April 20, 2023

Can a divided congress find common financial ground?

By Mike Townsend

The 118th Congress has been underway for three months, but razor-thin majorities in both chambers have made for a slow start to 2023. Democrats hold a 51-49 majority in the Senate, while Republicans have a 222-213 advantage in the House of Representatives. The sharp divide between the two chambers means major legislative accomplishments are likely to be few and far between this year.

But there is one critical issue that will require a bipartisan solution soon: the debt ceiling. Few issues in Washington have as direct an impact on the markets as a debt ceiling showdown.

The debt ceiling is the cap Congress puts on the total amount of debt the United States can accumulate. Congress raised the cap to $31.4 trillion in December 2021. On January 19, 2023, the U.S. hit the cap, meaning the Treasury can no longer borrow to pay the nation's debts. The Treasury Department has been taking "extraordinary measures," a series of administrative steps to ensure the country does not default, but those measures are expected to run out in late June or early July. Congress must either increase or suspend the debt ceiling by then or risk a potentially catastrophic default that could have reverberations across the global economy.

Both parties have staked out their positions. President Biden and Congressional Democrats have said they will only support a "clean" debt ceiling increase, with no strings attached. Republicans are demanding that a debt ceiling increase be paired with significant spending cuts to get the federal deficit under control. There has been virtually no progress toward finding a compromise.

The market's concerns stem largely from painful recollections of the 2011 debt ceiling battle. Washington had the same political configuration then as now—a Democrat in the White House, Democrats controlling the Senate, and Republicans controlling the House. The two parties couldn't reach an agreement in the weeks leading up to the default date, rattling the markets. The S&P 500 fell 16% in five weeks, volatility spiked, and Standard & Poor's downgraded the U.S. credit rating for the first time in history. At the last minute, Congress reached an agreement to raise the limit and the markets stabilized. A replay of the uncertainty and, potentially, the market volatility, looks likely in 2023.

Congress is waiting for a more specific deadline from Treasury Secretary Janet Yellen as to the true "default date." A date could be announced soon, after Treasury has assessed the level of April tax receipts. Negotiations should accelerate once the default date is known. Leaders of both parties have been adamant that they won't let the country default, but the path forward is murky. Markets will be watching carefully to see if the divided Congress can avoid a fiscal calamity.

Bank collapses spark questions on Capitol Hill

Another issue that has captured the attention of lawmakers and regulators is the stunning collapse of Silicon Valley Bank, the second-largest bank failure in history. Two other mid-sized banks – Signature and Silvergate – also failed in March, and First Republic of San Francisco received an infusion of cash from 11 large US banks. The turmoil has sparked a flurry of activity on Capitol Hill and at the bank regulatory agencies.

During two days of hearings on the banking crisis in late March, top officials from the Federal Reserve, the FDIC and the Treasury Department all said that tighter regulation of banks with assets above $100 billion is a virtual certainty, with a particular focus on stress testing and capital and liquidity standards. On Capitol Hill, lawmakers are also considering whether changes to the FDIC deposit insurance limit is warranted. The FDIC has undertaken a review of the deposit insurance landscape and has promised to make policy recommendations by May 1, though whether its suggestions will find bipartisan support remains uncertain.

Fight over DOL's ESG rule produces first veto

Meanwhile, the bitterly divided Congress has also focused on a retirement savings regulation in recent weeks. At issue is a new Department of Labor (DOL) rule on environmental, social and governance focused (ESG) investing in retirement plans. ESG investing has become a hot-button, highly politicized issue on Capitol Hill and in numerous states around the country. The DOL rule, which was finalized last fall and went into effect on January 30, allows retirement plan sponsors to consider ESG factors when choosing investment options for the plan, if the primary focus remains the plan's fiduciary duty to its participants. The rule reversed a regulation finalized during Donald Trump's presidency that prohibited plans from considering ESG factors. 

In March, both the House and Senate passed a "resolution of disapproval," a mechanism that allows Congress to reject or overturn a specific rule issued by a federal agency. President Biden vetoed that measure, saying that eliminating the rule "would prevent retirement plan fiduciaries from taking into account factors, such as the risks of climate and poor governance, that could affect investment returns." It was the first veto of Biden's presidency. Days later, the House took a vote to override the veto, but fell well short of the two-thirds majority needed. That effectively ends the debate on Capitol Hill over the ESG rule, but the rule has also been challenged in court by 25 states. That case is pending – meaning that the controversy over ESG investing will continue. No matter the eventual outcome to this court challenge, flip-flopping on ESG issues is likely to persist as control of the White House, Congress and state governments moves back and forth between the two parties in the years ahead.

SECURE 2.0 glitch is causing confusion

The SECURE 2.0 Act is now law of the land. About 92 separate provisions to boost retirement savings will go into effect over the next several years. The most significant change for 2023 is that the age at which individuals must begin taking required minimum distributions from their retirement accounts has gone up to 73. Among the provisions set to go into effect in 2024 are employer options to match student loan payments with plan contributions and to offer emergency savings accounts to plan participants. 2024 will also permit penalty-free withdrawals for emergency expense and for domestic abuse victims. The new law's "starter 401(k)" for small business is also slated to kick in next year. Dozens of the SECURE 2.0 provisions require rulemaking or guidance from the Internal Revenue Service or the Labor Department, so expect the focus to shift to the regulators in 2023.

One surprise that has popped up is the discovery of a drafting error in the SECURE 2.0 Act. The glitch appears to prohibit catch-up contributions in 401(k) plans in 2024 and beyond. The error stemmed from a change in the new law that requires catch-up contributions to be made on a Roth basis. In making that change, drafters inadvertently dropped a paragraph from the existing law, effectively eliminating all catch-up contributions next year. Both Congress and the IRS are aware of the issue and are exploring fixes, such as passing a technical corrections bill on Capitol Hill or using IRS guidance to clarify the mistake. For now, though, the timing of a solution is uncertain, so keep this one in the "stay tuned" category.

SEC mutual fund proposal has big ramifications for plans

It's often said that a split Congress emboldens regulators, who see an opportunity to fill the void when gridlock prevails. The Securities and Exchange Commission seems to be taking that to heart, as it continues its astonishing pace of rulemaking. A controversial climate risk disclosure proposal for public companies, reform of money market funds and a sweeping overhaul of equity market trading that has much of Wall Street baffled are just three among dozens of topics on the SEC's plate right now. 

One notable proposal with real-world implications for retirement plans would overhaul mutual funds by strengthening funds' liquidity risk-management programs, requiring funds to employ "swing pricing" on any day there are net redemptions, and imposing a "hard 4 p.m. close" for funds. The latter would require that orders be received by the funds by 4 p.m. each day, a move that would force intermediaries to stop taking fund orders well before market close to process and bundle orders by the deadline. Retirement plan participants would likely see a mid-morning cutoff for placing orders and lose the ability to make same-day exchanges from one fund to another within the plan. 

The industry strongly objects to the proposal. In a February comment letter, Schwab said that the proposal could destroy mutual funds by putting them at a significant disadvantage to other products, such as ETFs, that could continue accepting trades right up to the market close. "The one-size-fits-all approach is so prescriptive, so operationally challenging, and so unfriendly to investors that we question how long the mutual fund industry would be able to survive under these rules," wrote Schwab President Rick Wurster. The SEC is reviewing comments and expects to finalize a rule by the end of the year. The mutual fund industry hopes that near-universal opposition to the plan will convince the SEC to consider alternatives.