Much has been made of risk management in recent years. During the economic downturn that started sometime during Bush (43)'s second term (I'm not going to argue about specifically when it started) and that is still continuing (or is not depending on which "expert" you believe), every company that I am aware of talked about risk management in earnest. Some actively did something about, some just talked about it, but it became a buzzword (I'm sorry, but a buzzword can be more than one word in my blog).
Let's focus on employee benefit programs, both broad-based and executive. Most everyone out there does some sort of risk management in most of their welfare benefit plans. Their health care plans are often fully insured, or if not, they at least have some sort of stop-loss insurance in place. And, they know that they can increase the employee portion of cost-sharing next year. With regard to other welfare benefits, LTD plans are often fully insured, life insurance plans as well. Think about them, in virtually all of these plans, employers are pooling their risks.
Suppose we turn to retirement plans. I am going to look at them in four baskets:
- qualified defined benefit
- qualified defined contribution
- nonqualified defined contribution
- nonqualified defined benefit
What a trendy topic to write about: risk. The word has been out for nearly 25 years now. Get out of defined benefit plans. Diligent readers (I'm sure I have at least one) will recall that I wrote several weeks back that certain DB plans (specifically cash balance) managed appropriately are less risky than 401(k) plans from the plan sponsor standpoint. Since nobody commented on this, can I presume that everyone who read it agreed with me? I;m not that foolish, but ...
In any event, anyone who deals with qualified plans has heard about risk management, LDI, and lots of other trendy terms. When I got into this business, more large companies than not sponsored DB plans, and extremely few did anything to manage their inherent risks. Now, only those who think that they are omniscient with regard to both interest rate movement and equity and fixed income prices do nothing.
In my experience, very few companies even evaluate their risks here, but most companies have them. Consider these:
- Suppose an employer provides a matching contribution in their 401(k) plan and all of their communications to employees are successful. Then, employees will contribute more and employers will be on the hook for more matching contributions. Isn't this a risk? I think it is. How many companies forecast this under any, let alone many scenarios? Shouldn't they?
- Many private or closely held companies sponsor ESOPs. When a private company sponsors an ESOP, isn't there really only one way to pay out plan participants when they terminate with a vested benefit? And, isn't that to repurchase the shares? I know that there are some companies out there that perform (or have done for them) an assessment of their repurchase liability. For the ones, who don't, in my opinion, they are just rolling the dice.
- I've seen a lot of companies scrap their defined benefit plans in favor of a profit sharing plan. In doing so, they make an implicit promise to their employees (not all companies do this, but there are enough that do), that they will contribute at least some minimum percentage of pay to the plan on behalf of each employee. Suppose business is bad. Suppose there are no profits to support these profit sharing contributions. That's pretty risky. The old way of sponsoring a profit sharing plan, basing contributions on and sharing profits, is probably more prudent.
Why don't employers (as a group) manage their risks in these plans? Are the obligations too small to worry about? Is it because they are just executive plans and since they may not get ERISA protection, they are not worthy of risk management? Is it because they don't know how? Is it because they have never thought about it?
Let's go back a few years, say to some point before 1986 (there were sweeping changes to tax laws including the treatment of certain life insurance products). Nonqualified plans were much smaller than they are now. But the promises made in many of them were just plain silly.
I'm aware of one former Fortune 100 company (the company no longer exists due to acquisitions, but its particular identity is irrelevant) that promised a return in excess of 20% annually in its NQDC plan. They funded the plan using COLI, and they could point to broker illustrations that showed that all was taken care of. [pause for me to laugh out loud] I'm sure that there were other companies out there that did similar things. Remember that whoever it was that designed the plan (internally) was going to benefit from that large rate of return. If they were at the level that they were involved in the design, they were probably at least 40 years old at the time and they were smart enough to know that it doesn't take too many years at a guaranteed 20+% rate of return to build up a pretty good nest egg. And, they also knew if they thought about it that the risks that they created for the company wouldn't become really apparent until after they had become a wealthy retiree.
Why didn't this company manage this risk better? They were using the same mentality that many others have used in a retirement plan investment context -- that of total return. And, their assumptions were overly optimistic.
I'm going to make a bold statement (it's not really so bold, but teeing it up this way gets your attention better). Whether it be on a micro basis (at the plan level) or on a macro basis (at the enterprise level), it is critical that companies manage their nonqualified risks. This means that it is incumbent upon them to set aside assets to appropriately manage those risks (whatever that means to the particular company). While it may seem prudent to make the play that, on average, minimizes financial accounting costs, this is often wrong. While it may seem prudent to take the position that managing cash flow, in a way that on average, minimizes that cash flow, this is often wrong.
I'm going to attempt something drastic here. I'm going to try to insert a graphic in this blog (people over the age of 50 should generally not resort to such technological indulgences).
Tell me, in this matrix, which risk do you really want to take additional steps to actively manage? If I ask people (limited to ones that I consider to pretty intelligent), they assume that this is a trick question. Of course, they want to focus on the northeast corner -- the one with high risk and high likelihood. Think about it. Aren't these the risks that they are already very actively managing? With regard to these risks, companies tend to be fully insured, fully hedged, or at least fully something. They don't let these risks go unwatched. They know that they could bring down the company.
Does anyone remember what happened to BP in the Gulf of Mexico a few months ago? The likelihood of that event was small, but the downside risk was immense. Similarly, does anyone remember the performance of assets and liabilities together during the 10-year period that just recently ended? We had about 4 years of "left tail events during that 10 year period (the left tail in a normal distribution is where you usually find the low probability, but very poor outcome events). In other words, 40% of the time, we had an outcome that models said would occur less than 5% of the time. What went wrong?
I could go on and on about what went wrong in terms of bad models, bad laws, bad accounting rules and the like, but that's not the point. The point is that not enough companies prepared for this low-probability event. Now, risk management in pension plans is all the rage (at least for companies that still sponsor pension plans). As time goes by and the rich get richer (they do, don't they?) nonqualified liabilities grow rapidly. And, as those liabilities grow, companies are actively managing the risks attendant to those plans, right?
Some have looked at this carefully, but you can probably count that list of some pretty darn quickly. Am I suggesting that companies formally fund their nonqualified obligations in a secular trust? Probably not, the tax rules usually don't work. Am I suggesting that they fund in a rabbi trust? Maybe, perhaps more than maybe. Am I suggesting that they somehow evaluate their low probability, high magnitude risks in their nonqualified plans and then quickly take reasonable steps to ensure that those risks will not get in the way of the successful operation of their company?
With due credit to Rowan and Martin's Laugh-In, you bet your bippy I am.
Do it now, and do it right, and if you're not sure how, let me help you do it.