Frommert Redux Again

ERISA is a funny law. I guess there are other funny laws as well, but I haven't worked with most of them as often as I have worked with ERISA. Consider the somewhat curious ERISA litigation patterned as Frommert v Conkright (you can read the most recent verdict here.

I'm not quite certain when the original case was brought, but I am certain that I was not yet eligible to make 401(k) catch-up contributions and I started making them in 2007. Since then, the 2nd Circuit Court of Appeals has heard the case three times (well, it hasn't always been exactly the same case). If it follows the pattern that it has thus far, it may even make it to the Supreme Court for a second time. Frankly, I don't know how often that happens, but it doesn't feel like it happens a lot.

So, why is ERISA a funny law? Much like lots of other American laws (and the Constitution for that matter), it was written in a somewhat different era. You know how that goes. As time moves on and creative minds are brought to bear, stuff happens. Not everything that happens could have been contemplated when the law was written.

You need an example? There are a lot of people out there in legal land who refer to the US Constitution as a nearly perfect document (I have heard it referred to that way virtually ever since I knew it existed). In fact, it's only been amended 17 times since the Bill of Rights and one of those amendments was passed to repeal an earlier amendment. So, one could argue that with an average of one amendment being passed and left in roughly every 15 years, it was pretty good.

Okay, what did the Constitution say about the internet? I was pretty sure it was silent on the matter, but I checked (ctrl-F lets you do that pretty quickly). It's not in there. So, how do courts rule on matters related to the internet. They use this legal mumbo-jumbo known as a precedent and then they often construe a relationship from one case to another. And, at the end of the day, it seems to this non-attorney that a judge or panel of judges will determine what they think is the correct answer and then leave it up to a smart, young law clerk to find them a rationale.

At its core, Frommert is about something known to retirement plan experts as a floor-offset plan. Essentially, a participant is entitled to a minimum benefit (the floor) and company defined contributions represent an offset. Since one piece of the benefit (DB) is expressed as an annual annuity and the other an account balance, performing the offset calculation requires that an administrator convert one piece of the calculation to be parallel with the other. This is done using a concept known as actuarial equivalence.

The concept of actuarial equivalence allows us to convert an account balance to an annuity or conversely. So, there's only one way to do this, right? Wrong!

The actual conversion depends on a set of actuarial assumptions, in this case the discount rate and the rate of mortality. Said differently, an account balance will pay you a different amount of money annually for the rest of your life depending upon how long you live and what interest rate is earned on the money.

The math in a floor-offset arrangement is funny, in much the same vein as ERISA is funny. Calculations, even when performed in the fairest sense possible produce unexpected results. One thing about them is certain, however, they tend to provide, relatively speaking, much larger benefits for the higher paid employees than for the lower ones. And, there is nothing in ERISA that specifically tells an administrator how to address every possible situation.

How funny are they? In Frommert (III), the court found a situation where it considered two virtually identical employees. Each retired in 2005 with the same final average earnings. Each had been hired in 1980. Employee A, however, was a rehired employee, having also worked for the company from 1960 to 1970. Employee B was a new hire in 1980. Solely because of that earlier period of employment, Employee A had a smaller benefit than Employee B. That is, Employee A was essentially penalized for his earlier period of employment.

Among other things, the court found that if this was a result of the offset calculation methodology that the method of offset was unreasonable and violated ERISA. Further, it found that the notices provided by the employer (Xerox) to employees about this plan were insufficient. So, the case is remanded (yet again) to the District Court where it will be re-heard, undoubtedly re-appealed regardless of the verdict and will very possibly once again wind up at the Supreme Court. I wonder how many of the plaintiffs will still be alive by the time this case is finally put to rest.

If You Like Your Plan, You Can Have Something

Perhaps my mind is easily boggled, but it boggles the mind. The Department of Health and Human Services has once again, this time by Bulletin, reinvented the Affordable Care Act (ACA, PPACA, ObamaCare). This time, Health and Human Services (HHS) Secretary Kathleen Sebelius disclosed through a letter to six senators that HHS had issued a Bulletin modifying enforcement.

According to the Bulletin and letter, "If you have been notified that your individual market policy will not be renewed, you will be eligible for a hardship exemption and will be able to enroll in catastrophic coverage."

Call me a cynic. You wouldn't be the first person to do so. But, here is the way I view the last three-plus years in the evolution of the ACA. First, the bill was getting very close to having enough support to pass. Then, Scott Brown (R-MA) was elected to fill the senate seat vacated by the death of Ted Kennedy (D-MA). This gave the Republicans 41 seats, enough to stop the Democrats from invoking cloture. The Democrats outmaneuvered the Republicans in working around the rules of the Senate and the bill was passed and signed into law. It was trumpeted as we all know quite famously that it would expand coverage, reduce the cost of coverage for most, and if you like your health plan, you can keep your health plan, PERIOD. Then came a website rollout so atrocious that even many of the most ardent supporters of the Obama Administration criticized it. Enrollment deadlines were delayed and insurers were told to reinstate policies for which they had already provided cancellation notices.

Somebody never worked in the insurance industry. Reinstatement is not that easy. And, there is also state insurance law to deal with here. So, many who wanted insurance were left without it. Yes, some number of previously uninsured had found their way to "get covered" as the Administration likes to say, but many who had been covered were left out in the cold.

Now, according to the HHS Bulletin, these same people can go on to the exchange and buy catastrophic coverage. This is the type of coverage that has been labeled as a substandard policy by some in the Administration.

Yes, my mind is boggled.

I was not one of those people who had said that health care did not need reforming. I always thought that it did and I still do. But, this is a perfect example of what happens when debate is cut off and 535 people who between them have little cumulative expertise on a subject (yes, I know there are some physicians in the Senate and the House) and who don't read the bill go ahead and vote on it anyway. Agencies are then left the unenviable task of regulating it and it always seems that, at the very least, a sizable minority of the people don't like the regulations.

So, enforcement apparently will be done as the HHS Secretary, presumably speaking for the President (this is entirely my guess), sees fit.

Silly me, I thought it was a law.

Future Shock Meets 1984

I remember reading both of the books. Everyone seems to have read or be familiar with George Orwell's "1984." Fewer recall Alvin Toffler's "Future Shock." While Toffler's was more about the psychological aspects of reacting to rapid change, I am using my blog-owner's license to use it hear.

So, this is a blog usually devoted to benefits and compensation. What does this have to do with these two books by these two authors?

I'm going to take you into a future world. Perhaps it will never occur, perhaps it will occur sooner than you think. As Orwell suggested, Big Brother knows more about you than you would care to believe. Today, Big Brother is not just the government or the Thought Police, it's Google, Amazon, your credit card company, your favorite place to buy groceries, Netflix, and the like.

There are two approaches that you can take. You can hate it. Many people do not like the intrusion. Many people do not like the lack of privacy. But, you know what? This is going to happen to you whether you like it or not. It is virtually impossible in today's world to avoid this intrusion and lack of privacy. So, the second approach is to embrace it.

When Future Shock meets 1984, your identity will live on a chip. As far as my vision can take me, that chip currently lives in your smartphone, but perhaps it will be somewhere else by the time we get there. Perhaps it won't be a chip at all, but that's not the point here.

By this time, Congress has gotten its act together (wow, that seems like it must be far, far in the future) and reformed or eliminated the Tax Code as we know it. This will be important because this new model will require much more flexibility and customization.

So, you start your new job and instead of negotiating your pay, you negotiate your total worth to your new employer, The Third Wave, Inc. (TTWI). [Those who get the reference are pretty literate, by the way.] On your first day with TTWI, you go into a meeting with Winston Smith, the head of all things people. At TTWI, Winston is not even a person, but a drone leading up the people function.

As you walk into the meeting room, your chip activates and based on all the data on your chip, Winston instantly produces a recommended benefits and compensation package for you. Winston knows that you have a mortgage to pay monthly, he knows how much your spouse earns, and he knows about your family. He also knows that you have a proclivity for collecting autographed original vinyl 45s of one-hit wonders and that you need additional cash to cover that.

You look at the flexible design that Winston has provided you, make one small change because Winston didn't know that you plan to accelerate your mortgage payments starting in two months, and you are on your way.

So, what do you think? Are you bothered? Did you like how smoothly the process went? Did you like not having to read hundreds of pages of legalese? Did you like getting recommendations that were customized to you?

It's coming -- maybe not in my lifetime, but it's coming.

IRS Gives Limited Pension Nondiscrimination Relief

Just 10 days ago, I wrote about the request to the IRS and Treasury from Senators Portman and Cardin to provide pension nondiscrimination testing relief to sponsors who have soft frozen their defined benefit (DB) plans. In Notice 2014-5, the IRS has done that, albeit on a temporary basis.

For background, a DB plan is soft frozen typically when a grandfathered group of participants are allowed to continue accruing benefits, but no new entrants are allowed into the plan. From a testing standpoint under Code Sections 401(a)(4) and 410(b), the plan will typically pass in the early years as the group benefiting under the plan will look a lot like the group that was benefiting immediately before the soft freeze. Eventually, however, as turnover tends to be higher among nonhighly compensated employees (NHCEs) than among highly compensated employees (HCEs) and because more participants will 'graduate' from NHCE status to HCE status than conversely, testing results get worse.

The typical alternative then is to aggregate the soft frozen DB plan with one or more DC plans for testing purposes. The aggregated plan is then referred to as a DB/DC plan, a name that does not quite roll off the tongue, but is descriptive nonetheless. DB/DC plans may be tested on a benefits basis (usually will pass) or on a contributions basis (usually will fail), but in order to be tested on a benefits basis, the DB/DC plan must jump through one of a number of hoops. Without going into detail, this is usually easy in the early years and gets more and more difficult with each passing year. Add to that that the DC plan being aggregated with the DB plan cannot be a plan subject to Code Section 401(k) or 401(m) (or a part of a larger plan subject to one of those sections) or be an ESOP and the process gets a little bit more difficult to deal with.

According to the Notice, if a sponsor soft froze its DB plan before December 13, 2013 and its DB/DC plan met one of the requirements to be cross-tested on a benefits basis for the 2013 plan year, then for any plan year that begins before 2016, the sponsor generally may continue to test this DB/DC plan on a benefits basis. In the meantime, IRS has requested comments on this notice and will continue to evaluate how such situations should be handled.

This relief is only short-term in nature and there are many situations that will not be helped by this relief, but if you are one of the lucky sponsors, this may give you the help you were looking for.

When You Know a New Tax is Bad

It seems that every year, there is a new tax that I or someone that I know has to pay or a new tax credit or both. Oftentimes, it can be taken care of on Form 1040 or some form that I already file in one line item, even if it feels like a random number generator fills in the amount that I get to send to my good friends at the Treasury Department.

As all my readers know, the Affordable Care Act (ACA, PPACA, ObamaCare) wasn't just any old law. And, since even the most optimistic of all proponents of the law knew that it would cost a lot of money, new taxes were needed to pay for it. These aren't just any old taxes. I'm talking about two in particular -- the 3.8% Medicare surtax on investment income for those individuals earning over $200,000 and for couples filing jointly earning over $250,000, and the 0.9% additional Medicare tax on earned income in excess of those same thresholds. (By the way, just like perhaps the worst structured tax in history -- the Alternative Minimum Tax -- those thresholds are not indexed.)

I looked at many of the personal taxes in the Internal Revenue Code. Almost without exception, when taxes apply to individuals or to couples filing jointly, the dual threshold is either twice the individual threshold, or at least meaningfully (50% or more) higher.

But, these are not your ordinary taxes.

All you lucky people (maybe you are just hard-working and it's not just luck) who will be subject to these taxes get to fill out not just one new form, but two new forms. That's right, you have to fill out Form 8959 to determine if you (and your employer) paid enough Medicare tax for you [and your spouse]. And, you need to fill out Form 8960 to determine if you were both a lucky earner and a lucky investor for the year.

I'd link you to the forms, but they are only available as drafts right now. And, I'm sure you don't really want to see them anyway.

Suffice it to say that as of now, Form 8960 looks like an easy one, but Form 8959 must have been jointly produced by the makers of Tylenol, Advil, and Aleve. You will have to have your Form W-2(s) in front of you while you suffer through the calculations and the eventual answer. Then if you are really lucky, you get to attach these two forms to your Form 1040 and send more money.

My conclusion? A tax (I know, it's really two taxes, but it looks like one to me) that requires two new forms can't be a good tax. Let's just get rid of it. I want to go back to the original income tax provisions -- pay 1% of your income in excess of $3,000. I'll even accept that the $3,000 is not indexed.

The Curious Tale of Prescription Drugs and The Affordable Care Act

Much has been written about the Affordable Care Act (ACA, PPACA, ObamaCare) with regard to keeping your plan and keeping your doctor. For many enrollees, one of the most critical and little-known elements in choosing your ACA plan may be the prescription drugs they take.

Consider this. If you enroll in a Bronze plan (the cheapest alternative considering only premium costs), you will have the highest deductible and highest out-of-pocket limits. On the other hand, if you enroll in a Platinum plan (highest premiums), you will have the lowest deductible and the lowest out-of-pocket limits.

Simple enough so far, isn't it?

So, as a plan member, you would assume that you can continue to take your standard medications. And, since it's all part of a government-mandated benefit program, you would also assume that the same prescription drugs would be available under each plan.

You would be wrong.

An ACA plan's treatment of a particular drug is a function of whether or not that drug is in the plan's formulary. For people who prefer simpler terminology, each plan's formulary is the listing of drugs that are covered by the plan. If a drug is covered by your plan, you will get discounted (think in-network) rates and your payment for that prescription will count against your deductible and out-of-pocket maximum. If it's not covered, however, then your payments will be full retail (not discounted) and will not count against your deductible or out-of-pocket maximum.

If prescription drugs are a significant part of your annual health care costs, then that leaves you with an easy solution in choosing a plan, doesn't it? You will simply look at the plan's drug formulary, compare it to what you are taking and consider how that will affect your annual cost.

Not so fast.

I actually know something about this law. My online search capabilities are as good as the next person's. I've been to the websites of several plans that can be found on the "marketplace" and in only one case thus far have I been able to find the formulary.

Suppose I find the formulary for every plan for which I am eligible. Then, of course, I can make an intelligent buying decision, can't I?

Think again. Even if you know the formulary, there is no data that I could find telling me what the discounts are under the various plans. But, I heard from someone who said he spoke with a pharmacy benefit manager (PBM) on this topic. He said he was told that pricing may vary wildly under ACA marketplace plans..

So, you tell me. Do you now know how to make your ACA buying decisions? I don't.

There's More to Risk than Just Risk

Risk is a four-letter word. There is even a book with that title (I've never read it and I'm neither recommending it nor panning it). Every CFO will tell you that they hate risk. Most large companies in today's world have large departments whose sole function is to deal with risk. They are tasked with identifying risk, measuring risk, and mitigating risk.

So, John, you're telling me there is more?

I'm afraid there is. When you have fairly constant risk, you can develop a plan to measure it and often to control it. On the other hand, when your risk is volatile, that feels worse.

Consider a hypothetical element of risk related to some sort of performance. Let's say that the mean performance is denoted by 0 and that good performance is denoted by a positive number and poor performance is denoted by a negative number.

Which series of outcomes would you rather have?

• 1, -1, 1, -1, 1, -1, 1, -1, 1, -1
• 0, 7, -4, -8, 6, -3, -11, 5, 8, 0

I suspect that 100% of my readers like the first scenario better. Why? Each has mean and thus expected cumulative outcome 0. But, in the first scenario, the expected downside is (negative) 0.5. In the second scenario, it's (negative) 6.5. 

I developed those results by determining the probability (based on each data set separately) of achieving a sub-par performance and multiplying that by the average negative score in all years in which the score was negative. 

Suppose I want to insure or hedge against this risk. In the first case, it seems like I would be safe insuring against a risk of 1. Suppose I can afford to actually lose (and cover out of assets) 0.5, then I need to purchase insurance or a hedge to cover the other 0.5 each year. 

In the second case, however, it's not so easy. If I know that my loss could be 11, does that mean that I need to insure or hedge 10.5? At the very least, I need to be able to cover my expected downside (for years in which I have sub-par performance. So, in no event can I consider hedging or insuring less than 6.0. 

While the relationship may not be linear, it is probably not a bad approximation. So, in this case, depending upon my view of the situation, I need to insure or hedge somewhere between 13 (this possibly is a linear model and is 6.5/0.5) times as much and 21 (costs less than 21 times as much and developed as 10.5/0.5) times as much. 

That additional cost and it is likely very significant in this case is the cost of volatility. And, that's just the financial cost. There is also the headache cost, the reputational cost, and lots of other associated costs. 

So, when somebody tells you that some riskier strategy is better because it has more upside potential, look at it the other way. Nobody ever lost sleep over an upside. 

Think about it a different way. Consider yourself a golfer. On the 18th green, you have a 5 foot putt that affects a bet you have made. If you are a millionaire and the bet is for $1, you probably don't care all that much (other than for ego and pride) whether you make it or not. You can afford to lose or not win $1. On the other hand, suppose you have $50 to your name and the putt is for $5,000. If you're like most people I know, you will be petrified. You can't stand that kind of risk.

Business works the same way.

Think about it.

Senators Portman and Cardin Appeal to Treasury for Retirement Nondiscrimination Help

We don't see it much in Washington these days, but Senators Rob Portman (R-OH) and Ben Cardin (D-MD) are teaming up once again. That's right, senators from opposing parties are finding common ground to do something together. And, they have a worthy goal. The key question, in my mind, is whether or not they have found a good way to achieve that goal.

A little more than a week ago, the dynamic duo penned a letter to Treasury Secretary Jack Lew asking that the Treasury Department review pension nondiscrimination regulations, specifically with regard to so-called soft frozen plans. They did this under the guise of retirement security for working Americans.

I have mixed feelings about what they write and I will come back to that later. First, however, it is necessary to give some background on pension nondiscrimination and soft freezes.

ERISA, signed into law on Labor Day, 1974, generally prohibited companies from providing nondiscriminatory pension benefits. While the rules perhaps had more teeth than I am going to see, this was generally achieved by showing three things about the pension benefits that were offered:

• That they were properly integrated (with Social Security) under Revenue Ruling 71-446
• That they covered a reasonable cross-section of employees (this was difficult to not satisfy in my experience)
• That they were comparable within the meaning of Revenue Ruling 81-202

Along came the Tax Reform Act of 1986 (TRA). It added some more specific rules to the Internal Revenue Code (Code) among them sections 410(b) and 401(a)(4). Together with a few related provisions, this suite of rules became known generally as the nondiscrimination rules. Regulations were long and cumbersome. But, unlike previous rules, they prescribed objective tests to determine whether the retirement benefits offered by a company were nondiscriminatory.

Objective tests are good and they are bad. From a practitioner's standpoint, they give us a set of bright line rules to follow. Exceed the thresholds and you pass. Fall short and you fail. It's pretty simple.

These sections of the Code were regulated fairly early in my career and I became somewhat expert at dealing with them. What I learned, somewhat oversimplified, is that it is quite rare that a tester, highly knowledgeable with respect to the rules, cannot force a company's plans through the tests to prove them nondiscriminatory. In fact, I worked with some situations that on their faces were very discriminatory in favor of highly compensated employees (HCEs) and proved that they were not.

There is one situation, however, that has always proven to be troublesome -- that of soft frozen plans. Generally, a defined benefit (DB) plan is soft frozen when participation (and benefit accrual) continues for employees who were in the plan on the soft freeze date and never happens for those who were not. In a variation on the theme, future participation is sometimes limited to those who have met some age and service threshold with the company as of the soft freeze date. 

What frequently happens is that over time, the population that remains in the DB plan becomes more predominantly composed of HCEs. And, as this happens, the DB plan on its own is not nondiscriminatory. What companies would like to do is to look at the total retirement program and show that it is nondiscriminatory. But, as many of these companies have only a 401(k) plan going forward (401(k) plans cannot be aggregated with DB plans for most testing purposes), the math just doesn't work.

So, companies wind up taking the only alternative that they can see and eventually totally (hard) freeze the DB plan. When they do so, the grandfathered employees, as a group, are often just at the point in their careers that their pension accruals are largest. These are the years that were going to allow them to retire securely.

This is the problem that Portman and Cardin seek to address. They tell us that the nondiscrimination rules were meant to enhance retirement security, not to detract from it. To me, this is where the difference in views that often occurs between legislators and businesspeople comes to the fore. 

Legislators, when developing retirement rules have often preached that if we force companies to provide similar benefits to nonhighly compensated employees (NHCEs) as to HCEs that the companies would increase NHCE benefits to meet that bogey. To paraphrase President Kennedy (who used the slogan of the New England Council (Chamber of Commerce)), they assume that a rising tide will lift all boats.

Historically, it hasn't worked that way. Faced with that situation, companies have opted to provide smaller benefits across the board, thereby lessening retirement security for most, and have found other ways to provide for their key employees.

Senators Portman and Cardin have a worthy goal. They seek to find a way to allow companies to continue to provide meaningful benefits to those people who have an expectation of those benefits. But, even if they do, they cannot solve the whole problem.

For years, Congress has passed bills designed to enhance retirement security only to see that each one in turn has caused more and more companies to get out of the business of providing retirement benefits to their employees. Oftentimes, these rules, such as the Pension Protection Act of 2006, have been poorly thought through, and actually decrease retirement security for workers. In fact, during my career, each time a major piece of pension legislation has become law, a swath of companies seek ways to get out of the business of providing pensions. But, no law over that period has caused companies to start up new plans.

If we want to restore a sense of retirement security for typical working Americans, we need to start anew from the beginning, not simply apply another band-aid to the problem. That said, I applaud the senators for making far more of a constructive effort than any of their colleagues.