Tuesday, May 24, 2016

The Truth About Actuarial Valuations of Pension Plans

I've heard the same comments for years. I've heard that a company loves its actuary, but they can't give you one reason why. I've heard that actuarial work is a commodity and that everyone produces the same numbers, so you might as well go with the lowest bidder. There's more; there's lots more.

I'm here to tell you that it's all wrong and it's wrong now more than ever.

Let's revisit history a little bit. In the beginning (well, not quite the beginning), there was ERISA. And, Congress saw that it was good ... for a while.

ERISA brought us rules and choices. The rules said that plan sponsors had to fund the sum of the annual cost of benefits that were accruing (normal cost) plus a portion of the amount by which the plan was underfunded using some fairly complex formulas. But, those calculations were pretty malleable. In fact, there were many methods by which to calculate those numbers and if you couldn't find the methods to get you the answers you wanted, you could likely talk your actuary into selecting assumptions to get you to those numbers. That's the way the game was played from the mid-70s through the mid-80s.

Then, the rules began to change. Congress saw that corporate tax deductions for funding pensions were a significant drag on the federal budget. So, Congress sought to limit those deductions by bringing in multiple funding regimes. So, was passed the Pension Protection Act of 1987 as part of the Omnibus Budget Reconciliation Act of 1987. And, Congress saw that is was good ... for a while.

Multiple funding regimes theoretically brought multiple choices, but with the 90s came the era of full funding. With the use of high discount rates tied to assumed rates of returns on plan assets, those assets exceeded the calculated liabilities of the plan. More plans than not had no required contributions. Pensions were cheap.

And, then came the perfect storm. Interest rates fell, asset values fell, and Congress had to do something. In 2006, Congress passed another Pension Protection Act (PPA). And, Congress saw that it was good.

But, there was something different about PPA. It severely limited flexibility in calculating the actuarial liabilities of a pension plan. In fact, with very limited exceptions, without any knowledge of the actuarial assumptions being selected, another actuary could fairly well reproduce that calculation of actuarial liabilities (at least within in a few percent).

But, what we have now is a tangled web. There are some many liabilities and percentages. Every single one of them affects the cost of your plan. There is the funding target, the plan termination liability, the liability for purposes of calculating PBGC premiums. There's the FTAP, the AFTAP, and various other funding percentages.

While each individual calculation is simple, getting to the correct answer is not.

And, that's why your choice of actuary for your plan is actually far more important today than it used to be.

Suppose I told you that your actuary's lack of attention to your plan as compared to the rules was costing you more money annually than you pay in actuarial fees.

Suppose I told you that your actuary's not focusing on your business's cash flow needs was forcing you to borrow unnecessarily.

Suppose I told you that that renegotiation of a loan covenant that you just went through because your pension plan had too low a funded percentage could have been avoided.

The scary thing is that I have told companies all of those things. We're in an era now where calculation is easy, but strategy is difficult. In fact, more plans than not are using a suboptimal strategy. Don't you need to know if you are spending more money than you need to or if you are spending it inefficiently?

Monday, May 9, 2016

Multiemployer Law Fails to Work for the Plan it was Most Likely Developed For

In mid-2014, Congress enacted and the President signed into law the Multiemployer Pension Reform Act (MPRA) sometimes known as the Kline-Miller Act (for its original sponsors). MPRA was unique in modern political circles as it was sponsored by John Kline, a Republican from Minnesota and George Miller, a Democrat from California. It was also unique in that it had support from unions, from companies that employ union workers, from affected government agencies and from industry groups specializing in multiemployer plans.

All that makes it sound like a law that was practically perfect.

Some background for those who don't spend their days in the multiemployer plan world is useful. Generally, multiemployer plans exist in industries where an individual working in that industry may provide services to many different employers. In the Teamsters Unions (primarily truck drivers), for example, drivers may drive on behalf of many different employers. Each employer agrees to contribute an amount to the plan based on the amount of service provided to it by each worker under the agreement. So, for example, in the case of a Teamsters Union, contributions could be set at some number of dollars per thousand miles driven. Retirement benefits are set based on the levels that the trust can support.

Benefits under multiemployer plans are insured (to some extent) by the Pension Benefit Guaranty Corporation (PBGC). One of the reasons for the passage of MPRA was to protect the PBGC. This was to be accomplished by allowing plans that met a set of requirements (more later) to reduce benefits that had already accrued. As many of the industries often covered by multiemployer plans dwindle, the plans themselves are unable to support the levels of benefits that had been promised. There are just not enough dollars coming into the plans.

Based on data published initially by the Center for Retirement Research at Boston College, the single plan that was viewed as potentially most problematic was the Central States, Southeast, and Southwest Areas Pension Plan. With more than 400,000 member, a funded ratio just barely above 50%, and nearly 5 times as many inactives as actives (all as of 2012), the plan was estimated to become insolvent in 12 years. Many plans were projected to become insolvent sooner, but not represented nearly the liability of the Central States Plan.

As MPRA should have, it placed a strict set of conditions (see Code Section 432(e)(9)) on such suspensions. Cutting back retirement benefits had essentially never been permitted in an ERISA plan. Such a cutback needed to be in everyone's best interests.

The process for determining that was generally to be that the Trustees of a Plan would apply to the Treasury Department for such a suspension (the technical term for such a reduction). The application would need to demonstrate that the suspension met all of the conditions referenced above.

In the case of the Central States application, Special Master Ken Feinberg determined that some of those conditions were not met.

Specifically,


  • The suspension must be reasonably estimated to avoid insolvency
    • In making its projections, the Trustees or the outside consultants used by the Trustees assumed a rate of return on plan assets that for every asset class in the plan exceeded the 75th percentile (according to survey data) for that class
    • The entry age for new participants under the plan was assumed to be 32. While data shows that 32 is the average age, that is misleading because a group of new entrants at age 32 would have no new retirees in the next 20 years. On the other hand, a group with average age 32, including some who are much older, would have new retirees representing cash outflow from the plan far sooner than that.
  • The suspension of benefits must be equitably distributed meaning that a particular class of participants is not adversely affected more than other classes
    • The Trustees sought to make use of participants who are or were UPS employees under the plan. UPS had completely withdrawn from the plan and made withdrawal liability payments under the plan. In doing so, UPS had fulfilled its obligations with respect to the plan.
    • But, UPS made those participants whole under a different plan. In its application, the Trustees considered only the portion of UPS benefits attributable to the make-whole agreement. This was judged not to be an equitable distribution.
  • Upon application for suspension of benefits, notices must be distributed to participants explaining the suspension and the reasons for it
    • The notices must be understandable by the typical participant, but in fact contained lots of technical jargon.
    • In the notice's worst blemish, it contains a 98-word sentence with 4 technical terms not defined anywhere in the notice.
For all these reasons, the application was denied.

What does this do?

It leaves the Central States Plan in a position where it is likely within roughly 7 or 8 years of becoming insolvent. This means that the PBGC will become responsible for an extremely large liability for which its multiemployer fund does not have sufficient assets.

Who wins? Nobody.

Who loses? The PBGC, the plan participants, and the multiemployer system.

We might as well say that Americans are the losers.



Friday, April 15, 2016

IRS Withdraws Troubling Provision of Proposed Nondiscrimination Regulations

Yesterday, the IRS released Announcement 2016-16 withdrawing parts of the nondiscrimination regulations it proposed at the end of January. Those proposed regulations had troubled many in the defined benefit industry since their proposal for a number of reasons (more below). From the standpoint of the IRS, the troubling part of the proposal addressed some serious abuses by practitioners and the sponsors they consult to. From the standpoint of practitioners, the proposed regulations took an objective test that has been around for quite a while and essentially changed the rules of the game.

I'm going to have to get a little bit technical here before I bring you back to reality. What the proposed regulations would have done was to make retirement plans with multiple formulas show that each formula applied to reasonable business classifications of employees or to pass a more difficult test.

Under regulations that were finalized in 1993 and then amended for cross-tested plans in the late 90s, a rate group in the testing population must have a coverage ratio at least equal to either

  • 70% if the plan uses the Ratio Percentage Test to pass minimum coverage tests or
  • The midpoint of the safe harbor and unsafe harbor (the midpoint is typically in the 25% to 40% range, but is determined through a somewhat convoluted formula) if the plan uses the Average Benefit Test to satisfy minimum coverage
It is far easier for a rate group to satisfy a lower minimum coverage ratio than a higher one. And, many plans had been designed around satisfying the lower threshold. While the preamble to the proposed regulation said that it was targeting QSERPs, practitioners found that they also were potentially problematic for many plans of small businesses and plans of professional service firms. 

Why would this be troubling? Certainly, among larger corporations, the prevalence of ongoing defined benefit plans has dropped precipitously, but many small businesses and professional service firms have adopted new defined benefit plans (DB) over the last 15 years or so and many of these plans would have found it more difficult or perhaps impossible to pass these proposed rules.

This doesn't mean that DB plans of this sort are out of the woods yet, so to speak. Clearly, the current Treasury Department views that plans of this sort may be abusive in their application of the nondiscrimination regulations, so we could see another effort from the IRS to make the regulations a bit less QSERP-friendly. 

In the meantime, there are some great DB designs that exist for companies that wish to provide meaningful retirement benefits to their rank and file employees. You can learn more about them here.

Tuesday, April 12, 2016

The Quandaries of Being A Retirement Plan Fiduciary

Last week, the Department of Labor issued its final rule on what it means to be a fiduciary and on conflicts of interest. Virtually everyone in the retirement plan industry has been scurrying about to determine what the effect of the rule is. Some, including the US Chamber of Commerce, say it will lead to unnecessary litigation. Others say it will drive unknowledgeable advisers out of the retirement plan business.

If you're interested in the details of that regulation, every large consulting firm, law firm, and recordkeeper either has or will be publishing their take on it. Here, however, I want to address a different issue.

If you sit on the committee that oversees a retirement plan whether its called the Benefits Committee, the Investment Committee, or the Committee for All Things Good Not Evil, by virtue of that role, it is probable that you are a fiduciary. That means that both individually and as a member of that committee, when making decisions related to the plan (not your own account in the plan, but the plan generally), you have a requirement to act in a fiduciary manner and in the best interest of plan participants.

That's not a low bar.

Instead of bringing up situations that arise from the new final regulations (the other articles will present you with all of those that you need), let's instead consider an age old problem. Suppose your company sponsors a defined benefit plan and you are on the committee that oversees the plan. Let's complicate the situation a bit by adding in the following fact pattern:

  • The plan is covered by the PBGC (Title IV of ERISA)
  • The plan is frozen and the committee's minutes show that the intent of the committee is to terminate the plan whenever it becomes well enough funded
  • Your company is subject to US GAAP; in other words, you account for the plan under ASC 715 (previously FAS 87).
  • Your own personal incentive compensation is affected by corporate financial performance measured under US GAAP
  • Over time, you have received a material amount of equity compensation from your employer meaning that you now hold a combination of shares of stock, stock options, and restricted stock in your employer
Your actuary comes to a meeting with your committee and informs you that you have three options related to a funding strategy:
  • Option #1 will keep the ASC 715 pension expense down and will not result in a settlement (that would be a loss currently), but will result in the plan being less well funded
  • Option #2 will produce a settlement loss, but will get the plan closer to termination and leave it currently better funded for remaining plan participants
  • Option #3 will reduce ASC 715 pension expense and get the plan better funded and therefore closer to termination, but will have a material effect on the corporate balance sheet and could cause the company to violate certain loan covenants
You do have a quandary, don't you? Only Option #1 will help you to maximize your incentive pay. In my personal experience, in days gone by, for that particular reason, Option #1 would have gotten some votes. If you vote for Option #1, are you fulfilling your responsibilities as a fiduciary?

I'm not an attorney, so I'm not going to answer that question, but I'm sure you can find many who would be happy to weigh in.

Option #2 looks like it could be better for plan participants. Of course, that depends a little bit on what better means in this context. But, if the committee goes with Option #2, you know that your incentive payout could be smaller. If you vote against Option #2 (another question for the attorneys), are you fulfilling your fiduciary requirements?

And, then there's Option #3. How far do you have to go to fulfill your fiduciary requirements? Do you have to make decisions that are clearly not in the best interest of the company, but that may be in the best interests of plan participants? 

It's tricky, isn't it?

Now, let's consider a different situation that may not affect your personal compensation. Using Strategy #1, your company will pay PBGC premiums equal to about 10% of its free cash flow. Using Strategy #2, those same premiums will be reduced to about 3% of free cash flow. But, your actuary isn't familiar with Strategy #2. And, you do have a really good relationship with him. But, the people who brought you Strategy #2 say you can only implement it by using them.



Thursday, March 31, 2016

The Private Equity Multiemployer Plan Problem ... Litigated

For years, private equity funds have managed to do a good job of using the controlled group rules of Internal Revenue Code Section 1563 to avoid some of the complexities associated with them. In fact, where a single private equity group maintains multiple funds, it has typically ensured not having to deal with these rules by divvying up the ownership of any company among its funds. However, the United States District Court for Massachusetts may have dealt a serious blow to these strategies.

Section 1563(a) contains the key language specific to controlled groups.

(a)Controlled group of corporations For purposes of this part, the term “controlled group of corporations” means any group of—
(1)Parent-subsidiary controlled group One or more chains of corporations connected through stock ownership with a common parent corporation if—
(A)
stock possessing at least 80 percent of the total combined voting power of all classes of stock entitled to vote or at least 80 percent of the total value of shares of all classes of stock of each of the corporations, except the common parent corporation, is owned (within the meaning of subsection (d)(1)) by one or more of the other corporations; and
(B)
the common parent corporation owns (within the meaning of subsection (d)(1)) stock possessing at least 80 percent of the total combined voting power of all classes of stock entitled to vote or at least 80 percent of the total value of shares of all classes of stock of at least one of the other corporations, excluding, in computing such voting power or value, stock owned directly by such other corporations.
Long time followers of this blog may recall that Scott Brass has been fodder for issues specific to private equity funds in the past. Once again, we deal with Sun Capital Partners, here known by Sun Capital Partners III, III QP, and IV.

Scott Brass, Inc. was a bankrupt company essentially held 30% by Sun Capital III and 70% by Sun Capital IV. After going bankrupt, Scott Brass stopped contributing to the New England Teamsters pension fund and was assessed a withdrawal liability by the multiemployer plan.

Under the Multiemployer Pension Plan Amendments Act of 1980 (MPPAA), members of a controlled group may be jointly and severably liable for withdrawal liability payments. But, Sun Capital argued that Scott Brass was neither part of a controlled group with parent Sun Capital III nor one with parent Sun Capital IV.

The courts thought differently. Relying on ERISA Section 4001, in which we see outlined the PBGC's definition of controlled group, the courts in this case looked at substance over form. That is, the courts saw that there is, in fact, a single entity that owns Scott Brass, Inc,, despite the complex legal structure that was developed surrounding the company. In fact, the Managing Partners of Sun Capital freely admitted that the structure that they created was largely to avoid the possibility of joint and several liability for withdrawal liability.

The court ruled in favor of the Teamsters Fund. While this will surely be appealed to the First Circuit and perhaps to the Supreme Court if the First Circuit fails to overturn, this case provides an avenue by which multiemployer plans may seek payments of withdrawal liability that have previously not been available to them.

Private equity funds in similar situation should consider these potential liabilities both in due diligence and in their ongoing risk management assessments.




Thursday, March 24, 2016

The Pension Tale of the Cash and the Calendar

Once upon a time, there was a defined benefit (DB) pension plan. And, the plan was fully funded. And, that was good.

Well, at least, the plan's actuary told the plan sponsor that the plan was fully funded. And, then he said something else after that -- something about a HATFA basis. Oh, but it couldn't matter. That was clearly some foreign word. After all, the sponsor knew that the actuary was a really smart and he probably lapsed into foreign tongues once in a while. All that actuarial gibberish is pretty much a foreign language, anyway.

So, the plan sponsor, in this case represented by the Benefits Manager (Bob) and the Controller (Cliff), armed with the knowledge that its frozen plan was fully funded gleefully went off to see the CFO (Charlotte). It was time to tell her that the plan was fully funded and that the plan could be terminated.

Those of who work in the pension world know that this little story didn't end well. For those who don't work in that world, let's just say that being fully funded at the beginning of 2016 on a HATFA basis may mean that on a plan termination basis, assets may only be very roughly 2/3 of liabilities.

Our story goes on.

After understanding that they couldn't terminate the plan, the sponsor Craters R Yours (CRY), the world's largest manufacturer of inflatable moonwalks set about to continue managing their frozen DB plan. CRY had initially assumed that freezing the plan was an end to its pension worries, but it soon learned that was not the case.

They learned that frozen plan management can be a tale of volatility caused by cliffs and calendars. In year 1, we get funding relief. In year 2, it's gone and we revert to the old rules. We're 80.01% funded; all is well. We're 79.99% funded; life gets really tough. We make a contribution on March 31; a ratio gets better. We make it on April 2; there are things we have to tell the government.

Bob and Cliff learned that their jobs had become really difficult. Charlotte had roundly praised them when they found a new and inexpensive actuary, Numbers For Cheap. And, NFC always provided legally correct numbers. But, there was no strategy. NFC didn't tell Bob and Cliff that contributing $1,000,001 on March 31 was going to be much more valuable in the long run than contributing $999,999 on April 2. Because NFC really had no clue, CRY would up doing a lot of crying.

Bob and Cliff, and Charlotte, for that matter had been sure that when they froze CRY's pension plan that the actuarial work was a pure commodity. All the strategy was done. All that was left was to hire the cheapest actuary and get the plan terminated.

The moral of the story, of course, is that pension funding strategy doesn't end until the plan is gone. Until then, there is a difference, and you, as a plan sponsor need someone who can help you to find that optimal strategy. Let us help.

Wednesday, March 16, 2016

Is Your Executive Plan Top-Hat?

Most larger companies and some smaller ones provide many of their higher paid employees the opportunity to participate in a nonqualified retirement plan often referred to as a Supplemental Executive Retirement Plan or SERP. The rationale for having such a plan is spelled out in ERISA. The regulations specifically grants "top-hat" status to plans that are limited to a select group of management or highly compensated employees. The plan must also be unfunded (and for those people who say that lots of top-hat plans have assets set aside, that is informal funding in a rabbi trust or through insurance products or some other means).

Before going further, I'd be remiss if I did not mention that my motivation for posting this is a recent series on top-hat plan litigation in Mike Melbinger's blog.

So why should an employer or employee care if their plan is a top-hat plan or not? According to regulations under ERISA Section 104, top-hat plans are exempt from the participation, funding, vesting, and fiduciary rules under ERISA. As we shall see, this can be critically important, especially in the current statutory environment.

Backpedaling just a bit because this will help the less knowledgeable reader to understand why top-hat plans exist, let's consider what it could mean to be in a top-hat group. ERISA was enacted in 1974 to provide certain protections for employees in retirement and certain welfare benefit plans. When a plan is exempt from some of the key provisions of ERISA, it fails to provide those protections. So, being in a top-hat plan could alert a participant that he or she might not need those protections.

As some authors, mostly attorneys, have pointed out, the last year or two has seen more than the usual amount of litigation related to top-hat plans. In the typical situation, either an individual thinks that they were improperly excluded from a top-hat plan (in my completely non-legal view, this would be a tough claim to make) or because they were in a plan that was treated by their employer as being a top-hat plan, but they thought that it did not satisfy the criteria for being top-hat.

Depending on your viewpoint, the latter is either an easy claim or a difficult claim to make. Why is that? It's been more than 40 years since the passage of ERISA and we still don't have formal DOL guidance telling us what a top-hat group is. Some have argued that an individual may properly be in a top-hat group by being either management or highly compensated or both. Despite the current definition of highly compensated (Internal Revenue Code Section 414(q)) not existing until late 1986, some have argued that satisfying that criterion is sufficient. Many years ago, the DOL floated a concept that a person should be eligible for a top-hat group that a person would be eligible if their compensation was at least two times (three times in a separate informally floated concept) the Social Security Wage Base. And, finally, there is the concept that a person may rightfully be in a top-hat group if by the nature of their position, they have the ability to influence the design and amount of their compensation and benefits package.

So, knowing that we currently don't know what a top-hat group actually is, why do we care?

Suppose your company sponsors what it believes to be a top-hat plan and it turns out that it's not top-hat. Then, it's going to be subject to some fairly onerous provisions that could create massive current costs in some cases and unsolvable compliance issues in others.

Consider the following scenario.

Suppose you have a DB SERP with 20 participants. Further suppose that for whatever reason, this plan is found to not be a top-hat plan. Assuming that the company is large enough, then the plan will fail the minimum participation rules and it will necessarily (unless the company has only highly compensated employees) fail the minimum coverage tests. Full vesting must occur generally within 5 years of entry and that entry must occur not later than age 21 with 1 year of service. The plan must be funded according to ERISA's minimum funding rules. And, those plan assets must be invested according to ERISA's fiduciary standards. But, the plan will still not be a qualified plan as it doesn't meet all of the Internal Revenue Code's standards under Section 401(a).

If the plan is not qualified, it must be a nonqualified plan of deferred compensation. That makes the plan subject to Code Section 409A. So, let's throw in one more wrinkle. Let's suppose the company also sponsors a qualified DB plan and let's suppose that the qualified plan is less than 80% funded. Now, you are between a rock and a hard place. Setting aside assets (funding) for the nonqualified plan will violate Code Section 409A which will subject participants to a very large unplanned additional tax liability. (By the way, those participant will likely have to find a way to pay those taxes perhaps without having access to the deferred compensation assets in order to pay them.) Not funding the SERP will cause the plan to fail to meet minimum funding standards which will result in excise taxes under IRC 4971.

Ouch!

What should an employer do?

I've been told by more than one attorney that it is unlikely that you can get a formal legal opinion that your top-hat group is, in fact, a bona fide top hat group.

If you can't get a formal legal opinion, perhaps the best way to get comfort is to get an outsider with expertise in this area to assist with an independent analysis.

Looking at a history of case law and DOL opinion on the topic, one might consider these elements:

  • The percentage of the workforce in the top-hat group
  • The relative pay of the top-hat group as compared to the pay of those people not in the top-hat group
  • Whether the top-hat group was selected by the Board as compared to being, for example, any employee with the title Vice President or higher
  • Whether individuals in the top-hat group, especially those among the lower-paid in the group, have significant management responsibilities
  • Whether individuals in the group need the protection of ERISA
Nobody really knows. But, having an independent analysis might show that an employer is acting in good faith in determining the group. Given the downside of getting it wrong, it may just be worth it to find out.

Finally, I want to reiterate that I am not an attorney and I have no qualifications to provide legal advice. As such, nothing in this post or anything else that I write should be construed as legal advice or as the practice of law.