Tuesday, June 12, 2018

How Ready are Americans for a Successful Retirement


Every weekday morning, one of the first blasts that glamorizes my inbox is the Plan Sponsor News Dash. If you don't subscribe already, you should probably remedy that situation. It's free and it's pretty unobtrusive, and once in a while even features my wisdom or lack thereof. But, this morning, I read an article from the News Dash that struck my mathematical, actuarial, and consulting senses a bit funny.

This article told me that according to a study by the Employee Benefit Research Institute,  57.4% of U.S. households are on track to be able to cover 100% of expenses in retirement, but if long-term care costs are removed from the equation, the percentage jumps to 75.5%. Then it goes on to tell me how much rosier the picture gets if they only have to cover 90% of their household expenses, or even 80%, or finally even 100% if you also remove long-term care costs.


Holy Symmetry, Batman!


What happened to the scenario where expenses go up more than we are anticipating? I've not been able to find the EBRI research, so perhaps the article is explaining everything that the research actually does present.


According to the article, the research goes on to suggest that if we auto-enrolled all workers at 6% in an automatic DC plan that the retirement crisis would virtually disappear. 


From a policy standpoint, this just feels so wrong. If you look at your pay stub today, unless your compensation for the year has already gone above $128,400, you'll see that 6.2% of it is going to the government in the form of FICA tax. For those that don't know the terminology, that's the old age part of Social Security. In addition, regardless of how much you have made thus far this year, an additional 1.45% is going to the Social Security Administration to support the Medicare system. So, what this proposal is telling me is that it wants to, right off the top, direct 13.65% of my pay towards my retirement and the retirements of others. That's almost one dollar in seven of what most Americans earn. We would have no say. In fact, if you add that to federal, state, and local income taxes, it feels like the policymakers are directing more of what I make than I am.

Think about that.

But, returning to the original topic, how ready are Americans for a successful retirement? It doesn't seem likely to me that covering 80% of ones projected expenses is going to be sufficient. But, if we focus on the analysis in which we are supposed to cover 100%, 3 in 7 American households can't do it. Were we to bump that to 110% (inflation increases), we probably get to the point where more than half of those households cannot sustain retirement.


Why?


The 401(k) as the cornerstone of American retirement system does not work. Remember, this study was done after some huge run-ups in equity markets. What happens if we have a significant correction? What happens if we are in a bubble?


You want a policy solution? Reinvent the pension plan in ways that offer some degree of lifetime income, longevity protection, and inflation protection. Design it so that costs are stable (that's really easy by the way) while still providing for consistent and responsible funding. Let employees use the 401(k) as it was intended -- as a supplemental savings program.


Households will be ready for a successful retirement.

Monday, May 21, 2018

Compensating Executives Under the New 162(m)

Except for those who are either executives or people involved in determining the ways that executives are compensated, one of the changes to the Internal Revenue Code last fall seemed like a little throw-in designed to appease a small constituency, but that few would really care about. That small group that does understand the change, however, knows it is a pretty big deal.

Let's recap so that we can all be on the same page. Prior to the Tax Cut and Jobs Act (TCJA), and oversimplifying somewhat, public companies were entitled to deductions for executive compensation so long as such compensation did not exceed $1 million per year for a covered employee. Performance-based compensation was not to be counted against that limit and covered employees were the CEO plus the four other highest compensated employees.

Since the passage of the TCJA, there have been several key changes to Section 162(m):

  • Once you become a covered employee of a company (beginning in 2017), you remain a covered employee of that company, essentially forever;
  • The CEO plus four other highest paid has been changed to CEO plus CFO plus three other highest paid;
  • Companies no longer get an exemption for performance-based compensation; and
  • Some grandfathering exists for certain agreements that existed in writing.
That does not leave a whole lot of wiggle room for companies. And, for companies that have provided large amounts of performance-based compensation to their executive group, meaningful deductions may be gone.

I'm not about to suggest that I can fix this new problem. But, you should note that amounts that have been deductible under Section 404 are unaffected by these changes. Section 404 of the Internal Revenue Code relates to qualified pension plans. What this means is that to the extent that parts of an executive's compensation which would be subject to Section 162(m) are somehow moved into a qualified pension plan, the funding of that plan will, subject to the rules of Section 404, generally qualify for a corporate tax deduction.

Of course, there are a myriad of rules around what it takes to keep such a pension qualified including the nondiscrimination rules of Section 401(a)(4). But, for most companies that still maintain ongoing pensions, the ability to transfer some otherwise nondeductible compensation to such a pension plan may still exist. It's one of the tools in the tool box that companies should look into.

Tuesday, April 24, 2018

Desire to Move to Lifetime Income Options -- Is It Real?

I read an article this morning that tells me, among other things, that two in ten defined contribution (DC) plan participants plan to use some portion of their plan assets to purchase lifetime income products. I don't dispute the research that was done, but I absolutely dispute that behaviors will be as the data imply.

Before you read on, I want to be clear. Any criticism that I have here is not of the author. The piece does an excellent job of explaining what the data say. My criticism is also not of the data collection. The Employee Benefit Research Institute (EBRI) asked legitimate questions and reported the answers that they received.

But, this is a case where I posit that a perfectly good interpretation of perfectly good data is likely to not be a good predictor of future behaviors, at least not as the law exists today. What we need to help these data to be a reliable predictor is a statute that is focused on retirement policy not on the assumption that small groups of people will abuse the Tax Code. And, once that statute works, we need plan designs that give well-meaning plan participants the ability to customize their individual retirement income streams to meet their own needs without worry that somehow they will fall prey to regulations that were written to stop abuse by a few. (For the retirement and tax geeks reading this, yes, sections like 401(a)(9), I mean you.)

Is this newfangled design DC? Maybe or maybe not. Is this newfangled design defined benefit (DB)? Maybe or maybe not. Why do we really need such a broad distinction?

I'll return to the design issues later, but first I am going to make a u-turn back to my comment about these data as predictors.

Yes, two in ten DC plan participants would like to get some lifetime income or longevity protection from their DC plans. But, what options are available? Generally speaking, whether they are in plan or out of plan, they are retail priced annuities (meaning they are priced favorably for the annuity provider and therefore unfavorably for the annuity buyer). There are traditional annuities and there are qualified longevity annuity contracts (QLACs). The experience in the marketplace thus far (anecdotally) is that participants will pay anywhere from 15% to 40% more for these annuities from DC plans than would be considered actuarially equivalent to a lump sum in a DB plan. Insurers need to be both risk-averse and profitable and therein lies a difference. DB plans, on the other hand, are intended, generally speaking, to provide optional forms on an agnostic basis.

So, how do we get there? As I said earlier, changing the statute to allow common-sense streams of income for participants is a great first step. Then we need a new type of design. To me, it probably doesn't fall into the current, common notion of DB or DC.

Let's call it the Plan of the Future.

And, once those common-sense options are available, my prediction is that far more than two in ten participants will want some amount of lifetime income whether it's from DC plans, DB plans, or just qualified retirement plans.


Friday, March 9, 2018

Check Your Lenses to See Properly

Which lenses are you wearing right now? Come on, take a look. Are they the right ones?

No, this is not one of those cheesy Ray-Ban coupons that litter social media. This is about consulting.

Which lenses are you wearing right now?

I think it's a good question.

If you're like me, you've been wearing glasses or contact lenses for a long time in order to see more clearly. In my case, I wear progressive lenses (readers, mid-range, and distance all in one) for every day and work and I wear distance only lenses for sports. In case you're wondering, it's not easy to hit a tennis ball well when the size of the ball changes as you look through different parts of your lens.

But, back to consulting, did you check to see which lenses you are wearing?

Let's consider a simple example. I'm an actuary. A lot of the people I work with -- my peers -- are also actuaries. My clients generally are not.

If I am writing a memo for internal consumption by other actuaries, i can wear my actuarial lens. There is a high expectation that my readers will understand my position in the ways that I want them to understand it.

But, suppose I need to take that same memo and send it to a client. My client may not know the difference between a carryover balance and a prefunding balance. My client may not understand that PBO and ABO do not move necessarily in lockstep. My client may not even know what any of these things are.

So, when I write to my client, I explain things to them at the level that I perceive is right for them. Or, put differently, when going from my internal actuarial memo to my external consulting memo, I've changed lenses. In the first case, my lenses are thick and monocular. In the second case, they are gradual and at least binocular as I translate from that which is hard to see at a distance to something that my client can see easily close up.

My lenses have an emotional side to them as well. And, there's a fancy name for it, well not so fancy. Empathy. I try the best I can to put myself in my client's shoes -- to put myself in their position and to write for their benefit, not for anyone else's.

That's hard. When we write a consulting piece, we all want to seem brilliant to our clients. We take off that client lens and put on our own lens just dazzle from the keyboard with thoughts so profound and complex that we must truly be in a league of our own. But, who knows it? The poor client who reads it gets bored. They put it down. They call a competitor for a translation.

Uh oh, or if you are a fan of Scooby Doo, rutro.

So, let's take off our own lens and put the client lens back on. In doing so, we rewrite our masterpiece on the intricacies of an Internal Revenue Code section whose mere label fills up an entire line and simplify it. We make it so that our client can understand it. Yes, I know, we think we have dumbed it down. But, really, that client lens is the empathy lens. Done properly, our client doesn't find it dumbed down, but just right.

Now, our client thinks we are brilliant.

Tuesday, March 6, 2018

Fitting a Square Retirement Peg Into a Round Hole

I just don't get it. We knew what they were and honestly, they may have been well defined before then, but in 1974, Congress saw fit to codify defined benefit plans (DB) and defined contribution plans (DC) in ERISA. At the time, there was no Section 401(k) in the Internal Revenue Code.

It was also pretty clear back then. Pension plans were required to offer annuity options. Plans that were not pension plans (mostly profit sharing plans) were not required to offer annuity options. And ERISA said it was good.

In a profit sharing plan, a participant's accrued benefit was his or her account balance, generally. In a pension plan, generally, a participant's accrued benefit was the amount of his or her annuity. And ERISA said it was good.

But, time went by and despite ERISA saying things were good, Congress decided to tinker. And, as a group, Congress has few tools in its bag of tricks that exceed its ability to tinker. It usually works like this. Representative A introduces a bill and she has just enough votes locked up that she can almost get it through the House. And, Representative B comes to her with an idea and says that if you'll just add this one [stupid] provision, I'll vote with you and I can drag C, D, E, F, G, and H along.

That's how the sausage is made in the tinkering factory.

So, once upon a time, we had this round retirement hole (the structure that ERISA gave us) and it was good. It worked pretty well. The evidence of that is that people who spent a good part of their careers under the structure developed in ERISA have generally retired and if they planned at all well, their retirements are not at all bad compared to their working lifetimes.

But, as Congress saw fit to tinker with the rules, it found ways, among others, through bills known as Pension Protection Act[s] to convince employers to get rid of pensions. That's right, Pension Protection Acts killed pensions.

Irony.

So, through Pension Protection Acts, workers were suddenly left with nothing but account balances and through improved awareness of health risks and better medical care, they were also left with longer life spans. Those account balances that were perfectly sufficient to get them to the age 75 or so that was their life expectancy at birth had no chance of getting them to their new life expectancy that was closer to 85.

Now what?

The hue and cry was for annuities. And, thus Congress began to tinker again. How could they possibly fit this square account balance peg into the round annuity hole. So, Congress explored ideas for annuities in DC plans.

But, you see that if you offer actuarially equivalent annuities from a DC plan, then you have gains and losses and that would essentially be a DB plan. If you offer insurance company provided annuities (and recall that insurance companies are in business to make money), then you have too small of an annuity.

Oh the ignominy of the square peg.

We had a perfectly good system. It came with perfectly good benefits and for most plans, perfectly good actuarial assumptions and methods.

And Congress broke it. And after all these years, despite taking file and rasp and hammer to the square peg, the round hole remains empty.

Congress, there are smart people who do not sit in your chambers. Give us your objectives and let us find you a solution. We'll make that peg round and Americans will be able to look forward to their golden years again.

ERISA will once again say it is good.

Friday, February 23, 2018

Are You Better Off than You Were 20 Years Ago?

Nearly 40 years ago, Ronald Reagan asked voters if they were better off than they were four years earlier. And, that was the beginning of the end for Jimmy Carter's reelection hopes. So, without trying to end anything for you, I ask if you are better off from a retirement standpoint than you were 20 years ago.

For Americans as a group, I think the answer is a clear no. Our retirement system has been broken by the momentum that has gathered around the 401(k) plan. After all, when Section 401(k) was added to the Internal Revenue Code in the Revenue Act of 1978, it was never intended to be a primary retirement vehicle. In fact, it was a throw in that even among those who were there, there doesn't seem to be much agreement on why it was thrown into the Act.

When it was, however, defined benefit (DB) pension plans were in their heyday. People who were fortunate enough to be in those plans then are now retired and an awful lot of them are living very well in retirement. On the other hand, people who are now retiring having been in 401(k) plans only have their retirement fates scattered all over the place. Some are very well off, bit others are essentially living off of Social Security.

Let's consider where those people went wrong. For many, when they first had the opportunity to defer, they chose not to. They had bills to pay and they just couldn't make ends meet if they didn't take that current income. By the time they realized that they should have been saving all along, they couldn't catch up.

For others, they were doing well until they lost a job. Where could they get current income? They took a 401(k) distribution.

Yes, I am very well aware that the models show that people who are auto-enrolled and auto-escalated in a 401(k) plan with a safe harbor match will fare quite well. Those models all assume no disruptions and constant returns on account balances of usually around 7%.

Let's return to reality. The reality is that young workers are (likely because of all the campaigns telling them to do so) deferring liberally when they start in the workforce. The problem is, and I get this anecdotally from young workers, that more of them than not reach a point where they just can't defer at those levels any more. They get married, buy a house, and have kids, and the financial equation doesn't work. So, they cut back on deferrals. I know a number who have gutted one or more of their 401(k) plans in order to buy a house. The fact is that it's not easy to defer, for example, 10% of your pay into your 401(k), another 5% into your health savings account (HSA), and save money for a down payment on a house.

Where were we 20 years ago? For many Americans, they were about to be getting those notices that their DB plans were getting frozen. Congress killed those DB plans. The FASB killed those DB plans.

When I got into this business in 1985, most (not all) corporate pension plans were being funded responsibly. And, this status was helped, albeit for only a year or two by the Tax Reform Act of 1986 (shortening amortization periods). One of the big keys, and this will be understood largely by actuaries, is that we had choices of actuarial cost methods. My favorite then and it would be now as well for traditional DB plans is known as the entry age normal (EAN) method. The reason for this is that under EAN, the current (or normal) cost of a plan was either a level cost per participant (for non pay-related plans) or a level percentage of payroll for pay-related plans. Put yourself in the position of a CFO -- that makes it really easy to budget for.

But Congress and the FASB knew better. In the Pension Protection Act of 1987 (often referred to OBRA 87 because it was one title of the Omnibus Budget Reconciliation Act), we had it imposed on us that we must perform a Unit Credit (another actuarial cost method) valuation for all DB plans. And, in doing that Unit Credit (UC) valuation, we were given prescribed discount rates. At about the same time (most companies adopted what was then called FAS 87 and is now part of ASC 715), DB plan sponsors also had to start doing a separate accounting valuation using the Projected Unit Credit (PUC)  (Unit Credit for non-pay related plans) actuarial cost method. Most of those sponsors found that their fees would be less if they just used these various unit credit methods for their regular valuations as well and we were off and running ... in the wrong direction.

You see, PUC generally produced lower funding requirements than EAN and the arbitrary limits on funding put in place by that second funding regime known as current liability (the UC valuation) and most DB plans had what is known as a $0 full funding limit. In other words, they could not make deductible contributions to their DB plans during much of the 1990s. And, it stayed that way until prescribed discount rates plummeted and there were a few years of investment losses.

What happened then?

CFOs balked. They had gotten used to running these plans for free. Suddenly they had to contribute to them and because the funding rules were entirely broken, the amounts that they had to contribute were volatile and unpredictable. That's a bad combination.

So, one after another, sponsors began to freeze those DB plans. And, they did it at just the time that their workers could least afford it.

For all the data and models that tell us that it should be otherwise, more people than ever before are working into their 70s, generally, in my opinion, because they have to, not because they want to. As a population, we're not better off in this regard than we were 20 years ago In fact we are far worse off.

Even for those people who did accumulate large account balances, many of them don't know how to handle that money in retirement and they don't have longevity protection.

We need a fresh start. We need funding rules that makes sense and we need a plan of the future. It shouldn't be that difficult. I'd like to think that my actuarial brethren are smart people and that they can design that cadre of plans. They'll be understandable, they'll be portable as people change jobs, they'll have lump sum options and annuity options , and they'll even have longevity insurance. They'll allow participants the ability to combine all those in, for example, taking 30% of their benefit as a lump sum, using 55% for an annuity from the plan beginning at retirement, and 15% to "buy" cost-of-living protection from the plan.

That's great, isn't it? Even most of the 535 people in Congress would probably tell you that it is.

But those same 535 people don't really understand a lick about DB plans or generally about retirement plans (there are a few exceptions, but very few). In order to get that fresh start, we need laws that will allow those designs to work.

We surely don't have them now.

Over the years, Congress has punished the many plan sponsors because of a few bad actors. If 95% of DB plans were being funded responsibly, then Congress changed the funding rules for 100% of plans to be more punitive because of the other 5%.

Isn't it time to go back to the future to get this all fixed?

Let's kill the 401(k) as a primary retirement plan and develop the plan of the future. It could be here much sooner than you think.

Friday, February 2, 2018

How Big Does Your ROI Have to Be? You Can Get It Here

Let's make believe it's 2018. Let's further make believe that the Tax Cuts and Jobs Act (TCJA) or whatever it's long-winded name turned out to be was signed into law late last year. And, let's finally make believe that you hold a corporate position where you get to weigh in on corporate investments and deployment of capital.

Just how big of a return on investment do you need to be able to project in order to pull the trigger?

8%? 10%? 12%? 15%?

For most of you, I'm guessing that I've finally surpassed or at least hit your target. You'll definitely want to read on. For those that need a bigger number, give me a chance. But, I didn't want to scare away those people who think that really big numbers are only found in Fantasyland.

For those of you that really want to get into the technical details, I'm going to refer you to an excellent piece written by my Partner, Brian Donohue. Some of you may not want to get into that level of gory detail and you just want the big picture and a summary to convince you, you've come to the right place.

First off, you need to sponsor a defined benefit (DB) pension plan. It's fine if it's of the cash balance or some other hybrid variety. So, let's suppose that you do because if you don't and you have no plans to, unless you just really love my writing or just have a strange desire to find out what you are missing out on, you can probably stop reading now.

I don't want to put this in terms of dollars because if I talk about billions and you are a $100 million company, you may not think this is for you. And, conversely, if I talk about millions and you think millions go away in rounding, you won't think it's for you. So, let's talk about units.

Suppose your DB plan is fully funded on a Schedule SB basis. In other words, your funding target and your actuarial value of assets both equal 1000. Then your minimum required contribution, generally speaking, is equal to your target normal cost, probably not a big number compared to what we are talking about here.

Despite not having to, contribute 200 units. Go ahead. Do it. Trust me. I wouldn't sell you snake oil.

Here are your benefits from having done so before September 15, 2018 (assuming calendar year plan year and tax year):


  • The 200 units are tax-deductible under Code Section 404 for 2017 when your corporate marginal tax rate was likely 35% (yes, there are unusual circumstances where they may not be or where the deductions may not be of value to you, but for most sponsors, this is the case) as compared to 21% beginning in 2018. Savings of 14% of 200=28 units.
  • Your PBGC variable rate premiums may come down by as much as 8 units, But that could be as much as 8 units per year for multiple years (let's call it 5 years for sake of argument). Savings of 8 units times 5 years=40 units.
That's 68 units of savings on a 200 unit deployment of cash. That's 34%.

Now, I'm not going to claim that your ROI here is actually 34%. Yes, you will contribute these amounts more than likely in future years and when you do, you will take a tax deduction. But, you'll take it in the future (you remember time value of money) and you'll only get a 21% deduction when you do. And, yes, you may not get those full PBGC savings and some of them will be in the future, but your savings are likely to be significant.

And, then there is the other really key benefit -- your plan will now have a surplus on a funding basis meaning that you almost certainly don't have to contribute and deal with volatility of minimum required contributions in the near future.

I'd be doing you a disservice, of course, if I didn't give fair consideration to the downsides and perceived downsides of this strategy. So, I'm going to shoot straight with you.

Yes, you will have 200 units of cash tied up with no immediate means of accessing it. However, it's getting you a pretty good and rapid ROI, so in most cases, I think you'll get over that one.

Pension surplus is considered to be a bad thing. In fact, prevailing wisdom is that pension surplus is worth only pennies on the dollar. Well, sometimes prevailing wisdom shouldn't prevail.

If your DB plan is ongoing, this is just advance funding, plain and simple. It's money that you would have to contribute and the future when you could take your deductions at a 21% marginal tax rate.

If your DB plan is frozen, the argument is a little trickier. But, for most sponsors, if you do have a frozen plan, the cost to terminate is likely going to exceed your funding target. In fact, it's likely to exceed your funding target by a fair amount. So, those 200 units will be put to use.

But, let's take the extreme scenario where your investments do well, interest rates rise, and those 200 units really start to look like trapped surplus. 

Do you sponsor a defined contribution (DC) plan? It may not fit your current DC strategy, but generally speaking, your DB surplus upon termination can be used to fund a "qualified replacement plan" (think profit sharing or non-elective contributions) for up to seven years. So, in that case, you would be getting an advance deduction for future DC contributions.


Yes, I've simplified things and there are potential tax and legal issues here, so I leave you with this:

Nothing in here should be construed as tax or legal advice which can only be obtained from a qualified tax or legal professional. If you need tax or legal advice, you should consult such a professional. And as with any strategy of this sort, your mileage may vary.