Professional Standards

I haven't had a good rant for a while, but I think it's time. I am an actuary. For a number of reasons, including the standards of conduct to which we hold the members of our profession, I am proud to be an actuary.

We have a fairly rigorous Code of Professional Conduct. Trust me, this Code is well enforced. The Code tells us that we must adhere to a set of Actuarial Standards of Practice (ASOPs). Those of you who are reading this who are not actuaries would be amazed at the level of compliance with the ASOPs by actuaries. It is extremely high. We take our professional responsibility seriously.

Many actuaries are consultants. When we are viewed as consultants, we are often compared to strategy consultants, IT consultants, human resources consultants who are not actuaries and others with whom we may compete for business from time to time.

It gets frustrating sometimes. I have experienced more situations in my career where consultants who are not actuaries do things that would violate our Code of Conduct, but because of it, they have been viewed favorably. I am not suggesting that actuaries should have a more lax Code of Conduct or that we should not follow it, but I am suggesting that some of the other professions should be viewed less favorably.

Consider a particular large, well-known consulting firm whose name would probably be second nature to most of you. I have worked side-by-side with them on several assignments. On two of those assignments, they actually signed off on their own actuarial assumptions. They have neither the training nor the expertise to do so, but they do not belong to a professional organization or even a profession that seems to hold them to any level of standard. Clients believe them because of who they are. In my first-hand experience with them, they have gotten things wrong ... very wrong.

OK, I'm done with my rant. If you deal with actuaries, hopefully you have had positive experiences regarding professionalism. Check out our Code of Conduct. See if it gives you a new-found respect for the profession.

Beware the Compensation Audit

OK, HR people, if your company got audited, how would it do? I'm not talking about the audits of broad-based employee benefit plans that the IRS and DOL have been conducting for years. I've heard attorneys give advice with regard to those benefit plans that they may not be compliant, but you'll never get caught on audit. I'm talking about compensation audits, targeting primarily executives. I'm talking about 409A and 162(m) audits. Would you feel confident if you got that dreaded letter than an auditor would be arriving soon? Many companies have felt confident. Many of them have not been so happy when the auditor left.

Before discussing those audits and what you might do to prepare (long before you get that audit notice), I digress. What is your role in the company? Do you have a boss? Murphy's Law says that the first person in the company with a 409A problem will be either your boss or your boss's boss. In my experience, the 409A version of Murphy's Law strikes far more often than logic or probability dictate that it should. And, if it does, you are going to get blamed ... and that's not good.

Let's suppose you do get a request for information from the IRS for a 409A audit. They give such requests a nice name. They call them Information Document Requests. I have one sitting in front of me. Thankfully, from my standpoint, it was provided to me by a company that I did not assist with their 409A compliance process. I say thankfully because at the end of their audit, they were not happy with what the IRS found. In any event, here is what the IRS requested (paraphrasing somewhat to take out IRS-speak where possible) from them:

• Every plan and arrangement providing for a legally binding right to compensation in one year, but payment in some future year that is not subject to 409A. The company is then asked to explain why it is not subject to 409A. If the answer that they will give is the exclusion for short-term deferrals, then the company is to provide the relevant terms of that plan and and relevant terms for substantial risk of forfeiture.
• Terms and conditions, including deadlines for initial deferral elections.
• Terms and conditions for any subsequent deferral elections, including documentation of the initial deferral election, documentation to show that the subsequent election was made at least 12 months before the initial payment date and documentation to show that the subsequent election reflects at least a five-year pushback. 
• Detail related to any accelerations in payment that have been made.
• A list of specified employees and the times at which such employees have been specified employees.
• Payments made to specified employees and documentation demonstrating compliance with the six-month delay rule.
• Any funding of deferred compensation as a result of an event relating to a decline in the company's finances.
• Violations of 409A and whether they were fixed in one of the IRS 409A corrections programs.

For some companies, that's a lot of stuff (that's a technical term for saying that it may take you a long time to comply with the Information Document Request). But, that's only the first part of the misery. Let's look at where the IRS has been generating revenue (that is also a technical term, this time for finding compliance errors).

• Time and form of payments
• Short-term deferral rule
• Identifying specified employees

With regard to time and form of payments, the biggest culprit has probably been in severance plans. Recall that broad-based severance plans may be exempt from 409A, but to the extent that the payment is more than two times the pay cap under Code Section 401(a)(17), they are not. So, we are talking about executive severance payments here and there have been a lot of them the last few years. 

How have companies gone wrong? Many executives have had employment agreements that provide for significant severance payments in the event of termination without cause. And, in a lot of those cases, they allowed the executive freedom to take that payout in a lump sum or installments as he saw fit. 

Oops! That's a 409A violation. And, if he was a specified employee and he took the payment within 6 months of separation from service, Oops again.

Companies (and their advisers) have taken significant advantage of the short-term deferral rule. Oversimplifying somewhat, here's how it works. Suppose compensation is earned in one year (and vests in that year) and is paid out (without employee choice) by March 15 of the following year, then it usually qualifies as a short-term deferral. Think of a typical annual bonus plan.

Now, let's change the situation. An employee earns compensation (and it vests) in one year. He separates from service the next year before March 15 and the amount gets paid out (because of the separation from service). It is NOT a short-term deferral because the payment could have been after March 15 if the separation from service had occurred later. Essentially, you can't dodge the short-term deferral rule in this fashion.

Identification of specified employees is not easy for large companies. At a minimum, they are the key employee group as determined under Code Section 416(i). Here is the problem. During the year, you may not know who those 50 highest-paid officers are for a year. This is why the 409A regulations defined specified employees as compared to just key employees. Specified employees can be a group of up to 200 that includes the key employees, but may also include certain other employees. It's that group that must not be paid out within 6 months of separation from service. And, all 409A plans and arrangements of an employer must use the same definition of specified employees.

Many companies have applied the 6 month delay rule to all 409A plans of the company for all employees. In that case, it doesn't matter who the specified employees are. Other companies have chosen not to do this. Therefore, they need to know who their specified employees are. IRS experience says that many companies don't know who their specified employees are. This is another good revenue source for them.

So, how should companies prepare for the possibility that they may get audited? Have an independent third party review. Don't have it done by the people who did your initial compliance work. They'll never think they made any mistakes. If the initial work was done by an attorney, consider having the third party review done by a consultant. You'll get a different and hopefully useful perspective. If the initial work was done by a consultant, consider an attorney to do the third party review.

Or, in either case, if I didn't do the initial compliance work, I'll give you a different perspective than the person who did it originally.

Could CEOs of White Collar Companies Learn Something?

Through the wonders of modern technology, I can watch pretty much any TV show any time that I want to if I am at home or in front of a computer. I spend enough time on my computer, though, so I'd rather watch on the not so small anymore screen.

Why should you care about this? Well, there's this CBS show called "Undercover Boss". It's a little bit corny and sappy, but there is a learning experience there as well.

Here's how the show works. A corporate executive, usually the CEO, goes undercover and does jobs alongside some of the company's workers. Usually, the CEO learns a few things such as:

• Those jobs that are the meat and potatoes of the company may not be so easy
• Sums of money that are pocket change to the CEO are meaningful to the company's workers
• People that the CEO doesn't talk with every day have good ideas

And, for the sappy side of the viewer, most of the workers who are shown on TV have some back story such as a child with a disability or they work for a charity on weekends. At the end of the show, the CEO usually gives them some amount of money and other goodies. On the most recent episode, we saw the CEO if Oriental Trading Company give 'awards' of perhaps $125,000 and authorize expenditures of probably another $500,000 per year. We saw the CEO's house. It wouldn't surprise if, in a good year, he gets a bonus of more than $500,000 per year (by the way, he may deserve it, I'm not opining on that, but simply making a point).

I've worked for a few large firms in my life. [I've learned that smaller firms run differently. The CEO's can actually talk to their employees.] When I worked for Exxon way back when, I was a young blue-collar worker and frankly, I was pretty clueless about what was going on there. Since 1985, I've been in the consulting business. Mostly, I've worked for large firms (you can look them up if you like as I have not hidden my profile online). 

Let's consider one of those large firms (if you try to work out which one this is, that's at your peril and for your enjoyment). The CEO there has had earnings according to public disclosures in the broad range of roughly $3 million to roughly $20 million per year according to public disclosures. [Every company that I have worked for since 1985 has a make CEO, so using the masculine here is factual.]

I compared the progression of that CEO's pay to shareholder return. Guess which was bigger. It's not shareholder return. On the other hand, over that same period of time, anecdotal data (talking to co-workers) suggests that many of them, even high performers, had no increases in compensation. Certainly those increases were not as high as those experienced by the CEO. 

Let's dig deeper. The CEO was lauded by the Compensation Committee for cutting costs. He slowed down increases in compensation costs. He cut benefits. He cut the little things at work.

From an employee's standpoint, what did that get him? It made him unpopular. It got him high turnover. Turnover costs money. In the consulting business, turnover costs clients. In fact, in any customer service business, unhappy employees and high turnover cost clients. But that blame can be pushed elsewhere.

I dare one of these CEOs. Contact CBS. Go on Undercover Boss. See what your employees think. Maybe they have good ideas. Maybe you'll find out why so many of them leave. Maybe you'll find out why you are losing clients. Maybe then you'll earn your compensation.

Defined Benefit Supply and Demand

This should be good. This fool is writing about supply of DB plans and demand for DB plans? No, not really. But, we are going to look at a really simple way that supply and demand affect DB plans.

There are lots of DB plans out there that are frozen, be it soft or hard. Presumably, very few of them will ever be unfrozen. More likely is that plan sponsors are seeking to terminate those plans that are frozen. And, since the process for doing other than a standard termination often requires a plan sponsor to go into bankruptcy (yes, there are other ways, but that is beyond the scope of this article).

Let's look at the standard termination process in the simplest of terms. A plan has to be fully funded (including employer commitments) for the purchase of annuities, sufficient to provide all the benefits accrued and vested in the plan. Determining the level of assets to do that should be fairly simple, right?

Of course, it's simple. Presumably, you know what your funded status is on a PPA basis and you just pick up the phone and call your actuary. Actuaries have good rules of thumb for estimating everything, so your actuary will just give you a loading factor and you'll know where you stand, right?

Not so fast. Life insurance companies that are in the annuity business presumably want plan termination business. It's where they can get a large volume of business quickly. Let's consider a couple of scenarios.

Plan investments perform well, interest rates stay stable. If this is the case, then funded statuses will improve. A reasonable number of plans will be able to terminate. Insurance companies will presumably hit their goals for annuity volume.

Plan investments perform well, interest rates go up. Now, virtually everyone will think they can terminate their plans. The market will be flooded with demand for annuities. Insurers either will not be able to accommodate that much volume or will be able to create that impression.

In the second case, there is more demand, but no change in supply. I learned about this in Economics 101 (actually, it was called 14.001, and if you understand that, you'll know where I took it). Prices go up. So, your actuary's rule of thumb is going to be off by a bit ... and in the wrong direction.

We could create lots more scenarios to look at supply and demand, but this is pretty basic stuff. It's intuitive.

If you have a frozen plan and you're looking to terminate it, wouldn't you like to be able to track this loading factor or ratio of plan termination liability to PPA liability? Now you can. Contact us. Contact me.