Thursday, June 20, 2013

IMHO, Evidence that Legislators Need Real World Experience

I am going to warn you that this is going to sound like a political statement, but it's not. And, for full disclosure, while I have never worked for the IRS or any other part of the Department of Treasury or any other governmental agency (save for a short period of time at a public university), I do have friends who work for the IRS.

Trey Gowdy (R-SC) is a Representative from the State of South Carolina. According to his Wikipedia page and his Congressional website, Mr. Gowdy is a 1989 graduate of the University of South Carolina School of Law where he was a member of a scholastic honor society. He then clerked for several judges and went into private practice briefly before becoming a prosecutor and then solicitor. In 2010, he was elected to Congress by a wide margin. All indications are that Mr. Gowdy is an intelligent, hard-working man. I agree with him on some of his political positions and disagree with him on others.

Everyone who has not been hiding under a rock knows that we are still in the early stages of learning about a scandal that has occurred over the last few years at the IRS. While we don't have all the details, there has been an admission that at least one group within the IRS has "targeted" certain conservative organizations for additional scrutiny in their applications for tax-exempt status under Code Section 501(c)(4) as well as just holding up those applications. Among the groups that some IRS employees have admitted were targeted are those with Tea Party in their name. Important to note is that Mr. Gowdy was first elected to Congress in 2010 with strong support from Tea Party organizations in South Carolina.

It turns out that because of duly negotiated agreements that I understand to have been collectively bargained that the IRS is about to pay out $70 million in bonuses. Frankly, they will be paid out to a large number of people and most of them will not be of the magnitude that will turn your stomach.

Yesterday, Mr. Gowdy said that people in the federal government including the IRS don't get it. He said that you only pay bonuses for performance that significantly exceeds expectations. He bases this on what?

First, to the extent that the terms of the bonus program were collectively bargained, it is unlikely that there is anything that can be done to stop the bonuses from being paid. You see, there is a contract -- a legal contract. Mr. Gowdy, as an experienced attorney is familiar with such things. Second, Mr. Gowdy clearly has spent little time in the real world. Bonus programs are also often known as annual incentive programs. Properly constructed (and I have no idea whether this one was properly constructed), they represent variable pay for those covered and typically pay out some percentage of a target amount depending upon some combination of an individual's performance and their team's performance. Rarely do you find a situation where performance across an organization is so poor and so pervasively poor that no incentives are paid out.

Let's look back. This is an annual incentive program. That means that it was put in place, presumably, to motivate individuals to achieve a set of goals. Surely, a reasonable percentage of IRS employees met their goals and some exceeded them. Just like you and me, most employees of the IRS are honest hard-working people. Most of what the IRS has done over the past year has probably met expectations. In fact, in my personal work experience, their service has been pretty good.

So, despite Mr. Gowdy's belief that you only pay bonuses for exceptional performance, that is not what was negotiated in the contract. It makes for good press to rant about all that the IRS has been found to have done wrong, but, IMHO, Mr. Gowdy has picked the wrong fight.

From where I sit, we appear to have a legislator whose lack of experience with understanding compensation programs is causing him rail on and probably not look as smart as he is. He is not alone. But, Congress sees polls and makes rash decisions that affect public policy. So many people in Congress do not understand the employment deal between employees and employers, but still they make it more complex and bureaucratic each year through new law that none of us understand.

Top business schools often require applicants to have spent some time in the real world before pursuing their MBAs. Perhaps, one should not be eligible to represent his or her constituents in Congress before having achieved a threshold amount of experience in the real world.

OK, I'm done ranting ... for now.

Wednesday, June 19, 2013

Why Due Diligence Should be Like a Home Inspection

When you buy a house, even though you think of it as a home, it's also a long-term investment. Both from the standpoint of being a place to live and from a financial standpoint, you want everything to be right. Similarly, and even more so, when your company is buying another company, you want everything to be right. While you would like for everyone on both sides of the deal to be happy, it's purely a financial transaction.

If you were hiring a home inspector, how would you go about it? If you were prudent, I think you would want references not of how an inspector wrote a nice report, but about problems that he had found that either resulted in purchase price adjustments, things getting fixed before the deal closed, or even killed a deal. The alternative is that you get a nice guy who doesn't want to stir the pot and cause problems. He won't cause problems, but you will get stuck with the problems.

Due diligence when doing a corporate acquisition should be the same. Unfortunately, oftentimes, it is not.

Companies about to do an acquisition usually (in my experience) do not go through the same level of prudence in choosing their external partners for their due diligence team. So often, it consists of their regular accounting, tax, and legal advisers. Some of them may be excellent, but some may be in a comfort zone with respect to the company. They want the deal to go through. They don't want to be a troublemaker.

If you were to ask me whether I can be a due diligence "troublemaker" or not, that would be easy.

  • In one situation, a client was seeking to buy a company of similar size. My review caused me to tell them that the benefit and compensation plans were significantly undervalued and that their true cost was much higher. My client changed their offer. They were not the winning bidder. The winning bidder didn't win either; the deal put them out of business.
  • In another, a SERP attached to an employment agreement was worded very strangely. The seller said that it was the same thing that they had given their previous CEO. It sure was a good thing that somebody put pencil to paper, so to speak, to determine the cost of a change-in-control. Once the deal is done, there is not much leverage to go back and negotiate.
So, which home inspector are you going to engage? Who do you want to have performing your due diligence?

Wednesday, June 12, 2013

M&A Post McCutchen

Yesterday, I wrote about US Airways v. McCutchen. Today, I consider another practical application.

For those who didn't read yesterday's post or have already forgotten, McCutchen was clear in telling us that in the case of employee benefit plans, unambiguous plan provisions are controlling. What we also learn is that where plan provisions are ambiguous, well, we don't know exactly what we learned.

Now, let's consider the M&A world. Typically, when one organization is looking at buying another, a due diligence process starts. The acquiring company and its representatives (attorneys, accountants, consultants, etc) review documents, properties, and virtually everything else of any value that the potential acquisition may have. Typically, among the last of those elements to be reviewed are those that may fall under human resources, among them compensation and benefits programs.

Let's go back to McCutchen. Suppose the proposed deal is a stock sale, one in which the acquirer purchases the assets and liabilities of the other company. Among those liabilities are any resulting from benefits and compensation programs. Suppose one of the plans has terms that are vague. Further suppose that there is no particular documentation of the interpretation of those vague terms.

In my experience, representations and warranties frequently do not protect against such an occurrence. Consider a defined benefit pension plan. If the acquiring company has the opportunity to review all the documents and does, but in the case of this plan spends its time reviewing the results of actuarial calculations, what happens if the actuary is taking a reasonable, but incorrect interpretation of vague plan provisions. Perhaps the interpretation is based on the explanation of a benefits manager who retired years ago. Perhaps there is little if any documentation.

In a post-McCutchen world, this could be problematic. Perhaps the plan's obligations are larger than the acquirer has reason to know.

How can the acquiring company deal with this? During due diligence, review the plan provisions side-by-side with determinations of benefits. If every provision seems clear and the benefits determinations seem to confirm this, then things are probably just fine. If they are not, take particular care before the deal is done.

Again, typically, this sort of review is done by attorneys and accountants. Typically, neither has any experience with plan administration and often, neither has experience with actual determination of benefits. Ask an expert for help.

Tuesday, June 11, 2013

A Practical Response to the McCutchen Case

It's not often that an ERISA-founded lawsuit makes its way to the US Supreme Court. So, when it does, it's often big news. ERISA attorneys and litigators scramble to read the opinion and seemingly just as quickly work to analyze it and write on what the Justices said. Some do a very good job, others less so. I've read a lot of the legal analyses on US Airways, Inc. v. McCutchen and perhaps my favorite is this one from Morgan Lewis. If you are another attorney friend of mine who wrote on this case, your analysis was excellent as well.

All of my readers know, or at least I hope they know, that I am not an attorney. In fact, as of today, I've never even played one on TV. But, as a consulting actuary and sometimes expert witness, I deal with a lot of legal issues. I like to think though that my approach to them is practical and business-focused. In other words, I try to advise my clients to take actions that their attorneys would tell them are not in conflict with the law, but that are practical and facilitate them running their businesses rather than getting in the way. After all, administrivia is not our friend.

Before I get to the practical side, however, I find it incumbent upon me to tell you a little bit about the case. There may be some legal-sounding mumbo-jumbo (that's a term of art, by the way) in here, so be forewarned that stimulants could be called for.

James McCutchen was the unfortunate driver of a car whose vehicle was struck by what one might term an errant driver. As a participant in the US Airways health plan, a self-insured plan, Mr. McCutchen was reimbursed for $66,866 in medical expenses resulting from the crash. McCutchen also sued the driver of the other car for damages resulting from the crash. While McCutchen estimated said damages to exceed $1 million, he settled for $110,000. Of this amount, he paid his attorneys 40% or $44,000 leaving him with $66,000.

The terms of the health plan required McCutchen to reimburse US Airways for any amounts recovered from third parties. So, US Airways requested repayment of the entire $66,866. McCutchen argued that he had 1) recovered only a small portion of his actual damages and 2) that US Airways' share should be reduced proportionately to cover attorney's fees. After all, had he not engaged counsel, US Airways would not be entitled to any reimbursement.

The keys from a practical standpoint to the Supreme Court ruling were these:

  • The plan document is the governing document.
  • Where terms in the plan document are unambiguous, they absolutely control.
While not written, what may have been at least as important from where I sit were these less conclusive elements:
  • Where plan documents are not unambiguous (I know, you don't like double negatives, but I have used this one to make a point), the plan document may or may not be able to control.
  • In Firestone, Glenn, and Frommert, deference was given to the plan administrator's interpretation of the plan document, but what happens when the plan administrator either has not interpreted the provisions of the document or has not consistently interpreted them?
What should plan sponsors do? 
  1. Make sure that your plan document is well written. The mere fact that a plan has a favorable determination letter in the case of a qualified plan, for example, does not mean that the document is clear.
  2. Where the plan may not be crystal clear, the administrator should develop a set of administrative processes, procedures, and interpretations that are not inconsistent with the plan provisions and that are documented.
  3. Follow the processes, procedures, and interpretations that have been documented 100% of the time. 
  4. And, consider the advice that I am setting out below ...
For my final piece of advice on this case (for now), think about any plans that you sponsor that have any mathematical component to them. While I know many attorneys who are quite gifted mathematically, many others will admit that they are arithmetically challenged. Therefore, when they write the terms of a plan that have a computational element to them, those terms, to paraphrase Spock, may not compute. 

I offer you this. Do you have a plan with computational elements to it? [It can be a qualified retirement plan, a nonqualified plan, a welfare benefit plan, a compensation plan, or virtually any other type of plan related to your employees.] Are you not certain that the computational terms are unambiguous? Would you like another set of eyes -- a set of eyes that has experience with plan administration, plan document interpretation and that are not computationally challenged. Then go to my profile that you can find on this blog and contact me. I'll let you know if I can find ambiguity and if I do, I'll help you to fix it.

Monday, June 10, 2013

Asset Classes in DC Plans -- Should They be the Same as in DB?

I read several summaries of a BNY Mellon white paper entitled "Retirement Reset: Using Non-Traditional Investment Solution in DC Plans." Honestly, I would have read the whole white paper, but after searching for it on the BNY Mellon website using the exact name of the paper and having no related hits come up, I decided that I would have to stick with the summaries.

In any case, the paper attributes the limited range of investment options available in DC plans as the primary reason that participants' accounts in DC plans do not have the same performance as do DB assets. According to the author, Robert Capone, if DC plans were constructed more similarly to DB plans, participants would allocate about 20% of their assets to non-traditional strategies including real assets, total emerging markets, and liquid alternatives.

Reality check time, people!

The bulk of my readers are pretty savvy people. Would all of you choose to invest your own 401(k) money in these asset classes? Would you invest in a fund of liquid alternatives just because it was a fund of liquid alternatives?

There are a myriad of reason why participants in DC plans, on average, do not get the returns on investments that DB plan sponsors do. Here are some:

  • In theory, DB plans, have an infinitely long investment time horizon. That is, open DB plans generally do not have an accumulation phase and a decumulation phase. Sound sponsors can withstand blips.
  • In a DB plan, sponsors fight to keep asset-related fees low. They know that every dollar that they pay out in fees is a dollar that they will have to contribute. And, in fact, since PPA, it is generally a dollar that they will have to contribute immediately. In DC plans, usually, the investment management fees come right off of participants' top lines. It is human nature that plan sponsors will be seeking to get a good deal for participants, but not be as concerned as they are on the DC side.
  • DC plan participants, even if they choose to invest in non-traditional strategies, do not usually have the knowledge or the tools to develop an investment portfolio that sits on an efficient frontier.
  • DB plans don't have leakage. Whereas participants in DC plans may take plan loans or hardship withdrawals and have periods during which they are either unemployed or choose to not defer, DB plans have large pools of assets and liabilities.
  • DB plans spread those asset pools over a group of participants. The group has a liability profile and the group is diverse. In a DC plan, a participant is one unique person. That person is of a given age, and in an ideal world, one year later, that person will be exactly one year older. As the participant ages, if he follows prevailing wisdom, his portfolio should get more conservative. Are we really espousing that a 55-year old such as me should have 20% of his plan assets in non-traditional strategies? If so, should my bias be toward liquid alternatives? According to research that I did on a number of investment websites, this class has among the highest risk of all asset classes. Isn't it a little bit late in my working lifetime for me to be taking those kinds of risks?
In summary, I suspect that the BNY Mellon white paper is well-founded and well-written. But, it seems to me highly theoretical and perhaps not particularly practical advice. I have my own reasons why DC returns are not as good as those in DB plans.
  • Market timing -- many DC participants see that the markets are going up or down and move into equities after a rise or move out of them after a fall. Being behind the trend is not the way to increase investment performance. A set it and forget it strategy is generally better.
  • Target-date funds -- Target-date funds or TDFs are often the best way for participants in DC plans to have a properly diversified portfolio. However, when plan sponsors choose the family of TDFs for a plan for their employees, they typically do not do research to seek the best TDF. What happens more frequently is that they use the TDFs of their recordkeeper. As I have written many times, most TDFs are not funds of the best of the best. Instead, they are funds of proprietary funds. So, to pick on two of the largest players, a Fidelity TDF probably does not contain any Vanguard funds, and conversely, a Vanguard TDF probably does not contain any Fidelity funds. Custom TDFs are becoming more popular, but in practice, they are largely restricted to plans of large plan sponsors.
  • Lack of professional asset allocation -- A large DB plan will typically have an Investment Committee that controls its investments. That committee often has several people on it with professional training in investments. They engage outside advisers to monitor funds. They engage outside advisers to assist with asset allocation. They often pay large sums of money to see the results of asset-liability modeling. Such modeling often starts with goal-setting. On the DC side, even to the extent that a similar process is followed, it is done en masse. I'll bet that your plan's Investment Committee never asked you about your risks and your goals in developing an asset lineup for the plan in which you are fortunate enough to participate.
There are lots of reasons that DC plan returns, on average, are not as good as those in DB plans. I'm sorry to have to say it, but in my humble opinion, the lack of availability of real assets (are these different from fake assets), total emerging markets (as compared to partially hidden markets) and liquid alternatives (is this red versus white or Red Bull versus Monster) is not the answer.

I apologize for being so cheeky on a Monday morning, but I'm afraid that my parentheticals are not far from the average participant's comprehension of those asset classes.