilities
of ordinary prudent investors. Therefore, the integrity of the
obligations set out in the plan document rests upon the terms of
the contracts that govern program operation.
Wyoming's section 457 plan document is essentially a contract with
the IRS. Employees who choose to participate sign an agreement,
which is a contract authorizing the state to withhold compensation
and repay benefits according to the terms of the plan document.
The state then contracts with providers of investment options and
with a third party to carry out enrollment and record-keeping.
Thus, protecting the interests of both the employer and employees
requires well-drawn contracts, effectively monitored and enforced.
The Structure and Administration of 457 Plans
Investment providers and options. Participants can choose from
various products and providers to meet individual investment goals
and levels of risk tolerance. Insurance companies were the first
sector of the financial services industry to tailor investment
products for the programs. Surveys show that insurance and annuity
companies still hold the majority of the country's 457 program
assets, offered as two types of annuity products:
* Fixed annuities guarantee minimum interest rates, adjusted at
least once a year, and provide a low-risk way to accumulate
assets for retirement.
* Investments in variable annuities fluctuate with the value of
the underlying assets, usually growth stocks or mutual funds.
In addition to fixed annuities, certificates of deposit and life
insurance policies offer conservative participants low risk, fixed
investments. Mutual funds provide another choice for less risk-
adverse participants who want growth opportunities. In general,
457 program participants tend to invest their contributions
conservatively, choosing low-risk, low-return investments.
Participant Decisions
Employees who participate in 457 programs must make a number of
recurring decisions that can have significant effects on the amount
of supplemental retirement income they accrue. Participants
determine the amount of deferrals (above a specified minimum),
where to allocate deferrals, and whether to transfer funds among
investment options and/or providers.
When the accumulation phase of their participation ends (either at
retirement or termination), participants must decide what form of
benefit distribution to select and when it will commence. Under
IRS rules, this is an irrevocable decision. Participants select
from several payout options:
* Annuity contracts with insurance companies for fixed amounts
of income over prescribed periods of time.
* Periodic withdrawals from deferred investments.
* Lump-sum distributions.
* A combination of these options.
Overview of the Wyoming Plan
The enabling legislation for Wyoming's program, W.S. 9-3-501
through 9-3-507 [Appendix A], gives cities, towns, and other
political subdivisions the choice of establishing their own
deferred compensation program or joining the state's. Employers
affiliated with 106 political subdivisions throughout the state
have adopted the plan [Appendix B].
Administration. By statute, the State Treasurer serves as the
program administrator and chair of its advisory board. With the
advice of the advisory board, the administrator may:
* Approve investment of deferred compensation in insurance and
annuity contracts or other investment plans upon competitive
bidding.
* Establish by contract the fees for enrolling program
participants and servicing participant accounts with
providers.
Advisory board. The five-member advisory board is appointed by the
Governor, with the advice of the State Treasurer. It includes two
representatives of the state banking and investment community, two
state employees participating in the program, and one qualified
elector with business and financial experience. The board advises
the administrator on program administration, including:
* Investment of deferred compensation.
* Selection of providers.
* Selection and evaluation of the program coordinator.
* Establishment of policy governing overall program operation.
Trust account for plan administration expenses. The Legislature
authorized the deferred compensation program under the condition
that administrative costs would be absorbed by participants.
Providers pay fees to the Employees' Trust Account which are
derived from participant-paid fees and charges. The administrator
uses money in this account to pay program administration expenses.
Coordinator services. Statutes require the administrator to
contract, upon competitive bidding, with a Wyoming individual, firm
or corporation to serve as program coordinator. Coordinator
responsibilities include enrolling plan participants, servicing
participant accounts, and reporting to the administrator and the
advisory board. Currently, Wyoming Deferred Compensation, Inc.
(WDCI) serves as program coordinator.
State Auditor's Office role. In addition to the administrator and
the coordinator, the State Auditor's Office serves the program by
processing central payroll deferrals and making the appropriate
wire transfers to the providers.
Current Participation
Program officials reported plan assets totaling $129.4 million for
fiscal year 1995. The total deferral for March 1996 was $559,259.
If this rate of deferral remained constant throughout the year,
participants would defer an additional $6.7 million this year. The
coordinator's database included 7,952 names; this total represents
all individuals who have participated since the inception of the
program.
Active participants. There were 2,700 active participants, or
those deferring compensation to the plan during March 1996. They
represent 14 percent of the estimated 18,700 state and political
subdivision employees eligible to defer. Of the active
participants, 64 percent were state employees. The average
deferral for all participants was $207. The following table
provides a "snapshot" of active participants as of the end of March
1996:
Figure 1: Participant Characteristics
As Of March 1996
Participant Percent of Percent of Average
age group active March deferral
participants deferrals
25 yrs or less less than 1% less than 1% $102.59
26 - 35 years 12% 7% $116.56
36 - 45 years 36% 29% $163.97
46 - 55 years 38% 42% $230.82
56 yrs & older 13% 22% $344.27
Source: LSO analysis of coordinator data.
Inactive participants. The coordinator's database listed another
605 individuals who have plan accounts but did not defer
compensation to them in March.
Plan investment options. Participants can choose from five general
types of investment products offered by five providers. Two of the
five providers, Nationwide Insurance and Great West Life and
Annuity Insurance Company, offer fixed and variable annuities. One
provider, Dreyfus, offers mutual funds. A fourth provider, Great
Western Bank, offers FDIC insured certificates of deposit, and the
fifth provider, Colonial Life and Accident Insurance Company,
offers a universal life insurance policy.
As of year end 1995, nearly 76 percent of plan assets (this does
not include program reserves which are dedicated to pay annuitants)
were invested in fixed rate options: either certificates of
deposit or fixed annuities. Approximately 24 percent was invested
in variable investments. Less than one percent was invested in the
universal life insurance option. Figure 2 shows participants'
asset allocations:
Figure 2: Distribution of Plan Assets (this does not include
program reserves which are dedicated to pay annuitants) by Type of
Investment Product - As of December 1995
(Represented as a graph in report)
Fixed Annuities - 68%
Variable Annuities - 14%
Mutual Funds - 10%
Savings Deposits - 8%
Note: Life insurance policies, less than 1%.
Source: LSO analysis of data provided by coordinator
Most plan assets were invested with the program's insurance company
providers. The distribution of program assets among the four types
of investment providers is shown in Figure 3:
Figure 3: Distribution of Plan Assets (this does not include
program reserves which are dedicated to pay annuitants) by
Type of Provider - As of December 1995
(Represented as a graph in report)
Insurance Cos. 82%
Mutual Fund 10%
Bank 8%
Life Ins. Co 0%
Note: Life insurance company, .06%.
Source: LSO analysis of coordinator data.
Withdrawing benefits. Based on a review of a randomly selected
sample of 25 participants who had withdrawn from the program, we
found:
* The median age of participants when they began deferring was
54 years.
* The median age of participants at retirement was 60 years.
* The median account balance when distributions began was
approximately $35,000.
* Most retired participants selected an annuity form of benefit
distribution. For this group, the median monthly benefit was
approximately $450 over a 10-year period.
* The median age when distributions began was 67 years.
Assets Are Stable But Management Can Improve
In this report, we present findings about weaknesses in participant
education, poorly performing investments, unmonitored expenses, and
a lack of administrative checks, balances, and oversight. However,
these findings should not be misconstrued, and participants need
not be alarmed about the safety of their contributions and
benefits.
The philosophy, intent, and legal basis for the deferred
compensation program are strong. The purpose of this evaluation is
not to arouse fears among participants. Our findings are not about
money lost, but about opportunity lost. The intent of our
recommendations is to give policy makers and administrators
information on which to base improvements, so the program can reach
its full potential.
Finding 1: Better Educational Materials Are Needed To Ensure
Informed Program Participation
We found that opportunities exist to improve the kinds of
information available to employees to allow them to make informed
participation decisions. Participation in deferred compensation
often represents the first investment experience for many public
employees. By nature, investment materials are technical and
difficult for inexperienced investors to read and understand. We
found educational materials that would introduce the novice
investor to the program and assist the more experienced investor in
managing a portfolio are lacking. We believe program managers
could improve efforts to simplify complex information and produce
useful educational materials.
Although it is difficult to establish a specific cause and effect
relationship, we believe the lack of quality educational materials
tends to limit program participation and hinders effective
portfolio management by employees who do participate.
Marketing Deferred Compensation To Employees
Individual employees are responsible for deciding whether or not to
participate in the program and for selecting the types of products
and options in which to invest. For those who decide to
participate, the program provides a wide array of investment
options from which to choose.
To make informed investment decisions, participants must first
consider the types of investment products available through the
program and the risks and potential benefits of each. It is
important for them to have comparative information, such as:
* A detailed explanation of the plan, including basic investment
principles, geared for inexperienced investors.
* A description of the types of investment products available
and the risks and returns associated with each option.
* A comparison of the fees charged by providers for each
investment option offered through the deferred compensation
program.
Participants Cite Need For Information
While many of the participants we interviewed are satisfied with
the program, some expressed concerns that there is not enough basic
program and investment information available to make informed
choices. For example, if an employee expresses interest in the
program, the coordinator provides a generic packet containing
enrollment materials and prospectuses for more than 30 options
offered in the plan. The packet does not contain an explanation of
basic investment principles or describe how to use the materials.
Other participants were dissatisfied with the lack of information
provided to help them monitor their investments once they began
deferring.
Although individual participants must take the initiative and
educate themselves about the program, the state could assist in
this endeavor by improving the investment information offered. The
administrator and coordinator have raised legitimate concerns about
the distinctions between educating employees and advising them.
They do not want to be construed as giving investment advice.
Although we agree the program should be watchful about offering
advice, that does not preclude the need for basic investment
education. Many plan administrators in other states recognize that
a deferred compensation program can offer investment education --
as long as they do not offer customized advice, tailored to
individual needs.
Some Basic Program Information Is Lacking
Fee disclosure. The coordinator provides a limited amount of
written information to participants regarding the fees associated
with various investment options. We found this information hard to
understand, and in some cases misleading. Consequently,
participants may not be aware of all the fees for which they are
liable. The coordinator has not developed a complete and accurate
summary of all participant fees and expenses.
Depending on the investment, participants may be subject to
indirect expenses that reduce investment earnings. Providers
offering fixed fund options have agreed to reduce the effective
interest rate for these funds. The providers pay the difference
between the original interest rate and the actual rate to the Trust
Account monthly. Thus, this money is derived from a lower interest
rate than the provider would otherwise pay. Currently, program
officials do not disclose to participants this reduction to their
rate of return.
Participants with investments in variable funds are required to pay
for annual operating expense fees that the mutual fund company
charges. These fees vary by fund, and are disclosed in each fund's
prospectus.
Participants may not realize that these and other fees are charged
on their entire investment, not just each year's deferrals.
Ongoing annual expenses can have a long-term impact on investment
earnings. When the stock market is performing well and when
interest rates are up, the fees may seem insignificant. However,
when the market and interest rates are soft, fees reduce earning
potential proportionately more.
Inaccurate information. Some of the coordinator-provided
information regarding fees and expenses is inaccurate. For
example, the coordinator distributes one document comparing
providers' fees and terms. It states that Nationwide offers an
incoming transfer enhancement of four percent. However, the
document does not specify that this enhancement applies only to
transfers into fixed rate options. It also does not reveal that
transferred funds must remain with Nationwide for an established
period of time to maintain the credit.
Many of the other programs we reviewed disclose all fees, including
indirect expenses, in a comprehensive and easy to understand
manner. Several of these programs have also simplified the fee
structure. For example, participants in Utah and Illinois deferred
compensation programs pay only one administrative fee.
Effects Of Inadequate Information
Some participants may not be gaining the maximum benefits from the
program because they are not prepared to make basic investment
decisions. Based on our interviews, participants take pride in
their decision to invest in a supplemental retirement program, but
many have not thought through either their goals for the program or
how deferred compensation fits into a comprehensive retirement
plan.
We believe many employees may not understand basic investment
principles, such as fund selection, asset allocation, risk
assessment, or diversification. For example, nearly 76 percent of
the plan's assets are invested in fixed-rate options. While
investment choices are personal in nature, professionals note that
fixed-rate investments may not be the best choice for long-term
investors, because of their low yields and the effects of inflation
on these investments over time. Some experts contend that workers
need to be saving more, investing wisely, and, ironically,
investing less conservatively.
Program officials can provide better "tools" to assist participants
in making informed investment decisions. The Department of Labor
adopted regulations known as 404(c) in 1992, for private retirement
plans covered under the Employee Retirement Income Security Act of
1974 (ERISA), which recommend that sponsors provide more investment
education to participants. Although not required for 457 plans,
some plan sponsors are voluntarily following the 404(c) guidelines
to help employees make informed investment decisions.
Other states' deferred compensation programs provide excellent
models for education. For example, Wisconsin publishes a quarterly
newsletter that focuses on investment basics such as selecting a
mutual fund, creating a personalized investment mix, and
understanding basic market indices. Illinois publishes a
comprehensive guide that takes the participant through a step-by-
step planning and investing process.
Requirements For Educational Efforts Lacking
The administrator has not established well-defined expectations for
marketing the program and educating employees, and has not
communicated these expectations to the coordinator. For example,
the administrator has specified that the coordinator produce at
least two newsletters each year for participants. Although this is
a vital information source for participants, the coordinator has
only distributed nine newsletters plus some brief mailers and post
cards in the past seven years. We found that the administrator
primarily requires the coordinator to carry out minimal process-
oriented functions.
The administrator has not established specific goals for the
coordinator to achieve regarding educational and marketing efforts.
The contract between the two parties is structured so the
coordinator receives compensation whether employees elect to
participate in the program or not. Nevertheless, participants told
us that the coordinator, when contacted, is very helpful in
responding to their individual needs.
The coordinator appears to have focused recruitment efforts on
adding non-state entities to the program. The coordinator reports
91 such entities have adopted the program since 1985. It is not
clear whether these efforts have resulted in appreciable gains in
participation. Using the coordinator's estimate of number of
eligible employees, we calculated the participation rate for state
employees at 16 percent, and for local and political subdivisions
at 12 percent. If the administrator required the coordinator to
increase education and marketing efforts, the participation rate
might rise.
Recommendation: The administrator should require the coordinator
to improve educational materials and efforts.
In order to promote employee participation and provide ongoing
communication with participants, the administrator needs to more
clearly define short and long-term expectations for the program.
The administrator can require more effective services from the
coordinator by developing a performance-based contract. Such a
contract would require the coordinator to report results and meet
expectations for the program in the following areas:
* Providing feedback: The administrator should require the
coordinator to collect accurate and relevant data on marketing
efforts. For example, it would be important to review trends
in participation rates over a period of several years.
* Marketing the program: The administrator should establish
periodic goals for participation and require the coordinator
to administer a proactive marketing campaign that uses
comprehensive and understandable materials to explain the
program.
* Educating participants: The administrator could voluntarily
adopt those Department of Labor 404(c) guidelines which apply
to employee education, requiring informational materials
regarding basic investment principles. Also, the
administrator should require the coordinator to provide basic
information to enable participants to monitor their
investments. Educational materials should disclose all fees to
program participants, including indirect fees and expenses.
Finding 2: The Administrator Has Not Established An Effective
Investment Monitoring Process
We reviewed the performance of investment options in the deferred
compensation program and found a number of strong investment
options which have produced excellent rates of return for
participating savers. However, we also found that some other
investment choices were poorly rated and have not been producing
competitive long-term earnings, or "yields." This is important
because lower yields decrease participants' investment earnings and
can limit financial independence during retirement.
Participation in the deferred compensation program can provide an
effective and convenient method for public employees to prepare
themselves financially for retirement. However, the adequacy of
retirement savings depends not only on the amount of contributions
made, but also on the earned rate of return. Although it is up to
participants to judge relative risks and potential benefits of the
program's various investment options, the administrator determines
the range of choices that will be available.
We found the Wyoming deferred compensation program does not include
a rigorous process to periodically review the performance of
investment alternatives so that poorly performing options can be
eliminated or replaced. Both the administrator and the coordinator
told us they informally review investment literature on a regular
basis. Neither, however, has developed a regular, systematic
process -- such as an annual review of long-term performance -- to
evaluate program investment options based on results and eliminate
poor performers.
Performance Of Investment Options
Fixed-rate funds. Because three-fourths of the program's assets
are invested in fixed return options, we analyzed the performance
of the deferred compensation fixed-rate funds. We reviewed the
rates of return offered by these investment options and compared
them to yields on U.S. Treasury notes and bonds, which are
considered suitable indicators. We found that the fixed-rate fund
alternatives generally offer competitive rates in relation to these
indicators.
However, we learned that Montana's program negotiated a more
favorable rate for deferrals made to Nationwide's fixed-rate fund.
Wyoming's participants in this company's fixed-rate option -- which
is our state's most popular choice -- earn one half percent (0.5%)
less. Overall, while we felt that the fixed rate funds offered
competitive rates, it appears that some opportunities for
enhancements may exist.
Figure 4: Mutual Fund Performance
Compared To Industry Benchmarks
Annualized Returns For The Period Ending December 1995 (From the
Wall Street Journal, compares performance among funds with same
investment objectives.)
Mutual Fund Name 5-Yr Bench- Difference 5-Yr
Avg mark Rank
20th Century Ultra 23.92% 19.51% +4.41% A
20th Century Ultra 23.88% 19.51% +4.37% A
Vista Growth and Income 19.64% 15.48% +4.16% A
Putnam Voyager Fund 21.31% 17.46% +3.85% A
Fidelity Magellan 19.29% 16.29% +3.00% A
Dreyfus A Bond Plus 10.75% 8.97% +1.78% B
Bond Fund of America 10.55% 8.97% +1.58% A
T-Rowe Price Int'l 10.61% 10.06% +0.55% B
Fidelity Advs Inc & Gwth 12.75% 12.95% -0.20% B
Dreyfus Appreciation 15.79% 16.29% -0.50% C
Growth Fund of America 15.68% 16.29% -0.61% B
Nationwide Growth Fund 14.98% 16.29% -1.31% C
20th Century Balanced 11.45% 12.95% -1.50% C
Dreyfus New Leaders 19.23% 20.86% -1.63% D
20th Century Growth 13.72% 16.29% -2.57% D
Dreyfus Third Century 13.20% 16.29% -3.09% E
Nationwide Fund 12.33% 15.48% -3.15% E
Dreyfus Gth Opportunity 12.16% 16.29% -4.13% E
Dreyfus Fund 11.21% 15.48% -4.27% E
20th Century Select 9.41% 15.48% -6.07% E
Source: LSO analysis of data provided by Wyoming Deferred
Compensation, Incorporated and the Wall Street Journal.
Variable rate funds. Approximately one-fourth of program assets
are invested in variable funds. Because more than one-third of
active participants have some money invested in these variable
funds, and because these funds offer opportunities for significant
earnings, we believe this aspect of the program deserves careful
analysis.
As an indication of rate competitiveness, we reviewed a sample of
20 of the program's mutual fund investment options. In Figure 4,
we compare the performance of these funds to industry benchmarks,
which serve as reference points for comparisons of funds with
similar investment objectives. We also evaluated these funds using
benchmarks established by the Morningstar mutual fund rating
service and found similar results. Based on this preliminary
analysis, we believe the presence of questionable performers
demonstrates the importance of establishing a rigorous investment
monitoring process.
For our analysis, we relied on information published in the Wall
Street Journal because it was thorough, authoritative, and widely
available. The Journal provides interested investors with a source
of performance benchmarks as well as fund rankings. Mutual funds
that perform in the top 20 percent of all funds with the same
objective earn an "A" ranking. Similarly, funds in the second 20
percent interval earn a "B" ranking, and so on, to the bottom 20
percent which earn an "E" ranking.
For the group of 20 mutual fund options we reviewed, more than half
(12 out of 20) underperformed their benchmarks. Moreover, seven of
these alternatives earned either a "D" or "E" rating -- indicating
their performance was near the bottom of all funds with similar
investment goals. Given that there are many options in the
marketplace, we think there is little reason to include poor
performers in the program's offerings.
Impact Of Weak Investment Options
Public employees who participate in deferred compensation and who
select investment options that pay less than competitive rates
increase the risk that they will be financially unprepared for
retirement. These participants will be less able to provide for
their own financial needs in retirement due to reduced yields on
their savings.
Our analysis showed that a large number of participants have at
least part of their investments in underperforming funds. As of
March 1996, we found that 990 of the 2,700 active participants (37
percent) had deferred income to "D" or "E" rated funds. Overall,
the total amount invested in these poorly rated funds was $13.6
million.
Neighboring States Use Strong Review Processes
We contacted officials in neighboring states to learn how they
review investment performance in their deferred compensation
programs. South Dakota, Utah, and Colorado have established
explicit criteria or benchmarks to facilitate comparisons.
Nebraska and Montana intend to do so within the next few months.
Also, both Montana and Colorado have used independent consultants
for evaluations. Utah has an in-house investment department for
reviews, and Nebraska will use a state investment officer for
evaluations, beginning in July 1996. South Dakota, Idaho, Utah,
Colorado, and Nebraska officials said they were prepared to use the
information gleaned from evaluations to drop or "wall-off"
underperforming funds.
Recommendation: The administrator should direct a comprehensive
performance review of investment options to eliminate
underperforming funds.
The administrator, in consultation with the advisory board, should
direct a comprehensive review of all investment options available
through the Wyoming deferred compensation program. This could be
accomplished with the assistance of a qualified contractor, as it
is done in some other states. This review should identify the
program's underperforming options and provide recommendations for
improvements which can be considered by the administrator and
advisory board. Finally, to ensure ongoing competitiveness,
procedures should be developed which require periodic reassessment
of the program's investment options at defined intervals.
Finding 3: Effective Controls Are Needed To Contain Administrative
Costs And Participant Fees
Our review revealed a lack of management controls necessary to
minimize program costs and associated participant fees. Under this
program's structure, costs and fees effectively reduce participant
earnings. As a result, we believe opportunities exist for the
administrator to improve the program's cost-effectiveness and
increase participant earnings.
Participants Pay Fees To Cover Program Costs
The Legislature established Wyoming's deferred compensation program
with the intent that program costs would be absorbed by
participants, not the general fund. To accomplish this, providers
deposit money into the Employees' Trust Account each month to pay
for the state's cost of operating the program. Directly or
indirectly, participants pay some or all of those fees which
providers remit to the Trust Account.
Depending on their investment choices, participants pay various
fees, which can include: annual maintenance charges, basis point
fees, annual mortality expense risk fees, and contingent deferred
sales charges [Appendix C]. Providers derive fees from participant
earnings; they retain some of the money, remit some to the Trust
Account, and redistribute some to subcontractors. Due to the
complex nature of these transactions, and because these
relationships are not established in the contract between the
administrator and the providers, we were unable to determine the
specifics of this cash flow.
In 1995, the program's five providers remitted $304,110, derived
from various participant-paid fees and charges, to the Trust
Account. From this account, the administrator pays for program
expenses such as the coordinator's contract and board costs. For
1995, administrative expenditures from the Trust Account totaled
$273,152.
Program Costs Have Escalated
The administrator and board have not established controls over
program costs, and as a result, these costs have been escalating.
The coordinator's income from the deferred compensation program has
increased steadily during recent years. In 1989, that income was
$186,670. By 1995, it was $312,274, for an increase of 67 percent
in seven years. The coordinator receives this compensation from
two sources: from the Trust Account, and from commissions paid by
providers based on the sale of certain investment products.
We attempted to compare a per-participant cost of administration
with other states' 457 plans. However, we found each plan had
defined participation and divided administrative responsibilities
somewhat differently, making direct cost comparisons virtually
impossible. There is no national standard or benchmark for per-
participant administrative costs. Without industry benchmarks to
use as a standard or guideline, it is all the more important that
the administrator and board exercise vigilance in controlling
operational costs.
Coordinator receives compensation from Trust Account. Under terms
of the current contract, the administrator pays the coordinator a
fixed monthly amount of $18,000, plus reimbursement for in-state
travel expenses at state mileage and per diem rates. The contract
has not established incentives designed to encourage the
coordinator to control administrative costs. Instead, the
administrator says he bases the contract amount on historical
expenditures.
The administrator and board have not developed a process for
annually scrutinizing and tightly managing the coordinator's
proposed budget. In the seven years from 1989 through 1995, the
coordinator's compensation from the Trust Account increased from
$170,960 to $234,129. Although the contract did not require
changes in duties or performance, base compensation increased
$63,169 or almost 37 percent.
When the contract for coordinator services was rebid in 1994, one
company proposed an alternative to the flat fee approach for
coordinator services. The company suggested fixing payment at a
base amount, plus a per-participant charge which would decrease as
membership increased. Although this approach was not adopted, we
believe it would have had several advantages over the current
arrangement, which pays a flat fee plus specified reimbursements.
It would have provided an incentive for the coordinator to recruit
new participants, and it would have lowered the program's
administrative costs for the bid year.
Coordinator also receives commissions from providers. In addition
to contract amounts, the coordinator also receives and keeps a
commission on all variable products sold through the life insurance
companies, plus a commission on Colonial Life premiums. The
administrator allows commissions to flow to the coordinator without
either management controls or associated performance expectations.
Essentially, this sets up an "off-budget" revenue stream that
benefits the coordinator, not participants.
Commissions are derived indirectly from participants and paid to
the coordinator, with essentially no strings attached. The life
insurance companies which pay these commissions charge an annual
mortality expense risk fee annually against the participant account
balances. One source suggests that insurance companies charge the
annual mortality expense risk fee, in part, to pay commissions.
Consequently, the commission arrangement appears to reduce
participants' investment earnings.
This arrangement diverts income away from the Trust Account, where
it could be managed to benefit participants. Also, we believe
there may be a perceived conflict of interest in this arrangement
since the coordinator retains commissions for variable products,
but does not disclose that information to participants unless
asked.
Before 1989, providers paid commissions to the coordinator, who
forwarded the amounts to the administrator for deposit into the
Trust Account. This arrangement was devised because providers can
pay commissions only to registered sales agents; commissions cannot
be paid directly to the state.
In 1989 the administrator decided the commission amounts were
insignificant and that it would be simpler to allow the coordinator
to retain this income as an "incentive." We found no indication
that the board approved this arrangement and the administrator did
not specify what goal this incentive was intended to attain. The
administrator and board did not tie the incentive to performance
expectations and did not require an offset or reduction to the
monthly contract amount. The coordinator says commissions are used
to pay program expenses, even though program expenses are
purportedly covered under the contract with the administrator.
The commission amounts have become substantial in recent years.
The coordinator reported receiving commissions totaling $78,145
during 1995. That amount was fully 25 percent of the coordinator's
total revenues for the year. The coordinator believes 1995
commissions may have been high due to the large number of early
retirees taking advantage of catch-up provisions.
Figure 5: Commissions Paid to Coordinator
(linear graph unable to translate to Ferret)
Source: Annual financial audits
In annual financial audits, the coordinator reports commissions
received from providers. This information showed that the
commission totals have increased from $15,710 in 1989 to the
current $78,145. This represents an almost 400 percent increase
during a seven-year period. While the administrator has received
the audits showing substantial increases, the coordinator is still
allowed to retain these commissions.
Administrative Fees Reduce Investment Earnings
There is a direct correlation between administrative fees and a
participant's investment earnings. Although fees reduce investment
returns, the administrator and board do not regularly and
comprehensively review participant fees. Thus, they may not be
aware of the inter-relationship and the cumulative effects of such
expenses on participants.
The administrator has some leverage in negotiating certain fees
with the providers. The total charges a participant experiences
will vary from one investment to another, depending on the type of
investment (fixed or variable) and on what is allowable within the
provider's contract with the administrator.
The administrator has successfully negotiated to reduce several
provider fees. However, in 1993 the administrator negotiated with
providers to reduce the interest rate they would pay on
participants' fixed investments, and pay the difference into the
Trust Account. In addition, the administrator has asked one
provider to continue charging fees they were willing to forgive.
The administrator said these moves were necessary to increase Trust
Account reserves.
The administrator has stated a goal of making the Trust Account
"solvent," meaning it should contain an amount sufficient to cover
one year's administrative expenses. According to the
administrator, if the trust account were solvent, he could
negotiate with providers to reduce administrative fees. Lower fees
would improve participants' rates of return. However, we found the
administrator has not developed a plan to increase the Trust
Account by controlling the expenditures which reduce it.
Annuity-wrapped funds increase expenses. Variable products sold
through life insurance companies are similar to mutual funds, but
are packaged with an "annuity wrapper" by the companies. While
annuity wrappers provide benefits, such as tax reporting and access
to a broader range of investment options, the wrapper also involves
extra participant fees.
The program is heavily weighted to insurance company providers. We
found no evidence suggesting the administrator and the board have
systematically considered the costs and benefits to participants
from annuity-wrapped investments. Some state programs contract
only with mutual fund houses, enabling them to eliminate
participant fees associated with annuity-wrapped funds.
Twenty of the 27 (74 percent) variable products available in
Wyoming's program are offered through Nationwide and Great-West
Life insurance companies. We calculated the median fees charged
for the variable products offered by the insurance companies to be
1.82 percent per year. By contrast, the median fees for the mutual
funds offered through Dreyfus are .96 percent. The insurance
companies have higher cumulative fees due to a .85 percent
mortality expense risk fee on the annuity-wrapped funds.
The annuity wrapper, with the associated mortality expense risk
fee, buys the participant some insurance and offsets the providers'
risk. In effect, the wrapper protects the principal investment for
beneficiaries. The extra fees paid guarantee that if the investor
dies before beginning withdrawals, the beneficiary will be entitled
to, at a minimum, the original investment. However, some analysts
maintain that investors may not need this insurance if they are
long-term investors, because the stock market has not lost money
over any 10-year period since the Great Depression.
Finally, people who invest in an annuity product offered inside a
retirement plan may be misinformed about the benefits they are
obtaining. A 457 plan is a tax deferral program; annuities also
offer a tax deferral for investments. If an investor is depositing
money to an annuity-wrapped investment within a tax-deferred
retirement program, little is added but an additional layer of
fees.
Administrator Has Not Ensured That Program Costs And Fees Are
Reasonable
W.S. 9-3-507 authorizes the administrator to manage fees and
expenses to provide "maximum investment earnings and benefits to
program participants." This statute, in effect, asks the
administrator to plan, budget, contract for, monitor, and control
administrative expenses. We found a lack of such systematic
controls. Without these means of evaluating and managing program
costs, the administrator cannot ensure that statutory intent is
being met. Participants may be receiving a lower rate of return on
their investments than would be possible if administrative costs
and participant fees were carefully monitored and controlled.
Recommendation: The administrator should review program costs and
fees and consider alternatives to increase participant yields.
Administrative expenses, participant-paid fees, and investment
yields are linked; individually and collectively, they affect
participant yields. It is very important that the administrator
exert control over these aspects of the program.
The administrator and the board should take steps to control and
reduce administrative costs. They should also consider requiring
the coordinator to deposit commissions into the Employees' Trust
Account. This money should be used to augment the Trust Account, so
the program has more leverage when negotiating with providers.
In addition, they should undertake a comprehensive analysis of
participant fees, with a view to reducing them where possible. The
administrator and board should also consider whether Wyoming's
program should be so heavily weighted to annuity-wrapped options.
While it may be appropriate to offer some variable annuity products
for those investors who like this option, many participants may not
understand that they are paying additional fees to have these
products packaged through an insurance company. Together, these
steps could have the desired effect of increasing participant
returns.
Finding 4: Deficiencies Identified In 1985 Are Unresolved
In 1985, a legislative interim committee studied Wyoming's deferred
compensation program and reported concerns about effective
oversight and management of the program, as well as concerns about
accountability to participants. More specifically, the report
identified problems in three main areas:
* Lack of board involvement in decision making.
* Lack of competitive bidding for coordinator services.
* Confusion regarding the effects on participants when a
provider contract was terminated.
The Legislature strengthened some statutory provisions, but 11
years after the committee's report, we determined there are still
significant weaknesses in these three areas. In addition, we found
that participants are not protected by performance-based
coordinator and provider contracts, some participant benefits are
not guaranteed in the contracts, and there are no formally
promulgated rules to guide effective program administration.
Board Expertise Has Not Been Fully Used
With assets of nearly $130 million, the deferred compensation
program warrants top quality advice from investment professionals
and participants. Recognizing this, statutes require the
administrator to consult with an advisory board on matters
pertaining to provider contracts, evaluation of investment plans,
coordinator selection, and policy development.
However, the board has not materialized as a potential source of
balance and expertise. The board does not routinely and
systematically evaluate the investment mix, the performance of
individual investment options, or the coordinator's performance.
This may have occurred because the board holds brief and infrequent
meetings. Our review of minutes indicates the board generally
meets only twice a year, the minimum required by statutes, at lunch
meetings lasting one and one-half hours.
In addition, the administrator does not provide members the
information which would be needed to formulate an independent
stance. Board members appointed in 1996 told us the orientation
given at their first meeting was weak. Board packets (briefing
materials and reports) include limited data, such as the number of
new contacts the coordinator has made, and allocations by provider.
The packets do not contain the kind of analytical information that
would assist members in evaluating program performance and in
developing policy. Annual financial audits are narrow in scope,
covering only the administrator's contract with the coordinator.
These audits do not give board members a program-wide perspective.
The administrator prepares meeting agendas and chairs the meetings.
The board receives updates from the coordinator and administrator
and rarely suggests policy changes, offers advice, or takes votes
on issues. The minutes note a total of nine votes taken during six
years of meetings, from 1990 through 1995. We found the board
tends to ratify decisions already made and actions already taken by
the administrator. One member characterized it as a "token board."
Unreliable program information. We found the board has received
some unreliable program information from the administrator and
coordinator. We attempted to gather basic data on the number of
program participants and on participation rates over the life of
the program, but found considerable variation in the numbers
reported from one year to the next. We determined this occurred
because the definition of a program participant had often changed.
Also, we found the coordinator does not have a reliable method of
counting the number of eligible employees. These inconsistencies
tend to undermine confidence in the program's self-reported
accomplishments. Because of these problems, we could not determine
whether participation rates had increased, decreased, or remained
steady.
We noted another discrepancy in the value of program assets which
had been reported in the state's annual financial report. It
appears that a $13.5 million over-reporting had occurred on the
fiscal year 1994 report. Without reliable basic program
information, the board cannot accurately evaluate the program or
provide the feedback necessary to improve it.
Regular And Open Bidding Has Not Occurred
W.S. 9-3-503(a) and 506(a) authorize the administrator, with the
advice of the advisory board, to approve contracts with providers
and a coordinator upon competitive bidding. The statutes do not
require periodic rebidding of these contracts.
Open bidding for provider and coordinator services at regular
intervals is common among other 457 programs. However, we found
that the administrator has not established a process for conducting
competitive, open bidding on a regular basis. Without benefit of
that process, participants in Wyoming's program do not have
assurance that they are receiving the best administrative services
and investment options at the lowest cost.
Coordinator services. Other states' plans have found there are
advantages to soliciting competition for coordinator services on a
regular cycle of three to five years. Although competition can
encourage high quality services and help contain administrative
costs, the administrator and board have not incorporated open
bidding into Wyoming's program.
The administrator issued a request for proposals (RFP) for
coordinator services two times in the program's history. The first
was in 1977, resulting in a contract with the Public Employees
Benefit Services Corporation (PEBSCO), a subsidiary of Nationwide.
Later, the program contracted with National Benefits, Inc., which
was the umbrella firm of Wyoming Benefits, Inc. This firm acted as
coordinator until 1985, when the administrator contracted with
Wyoming Deferred Compensation, Inc. (WDCI). The administrator did
not request competitive bids prior to entering into the 1985
contract.
Since then, minutes show that board members discussed competitive
bidding on several occasions but preferred to continue contracting
with WDCI. In interviews with us, the administrator and board
members cited a high rate of satisfaction among participants with
this coordinator's performance. However, in 1994, after a
participant complained about lack of open bidding, the
administrator issued an RFP for coordinator services. The RFP was
widely distributed, the incumbent competed for the contract, and
the administrator sought board input on the decision.
However, we concluded that the RFP was drafted in a way that
favored the incumbents, WDCI. We found no evidence that the board
had reviewed and approved the RFP prior to issuance. The RFP did
not require specific performance expectations, or outcomes, be met.
Instead, it focused on incidentals, and its requirements appear to
describe WDCI's operation [see Appendix D].
For example, the RFP required 1,600 square feet of office space,
including a work room at least 300 square feet in size with tables
and shelves. It required an exact number of personnel with certain
qualifications; the number and qualifications mirrored the staffing
pattern of WDCI. Finally, the RFP required the bidders to provide
specified items of office furniture and equipment, including a
vacuum cleaner, dictation equipment, coffee maker, and a fire
extinguisher. It is not clear how items such as office size and
specific pieces of minor equipment would contribute substantially
to the quality of services provided by a coordinator.
Only three proposals were received in response to the RFP: WDCI,
Great-West Life (a provider), and Penuel Benefits Group, Inc. The
administrator and the board awarded the contract to WDCI despite
the fact that it was not low bidder among the three companies.
WDCI's five-year contract expires in 1999; since the program's
inception, contracts for coordinator services have consistently
been awarded to firms associated with or operated by members of the
same family.
Provider services. Provider services have not been bid openly
since the early years of the program. The administrator has
contracted with some of the same investment providers since the
early 1980s, and last added a new provider in 1990. In 1991,
citing concerns that participants would be confused by too many
providers, the board and the administrator voted not to add any
more providers. Instead, they voted to add other options through
the current providers, without going through the RFP process.
That policy is still in effect, and it limits other options which
could benefit participants. Because the providers appear to be
locked in, there is little incentive for them to improve current
contract terms. In addition, other providers may have different
programs and better terms to offer, but they are effectively closed
out of the program. A former board member described this as a
"comfortable arrangement" for the administrator, board, and
providers.
Contract Negotiation And Oversight Are Weak
The administrator is responsible for negotiating favorable
contracts that will protect participant contributions and enhance
earnings. Contracts with providers and a coordinator specify the
types of investment options offered, whether the program is run
economically, and the degree to which provider fees will affect
participant yields. Contract terms are important because the state
owns the assets and is therefore accountable to participants for
managing them properly.
Provider contracts. We reviewed the two current contracts with the
largest provider, Nationwide: one for fixed rate investments and
the other for variable funds. Since 68 percent of program assets
are held by Nationwide, our analysis focuses on their contracts.
We found the following examples of provisions which could be
strengthened to protect participants:
* The contracts allow the company to charge a deferred sales
charge on all fixed fund qualified withdrawals, including
retirements and job terminations. (The administrator says it
is not the company's practice to invoke this charge.)
* A 1991 contract endorsement with Nationwide states that it
will pay a four percent enhancement on money transferred into
fixed funds from another company. However, the 1993 contract
which supercedes that endorsement says the company may pay the
enhancement. (The administrator says the company has never
failed to pay the full four percent.)
* The contracts limit exchanges within company options and
transfers of funds out of the company to no more than 10
percent per year of total fixed rate funds. (The
administrator says this has not been a problem.)
Whether the contracts continue in effect or the administrator
terminates them, Nationwide is well protected. At any time, the
company may decide to pay less than the four percent enhancement on
funds transferred into fixed options. On termination, it can
deduct two percent from retirees' accounts and can retain control
over 90 percent of program deposits for the first year and 90
percent every year thereafter.
We did not find comparable protections for participants in the
Nationwide contracts. The administrator and coordinator maintain
that the company adheres to informal agreements which protect
participants from such charges. They told us the items listed
above are just generic contract provisions, or company
"boilerplate."
Nationwide holds over $80 million in program assets. Under these
circumstances, we believe informal agreements are not strong enough
to protect participants in this program. Circumstances may change
and the company's performance could become less satisfactory. In
order to move to a more competitive provider, the administrator
could face major contractual and financial obstacles.
Coordinator contract. We reviewed the administrator's contract
with the coordinator and found areas in need of improvement:
* The coordinator's contract contains no requirements or
incentives to improve its performance in marketing and
enrollment.
* The contract requires the administrator to pay a flat fee plus
certain reimbursements for actual costs; the contract is not
structured to encourage cost control.
A contract that contains neither performance incentives nor cost-
controlling mechanisms means there is no way for the coordinator to
fail. Under these circumstances, participants have no assurance
that they are paying a competitive amount for the best possible
program administration.
Other contracting issues. The administrator's process for
negotiating contracts, monitoring adherence, and retaining
associated records is relatively unstructured. The administrator
conducts contract negotiations without active involvement by the
board. We found no evidence that the Attorney General's Office has
reviewed these contracts, which involve many millions of dollars.
During our research, we discovered that the contract with one
provider, Colonial Life, had expired in 1994. Funds continue to be
deferred to that company. Also, we experienced considerable
difficulty in obtaining complete program records such as contract
addenda and letters of agreement. Of the documents made available
to us, some were stored with the administrator, others with the
coordinator, and others had to be requested from the providers.
These problems caused us to question who is in charge of contract
oversight.
Finally, we reviewed two 1990 agreements between the administrator
and the coordinator. By terms contained in those agreements, the
agreements purported to be no-interest loans to the coordinator for
two purposes: to pay early retirement expenses of a WDCI employee,
and to purchase office furniture for WDCI. These uses of the
Employees' Trust Account do not appear to be consistent with
statutory purposes for the account or with an arm's length
contractual relationship. If they were in fact no-interest loans,
they may also have violated the Wyoming Constitution. We found no
indication that the Attorney General's Office had reviewed these
agreements.
Although these agreements seemed unusual, we did not find
indications that this was a recurring practice after 1990.
Therefore, at present, we see no apparent danger to the Trust
Account.
Participants May Be Penalized If Administrator Terminates Contract
Contracts with Wyoming's largest provider, Nationwide, allow the
administrator to terminate, but under conditions which appear to
favor the provider. Prior to 1990, Montana had similar fees and
charges in its contract with Nationwide. However, Montana
negotiated with the company and is now in the last year of a six-
year phase-out of the contingent deferred sales charge (CDSC).
If the administrator decides to terminate a Nationwide contract,
the owner (the state) must pay several kinds of fees. The likely
source of such payment would be the Employees' Trust Account,
individual participant accounts, or both. The company would be
entitled to the following fees and charges:
* Contingent Deferred Sales Charge Applies to fixed and variable
funds 2 percent if participant has had an account with
Nationwide for 14 years or less; 1 percent if 15 years; no
charge after 16 years.
* Market Value Adjustment (MVA) Applies to fixed rate funds An
amount which the company determines (emphasis added), "in
accordance with its then current procedures applicable to all
Contracts of this type and class, would be the net capital
loss, if any, resulting to the Company if investments were
liquidated to make the lump sum withdrawal."
* Pro-rata Administrative Charges Applies to fixed and variable
rate fund accounts Currently $12 per participant per year.
Since one fee, the MVA, would be determined solely by the company,
we were unable to estimate what the total of these charges would
be. However, if this contract is terminated, it is clear that many
participants are at risk of significant charges to their accounts.
Such an event might occur if Nationwide were to give such
unsatisfactory performance that the administrator and board find it
necessary to end the contract.
Other factors. Nationwide was Wyoming's first provider in 1979;
five years later, the administrator canceled the contract due to
"several administrative problems with Nationwide." The company was
allowed back into the program several years after that and since
then, has attracted the bulk of program participants and their
assets.
The state of Massachusetts also experienced difficulty with
Nationwide and in September 1992, sued the company. The state
maintained Nationwide was overcharging participants on
administrative fees, assets charges, and deferred sales charges.
Several months later, the dispute was settled on terms favorable to
the Massachusetts participants.
In light of this background, we believe good business practice
calls for contract terms that protect participants and hold them
harmless in the event of a termination. Such changes were not made
when Nationwide's contract was renewed in 1993. The
administrator's current contract with the company expires in 1999;
until then, the CDSC and MVA remain in effect.
Eligibility Needs More Careful Definition
While Wyoming statutes establish a basic definition for program
eligibility, the administrator has not adopted a more detailed
policy to guide the coordinator in approving other pubic entities
for membership. As a result, several organizations have joined the
program and their employees are participating, even though they may
not technically be eligible under Wyoming statutes.
If questions arise, the coordinator uses two tests: the Internal
Revenue Code, and state retirement system eligibility. However,
the statutes establishing eligibility for state retirement are
quite different from those establishing eligibility for the
deferred compensation program. Thus, in some cases, it appears
likely that the deferred compensation program may be out of
compliance with its own statute regarding eligibility. We question
in particular the participation of employees of a children's center
and several counseling services, as they appear to be private, not
public, entities.
Reasonable Program Standards Exist
All 457 plans are exempt from ERISA requirements, but professionals
in the field encourage programs to adopt the standards and
practices set forth in that legislation. We believe ERISA
standards represent good risk management techniques, and adherence
to them would support the best interests of participants. The
principles stress an administrator's duty to:
* Regularly review investment expenses.
* Monitor investment performance on at least an annual basis,
and be prepared to replace one investment option with another.
Neighboring states' 457 programs provide excellent models for
several of these principles:
* Colorado employs a consultant to conduct an annual performance
review of investment portfolio mix and performance.
* Idaho monitors investment results quarterly.
* Montana discloses all administrative fees in the initial memo
of understanding signed by each participant. It contracts
with a consultant for assistance in bidding and negotiating.
In Wyoming, recent legislation establishes standards for oversight
of investment of state funds by the Farm Loan Board. Effective
July 1, 1996, the State Treasurer must report quarterly on the mix
and performance of certain investments. The new law also requires
the Farm Loan Board to adopt a state investment policy, including
definition of risk tolerance, quality standards for investments,
procedures for selecting and dismissing investment managers, and
benchmarks for evaluating investment returns. We believe
guidelines similar to these, if applied to the deferred
compensation program, would improve program accountability.
Recommendation: The administrator should develop a plan to
strengthen program accountability.
Deferred compensation participants need tangible assurances that
the program is protecting and maximizing their investments.
Assurance can come from such sources as established benchmarks for
evaluating program performance, collection of accurate and reliable
data, promulgated rules, and from incorporation of more board
member and consultant expertise in the decision making.
The administrator should develop a comprehensive plan for
addressing the program's operational weaknesses. Important
procedural safeguards should include: regular and open bidding of
contracts; criteria for selecting a coordinator, providers, and
investment options; at least an annual review of investment mix and
performance; and a similar review of coordinator performance. In
addition, the administrator should take steps to clarify questions
about program eligibility, perhaps by proposing legislation that
would conform statutes to current practices.
An initial plan should be submitted to the Management Audit
Committee by October 1, 1996 so the Committee can review it and
determine if statutory changes should be proposed for the 1997
legislative session. The plan could also include an analysis of
alternate placement options for the program. The 1985 interim
committee report on deferred compensation suggested the possibility
of moving the program to the Retirement System or to the State
Auditor's Office. Eleven years later, the idea of examining
alternate placements for the program continues to have merit.
Conclusion
According to retirement planning experts, deferred compensation
plans for state and local employees represent one of the most
beneficial and least expensive benefits available for public
employees. For more than 15 years, such plans have been available
to public employees to help them prepare for retirement and
minimize their dependency on government in their later years.
However, the success of deferred compensation depends on strong
administration, effective employee communication, and responsible
selection of investment options.
We found that Wyoming participants tend to place a great deal of
trust in this program and in the individuals in charge of it.
During interviews, several participants told us they "assumed" the
investment options were carefully chosen and their performance
closely monitored. Participants were pleased with the program
coordinator's helpful, customer-oriented focus. Many were
obviously proud of the retirement nest eggs they had accumulated in
deferred compensation by foregoing a part of their regular
paychecks.
With these perceptions at work, however, participants may have let
down their guard. Because of the plan's "official" state-
sponsorship, participants may not be as vigilant in monitoring and
protecting their assets as they might be in other investment
settings. Therefore, public officials have a fundamental duty to
monitor and protect those assets.
The administrative weaknesses identified in this report indicate
that such a high level of participant trust may not be fully
warranted. We found the program lacks precise goals and well-
defined rules, policies, performance benchmarks, and rigorous
monitoring procedures. This is not to suggest that participants'
assets are at risk, but rather to stress the importance of careful,
consistent, long-term management and direction at the state level.
These administrative weaknesses limit the potential of the program
to help public employees prepare for a secure retirement.
Moreover, solutions to some of these problems have languished for
more than a decade, since they were first identified in a 1985
legislative report. During the intervening years, the program has
not undergone close scrutiny and officials have not resolved
critical shortcomings. With this report, we call for improvements
which are necessary to ensure the quality, cost-effectiveness, and
integrity of this important program.
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