Friday, September 23, 2016

More on the Public Pension Controversy

The media has fallen in love with the ongoing controversy over public pensions. In the last few weeks, article after article has appeared in major print and electronic media mostly discussing how poorly funded the majority of public pension funds are and placing blame everywhere they can. This is not to say that there are not problems and it's also not to say that there's not plenty of blame to go around, but as in most any controversy, there's more than one side to this issue.

Before delving into it, let me provide some background for those who may not be particularly familiar with public pensions.

Virtually all public pension plans are traditional defined benefit (DB) pension plans in which most, if not all, of the benefit is provided through contributions from the sponsoring governmental entity (some do require significant participant contributions in order to get that benefit). The benefit is typically related to final year's (or the average of the last three or five years) compensation. As a result, spikes in compensation in the final year or years of a career produce much larger pensions. And, when overtime pay is included in those amounts, workers are smart enough to know that their pensions can easily be boosted by getting as much overtime as possible.

As I said, most of these pensions are funded largely through contributions from the governmental entities. Where do those contributions come from? Well, for most of those entities, the very large majority of their budgets come from tax dollars. So, if the recommended, or even legally mandated contributions get too large, there are only two choices -- ignore those requirements or raise taxes (of course in most jurisdictions, future benefits can be reduced prospectively, but that's a different story for a different day).

The current debate centers on public plans in California. What we have recently learned is that the California Public Employers Retirement System (CalPers) values pension liabilities in two ways -- one using what the New York Times referred to as the actuarial value and another referring to it as a market value.

The next two paragraphs briefly discuss a rationale for each basis. For the sake of both simplicity and brevity, both are oversimplified and should not be taken as a precise rationale for either.

The actuarial value discounts obligations using a discount rate at the expected long-term rate of return on plan assets. Proponents argue that this is correct because plans are expected to have a degree of permanence and as assets are invested for the long haul, the obligations that they support should be discounted on that same basis.

Market value discounts obligations using a current settlement rate; roughly speaking, that is the rate at which you could go out to the insurance market to settle those obligations. Proponents argue that in an efficient market, there is no risk premium in investments and therefore, this is the only appropriate basis on which to discount.

What we have read about in the news is that governments that thought that the plans that they sponsor were well funded and that wanted to pull out of the system are learning that to do so will cost them money that they will likely never have.

So, which method is correct? I suppose I could argue that it depends upon which media piece you read. You see, what is happening is that most of the articles have interviewed experts (or self-proclaimed experts) on only one side of the debate. So, they present that side.

The reality is that neither side is correct. It's not as simple a question as the strong proponents on either side would have you believe.

So, here's my take (you knew I would get to it eventually).

Public plan trustees need to understand the true costs of the plans they sponsor. On average, when an employee retires, their pension should be fully funded. This is often not happening. In years when investment returns are good, they use them to reduce contribution requirements. In years when investment returns are poor, they say they can't afford to make the appropriate contributions. It doesn't take an experienced actuary to tell you this is a problem.

I would urge that governments embark on prudent funding policies that build up surpluses in strong years in order to pay for shortfalls in lean years. Doing so will have only minimal effect on the tax base. Studies to understand these issues should be par for the course.

I also urge the popular media to realize that this is not a one-sided issue. While it may make for a great read to tell of the sad tale of a small Citrus District pension plan that is woefully underfunded, it's a small part of the story.

Within the Conference of Consulting Actuaries (yes, I am biased, I serve on the Board of Directors), there is a Public Plans Community that regularly discusses issues such as this. For those who are interested in a view of the problem from people who understand the issues, it's an excellent read.

Monday, September 19, 2016

Lessons From California Public Pensions

Over the last few days, the print media (at least we used to call it print media) has hit hard on public pensions in the State of California. The New York Times hit hard on the differences between the "actuarial approach" and the "market approach." The Los Angeles Times took on a pension deal from the late 90s. Both of these are symptomatic of the issues that all of taxpayers, legislators, workers, and actuaries face in the public pension world.

Let's take a step back. Some of the most generous of all public pensions are those available to public safety officers primarily police and fire. I could give you lots of reasons why this approach is correct and why it's not. You might disagree with my analysis on all of them, but that's not what's important here.

Historically, people who have chosen careers in police and fire have thought of their careers differently than people in most other professions. Those careers are very risky and they are physically demanding. Many in those professions would tell you and me that lasting more than 30 years or so is just not practical. And, if we take that as a correct statement (I do), then it is reasonable that such public safety officers be eligible to retire from that career earlier than we would expect in most other careers. After all, if you were trapped in a burning building, would you be happy if the people trying to save you were just trying to hang on until normal retirement age at 65, but weren't really physically capable of handling such a demanding task?

Over time, states, cities, towns, and other governmental organizations found the answer. Provide those public safety officers with a significant incentive to retire early (compared to other careers) and if you do that, you don't have to pay them all that much. So, what that has historically achieved is that costs for current public safety employees have been relatively lower and costs have been deferred into their retirements.

That's a problem. It doesn't need to occur. The correct answer for a governmental employer, or other employer, is to realize that deferred compensation (that's what a pension is) is earned during a employee's working lifetime. Therefore, it should be paid for during that working lifetime. After all, once an individual in any profession retires, they no longer provide a benefit to the organization that they previously worked for. Further, the burden to pay for those pensions should not be passed on to future generations of taxpayers.

In the past, I have commented about various actuarial cost methods. An actuarial cost method is a technique for allocating costs to the past, the present, and the future. Looking at things as any of a taxpayer, legislator, employer, or employee (I happen to not be all of those, but even so, I can put myself in the shoes of those that I am not), the correct answer has the following characteristics:

  • An employee's pension is paid for (funded) over their working lifetime. Once they retire, the cost of providing their benefit is over. (Understand that actuarial gains and losses make this an inexact science, but we should be close.)
  • The cost of providing that employee's pension should be level. That is, it should either be a constant percentage of their pay or a constant dollar amount. As an employer, I can budget for that. 
Let's consider an example of that second bullet. Suppose I pay a public safety officer $60,000 per year (I know -- in some jurisdictions that seems high and in others it seems low) in salary. Further suppose that their deferred compensation costs me 10% of pay annually. Then when I am budgeting for that person, I know how to budget every year. If their pay goes up by 5%, so does the cost of their pension, roughly. This year, I budget $66,000 for current plus deferred compensation. Next year, with that 5% budgeted increase, I budget $69,300 for current plus deferred compensation.
There is an actuarial cost method that does exactly this. It's called Entry Age Normal (EAN). When I entered the actuarial profession back during the days when we used green accounting paper rather than spreadsheets, in my experience, EAN was the actuarial cost method of choice. But, it had its downsides. 
  • Neither the accounting profession nor the federal legislators accepted it as the method of choice.
  • Employers were advised that their current cash cost would be lower using a different actuarial cost method. It's easy to say you will fix that problem later on.
  • Observers understand a method where you pay for benefits as they accrue, but nor one in which you pay for benefits as they are allocated by actuaries.
So, now we have come to a crossroads. Many of the largest public pension plans are horribly underfunded regardless of how you determine funding levels (some have been funded responsibly; others have not). Getting them well funded requires cash which can only come from increasing taxes or from taking money from elsewhere in the budget (dream on). Legislators want to get re-elected which means you don't raise taxes. 

Hmm, I see a problem here.

The problem extends to private pensions as well, but there are  good solutions there. Since EAN is not available as an actuarial cost method anymore (we could choose to have our valuation done using the legally prescribed Unit Credit actuarial cost method, but fund not less than the EAN cost although that is very rarely done), we need to look in other places. 

Plan design is an excellent lever in this regard. Suppose we had a plan design  that even under a Unit Credit cost method allowed us to achieve exactly what we are talking about here. And, suppose that design allowed for all the benefits of defined benefit plans (DB) including market-priced with no built-in profits annuity options, professional investing, no leakage, portability, and virtually no cost volatility. Wouldn't that be an ideal world?


Thursday, September 15, 2016

It's Your Plan's Money They are Wasting

You're a defined benefit plan sponsor. That means that you have to hire an Enrolled Actuary (EA). No, you don't have to have one on staff, but you must have an Enrolled Actuary provide an annual actuarial valuation for the plan.

You know that your EA is providing great service and making smart decisions on your behalf, don't you?

If you are a prudent sponsor, you will periodically bid that work. In other words, you will put out a request for proposal to ensure that your current EA and his or her firm are providing you with excellent service at a fair price.

Fair is in the eye of the beholder. If what you are looking for is a cheaper price, you can almost always find one. There's usually someone out there who will do the work for less money. That doesn't necessarily mean that engaging them will be a good decision.

Suppose I pointed out to you, however, that your plan's EA was making bad decisions on your behalf. Perhaps those decisions are costing your plan more money than you are spending on the services for that EA. You probably think that can't be your plan. But, it could be.

Suppose I told you that I could educate you as to those decisions for your plan. I know, you don't have the time to give me all the information that I'll need. Well, suppose I told you that I don't need your time for that. I just want to be able show you what I've learned.

Would you be interested then?

Send me a note or call me at 770-235-8566. You'll never know unless you do.


Thursday, September 8, 2016

Laws Affecting Benefits and Compensation Nearly Always Failures

I suspect that the authors of every law that affects employee benefits and compensation have good intentions when they draft those laws. As T.S. Eliot said however, "Most of the evil in this world is done by people with good intentions."

Where do these laws go wrong? To understand this, it's helpful to understand the process.

Usually, bills are drafted by Congressional staffers perhaps with the assistance of outside experts, often lobbyists. From there, bills are introduced and then haggled over by 435 people with no subject matter expertise in one chamber of Congress and then by 100 people with a similar lack of subject matter expertise in the other chamber. Once the sausage has been ground sufficiently, a bill may be approved and passed to the President for signature.

What could possibly go wrong?

Assuming that nothing could go wrong up until that point, these bills that by this point in the process have become laws leave it up to the various government agencies to create regulations that help to implement these laws. Some of the regulations make sense, and then there are the others.

Looking at this as someone who doesn't work for one of those agencies, it strikes me that each of them seeks to assert their power where possible. After all, if a government agency cannot show that it has power, why should it not simply cease to exist?

Further, if between Congress and the various government agencies, a bill and then law has not been messed up, there is still the court system to fall back on.

As an example, let's consider Internal Revenue Code Section 401(k). Essentially, it was added to the Code by the Revenue Act of 1978. And, while it was a throw-in, as we all know, once 401(k) plans were truly discovered, they took off in their popularity.

There are several things that we know about 401(k) plans. They are qualified retirement plans, thus governed by ERISA. They provide tax deductions and are thus also governed by the Internal Revenue Code. They have become very popular, so the amount of plan assets in many 401(k) plans is massive.

So now, let's look at the evolution of a current nightmare.

401(k) plans were created by the Revenue Act of 1978. They provided employees with an opportunity to save money for retirement on a tax-favored basis. Employers have the ability to match those employee deferrals and receive a tax deduction for those matching contributions. The Investment Committee (or some similar name) for the plan or its designee is responsible for selecting and monitoring investments in the plan. In that role, the Committee must act in the best interests of plan participants and in a fiduciary manner.

What does that mean?

The old regulations were very vague. Vagary has led to different courts imparting their wisdom in different ways. To be acting in the BEST interest of plan participants, what does a committee need to do? Does it need to find the LEAST expensive investment options? Does it need to find the HIGHEST returning investment options? If not, then how close to that optimum? Where is the bright line?

So, now we have new Department of Labor (DOL) fiduciary regulations. What they do more of than anything else is make more people fiduciaries of the plans than were before. Or, if they don't, then they certainly make clearer who the fiduciaries are and establish that there are, in fact, a lot of fiduciaries out there. Does this mean that more people will  be sued for fiduciary breaches?

Looking back, Section 401(k) should have been a great addition to the Code. And, weighing everything, perhaps it was (although regular readers of this blog will know my opinion that the addition of Section 401(k), more than anything else, probably ruined the American retirement system). But, over time, through this process, the 401(k) plan has become a mess. Each government agency thinks it has turf to protect. Employers feel that they have to offer a 401(k) plan, but few are equipped to handle one according to the current state of regulation and litigation.

The good news is that 401(k) plans through the Revenue Act of 1978 don't represent the only benefits or compensation law that is broken. Yes, that's also the bad news.

Consider these:

  • The Pension Protection Act of 1987 and the Pension Protection Act of 2006 have probably done more to drive down the number of US pension plans than any other laws.
  • A provision in the Multiemployer Pension Reform Act of 2014  that was intended to address the problem of serious underfunding in plans such as the Central States Teamsters Plan was dealt its first major setback specifically with respect to the Central States Teamsters Plan.
  • The million dollar pay cap in Code Section 162(m) that was designed to limit executive compensation has done more to increase executive compensation than probably all other legislation combined.
  • The Affordable Care Act of 2010 as we are seeing with announcements of 2017 exchange premiums is making health care anything but affordable.
  • The Pension Benefits Guaranty Corporation's (PBGC) shortsightedness in addressing its self-determined shortfall has taken millions of participants out of the pension system thus increasing the PBGC's shortfall.
I could go, but you get the picture.




Tuesday, August 9, 2016

409A Audit Could Be Coming to Your Company

All the way back in 2004, Congress passed and President George W. Bush signed into law the American Jobs Creation Act (Jobs Act). While it does not appear to have created many jobs, the Jobs Act added Section 409A to the Internal Revenue Code. The reasons were twofold -- first, to ensure that participants in nonqualified deferred compensation plans (NQDC) would never be advantaged over those in qualified plans; and second, to raise revenue for the federal government.

Thus far, the addition of 409A has done a pretty good job at the first of those goals by imposing a very strict set of rules on participants, usually executives, in NQDC arrangements. With regard to raising revenue, however, 409A has been fairly impotent to date.

Several years ago, the IRS rolled out an audit initiative of 409A plans. It had some teeth, but mostly with regard to larger plans (more participants) of larger companies. While there were exceptions, for the most part, if your company has less than about 5,000 employees or if your NQDC plans in total have less than about 100 covered participants, you've been mostly immune from this audit initiative.

Reports are now that the IRS has stepped up their audits. They are doing more of them and they are investigating more and more plans of companies that did seem immune in the early years of the program. In fact, I heard from an NQDC recordkeeper that a client of theirs with only 19 NQDC participants is currently under a 409A audit. I spoke with that recordkeeper, but between us, we couldn't determine what the pattern of companies that have recently come under 409A audit has been. That recordkeeper's anecdotal evidence, though, suggests that in other than very large companies, the primary target plans have been in order:

  • Nonqualified defined benefit pension plans that do not have the same formula as a broad-based DB plan in which the covered executives also participate;
  • Other nonqualified DB plans that simply make up for IRS limits (415 and 401(a)(17));
  • Deferred compensation plans that look different from the company's 401(k) plans; and
  • 401(k) mirror plans.
In other words, the target seems to be executive retirement plans.


To understand what the solutions might be, your first need to understand the problems. Generally, there are two ways that you can violate 409A -- either by failing to have or failing to have an appropriate written plan document, or by failing to follow both the plan document and the law and regulations.

In either case, the penalties are severe. But, those penalties are not imposed on the company. Instead, they are imposed on the executive, even if he had neither influence on nor knowledge of the defect from which that penalty will arise.

How bad is the penalty? It's this bad:
  • An additional 20% income surtax on the amounts deferred and not compliant for all taxable years in which that was the case; plus
  • Interest on previously unpaid taxes (due to failure to include the deferred amounts in income in the year in which they were deferred) at the Federal Underpayment Rate plus 1%.
And, that's in addition to ordinary income (and other) taxes that would be owed on those amounts. They add up quickly.

For most 409A defects, however, there are correction methods, structured somewhat analogously to those under the EPCRS program for qualified plans.

Many of you will seek help from counsel and from tax advisers. That may be a good solution for you. A problem that can occur in either case, though, is that it's very possible that neither has significant experience with determination of 409A benefits or with the administration of those benefits.If they do, that's great. But, if they don't, you probably need to look for additional expertise.

Thursday, August 4, 2016

Thinking About Compensation -- Cash and Otherwise

Suppose someone asks you how much you get paid. Probably the first thought that comes to mind for you is something like that your base pay is some amount of money per year or that you earn some amount per hour. You might include bonuses in your thoughts, or if you are hourly paid, you might include some overtime that you typically get. Let's just say, hypothetically, and because it's an easy number to work with, that your base pay is $100,000 per year and that you are not bonus eligible.

You're pretty happy in your job, but one evening, you get a call out of the blue from a recruiter or headhunter, if you prefer, who tells you that she would like to talk to you about a job in your field that has a budget of $110,000 per year. My question for you would be whether relative to your $100,000, is that $110,000 a good deal?

It seems obvious, doesn't it? You'd be getting a raise. But, it's not really that simple. Your current employer has a defined benefit pension plan and a 401(k) plan. They also provide you with a good health care program, four weeks of vacation per year, and some other benefits that probably don't seem like they will make a difference to you. Your potential new employer just has pretty basic health care and a garden variety 401(k) plan. They will start you at two weeks of vacation, but you work your way up to four weeks after ten years with the new company.

What should you do?

To people who often read my blog, the analysis is pretty simple, but to the average person, it's not. They often don't understand the value of these various benefits. And, that's why they tend to look at pay alone and perhaps the amount of vacation time that they are getting and whether or not their work schedule or work site (office versus home) will have any flexibility. That's work in 2016.

Suppose you are the employer and you happen to be the employer that offers good benefits, but doesn't pay quite as much as some of the employers against whom you compete for talent. I have an idea for you. Suppose you created a tool, or model if you prefer, to help prospective employees to compare what they are currently receiving with what you are offering them. It sounds like you've already made the commitment that you're not going to win on pay alone, so you have to find a way to make them understand the value.

Let them input all these various components side-by-side and see which one is the winner, especially if the pay you are offering is sufficient for them to live on. If you want to get even more sophisticated, you could tax-effect it.

Interestingly, the same concept works in executive compensation.

A company recently asked me to benchmark their executive retirement benefits (of course, those benefits are pay related). So, if their plans are 50th percentile, but their pay is only 40th percentile, then in reality, their plans fall short (50th percentile applies to 40th percentile gets you to somewhere less than 50th percentile retirement value), and conversely if you pay above the 50th percentile and provide 50th percentile retirement benefits.

It's surprising to me how often looking at things this way is a revelation. Perhaps you need that revelation.

Wednesday, July 27, 2016

Doing Your Due Diligence on Advisers and Actuaries

I read an interesting article this morning. In it, I read about a company that had used the same retirement plan adviser for quite a long time and developed a good relationship with them. After 13 years of this adviser assisting them with investment monitory, a fiduciary policy, and an investment policy, as well as manager searches, the company in question decided that just as part of due diligence, even though they figured there would only be about a 10% of chance of changing advisers to go through that due diligence process and bid those services out as well.

What the company, Dot Foods, found was that it was being charged perhaps more than a market competitive price and getting less than market competitive level of service. It was time for a change.

We could draw an analogy to lots of different kinds of services, but as consultants like to say, I'm going to drill down a little bit (I can't believe I used that term as hearing it always makes me hear a dentist's drill).

Let's put this in the context of a decent-sized, but not enormous defined benefit pension plan. To give some context, let's say that the plan has between $50 million and $1 billion in plan assets and let's assume that the plan is frozen (this is not an uncommon situation).

Now consider your plan advisers, particularly your actuary. Ask yourself these questions:

  • How long have you been working with your current actuarial firm?
  • Over that time, how many fresh ideas or analyses have they brought you with respect to your plan? When was the last time they brought you one that they didn't charge you for?
  • Reflecting the fact that your plan was frozen and that some of the work behind the actuarial valuation would be much simpler, did they voluntarily reduce your actuarial fees the year after you froze your plan?
  • Do you get as much attention from them as you did before your plan was frozen?
  • Have they given you a strategic plan to get to termination of your plan? Or, have they just told you that interest rates are too low now and you'll have to wait it out?
  • If they have given you a plan, was it provided in the context of your business or was it just their standard template?
You can pretty easily tell what the so-called best practice answers to all of these questions are. And, for your sake, I hope that after reflecting on your answers that you are able to tell yourself and your colleagues that most or all of those answers are what you would like them to be.

Suppose they're not. 

I know. You have a frozen plan and you think you are in set it and forget it mode. You don't really want to spend time both in the due diligence or RFP process to do this check and you certainly don't want to invest the time and effort that you think will be necessary during transition. 

Consider this scenario. You are able through that process to identify enough hard savings and soft savings that hiring a contractor or temporary employee to help with the transition would be a drop in the bucket in terms of cost compared to what you will be saving. During the RFP process, you get a freebie of some ideas that will help you to meet your strategic objectives with a promise of more to come. You learn that your actuary had gotten lazy and was delivering sub-optimal consulting.

Hmm ... there's an interesting term. What in the world is sub-optimal consulting

Sub-optimal consulting is a fancy way of saying that your actuary is just going through the motions. Everything they are providing you is correct, but none of it is the best correct answer.

I'm not implying here that your actuary should be doing anything underhanded or unethical. Quite to the contrary, your actuary should be following the law and Actuarial Standards of Practice to a tee. Oftentimes, however, within those constraints, there are a range of potential answers. Some are far more conducive to your business than others.

Consider this recent real example. A company, now a client, didn't like the news it was consistently getting from its actuary. That company didn't know if that news was the only way or if there was a better way. So, they asked. 

What they learned was that if their actuary did take the time to understand the interrelationship between their plan and their business that there was better news that they could be getting. The company came back to us and asked, "Can you save us money?" The answer was that there were hard dollar savings (fees) that would be small and other savings that would be significant. 

Perhaps you are the company that is getting great service and perhaps you maintain the plan for which everything is being done properly.