Thursday, December 17, 2015

A Less Expensive Way to Provide Better Retirement Benefits -- DB

I've been pushing defined benefit (DB) plans hard lately. I still believe in them. The problem as I have noted is that regulators don't. They have done everything they can to kill them. Many are gone, many remain.

Yesterday, I happened upon a brief from Boston College's Center for Retirement Research. If you want, you can get the full brief here. In the brief, based on 23 years of data, Alicia Munnell, Jean-Pierre Aubry, and Caroline Crawford -- all from the CCRC -- demonstrate that returns on assets in DB plans actually are better than those in defined contribution (DC) plans.

When you combine this with the inability of many to defer enough to their 401(k) plans to get the full company match, you can see why many will never be able to retire well with a 401(k) as their core retirement plan.

For years, though, the cry has been that people understand 401(k) plans, but don't understand DB. But, suppose I gave you a DB plan that looked like a DC plan, provided returns for participants like a particularly well-invested DC plan, provided better downside investment return protection than a DC plan, and cost the employer less than a DC plan. What would you think?

In the Pension Protection Act of 2006 (yes, that was more than 9 years ago), Congress sanctioned what are now known as market return cash balance plans. What they are are DB plans that look like DC plans to participants, provide more and better opportunities for participants to elect annuity forms of distribution if they like, and provide the opportunity for plan sponsors to control costs and create almost a perfect investment hedge if they choose.

Suppose you had such a plan. Suppose to participants looking at their retirement website, the plan just looked like another account any day they chose to look. Suppose the costs were stable. Suppose the plan provided you as a sponsor more flexibility.

That would be nirvana in Xanadu, or something like that, wouldn't it?

Wednesday, December 16, 2015

Women's Pension Protection Act

Without much fanfare, on September 30, Senator Patty Murray (D-WA) introduced the Women's Pension Protection Act of 2015. Thus far, all of the co-sponsors are Democrats (or caucus as Democrats) and until Senator (and Democratic Presidential hopeful) Bernie Sanders (I-VT) signed on, all of the co-sponsors were women.

The bill is intended to address what a fairly large number of us view as an issue, that women are often not as prepared for retirement as men. And, there is no real thought here that this is because women choose to not prepare, but instead that their life circumstances (women bear children and men don't) are often different.

With no Republicans signing on, it seems unlikely that this bill will become law on a stand-alone basis, but it could become a negotiating point and get tossed into another bill of type or another that has broader support.

Generally, the bill would make two key changes:

  • Require spousal consent for lump sum distributions from defined contribution plans unless those distributions are made as part of a direct rollover (to another plan or IRA)
  • Change the coverage rules of ERISA Section 202 and analogously Code Section 410 to require broader coverage under qualified retirement plans for part-time workers who customarily work at least 500 hours per year
Fundamentally, what this bill would attempt to do is a step in the right direction. However, the implications of this bill from an employer standpoint would be to increase the cost of employing part-time workers. For many businesses that do employ such low-hour (10-20 hours per week or seasonal) workers, their choices would seem to come from among these:
  • Absorb the additional costs of employing these part-timers
  • Employ fewer part-time workers
  • Not have a qualified retirement plan
Two of those three options are not good for women (or for men, for that matter). And, this appears to be part of a trend in legislation that increases the cost of part-time, seasonal, and temporary labor.

Proponents of the bill would say that something needs to be done and that this would be a good start. They would tell you that minimum wages need to be raised and there needs to be a place in the workforce for less than full-time workers who will eventually be able to retire.

As I said, I would be very surprised if this bill were to move anywhere on a stand-alone basis, but it could be a bargaining chip as part of a larger piece of legislation.

Monday, December 14, 2015

Pension Risk (where to) Transfer

I opened my Plan Sponsor News Dash this morning and staring me in the face was the headline "Pension Risk Transfer Decisions More Than Financial." It was catchy enough that I decided to click on the link. What I found was that the attendant article was based on a white paper published by Prudential.

Think about that. One of the insurers that seeks business from companies looking to transfer their pension risks is warning plan sponsors that there may be more than meets the eye. While I give Prudential credit for laying out some of the issues, their doing so would certainly make me if I were a plan sponsor think twice.

Prudential focuses on what they describe as the three pillars of service delivery:

  • Retiree communication and education
  • Transaction and transition
  • Consultation and commitment
This is good stuff and it is important.

There are a few other elements that get less notice in the white paper (and perhaps it is Plan Sponsor's analysis of it). Prominent to me among those elements are the irreversibility of a decision to annuitize obligations of the plan and that such a decision is fiduciary in nature. Without commenting on whether they will have merit, what this commentator smells is litigation.

That's right. Not all annuity purchases will provide the same levels of security and service as plan sponsors expected. Without offering a legal opinion as I am not qualified to do so (I am not an attorney and do not and can not practice law), plan sponsors would appear to be well protected by following guidance from the Department of Labor (DOL) regarding "safest available annuity providers." But, as in many transactions that take time, that status could change during the process.

Consider insurer EL (those who were in this business 25 years ago may recognize a thinly veiled reference). At the time that defined benefit sponsor DBS makes its decision to annuitize certain of its obligations under the plan, EL has solid ratings from all of the major ratings agencies. DBS makes the decision based on a financial analysis to annuitize those obligations with EL. As we know, the process takes significant time and after a number of months, there are rumblings that EL may not be as solid as had been thought. Its ratings begin to slip.

Is DBS required to rethink its decision to annuitize with EL? Does it matter how far along in the process they are? Do the rumblings have to be substantiated? Do ratings have to have changed? Does anybody really know?

It's not unlikely that some attorney somewhere will find some potentially wronged participant or conversely and that the participant will decide that it's the right time to engage that attorney to litigate the matter. The fact is that even when you are fairly certain as a defendant that you will prevail in litigation, the defense is expensive. Did you factor that cost into your analysis of the financial effects of pension risk transfer (PRT)?

Suppose there was a better way. Suppose there was a way to intelligently transfer pension risk without making potentially questionable fiduciary decisions. Suppose you could leave the decisions that you really don't want to make up to your plan participants.

I'm not suggesting that you make the PRT process a democracy. No, I'm not suggesting that you assemble a quorum of participants and put the decision to a vote. But, there might be ways to give participants a say in the matter. And once a participant makes the decision for you, aren't you alleviating the burdens of litigation risk and front page of the newspaper risk?

If you are looking to go down the PRT road, annuitizing might be the right decision. On the other hand, it might not. 

Tuesday, December 8, 2015

Are You Missing Out Because Your Company Uses an actuary not an ACTUARY?

Okay, your company sponsors a defined benefit (DB) plan and you have an actuary and of course, your actuary is the best. Having been in this profession for 30 years, I've learned that most companies and their actuaries develop a mutual trust.

The reason is not as obvious as you think. How do I know that? It's because I have seen it in action. You see, actuaries produce numbers and results that most people don't understand. It seems magical. And because those numbers and results are often important to plan sponsors and the people who work for them, they develop a trust for the people who bring them those numbers.

Are those numbers correct? Almost always, they are.

So, tell us, John, what's your point? We should trust those actuaries, right?

In short, you should trust the numbers that they produce. Today, with sophisticated actuarial valuation software that is relatively uniform in the industry, most actuaries produce about the same bottom line numbers in an actuarial valuation.

So, what's the problem? It's just a commodity, isn't it?

Frankly, the problem may be in what your actuary doesn't tell you that an ACTUARY would. What I'm not being specific about here are things that would take up far too much space for this blog. But, how well do you understand the true financial effects of your plan? Are there opportunities that you are missing out on because your actuary hasn't told you? Is the problem that your actuary just hasn't thought about these things?

Honestly, it doesn't matter why you're not getting that kind of information, but just that you're not getting it.

An ACTUARY could show you what you're missing out on.

Contact me here or after January 1, contact me here.

It couldn't hurt, not even a little bit.

Sunday, December 6, 2015

October Three

January 1 of next year, I will be joining October Three, a concept-driven, results-oriented consulting firm. October Three brings the solutions that will shape the most successful retirement solutions now and in the future.

The firm consists of many of the innovative consultants from the firm formerly known as Chicago Consulting Actuaries and CCA Strategies.

I couldn't be happier than to be joining this group of smart, creative, and innovative consultants. Their work is of the highest quality and can bring your company, its plans, and its employees, solutions to any and all of your retirement problems. You won't get the same solution that some other company gets because that's the right one for them. Instead, you will get the ideal solution for your company and your employees to meet your goals.

Contact me now to start the process.

Friday, December 4, 2015

Another Argument for Defined Benefit

I know, defined benefit (DB) plans are dead. Actually, while there aren't as many as there used to be, I'm going to give you one more argument why they make more sense as a retirement vehicle.

Yesterday, I wrote about managing the risk in active pension liabilities. Way back in 2010, I wrote about generally managing risks and noted that plan sponsors tend not to manage defined contribution plan risks. Most of those risks that I have considered have been financial risk. Today, I am going to focus on the intersection of financial risk and compliance risk and make a case to have a DB plan as your primary retirement vehicle rather than a 401(k) plan.

In the world of 2015, we see consolidation in many industries. We also see companies, often private, being gobbled up by private equity firms. Either of these actions will usually create a larger controlled group. And, people who focus on retirement plan compliance know that most retirement plan compliance testing must be done on a controlled group basis.

Before working to point out a solution, let me give you an example to help focus on the problem.

BPE is a big private equity firm. Their general approach to retirement plans (and other benefits) has been to ignore them and let each company do what it wants. But, as BPE get bigger, its controlled group gets more complex. Having multiple industries represented in its portfolio, BPE is ultimately the sponsor of all kinds of 401(k) plans. Their engineering company (EC) has an extremely generous 401(k) plan that matches 150% on the first 8% of pay that an employee defers. Their pork rinds company (PRC) has a 401(k) plan that matches 10 cents on the dollar on the first 2% of pay that an employee defers.

BPE never saw this as a problem. But, then one day, an inquisitive Principal (IP) at BPE was reading my blog (of all things) and came across this. He saw that BPE might have a compliance problem in its controlled group because of the disparate nature of its 401(k) plans.

Ring ring ring -- that's my phone as IP calls me. He wants to know how to fix the problem. He says that surely this problem can't be real. After an hour on the phone, we have inventoried all the plans at BPE and found that they have failed to satisfy various compliance tests (coverage under Code Section 410(b), for example) for several years.

IP has a solution though. He tells me that BPE will force some of its companies to retroactively cut the employer match in some of these more generous plans.

Bzzz!

You can't do that. In fact, if BPE were to choose to fall on its sword and approach the IRS for a negotiated retroactive solution, we would suspect that the IRS would only be receptive to increasing benefits for nonhighly compensated employees (NHCEs) in the less generous plans.

IP is not happy about this. PRC runs on very low margins, but because they make more pork rinds than any company in the world, they do throw off a lot of cash. However, increasing benefits would eliminate most of that free cash that is being generated. There is stunned silence on the other end of my phone.

While the story is fictitious, the gist of the scenario is not. I've seen this happen. By being a serial acquirer, companies run into compliance problems and with 401(k) plans not being the easiest to prove nondiscriminatory, either costs escalate or they get cut at the portfolio companies that tend to employ more higher paid individuals.

What sort of plan tests better? A few weeks ago, I wrote about some. Suppose BPE had a defined contribution looking cash balance plan. One of the nice things about these plans is that they test well. Designed properly, and proper design truly is a key, financial risk is manageable. And, with that as their primary plan, the secondary 401(k)s can be managed so that compliance there will no longer be an issue.

Unfortunately, the benefits world has been resistant to this whole concept. But, you have an open mind, don't you?

We need to talk.

Thursday, December 3, 2015

Managing the Risk in Active Pension Liabilities

If you work with defined benefit (DB) pension plans at all, or if you happen to be among those responsible for them at a company that still sponsors an ongoing DB plan, you know that de-risking has been all the rage in recent years. And, this is not to say that this is not without good reason. With the inherent volatility in cash flow and accounting expense that has been added to the DB world by what some (including me) would consider poorly conceived funding and accounting rules, risk mitigation is often critically important.

So, let's consider what have been the trends in de-risking. There have been a mass of so-called lump sum windows in which former employees have been offered one-time opportunity to take a single sum distribution of the value of their remaining benefits thereby removing those liabilities from the plan's 'balance sheet' and thus eliminating the company's future liabilities with respect to them. And, there has been lots of liability driven investing (LDI). That is, companies look to invest assets in fixed income instruments of durations similar to the liabilities in the plan. By doing this, liabilities in the plan tend to move roughly in lockstep with the underlying assets intended to support those liabilities.

All this is great, especially for well-funded plans, but how about all the rest of those plans? And, these strategies tend to look at the liabilities that currently exist. How about the liabilities that will exist in the future (we used to consider those in actuarial valuations, but the law changes made them irrelevant in the annual valuations)? What do I mean by that? Consider an example.

The XYZ Pension Plan currently has its funding target (liability for accrued benefits). We can split that out among three groups of participants, two of which are composed of former employees. Suppose they are broken out as follows:

Retired participants: 100,000,000
Terminated Vested participants (former employees who are not yet in pay status, but are entitled to a benefit in the future): 30,000,000
Active participants: 70,000,000

for a total funding target of $200,000,000.

What do we know about the liabilities that compose this funding target? We know that the amount attributable to current retirees will generally decrease because for each year that a retiree lives, there are 12 months fewer of benefit payments that the retiree will receive in the future. This might tend to imply that this group represents a diminishing risk.

We know that the terminated vested group will become retirees. Generally, these are former employees with smaller benefits (they didn't work for the company until a retirement age). In the usual profile, they represent a far smaller liability than do retirees or actives. For a given vested term, the liability with respect to their benefit will generally increase as they approach retirement and then decrease. Lump sum windows were designed to target this group and have been quite successful. But, because their accrued benefits, and therefore attendant liabilities are smaller, the effect of having done this has not been as significant as it would be with a group of active employees.

The active employees currently accruing benefits are the most important group to de-risk. Why is this? There are several reasons:

  • In our example, and typically, their accrued benefits represent a meaningful liability to the plan and plan sponsor.
  • With each year that an active employee remains with the company, they are one year closer to retirement meaning that the discounting period until retirement has shortened.
  • In an active plan, these employees continue to accrue benefits (more on this to follow).
Yes, active employees continue to accrue benefits. Suppose we consider a concept that used to be paramount to actuarial valuations of DB plans -- the actuarial present value of projected benefits under the plan (PVB). This is the actuarially determined amount that if it sat in a pool of assets today would be sufficient to eventually fund the benefits of that individual. 

For retirees and vested terms, the PVB and the accrued liability or funding target or accumulated benefit obligation (ABO in accounting parlance) are, save differences in actuarial assumptions, the same as each other and the same as the PVB.

For active participants, they are not. In fact, for a mid-career person, the PVB may be more than twice as large as the liabilities we are consider. And, if we are de-risking, isn't it really the eventual benefit liability that needs to be de-risked? 

If you agree, you're correct, and if you're a plan sponsor, we need to talk. 

If you disagree, you're likely not correct, and if you're a plan sponsor, we need to talk.

There is a really easy approach to this that many companies have taken and that is to freeze benefit accruals under the plan. But, not everyone wants to do that. Some companies actually philosophically like the concept of DB plans. But, the funding and accounting rules have made it more difficult to get comfortable with sponsoring them.

Suppose I told you that you could mitigate the risk in the active PVB. And, suppose I told you that you could do that without freezing accruals. 

You'd be interested, wouldn't you?

Let's talk. You won't regret it. Here is one way.

Friday, November 20, 2015

How The SEC Got DB Plans All Wrong

Yesterday, I wrote that the SEC contributed to the downfall of defined benefit (DB) plans. I promised to explain in more detail in a future post.

Well, the future is now (I wonder if anyone else ever used that line before).

As readers of this blog well know, for about 10 years, issuers of proxies under the auspices of the Securities and Exchange Commission have been required to disclose compensation for their five highest paid employees. This compensation has been disclosed in a little beast known as the Summary Compensation Table and in more detail in several other places.

Some of the disclosure makes sense. For example, the salary that an individual actually receives is what it is. There is no disputing that. Similarly, the matching contribution that an individual receives in her 401(k) plan or in the nonqualified analog is what it is.

Some of the disclosure makes less sense. Fingers point to the defined benefit disclosures.

What the rules ask be disclosed as compensation with respect to a defined benefit plan (qualified or nonqualified) is the increase, if any, in the actuarial present value of accrued benefits from one measurement date to the next. That seems simple and reasonable enough on its face, but that is exactly where, how, and why the SEC went wrong.

Let's make up some Illustrative numbers for Well Paid Executive who we will refer to as WPE.

  • Total pension accrued benefit as of 12/31/2014: $1,000,000
  • Total pension accrued benefit as of 12/31/2015: $1,100,000
  • Actuarial present value "factor" as of 12/31/2014 using 2014 discount rates and 2014 mortality table: 11.00
  • Actuarial present value "factor" as of 12/31/2015 using 2014 discount rates and 2014 mortality table: 11.50
  • Actuarial present value "factor" as of 12/31/2015 using 2015 discount rates and 2015 mortality table: 12.50
So, the actuarial present value of WPE's defined benefit as of 12/31/2014 was 11*1,000,000 or $11,000,000. 

The actuarial present value of WPE's defined benefit as of 12/31/2015 was 12.50*1,100,000 or $13,750,000.

The compensation due to defined benefits that must be reported for WPE was 13,750,000 - 11,000,000 or $2,750,000.

But, this is not an apples to apples comparison. Really Big Company (RBC) did not actually compensate WPE for the fact that interest rates on bonds declined during the year. RBC also did not actually compensate WPE for the fact that the Society of Actuaries had finished a new mortality study. 

The actuarial present value of WPE's defined benefit as of 12/31/2015 using 2014 actuarial assumptions was 11.50*1,100,000 or $12,650,000. This means that the increase, on an apples to apples basis, in the actuarial present value of WPE's defined benefits was 12,650,000 - 11,000,000 or 1,650,000. The other 1,100,000 was due to changes in actuarial assumptions and DOES NOT REFLECT THE AMOUNT THAT RBC PAID WPE DURING 2015.

The SEC's methodology has thrown proxy disclosures out of whack. In light of Dodd-Frank and its Say-on-Pay requirement and Pay Ratio Disclosure requirement, the SEC methodology puts an inappropriate burden on companies sponsoring DB plans. For some, this may signal a reason for them to exit that space ... for all the wrong reasons.

Thursday, November 19, 2015

Who Put the Dagger in the Heart of Defined Benefit

What happened to defined benefit (DB) plans? We, at least those of us who can remember those times, saw a rise of them from the passage of ERISA in 1974 until the Tax Reform Act of 1986 (TRA86). They were viewed as an affordable way for companies to provide an excellent retirement benefit to their employees, especially ones that showed loyalty to those companies. In fact, most current retirees who have been retired for at least 10 years retired in part because they had those DB plans. And, companies that sponsored them and did so responsibly did not go out of business because of them.

Unfortunately, the number of DB plans has dwindled significantly. There was not a single killer, though. The list is long. It includes:

  • Congress
  • The Pension Benefit Guaranty Corporation (PBGC)
  • The global economy
  • The e-commerce economy
  • The temporary worker for hire economy
  • The Financial Accounting Standards Board (FASB)
  • The Securities and Exchange Commission (SEC)
Congress

What did Congress do that was so bad? Frankly, that crew of 535 individuals that changes in makeup from time to time did a lot. Between them, they rarely have anyone among them that knows much about DB plans. And, today, because their staffers who give them what they think is excellent guidance tend to be young, the advice that they actually get is colored by propaganda of the last 30 years or so. 

Nevertheless, Congress passed laws ... lots of them. And, lots of them included DB provision and each one was worse than the last. More than anything, though, because Congress intermingled retirement policy with tax policy so intimately, it eliminated plan sponsors' ability to fund DB plans responsibly.

Back in 1987, just one year after passage of TRA86, Congress, in its infinite wisdom, decided that the status quo, having existed for about a year, needed change. Included in that necessary change was limiting the amount that companies could contribute (and deduct on their tax returns) to DB plans. We were switched from a regime that was sound actuarially to one that never was and never will be.

Think about. Suppose you agree to pay someone an amount in the future. Shouldn't you be setting aside money regularly to pay for those future benefits? Of course, you should. And, DB funding used to be based on funding methods that allocated costs intelligently to the past, present, and future. But OBRA 87 began the path to dismantling those methods as Congress thought it better that DB deductions would be limited so that it could spend more money elsewhere. Thus was limited the ability of companies to responsibly fund their plans. And, as a result, as interest rates fell and there were a few significant downturns in equity markets, DB plans became [often] severely underfunded. Finally, the way these regimes worked, companies had no room to make deductible pension contributions in years that they could afford to, but were required to make large contributions in years that they could not afford them.

PBGC

For those that don't know, the PBGC is a corporation, run under the auspices of the Department of Labor, that was established by ERISA to protect the pensions of participants in corporate DB plans. The PBGC was and is funded by premiums paid by plan sponsors. 

While the purpose of the PBGC has always been to protect pensions, it has behaved over the last 30 years or so as if pensions should be in place to protect the PBGC. To the PBGC's policymakers, nothing would be a greater tragedy than the PBGC projecting that it would run out of money.

So, the PBGC lobbied Congress. And, with that lobbying, the PBGC got increased ability to intervene in business and in corporate transactions. It got increased premiums. It got even high premiums for underfunded DB plans, often ones to which the sponsors wanted to make contributions when business was good, but were precluded from doing so.

What happened?

The PBGC tried to commit suicide.

You see, as the PBGC helped to make DB plans less attractive for employers, employers froze entry to or terminated DB plans. This meant that there were fewer participants in DB plans on whom premiums were paid to the PBGC. Companies that couldn't terminate DB plans were the ones that had plans that were so underfunded that they didn't have enough money to fully fund them. Often, the PBGC had to assume responsibility for those plans. So, as the PBGC incurred more liabilities, it also got less premium revenue. It's awfully tough to run  a business that way.

Various Economies

As the US economy has become more global, more electronic, and more temporary, DB plans have lost some of their appeal, When a company was competing primarily with other US companies, providing excellent retirement benefits was important to attracting and retaining good employees. But, non-US companies didn't have to do that and as competition from offshore became fierce, retirement benefits became less of an issue.

And, as employers began to show less loyalty to their employees and were less worried about retaining them, retirement benefits lost some of their appeal. The prophecy was somewhat self-fulfilling; as retirement benefits lost some appeal, they continued to lose appeal.

FASB

Accounting for DB plans use to be more cash based than accrual based. In 1985, the FASB gave us Standards Number 87 and 88 that instructed companies how to account for DB plans. Previous to then, companies used Accounting Principles Bulletin (APB) 8, under which most companies expensed as part of P&L their cash contributions. The FASB saw this as incorrect.

So, we moved from a regime under which pension expense was somewhat controllable (a company by building up a surplus in good times could contribute less in bad times and thereby have some control over their pension expense) to one that had components that became quite volatile as the economy did. CFOs abhor volatility and thus had one more reason to not want DB plans.

SEC

The SEC didn't get deeply involved in pensions until recent times. But, when they did, they got them all wrong.

Primarily, the SEC's involvement with pensions has been in corporate proxies. For the last 10 or more years, companies have been required to provide as part of their proxy materials a table of Summary Annual Compensation for (generally) their top five paid employees. Included in compensation is the increase in actuarial present value from one year to the next of defined benefit pensions both qualified and nonqualified. 

Often times, that increase is largely due to a decrease in underlying discount rates or more recently, to a change in mortality assumptions. Yes, according to SEC rules, when the Society of Actuaries publishes a new, more up-to-date mortality table, that represents compensation to executives. And, of course, the media loves to look at those numbers as if someone had written checks for those amounts in those years to those executives. And, some investors look at those numbers and want to use them to explain how the companies in which they invest overpay their executives. (This is not to say that they don't overpay their executives, but when a large piece of the overpayment is simply due to year over year changes in actuarial assumptions, the logic is bad.) 

There are better ways. Actuaries understand them. And, actuaries, in some cases, have tried to explain them to the SEC. But, the SEC has chosen to listen more to attorneys, accountants, lobbyists, and unions. They carry more sway and are more emotional about this issue, but generally speaking, they don't get it.

I'll write about a better way in another post soon.

But, in the meantime, now you know where the dagger came from. DB plans use to allow people to look forward to retirement. For most, they don't anymore.

Friday, November 13, 2015

Identifying the Wrong Vendor

When we seek a consultant or any sort of vendor for that matter, there are signs that we have identified a good one. Most of us can recognize some of those signs, but they don't always jump off the page at us.

Often, just as important is the ability to recognize the wrong vendor or consultant. In fact, personally, I might rather miss out on the most qualified so long as I know I am not getting someone who is not qualified at all.

I could highlight some things to look for or even make a list, but I'm going to take a different approach. Everyone seems to like illustrative stories. So, let me give you one that I recently encountered where I'll change the names and fact patterns a bit to protect the innocent ... and the guilty.

A mid-sized company (let's call them National Widget or NW) issued a request for proposal (RFP) for assistance with developing the components of an employment agreement for a potential new CEO. As is good practice, they issued the RFP to five prospective consultants (five is not necessarily THE right number, but it is certainly in a range of reasonable) asking among other things for

  • Staffing
  • Qualifications
  • Experience
  • Timing
  • Fees
  • Project methodology
A key place that National Widget went wrong is that the three people making the decision on choosing a vendor didn't really have experience in this area. Of the five companies that received the RFP (all responded), three were name-brand firms, one was a niche firm specializing in consulting on executive issues, and one was a firm (WCDA (I'll explain the acronym later) that had done good work for NW on a health insurance related project.

I thought that three of the proposals (two from the name-brand firms and one from the niche firm) were good enough that if I were choosing, I would have been comfortable with them. Let's consider the other one.

Big Firm B (BFB) came in with the lowest fee quote. In fact, it was the lowest by a wide margin. The proposed staffing on the assignment consisted of two relatively junior consultants. Their bios pitched that they had MBAs from top-5 programs. When the proposal discussed experience, it didn't mention any assignments related to CEOs. It also didn't reference any assignments related to employment agreements. And, the proposal was filled with fancy graphics laying out the project methodology and timeline. What is was missing though was anything that would have convinced me that the two young rising stars actually understood the assignment. Fortunately, NW chose not to engage BFB. 

As I see it, there were a few red flags here:
  • If there is one fee quote that is far below the rest, consider whether the people preparing that quote understand the entire assignment.
  • Why are they quoting that low? Are they overly tightly scoping and then going to nickel and dime you on extras to make it back?
  • When a proposal that doesn't need pictures and graphics to explain itself is filled with them, what are the bidders using the visuals to hide?
  • Does the staffing chosen seem to fit the proposed assignment?
Now let's consider the WCDA proposal. 

It was delivered by the project lead from the health insurance project. It spent two full pages telling NW about all the money that WCDA had saved NW on their health care costs. It played up the fact that WCDA has more than 50 employees who have passed their FINRA Series 7 exam. We learned that they also have 11 employees with PhDs. Further, of the three people assigned to this project, two would be chosen from among that group with PhDs (I'm not knocking attainment of a PhD; that's a tremendous achievement.). Finally, the proposal from WCDA pointed out many of the different types of projects that their firm had completed in the last twelve months including a business valuation on behalf of a private equity firm, development of a new e-commerce platform for a new fantasy football oriented company, and a conjoint analysis of employee preferences related to volunteerism opportunities. 

Note the red flags:
  • Most of what was in the WCDA proposal was unrelated to this assignment.
  • WCDA highlighted credentials and qualifications that were irrelevant to development of an employment agreement.
  • WCDA led with a reminder that it had helped to save NW money in an unrelated area.
The bad news was that NW hired WCDA. What I didn't tell you was that the closing sentence of WCDA's proposal was, " For NW, We Can Do Anything."

Well, WCDA may think they can do anything, but the fact is that they didn't understand this assignment. In the recommendations that they delivered, WCDA spent a full page explaining that they are 
  • Registered Investment Advisors
  • Chartered Arbitrators
  • Fellows of the World Coffee Drinkers Association (there actually is a World Coffee Drinkers Association, but I chose it for the WCDA acronym)
WCDA's recommendation report was long. It needed to be to justify the level of fees. It contained lots of filler, or fluff, if you prefer. What is was short on was substance. That shouldn't come as a surprise, though, because WCDA's proposal was also short on substance.

The end result was that National Widget couldn't use the work that WCDA had done for them. They had to go out and pay a second firm to do the work properly. The red flags were waving right in National Widget's face, but they chose not to see them.

Don't make the same mistake. Engage qualified people who understand what you are looking for.

Thursday, November 12, 2015

CFO Priorities and Benefits and Compensation

CFO magazine did their annual survey of the priorities of chief financial officers recently. I read their article summarizing the findings from the survey and considered what this might mean for benefits and compensation.

Before I go on to my main topic, however, I need to bring up a few of the issues that I found near the bottom of the article. Three priorities that the article highlighted were written communication, networking with peers and presenting to large groups. Frankly, these are not just CFO priorities; they should be priorities for every professional in our 2015 world, and I was absolutely thrilled to see written communication in the list.

Returning to the main points of the article, I point out some of the top priorities that are more day-to-day for CFOs.


  • Precision and efficiency in cash forecasting
  • Budgeting
  • Balanced scorecards
  • Margins
  • Risk management
  • Performance management
Additionally, and in many cases perhaps more important, but less relevant for this blog is cybersecurity.

Let's also consider what some of the main elements of traditional benefits and compensation packages look like (with some grouping at my discretion).

  • Health and wellness benefits
  • Retirement benefits
  • Other traditional welfare benefits
  • Feelgood benefits
  • Base pay
  • Short-term incentives (bonus)
  • Long-term incentives (often equity)
Health benefits are now essentially a requirement. Either you provide them or pay a fine under the Affordable Care Act (ACA). But, companies have lots of techniques that they can use to control costs. Popular today are high-deductible health plans (HDHP) where oftentimes, companies contribute fixed amounts to health savings accounts (HSAs) to help employees pay for costs up to those deductibles. Among the major advantages of these designs are that companies do a much better job of locking in their costs. In other words, more costs are known and far fewer costs are variable or unknown. 

On the subject of retirement benefits, I'm going to give you a shocker. In matching those CFO priorities, the single worst sort of retirement plan that a company can sponsor is a traditional 401(k) plan with a company match. That's right -- it's the worst! Why is that? In a 401(k) plan, the amount of money that a company spends is almost entirely dependent upon employee behavior. If you, as an employer, communicate the value of the plan, employees defer more and that costs you more. Most companies budget a number for their cash outlay for the 401(k) plan. Very few, in my experience, look at potential variability. One that does and that I worked with on this a number of years ago, estimates that between best case and worst case, that the difference in their cash outlay could be in the range of several hundred million dollars. That is a lot of money.

So, what is better?

Believe it or not, I can come up with lots of rationales (much beyond the scope of this post) for why having a defined benefit plan as a company's primary retirement vehicle is superior to using a 401(k) plan. Understand, I'm not talking about just any DB plan. But, the Pension Protection Act of 2006 (PPA) opened the door for new types of DB plans that either were not expressly permitted previously or, in other cases, that were generally not considered feasible. Think about a cash balance plan using a market return interest crediting rate with plan investments selected to properly hedge fluctuation. Cash flow becomes predictable. Volatility generally goes away. Budgeting is simple. The plan can be designed to not negatively affect margins.

I may write more in a future post, but for now, suffice it to say that this design that has not yet caught on in the corporate world needs some real consideration.

How about compensation? 

Base pay is the easiest to budget for. If you do have a budget and commit to not spending outside of that budget, base pay is pretty simple to keep within your goals. 

Incentive compensation is trickier. While many organizations have "bonus pools", they also tend to have formulaic incentive programs. So, what happens when the some of the formulaic incentives exceeds the amount in the bonus pool? Either you blow your budget or you make people particularly unhappy. There is little that will cause a top performer to leave your company faster than having her calculate that her bonus is to be some particular number of dollars only to learn that it got cut back to 70% of that number because the company didn't budget properly.

Perhaps it is better to assign an individual a number of bonus credits based on their performance and then compare their number of credits to the total number of credits allocated to determine a ratio of the total bonus pool awarded to that individual. After all, isn't the performance of the company roughly equal to the sum pf the performances of individuals and teams? And, if the company has a bad year, isn't it impossible that every individual and team exceeded expectations? Be honest, you know that has happened at lots of companies and the companies don't know what to do or how to explain it.

There is lots more to be said, but I want to keep it brief for now. If you have questions on some of the specifics, please post here or on Twitter or LinkedIn in reply to my post or tweet. And, if you have one of these areas on which you'd like to see me expand in a future post, let me know about that as well.

Wednesday, August 26, 2015

30 Years Ago Today

Thirty years ago, I started on a journey. I arrived at a new job with a firm that no longer exists in the form that it was in back in 1985. Hewitt Associates (HA as it was referred to internally) was a consulting firm whose primary business was actuarial consulting on defined benefit pension plans in the US. It was a partnership. The number of firms like that that still exist has dwindled. In that size range of company, their number has dwindled to zero.

In any event, I was embarking on a career as an actuary. Frankly, I had no idea what I would be doing in that career. I had taken the first two actuarial exams because my starting salary depended on them. One was basic college math (mostly calculus) and the other was probability and statistics, so I thought I would be doing a lot of math in my career. I guess I have, but rarely that type of math.

I was going to be working on corporate pension plans. I didn't know what a pension plan was. I didn't know much else about what I was going to be doing either. I recall a friend asking me just the day before what I was going to be doing. I had no idea.

What I do recall is that I ran a proprietary computer program on a mainframe computer. As I was instructed to do, I took a lot of numbers from the output and put them in rows and columns on large green ledger sheets. Mostly, I added them vertically and I was very good at that. I then took the sums and placed them on other worksheets where I got to do addition and subtraction mostly. Sometimes, I amortized these numbers over time, usually using an HP-12C. It's still the calculator of choice in the profession.

Eventually, I took many of these numbers and used them to mark up something that I learned was called an actuarial report. My markup went to this ancient-sounding thing called a typing pool where a group of really good typists would make my ugly handwritten draft look pretty. They used another ancient device known as an electric typewriter.

I don't quite do the same things anymore, but some of it is still related to corporate pension plans. As time passed, my career moved from doing the grunt work to consulting based oftentimes on what others did.

It's a career that has taken me through highs and lows. I've made some of the finest friends a person could ever imagine. And, along the way, I think I've gotten pretty good at what I do. My profession has been good enough to honor me a few times. That was pretty cool.

One thing that has not changed at all about what I do is the respect and actual greatness of the profession While we are joked about as being boring nerds, actuaries are a rare, yet important breed. We tend to look at problems differently than most and that view that we take is often incredibly effective.

I'm proud of the profession. I'll take this moment to say that I'm pretty proud of what I have accomplished, too.

Monday, August 24, 2015

How to Handle Your Pay Ratio Disclosures

This is an article that I wrote for Bloomberg BNA that was published last Friday, August 21. Note that you may not reproduce this article without express written permission from BNA.


Reproduced with permission from Pension & Benefits Daily, 162 PBD, 08/21/2015. Copyright 2015 by The Bureau of National Affairs, Inc. (800-372-1033)
 http://www.bna.com


Pay Ratio Rule: Practical Tips for Making the Best of a Bad Disclosure Day

 BY JOHN H. LOWELL

Introduction
I t’s been about five years since Congress passed and President Obama signed into law the Dodd-Frank Wall Street Reform and Consumer Protection Act. In response to the financial crisis that escalated in 2008, legislators sought to put more controls on primarily the larger financial institutions that do business in the U.S. But, buried in this law was a little-debated provision sitting in Section 953(b). It has become known as the ‘‘pay ratio’’ rule.

On its surface, the pay ratio rule seems innocuous. Filers of proxies are to disclose the ratio of the compensation of the median-paid employee of the company to that of the CEO. However, as many have learned, this may be more difficult and more inflammatory than it seems.

In early August 2015, the Securities and Exchange Commission issued a final rule, effective for proxies for fiscal years beginning after 2016, explaining exactly who needs to disclose this ratio and how this is to be done. To its credit, the SEC tried its best to satisfy the needs of those who view this ratio as an important data point for a company and to satisfy companies that complained of potentially large expenditures to produce what they view as a seemingly meaningless number.

If what you need are the technical details specific to your company as to how these calculations are to be done, you can find summaries all over the Internet. Securities or executive compensation counsel will be more than happy to help you. What you may have more difficulty finding are explanations of how to prepare for that 2018 proxy season and what strategies your company may employ as permitted by the final rule.

Key Elements

Before we dive into that, it’s important to review some of the key elements of the final rule, particularly in places where either the SEC has made changes from the proposed rule or where it has afforded employers certain options.


  • While the statute tells us that the number disclosed shall be the compensation of the median employee divided by that of the Principal Executive Officer (CEO for our purposes), both the proposed and final rules specify that it is in fact the reciprocal of that (a positive integer is intended). 
  • Generally, all employees of the parent company and subsidiaries included in the consolidated financials must be included, but:  
    • who is an employee may be determined as of any representative date within three months of the end of the fiscal year; 
    • compensation for full-time employees may be annualized, but part-time, temporary and seasonal workers’ pay may not be annualized; 
    • workers from countries with privacy rules that may preclude obtaining the necessary data may be excluded (if you exclude one worker from a country, you must exclude all of them); and 
    • companies may exclude all workers from additional countries up to a total of 5 percent of the total company employee population. In doing so, first the employees excluded due to privacy laws are counted. If that gets the company to 5 percent or more, then there are no more exclusions. If not, then additional countries may be excluded so long as the total of privacy exclusions and selected exclusions does not exceed 5 percent of the total number of employees of the company. 
  • Determination of the median-paid employee has been simplified: 
    • solely for purposes of determining who is the median employee, the company may look to compensation amounts from payroll or tax records; and 
    • once a median employee is chosen, the company may use the same employee as the median for two more years so long as there have not been changes to the company’s population or pay practices significant enough to make that determination unreasonable. 
  • Companies may apply cost-of-living adjustments to equalize pay between countries. s Companies may add to their disclosures so long as the additions are no more prominent than the required disclosure. All that gives companies some useful options, but with options comes analysis to determine what to do and where the data will come from. 
  • Determine which countries the company operates in. For those countries, determine: 
    • whether privacy laws preclude obtaining necessary data, 
    • what percentage of employees is excluded due to privacy laws, and  
    • if less than 5 percent, are there other countries that it would be possible and beneficial to exclude? 
  • What will it take to get payroll or tax records from all the countries? Alert people responsible for them in each foreign country now as to what you will need. 
  • Consider whether the value in using cost-of-living adjustments outweighs the cost of doing so. For some countries, good cost-of-living data may be very difficult to obtain. For others, while the national cost-of-living index may be high or low, the cost in the areas in which your employees work may be very different.
  • Consider the benefits of sampling employees rather than using the whole population. Based on the descriptions of sampling techniques described by the SEC in both the proposed and final rules, for most companies, this exercise will not be worth the trouble of understanding the sampling techniques. 
Perhaps the most important decision that a company will make regarding the pay ratio is what it chooses to disclose. Some companies won’t have to worry about it every year, but in some years these pay ratios are going to be very large. Even if the company’s board of directors feels certain that CEO compensation at their company is reasonable, the optics will be bad.

Good consultative thinking can be very helpful here. Let’s consider a few possible situations.

Examples

Company A – Many Seasonal Employees.

Company A (calendar-year filer) does significant business around the holidays. In fact, its workforce is typically about three times as large between September 15 and January 15 as it is the rest of the year. Because of that, the median-paid employee of Company A is likely to be a seasonal employee (recall that companies are not permitted to annualize the compensation of seasonal employees). Additionally, those seasonal employees likely never meet the requirements to participate in most of Company A’s benefit programs including its pension plan. This pay ratio is going to be high. Company A should consider making an additional disclosure showing a comparison of the compensation of its CEO to that of its median full-time employee. While this won’t change the required number, it will improve the optics significantly.

Company B – U.S. Pension Only.

Company B is a multinational organization with significant employees in countries around the globe. Most of the U.S. workforce is well-paid, making it unlikely that the median employee will be from the U.S. Company B has provided both a broad-based and a nonqualified pension plan in the U.S. for many years. In most of the countries in which it operates, providing pensions is not the norm and doing so would make Company B less competitive. Because the increase in the actuarial present value of accrued pensions is part of the calculation of ‘‘annual total compensation,’’ the pay ratio is going to be larger than Company B might like and its board thinks the required ratio is not representative. Company B should consider providing a ratio for the U.S. only and a ratio without regard to pensions as supplemental disclosures.

Company C – Excellent Performance Leads to Larger-Than-Usual Incentive Payouts.

Because of extraordinary performance over the period ending Dec. 31, 2016, Company C’s executives received much larger-than-normal cash incentive payouts (short-term incentive) and equity grants and awards (long-term incentive) in 2017. The pay ratio here is going to be very high, but the board’s rationale is that the CEO deserved it. There may be many readers of the pay ratio who don’t agree. Perhaps they won’t look at the reasons for the high pay ratio, but simply the number itself.

Company C might consider a number of options. First, there might be a narrative describing why certain elements of compensation were as high as they were. Second, Company C might disclose what the pay ratio would have been had the company (and CEO) merely met goals for the year rather than exceeding them. Third, Company C might disclose what the pay ratio would have been had its CEO received his average incentive payouts for the last three years or five years. Any or all of these will help to lend some perspective to the otherwise high pay ratio.

Company D – Varying Global Economies.

Company D has its operations primarily in the U.S. and in South America. It provides broad-based and nonqualified pensions in virtually every country in which it operates. During 2017, the economy in South America was vastly different from that in the U.S. As a result, while interest rates dipped in the U.S., they rose significantly in every country in South America in which Company D operates. This combination produced massive increases in pension values in the U.S. (for executives and for rank-and-file), but decreases (zero for annual total compensation purposes) in all of South America. Since pensions are a significant portion of actual compensation for Company D’s South American employees, their compensation will appear understated for 2017 while the CEO’s compensation will appear overstated.

Company D should consider several additional disclosure options:


  • Disclose a ratio for its U.S. employees only,  
  • Disclose a ratio assuming that pension discount rates had not changed in any country, or 
  • Disclose a ratio without regard to pensions. 
Company E – Highly Diversified Global Business.

Company E is probably the most complex situation we will face. In the last few years leading up to and including 2017, it has generated a significant part of its revenue and most of its profits from its financial services division, which operates mostly in the U.S. Its CEO has to operate like the leader of a large bank and is therefore compensated commensurate with that. But, as a hedge against cyclical issues, Company E also operates in a variety of other industries and in multiple countries. The industries that are the most labor-intensive also employ the majority of their workers in low-paid third world countries. And, to the extent that Company E is involved in those industries in the U.S., its workers are largely unionized.

Company E has considered sampling to simplify the process. However, upon an examination of the rules, Company E realizes that it will have to do samples of each of its industry groupings in each country in which it operates. While it might reduce the number of employees that it has to evaluate, the expense of getting through the samplings outweighs the gains.

Company E realizes that its pay ratio is going to look very high. Philosophically, it is fine with that as its board feels certain that it is justified. But with multiple union contracts coming up for bargaining, Company E also knows that the unions will use the pay ratios to wage multiple media campaigns against Company E and its CEO.

In its disclosures that will go along with its required pay ratio disclosure, Company E needs to consider all of this. Here are some of the disclosures that Company E might make:

  • U.S.-only pay ratio, 
  • Disclosure of median pay for a typical employee in each of the U.S. unions with a breakout highlighting the company’s large expenditure on union pensions,  
  • Salaried-employee-only pay ratio, or 
  • Additional pay ratio compared to the union employee’s median pay encompassing elements not normally included in annual total compensation such as health care expenditure. 
Each of these additional disclosures has a cost associated with producing it. But, in Company E’s view, not producing ratios like this may be more costly than the hard costs to generate them.

Now What?

If you happen to be a part of one of the fortunate companies for whom this disclosure will neither be a calculational nor public relations problem, then your job should be easy. If, on the other hand, your company is closer to one of these more problematic situations, then you might have your work cut out for you.

Chances are that most in your company will not focus on this until after the end of fiscal year 2017. That may be okay, or it may not. Developing some of the ratios that we’ve discussed may be time-consuming and data-intensive. Trying to do that at the last minute may not be advisable.

Similarly, for a number of companies, this will be more than a calculation. It will be a strategy. Given the potential cost in investor relations and perhaps a battle over say-on-pay, it might be wise to have someone independently thinking about these issues. While using consultants haphazardly can create problems that were never there instead of solving them, here using a consultant who has thought through the issues and can help your company do the same would likely be money well spent.

You know that your company pays both rank-and-file and executives appropriately. Now you have to ensure that you manage the message so that all the interested observers know that as well.

Friday, August 7, 2015

SEC Finalizes Pay Ratio Rule -- Read the Plain English Description Here

Wednesday, after much controversy over the last five years, the Securities and Exchange Commission (SEC) released its final rule under Dodd-Frank Section 953(b) sometimes known as the Pay Ratio Rule. I have friends who are executive compensation attorneys and if you need legal advice on this rule, I can recommend any number of them to you, but I am going to write about it from a practical standpoint in plain English. What happened?

First, I'd like to commend the SEC. The statute on this rule has been very controversial. The SEC, in my opinion, has taken an approach that remains largely faithful to the exact wording of the statute and fully faithful to the intent of the statute (I'm not here to argue if the statute is worthwhile) while at the same time being sensitive to the concerns of employers with regard to the potential cost of compliance. It's rare that a government agency handles such a quandary this well.

Back in 2013, the SEC released a proposed rule on this topic. Since that time, the SEC received 287,400 comments on the proposed rule. More than 285,000 of them were form letters, but that still means that roughly 2,000 people took the time to write customized comments. To the credit of the Commissioners, they appear to have considered every last one of them. What they have crafted is practical, assuming that you find the result of the work practical.

What does the rule say? Here we go.

In its definitive proxy, each registrant shall disclose three items (at least since the rule says that the disclosure may be augmented):

  • The pay (as defined for proxy purposes) of the PEO (generally known as the CEO or Chief Executive Officer),
  • The pay (same definition) of the median-compensated employee of the employer, and
  • The ratio of the first item to the second expressed as some number (integer will work) to 1.
Identifying the median compensated employee can be a very costly process. Consider a company with 1001 employees. The median compensated will be the one whose compensation is more than that of 500 others and less than that of 500 others. In order to determine this (by the letter of the law), one would need to determine the annual total compensation (that's the proxy compensation) or ATC for each of the 1001. They would need to be ranked and then we would find the 501st person. That is a lot of work.

The final rule allows for two significant simplifications for purposes of determining the median employee:
  • Companies may choose to use sampling techniques in order to reasonably determine who the median paid employee is, and
  • Companies may use and consistently applied measure of compensation from payroll or tax records.
While the first of those may be more trouble than it is worth, the second should be a big help to lots of companies.

Further, once a company establishes a median employee, it may use that same employee for three years provided that there have not been significant changes (undefined term) in the compensation practices or the makeup of employees. If that employee terminates, then the company may reasonably select a similarly situated employee as a replacement.

Many commenters were concerned about the disclosures for multi-national companies especially those with significant numbers of employees in lower cost-of-living countries. Certainly, for example, $50,000 per year goes further in Kyrgyzstan than it does in the US. The final rule allows companies to adjust (on a nation-by-nation basis) compensation for cost-of-living differences.

Calculating proxy compensation can be cumbersome. It includes other than just cash compensation. So, for companies with defined benefit plans and broad-based equity compensation arrangements, it is entirely possible that multiple outside experts would need to be engaged. While that remains the case, the final rule allows companies to make reasonable estimates of components of compensation.

The statute makes clear that an employee is every employee worldwide, whether full-time, part-time, temporary, or seasonal of the controlled group. The final rule allows for all of these simplifications or adjustments:
  • A determination date applied consistently within 3 months of the end of the fiscal year
  • Only subsidiaries included in the consolidated financial statements need be considered
  • Employees where data may be unattainable due to national (or EU) privacy rules may be excluded
  • De minimis numbers of employees (up to 5% in total) may be excluded on a country by country basis
Let's look in more detail at those last two. Suppose the number of employees excluded under the privacy rule exception exceeds 5%. Then you are done with your exclusions. On the other hand, if your privacy exclusions are exactly 2% of your total population, then you may exclude other countries whose total employee population is less than an additional 3% of your total population. If, for example, you can't find another country with fewer than 3% of your total employees, then you are done with your exclusions.

In preparing these disclosures, companies will make lots of assumptions, simplifications, and estimates. All must be disclosed.

In somewhat of a gift to employers, additional disclosures and ratios are permitted, but not required so long as the additional disclosures and ratios are no more prominent than the required ones. I think this could be useful.

Consider a company with its management team and sales force in the US, but the bulk of its production facilities in third world countries (I'm not weighing in on whether this is a good or responsible practice or not). Because manual labor is particularly inexpensive in Burkina Faso, for example, Everybody's Favorite Company (EFC) has an extremely high pay ratio, say 10000 to 1. Its CEO had total compensation of $10 million and most employees in Burkina Faso earned only $1000. And further, EFC can't find cost-of-living data for Burkina Faso, so it is not able to do that adjustment. EFC is perhaps rightfully concerned about its pay ratio disclosure, so it elects to do a second pay ratio disclosure limited specifically to US employees. In this case, the ratio declines to 100 to 1.

A second company with a December 31 fiscal year end, everest.com, does a massive holiday business. As a result, Everest has a high pay ratio reflective of its hiring each year of seasonal employees. In fact, in a typical year, Everest has more than twice as many employees from September 1 through December 31 than it does the rest of the year. As a result, Everest reports a pay ratio of 750 to 1. Everest doesn't like this, so it chooses to determine an additional ratio of all but seasonal employees. The company is much more pleased to find that this ratio is only 175 to 1.

Generally, companies are required to report the pay ratio for any fiscal year beginning on or after January 1, 2017 (there are exceptions for certain new filers and emerging companies). This means that the first required disclosures (companies are encouraged to disclose before then) will generally be in the early months of 2018.

The final rule is long and complex. There are many legal issues around it and for those you should contact an attorney. 

There are also issues that are far more consultative in nature. They will generally require quantitative acumen, actuarial knowledge, and comfort with executive compensation, as well as a focus on business issues. For those, you should just click here.

Thursday, July 23, 2015

Derisking Your Defined Benefit Plan or Not

Every couple of years, there is a new trend in the remaining corporate defined benefit plans. Lately, it has been derisking in one sense or another. In fact, the Mercer/CFO Research 2015 Pension Risk Survey says that plan sponsors have been spurred by a perfect storm of events.

I'm not going to argue with there having been a perfect storm of events, but I think that everyone else's idea of what constituted the perfect storm is a bit specific and technical. They focus on falling interest rates, a volatile equity market, and a newly (last year) released mortality table. Instead, I would tend to focus on constantly changing pension rules both in the law and in financial accounting requirements that give plan sponsors a constantly moving target.

But, all that said, the study tells us that 80%-90% of plan sponsors are pleased with the risk management actions they have taken to date. What makes them pleased? Is it that they have cleaned up their balance sheets? Is it that their funding requirements have decreased? Has the derisking decision helped them to better focus on or run their businesses?

Isn't that last one what should be at the crux of the matter? The fact is that 2014 was not a good year to offer lump sum payments to individuals with vested benefits if what you were looking to do was to pay out those lump sums when the amounts would be low. Underlying discount rates were very low meaning that lump sums would be larger. Similarly, the cost of annuities was high, but many chose to purchase annuities for substantial parts of their terminated and retired participants.

What all of these plan sponsors did was to decrease future volatility in pension costs (however they choose to think of cost). For many, that truly was a good thing. But, at what cost?

For some, that cost was significant. For others, it was not.

Defined benefit pension plans used to be viewed as having a degree of permanence. That is, when funding them, calculations assumed that the plan would go on forever. While we know that forever is a very long time, we also know that plans with benefits that are based on participants' pay in the last years of their careers are wise to consider the amounts that they are likely to have to pay out in the future as compared to the amounts that would be paid out if everybody quit today. That is not reality. There used to be what are known as actuarial cost methods that allowed sponsors to do that and frankly, they resulted in larger current required contributions. But, those larger current contributions tended to be very steady as a percentage of payroll and that was something that CFOs were comfortable with.

But, the wise minds in Congress with the advice of some key government workers determined that this was not the right way to fund pension plans. Actually, their real reasons for doing so were to reduce tax deductions for pension plan funding thereby helping to balance the budget.

Sounds stupid, doesn't it? It is stupid if what you are doing is making sponsorship of a pension plan untenable for most corporations.

Risk truly became a 4-letter word for pension plan sponsors. As time went by, it became important for sponsors to find new ways to mitigate that risk.

Unfortunately, many of them have been so eager to do that over the last few years that they likely overspent in their derisking efforts. For others, it was clearly the prudent thing to do.

My advice is this if you are considering your first or some further tranche of derisking. Consider the costs. Consider how much risk you mitigate. Make the prudent business decision. What would your shareholders want you to do?

Then decide whether you should derisk.


Wednesday, July 15, 2015

Get Your 401(k) Design Right

I happened to read a few things today about 401(k) matching contributions. One in particular talked about stretching the match. Apparently that means that if you are willing to spend 3% of pay on your workforce, consider making your match 50 cents on the dollar on the first 6% of pay deferred instead of dollar for dollar on the first 3% of pay deferred. This will encourage employees to save more.

That might be a really good idea ... for some companies. For other companies, it might not be.

First and foremost a 401(k) plan is, and should be, an employee benefit plan. Taken quite literally, that means that it should be for the benefit of employees.

Plan sponsors may look at the plan and say that they get a tax deduction. That's true, but they also get a tax deduction for reasonable compensation. And, there is probably less of a compliance burden with paying cash than there is with maintaining a 401(k) plan.

Where does the typical 401(k) design come from? Usually, it's the brainchild, or lack thereof, of someone internal to the plan sponsor or of an external adviser. Either way, that could be a good thing or a bad thing. Most plan sponsors have plenty of smart and thoughtful employees and many external advisers are really good.

On the other hand, when it comes to designing a 401(k) plan, some people just don't ask the right questions. And, just as important, they don't answer the right questions. We often see this in marketing pieces or other similar propaganda that talk about designing the best plan. We might see that the best plan has all of these features:

  • Safe harbor design (to avoid ADP and ACP testing)
  • Auto-enrollment (to get higher participation rates)
  • Auto-escalation (so that people will save more)
  • Target date fund as a QDIA (because virtually every recordkeeper wants you in their target date funds)
All of these could be great features for your 401(k) plan, but on the other hand, they might not be. Let's consider why.

Safe harbor designs are really nice. They eliminate the need for ADP and ACP nondiscrimination testing. They also provide for immediate vesting of matching contributions. Suppose your goal, as plan sponsor, is to use your 401(k) plan at least in part as a retention device. Suppose further that every year, you pass your ADP and ACP tests with ease. Then, one would wonder why you are adopting a plan with immediate vesting whose sole benefit is the elimination of ADP and ACP testing. Perhaps someone told you that safe harbor plans were the best and you listened. Perhaps nobody bothered to find out why you were sponsoring a 401(k) plan and what you expected to gain from having that plan.

Auto-enrollment is another feature that is considered a best practice. (Oh I despise that term and would prefer to call it something other than best, but best practice is a consulting buzzword.) Most surveys that I have read indicate that where auto-enrollment is in place, the most common auto-enrollment level is 3% of pay. Your adviser who just knows that he has to tell you about auto-enrollment tells you that it is a best practice. Perhaps he didn't consider that prior to auto-enrollment, you had 93% participation and that 87% of those 93% already deferred more than 3% of pay. Since he heard it was the thing to do, he advised you to re-enroll everyone and now, you are up to 95% participation, but only 45% of them defer more than 3% of pay. Perhaps nobody bothered to ask you how your current plan was doing.

In the words of a generation younger than me, this is an epic fail.

I could go on and on about other highly recommended features, but the moral of the story is largely the same. Your plan design should fit with your company, your employees, your recruiting and retention needs, and your budget. That your largest competitor has a safe harbor plan doesn't make it right for you. It may not even be right for them. That the company whose headquarters are across the hall from yours has auto-escalation doesn't make it right for you. It may not be right for them either.

If you are designing or redesigning a plan for your company, ask some basic questions before you go there.
  • What do you want to accomplish with the plan?
    • Enough wealth accumulation so that your employees can retire based solely on that plan?
    • Enough so that the plan is competitive?
    • Something else?
  • Will eliminating nondiscrimination testing be important?
  • What is your budget? Will it change from year to year? As a dollar amount? As a percentage of payroll?
  • What do you want your employees to think of the plan?
    • It's a primary retirement vehicle.
    • My employer has a 401(k) plan; that's all I need to know.
    • My employer has a great 401(k) plan.
    • My 401(k) is a great place to save, but I need additional savings as well.
  • Will any complexity that I add to the plan help my company to meet its goals or my employees to meet their goals? If not, why did I add that complexity?
These are the types of questions that your adviser asked you when you designed or last redesigned your plan, aren't they?

They're not?

Perhaps it's time to rethink your plan.

Wednesday, July 8, 2015

You Run a Business -- Why Do You Choose to be in the Benefit Plan Business, Too?

You've been successful in the business world. You've made your way up through the ranks. Suddenly, because your title starts with the word "chief", you find yourself on the company's Benefits (or some other similar name) Committee.

You're an accidental fiduciary. You have no benefits training. You've never studied ERISA. In some cases, you've never heard of ERISA. What are you doing in this role and why?

Perhaps there is not a single person on your committee with a strong grounding in ERISA issues. But, you know that in order to compete for employees, you have to provide your employees with some benefits. It's likely that some or all of those benefit plans are covered by ERISA. And, ERISA coverage brings with it a myriad of rules and requirements.

Oh no, now I have you panicking. What should you do?

Let's consider one of the most common benefit plan offerings in 2015, the 401(k) plan. What is your committee responsible for? Do you know?

While one could argue that the list might be slightly different, here is a pretty decent summary:

  • Plan design
  • Selection of plan investment options
  • Compliance (with laws, regulations, and other requirements)
  • Plan administration
  • Communication to participants and education of those participants
That's a lot to swallow. Look around your committee. Presumably, since the committee has responsibility for all of those elements, at the very least, you can find people in the room who, between them, have expertise in all of those areas,

You can't? 

Do you really want the responsibility that comes with being a member of that committee when you have just realized that the expertise to handle the committee's roles doesn't reside on the committee?

You have choices, or at least you might. You could resign from the committee. Frankly, that usually doesn't go over well.

You could engage an expert. Suppose you could find an individual who could function in the role that a committee Chair would play in a perfect world. We're likely talking about someone who doesn't work for your company. This person will bring you peace of mind and essentially serve as the quarterback for the committee. He or she won't have a vote, but will guide you through the processes so that 

  • Your plan is well-designed for your population and budgets, 
  • It has investment options for plan participants that are prudently chosen and monitored according to an Investment Policy Statement (sometimes called an IPS), 
  • It gets and stays in compliance with applicable rules, 
  • Is administered properly and the firm that administers it is well-monitored, and
  • Is communicated to participants in a clear fashion that properly educates those participants as to the benefits of plan participation.
That sounds great, doesn't it?

If you don't currently have such a quarterback for your committee, perhaps you should. I can help you find one.

Tuesday, July 7, 2015

DOL Weighs in Again on Top-Hat Plans

ERISA contemplated so-called top-hat plans. In fact, it spelled out exactly what was contemplated in providing this opportunity for nonqualified deferred compensation so clearly that the legislative intent could never be misconstrued.

No, it didn't.

As is often the case when bills go from staffer to staffer and then to the floors of the houses of Congress, the bills tend to emerge with run-on sentences often punctuated by a myriad of commas making Congressional intent something upon which otherwise knowing people cannot agree.

Perhaps, some day they will learn.

No they won't, not in my lifetime anyway.

In any event, in a case (Bond v Marriott) concerning top-hat plans in front of the 4th Circuit Court of Appeals, the Department of Labor (DOL) wrote an amicus brief providing its opinion on the statutory wording around top-hat plans.

So, I know that those not familiar are just itching to find out. What does the statute say?

Congress gave us an exception to certain provisions of ERISA for a "[p]lan which is unfunded and is maintained by an employer primarily for the purpose of providing deferred compensation for a select group of management or highly compensated employees."

What is the primary purpose of a top-hat plan? Is it to be primarily for providing deferred compensation to a select group that is composed of management or highly compensated employees? Or, is it to be for providing deferred compensation to select group that is composed primarily of management or highly compensated employees?

It's one of those great questions that has confounded us through the ages. No, actually, it's a question that has confounded a select group of us since the passage of ERISA in 1974. To add to that confounding just a bit, everyone who practices in this field knows what a highly compensated employee is. The term is well defined in Code Section 414(q). But wait, Section 414(q), as written, has only been around since 1986 (added by Tax Reform) meaning that perhaps for these purposes, we don't even know what a highly compensated employee really is.

In its amicus brief, the DOL gives us its opinion, one that it claims to have held at least since 1985 and perhaps longer. The DOL tells the court that the primary purpose should be the provision of deferred compensation [for this select group] and that other purposes might include retaining top talent, allowing highly compensated individuals to defer taxation to years with lower marginal tax rates, or avoiding certain limitations applicable to qualified plans in the Internal Revenue Code. DOL further tells us that it does not mean that the select group may be composed primarily [emphasis added] of management or highly compensated employees or that the plan may have some other secondary purpose which is not consistent with its primary purpose.

The brief goes on to give us the judicial history around the provision and of course informs us which case law got it right and which did not. But, the DOL is clear in its claims and steadfastly denies that exceptions should be allowed.

I may be missing something here regarding the DOL. I think that the DOL has regulatory purview over ERISA. While the DOL has ceded that purview most of the time to the IRS where the Internal Revenue Code has a conforming section, that does not seem to be the case here. Could the DOL not have written regulations in 1975 or 1985 or 1995, or 2005 clarifying who, in fact, is eligible for participation in a top-hat plan? Or did they think it so clear that it was not worth their effort, despite being befuddled by decision after decision handed down by federal courts?

I know that when I got into this business, coincidentally in 1985, the more experienced people who taught me instructed that top-hat plans were to be for a group that was primarily management or highly compensated. In fact, it is difficult, in my experience to find practitioners who learned otherwise.

Perhaps that's wishful thinking. Perhaps, on the other hand, it's wishful thinking on the DOL's part. Perhaps the case will go to the US Supreme Court eventually so that nine wise jurists can put their own spin on it and settle this argument once and for all.

Until then, ...


Wednesday, June 24, 2015

On Successful RFPs and Circuit Breakers

This morning, I read an article that appears in the June issue of Plan Sponsor magazine. What attracted me to it was a blurb in the email blast "NewsDash" that magically appears in my inbox every weekday morning (actually, I highly recommend NewsDash for benefits professionals).

What I found strange about the article is that it is largely a compendium of quotes from a few defined contribution recordkeeper search consultants. But, it never quite brings them together to inform the plan sponsor on what makes for a successful RFP. Instead, it is somewhat akin to listening to a roundtable discussion, but only hearing about 1 comment in 20 and that without any context.

Since this article left me somewhat cold (and that on a day when our heat index is supposed to exceed 105), I decided to think about this myself. I've been involved in RFPs (not necessarily defined contribution or even benefits) in what I view are all of the possible contexts:

  • A bidder
  • A search consultant
  • A proposal evaluator
  • An end user (the client)
Ultimately, in my opinion, the client is looking for the best value, however they define value. Some place a very high value on the relationship with the provider. Some consider it most important for participants to have a great user experience. Others focus on employee education. Still others think that price is the winner.

Each of those may be a reasonable position to take. But, it is also important to understand that there are more than just the issues of value. 

A typical proposal scoring process assigns a weighting or point value to a number of categories. Finally, the bidder with the highest weighted score is usually the winner. 

I'd like to make some changes to this. In doing so, I am going to steal some terminology from other areas.

We all know that having a relationship manager who doesn't care about you makes the relationship untenable. It's a turn-off and it should kill the deal with that particular provider. Similarly, if you are going to be the point person (on the client side) for the relationship and you just really dislike the relationship manager, that relationship won't work either.

I refer to this and other similar deal killers as circuit breakers. That is, if the breaker is turned off, the circuit doesn't connect and the deal cannot happen.

The client should establish circuit breakers. You might also think of them as minimum standards. Here are a few to consider (with a DC recordkeeping bias):
  • Unacceptable relationship manager (if you really like the potential vendor other than that, you might be able to force a relationship manager of your choosing)
  • Fees above a certain pre-set level
  • Poor participant experience
  • No projection tool on the vendor website
  • Requirement to use a particular percentage of proprietary funds
I think this is fairly clear, but suppose it's not. Consider that Vendor A has the best scoring proposal. That is, Vendor A, using the pre-determined scoring mechanism gets a score of 185 out of a possible 200. Neither of the other two potential vendors scores above 160. But, you have heard from a friend at another company that the assigned relationship manager does not usually return phone calls in the same week that they are received. You view this as unacceptable. If Vendor A will not give you a different relationship manager, then they have triggered a circuit breaker and they are out of the running.

Triggering a circuit breaker outweighs a great score. Think about it. It makes sense.

Tuesday, June 23, 2015

Is IRS Stepping Up Nonqualified Audits?

Two weeks ago, the IRS released nonqualified deferred compensation audit techniques guide. While no one can be certain, this would seem to signal that the Service is showing more interest in auditing these plans, available almost exclusively to the highest paid of employees.

For years, many have thought that nonqualified (NQDC or NQ) plans to be a significant area of tax abuse and a potential source of tax revenue for the federal government. And, whether this is simply a much needed update or the beginning of a push, the language in the guide would seem to suggest where the IRS thinks there are problems.

Let's look at the paragraph headers in the guide as a means of determining where the focus is likely to be:

  1. Examining Constructive Receipt and Economic Benefit Issues
  2. Audit Techniques
  3. Examining the Employer's Deduction
  4. Employment Taxes
  5. Important Note [related to 401(k) plans]
  6. The American Jobs Creation Act of 2004 [the law that brought us Code Section 409A]
Constructive Receipt and Economic Benefit Issues

Here, the guide instructs auditors to look for assets set aside free from creditors for the benefit of employees. It also instructs these auditors to look to see how executives can use the benefits in these nonqualified plans. For example, if a SERP might be pledged as collateral, then the employee has enough control to have constructively received the benefit and is subject to current taxation, or was when the benefit was first constructively received. 

For employers with any knowledge of NQDC plans or those who use counsel who work at all in this area, getting this right falls under the heading of basic blocking and tackling. So, while the IRS might be able to find some defects here, it would not seem to be a source of significant revenue.

Audit Techniques

In this section, frankly, I think that the IRS is grasping at straws. It asks auditors to interview personnel most knowledgeable about the plans. Further, the auditors are encouraged to review Forms 10-K and to learn whether the company uses a consulting firm to assist with its NQDC plans. 

There seems to be little glue holding this section together. Instead, what I am seeing is that their may be a needle in a haystack and a fortunate auditor might find that needle. Other sections of the guide may prove more fruitful.

Examining the Employer's Deduction

Generally, the amount and timing of the employer's deduction must match the amount and timing of the executive's inclusion in income. Looking from the outside in, this would seem to be simple. But, corporate tax returns, especially for large corporations are quite complex. Similarly, a corporate executive is fairly likely to have a complex tax return. It's not unlikely that treatment of income from NQDC plans is nowhere near the top of the priority list for either the corporate tax department or for the executive's accountant. 

In fact, in my experience, some corporate tax departments do not have significant familiarity with this type of plan (some have exceptional knowledge). Similarly, and perhaps more glaring, many personal accountants, again in my experience, just don't know much about nonqualified plans. 

The Internal Revenue Code is a complex instrument. The instructions to government forms, especially if you include the various Publications that they reference, are quite confusing. If an accountant deals with particularly few NQDC plans, it would not be shocking to find that accountant confused by their tax treatment. Certainly, I would not expect them to confirm that the amount and timing of inclusion in income coincides with the corporate tax deduction.

Employment Taxes

This is the section that deals with FICA and FUTA taxes. Until the cap was removed from Medicare wages, this section would have been ignored. The reason is that although nonqualified deferred compensation is subject to these taxes when it is both vested and reasonably ascertainable (a technical term meaning that a knowledgeable person can figure out about how much it is worth), virtually all NQDC participants earned far more than the Social Security Wage Base each year. But, when the cap at the Wage Base was removed for Medicare taxes, new NQDC was necessarily subject to that tax. 

The regulations on this topic are, in a word, confusing. Specifically for what are known as non-account balance plans (generally defined benefit SERPs), the guidance on how to perform calculations was likely written by someone who did not know what they were prescribing and the guidance on the actuarial assumptions to be used in those calculations is virtually nonexistent.

However, in my experience with this topic, the IRS does have strong opinion on what the Treasury Regulations mean and intend. That said, when the regulations under Section 3121(v) were issued, I co-authored a research memo on the calculation of the amount of FICA wages from NQDC plans (the focus was on non-account balance plans). To say that the authors went back and forth many times before agreeing on the intended methodology is an understatement. To think that similar authors at other actuarial consulting firms would reach exactly the same conclusion is no plausible. Add to that the various accounting and tax firms who might have their own opinions and you would certainly have a lack of consistency. About 15 years ago, however, one IRS examiner that I spoke with off the record said that there was just one consistent method available under the regulations.

Said differently, while I don't know how much revenue is potentially available, the calculation of employment taxes with respect to NQDC plans, and specifically non-account balance plans would not all meet with the approval of that particular examiner.

Important Note [related to 401(k) plans]

The coordination of qualified 401(k) plans and NQDC plans that provide for deferrals in excess of those allowed in the qualified plan seems like it should be simple. It's not. In particular, it's not if the two plans (qualified and nonqualified) are administered by different providers (or if one is administered externally and the other internally). Generally, these plans allow participants to defer amounts where IRS limits would otherwise preclude such deferrals. In the simple situations where the 401(k) plan passes nondiscrimination testing, this is pretty easy. But, when the plan is forced to refund deferrals due to test failure or when deferrals are restricted in hopes of making the testing work, things can go horribly wrong. Do the two separate administrators communicate with each other? It's doubtful.

There is likely not a lot of revenue for the government to find here, but there are probably a large number of very small problems.

The American Jobs Creation Act of 2004 [the law that added Section 409A to the Internal Revenue Code]

I've written about 409A here many times. If you are interested, go the little search box at the top of the page and type 409A. I'd be surprised if you get fewer than 25 hits in this blog, but I've not counted. 

As is often said about relationships, it's complicated. 

The regulations are long and were written in a fashion similar to the regulations under Section 3121(v). Frankly, I don't think the people who worked on the project did a bad job writing the regulations. They're not perfect, but they wouldn't have been perfect if you or I had written them either, so we must be careful with our criticism.

But, certain parts of the regulations that have lots of calculational elements where the calculations almost necessarily must be performed by actuaries were written by attorneys. I know some of those attorneys. They're smart people. And, they spent lots of time understanding the statute and developing regulations to enforce that statute. They could have done far worse.

The people that I know, however, who worked on the project are not actuaries. While they have some familiarity with actuarial calculations, they don't actually do them and I think they would tell you if you asked candidly that they have only a minimal understanding of them. Yet, for certain types of plans (mostly non-account balance plans), there is much in the way of actuarial calculations that determines potential tax liabilities. 

Frankly, we don't know what was intended. We tend to reference the FICA regulations, but even there as I noted above, the regulations are not prescriptive.

Section 409A is a mess. I don't think anyone intends to violate it, but there are lots of people who don't get it right. Finding the violations is difficult, but if examiners do find violations, with those violations will come some fairly meaningful tax revenue.

*           *          *          *          *           *             *              *             *            *            *           *          *

So, that's my take on where the IRS is headed and what value it has to them. Time will tell if I got it right for a change or not.