Friday, December 2, 2016

Instead of Making Defined Contribution Look More Like Defined Benefit, ...

I don't think I've ever ended the title of a blog post with an ellipsis before. But, surely, there's a first time for everything.

Lately, the benefits press has written an awful lot about what must be the latest trend in employer-provided retirement benefits -- making the defined contribution (DC) plan look more like the defined benefit (DB) plan. Perhaps I am missing something, but it appears that this "major" initiative has two components to it (that's right, just two):

  • Communication of an estimate of the amount of annuity a participant's account balance can buy
  • The option to take a distribution from the plan as either a series of installments or as an annuity
Let's consider what's going on here.

Annuity Estimate

Yes, there is a huge push from the government and from some employers to communicate the annual benefit that can be "bought" with the participant's account balance. Most commonly, this is framed as a single life annuity beginning at age 65 using a dreamworld set of actuarial assumptions. For example, it might assume a discount rate in the range of 5 to 7 percent because that's the rate of return that the recordkeeper or other decision maker thinks or wants the participant to think the participant can get.

I have a challenge for those people. Go to the open annuity market. Find me some annuities from safe providers that have an underlying discount rate of 5 to 7 percent. You did say that you wanted a challenge, didn't you?

I'm taking a wild (perhaps not so wild) guess that in late 2016, you couldn't find those annuities. In fact, an insurer in business to make money (that is why they're in business, isn't it) would be crazy today to offer annuities with an implicit discount rate in that range.

But, annuity estimates often continue to use discount rates like that.

Distribution Options

Many DC plans offer distribution in a series of installments. Participants rarely take them, however, For most participants, the default behaviors are either 1) taking a lump sum distribution and rolling it over, or 2) taking a lump sum distribution and buying a proverbial (or not so proverbial) bass boat.

Why is this? I think it's a behavioral question. But, when retiring participants look at the amount that they can draw down from their account balances, it's just not as much as they had hoped. In fact, there is a tendency to suddenly wonder how they can possibly live on such a small amount. So, they might take a lump sum and spend it as needed and then hope something good will happen eventually.

Similarly, if they have the option of getting an annuity from the plan, they are typically amazed at how small that annuity payout is. And, even with the uptick in the number of DC plans offering annuity options, the take rate remains inconsequentially small.

A Better Way?

Isn't there a better way? 

Part of the switch from DB plans to DC plans was predicated on the concept of employees get it. They understand an account balance, but they can't get their arms around a deferred annuity. So, let's give them an account balance.

Part of the switch from DB to DC plans was to be able to capture the potential investment returns. Of course, with that upside potential comes downside risk. Let's give them most of that upside potential and let's take away the worst of that downside risk. That sounds great, doesn't it.

Once these participants got into their DC plans, they wanted investment options. I recall back in the late 80s and early 90s that a plan with as many as 8 investment options was viewed as having too many. Now, many plans have 25 or more such options. For what? The average participant isn't a knowledgeable investor. And, even the miraculous invention commonly known as robo-advice isn't going to make them one. Suppose we give them that upside potential with professionally managed assets that they don't have to choose.

Oh, that's available in many DC plans. They call them managed accounts. According to a Forbes article, management fees of 15 to 70 basis points on top of the fund fees are common. That can be a lot of expense. Suppose your account was part of a managed account with hundreds of millions or billions of dollars in it, therefore making it eligible for deeply discounted pricing.

There is a Better Way

You can give your participants all of this. It seems hard to believe, but it's been a little more than 10 years since Congress passed and President George W Bush signed the Pension Protection Act (PPA) of 2006. PPA was lauded for various changes made to 401(k) structures. These changes were going to make retirement plans great again. But, for most, they didn't.

Also buried in that bill was a not new, but previously legally uncertain concept now known as a market-return cash balance plan (MRCB). 

Remember all those concepts that I asked for in the last section, the MRCB has them all. Remember the annuity option that participants wanted, but didn't like because insurance company profits made the benefits too low. Well, the MRCB doesn't need to turn a profit. And, for the participants who prefer a lump sum, it would be an exceptionally rare (I am not aware of any) MRCB that doesn't have a lump sum option.

Plan Sponsor Financial Implications

Plan sponsors wanted out of the DB business largely because their costs were unpredictable. But, in an MRCB, properly designed, costs should be easy to budget for and within very tight margins. In fact, I might expect an MRCB to stay closer to budget than a 401(k) with a match (remember that the amount of the match is dependent upon participant behavior). And, in a DB world, if a company happens to be cash rich and in need of a tax deduction, there will almost always be the opportunity to advance fund, thereby accelerating those deductions.


It is a win-win. Why make your DC plan look like a DB when there is already a plan that gives you the best of both worlds.

Monday, November 28, 2016

Saving for Retirement in a President Trump World

I know this sounds like a politically charged topic, but it's not intended to be. I just want to pose the situation to let readers know a few things. While the Trump platform didn't particularly address retirement issues, how will retirement be affected?

In order to understand this, let's consider a few key non-retirement items that both the Republican-controlled Congress and President-Elect Trump have weighed in on to one extent or another:

  • Repeal of the Affordable Care Act (ACA)
  • Replace the ACA with a framework that is expected to feature competition across state lines, high-deductible health plans (HDHPs) with Health Savings Accounts (HSAs), and a la carte shopping for health plans (you insure what you want to insure to the extent that such coverage is available)
  • Simplified (somewhat) Tax Code with lower marginal tax rates for most taxpayers
  • Elimination of the Head of Household status for filing taxes
As I've remarked many times, our current retirement system for American workers is not what it was, for example, 30 years ago. It's no longer the norm to have the solid three-legged stool of
  • the defined benefit (DB) pension plan from the company you spent most of your career with
  • your personal savings in a high-return savings or money market account (you probably even had your choice of a free toaster or alarm clock when you opened the account)
  • Social Security
Recall that 401(k) plans were in their infancy and even employees who had them didn't tend to make heavy use of them. 

Under the new [proposed] regime, personal responsibility will be king. Out of your higher after-tax income (not significantly higher for most Americans unless the economy booms to where employers are inclined to offer higher compensation to their employees), you'll need to save for retirement and make HSA deductions to accumulate a rainy-day fund just in case you have a high-cost medical expense. Is that practical?

Under the ACA, $10,000 annual health care deductibles are not all that uncommon. So, you'll want to build up your HSA account to ensure that you're not bankrupted by a large medical expense or even by one that you choose to not purchase coverage for. Let's say you choose to defer the family limit for 2017 -- $6,750. Further, since you've been reading about it online, you need to defer, say, 10% of your family income of $75,000 per year (or $6,250 per month) (well above the national median of about $52,000) or $7,500 to your 401(k). Let's add to that your $2,000 per month house payments (including escrow) and your $750 per month car payments (including insurance) and see where you are before basics like utilities, food, and clothing.

We start with $75,000 and let's pull out 22% of that for federal, state, and FICA taxes bringing you down to $58,500. Let's take out another $4,000 per year for health care through your employer (we'll assume they are subsidizing it) and you're down to $54,500. Now subtract your HSA, 401(k), house payments, and car payments and you're down to $7,750. That's $650 per month to pay for food, clothing, gasoline, and to build up a rainy day account, and you haven't even had a chance to buy anything because you just wanted it.

As they said in the movie, something's gotta give. What's it going to be? My guess is that the first thing you cut back on is your retirement savings. You'll worry about that in some future year. Or, will you? Recent history suggests you won't. 

People who retired 30 years ago tended to be much more prepared for retirement despite their lack of 401(k) plans. They were intended to be merely supplemental to employer-provided pension benefits. Is it possible that the Trump Administration should consider the benefits of incentives to get us back into a DB-biased world? Just asking.

Thursday, November 3, 2016

A Modest Retirement Benefits Proposal With Apologies to Jonathan Swift

If you were to ask an employee what are their most important employee benefits, they might tell you that they are their health coverage and their retirement benefits. And, for the last several years, with the passage of the ACA (ObamaCare if you prefer), their health care benefits are fairly well mandated.

Yes, employers have an option -- they can play (provide at least minimum essential coverage) or pay (a penalty for not providing such coverage. And employees not covered by their employers have an option -- they can get coverage (play) outside of their employer either privately or through a federal or state exchange or they can pay a penalty as part of their Shared Responsibility.

To a large extent, the Affordable Care Act came about because of what was viewed (perhaps rightfully) as a health care crisis in the US. Cost of care was increasing rapidly. The number of uninsured was growing. Insurers were perceived to be denying treatment to their insured, not because the medical option being pursued was not the best medical option, but because it was a better business decision for the insurer (the cost of care might include the savings related to the decreased cost of future care). So, for better, for worse, or for some combination, the federal government has largely told us what our health coverage should look like. Depending on your personal situation, you might choose to be the judge of how well that works for you.

Suppose that applied to retirement benefits as well. After all, many would tell us that we are in a retirement crisis as well. Yesterday, I saw some data that while I happen to not believe it said that 50% of Americans over the age of 50 have less than $5,000 in retirement savings. Frankly, if that is remotely close to the truth, we do have a retirement crisis.

Suppose we modeled a retirement benefit system after the ACA. And, suppose this was in addition to Social Security. What would be minimum essential coverage under the Affordable Retirement Act? Let's take a shot at it.

  • Everyone has an account balance into which their employer makes a mandatory contribution and the employee also makes a mandatory contribution. 
  • To the extent that the employee contributes more than that up to a point, their employer must match it. That match is to be more generous for the lowest-paid employees and phases out altogether for employees earning at least $250,000.
  • Withdrawals from the account will not be allowed before retirement.
  • When you do retire, your benefit will be distributed in the form of an annuity with death benefit protection much like a Joint and Survivor Annuity and will have annual cost-of-living adjustments.
  • Those annuities will be provided by insurance companies participating in retirement exchanges. The insurers will not be able to collect data on the participants to whom they are providing annuities, so they will likely not be able to understand the risk they are taking on.
  • Insurers will be limited in the cumulative profit they can earn on these annuities.
  • Employers and or employees who do not participate will have to pay into the system on behalf of others.
How does all that sound? Can you make it work for you?

Special note: there may be as little as nothing in this post that anyone agrees with including its author.

Wednesday, November 2, 2016

Interpretive Guidance Issued, But Pay Ratio Determination Still Difficult

Staff at the SEC recently issued interpretive guidance on the pay ratio rules under Section 953(b) of Dodd-Frank. Regular readers will know that I have written on the pay ratio many times. What many regular readers (those who are used to dealing with benefits issues, for example) may be less familiar with is that the interpretive guidance of staff carries full weight. That is, it's not just a suggestion.

Before digging into the guidance, let's recall what the pay ratio disclosure is. Generally, companies that issue definitive proxies in the US must, beginning with fiscal years starting in 2017, disclose the ratio of CEO compensation to that of the median-compensated employee in the company. And, for those purposes, compensation is that used in the Summary Compensation Table of the proxy. So, it includes (oversimplifying a bit), for example, the value of equity, deferred compensation, and qualified retirement plans provided by the employer.

The employee population for this purpose is not limited to full-time workers or to US workers. So, companies with lots of international employees who are compensated in a variety of different ways may have difficulty with this determination.

If you need a refresher on what the final rule said and how you might handle it, there is useful material here.

Back to the interpretive guidance.

As you may recall, you may determine who your median employee is by using simplified definitions of annual total compensation so long as your facts and circumstances support it. For example, if it's clear that compensation for the median employee will resemble W2 pay, then you can use information from tax or payroll records to determine who the median-compensated employee is. But, if you provide pensions or equity compensation broadly, this may be inappropriate to your situation. In fact, for many companies, determination of who their median-compensated employee is will be the most difficult part of the process.

What staff made clear is that rate of pay (hourly rates or salary) is not reasonable to use as a consistently applied compensation measure (CACM). Staff gave examples where those rates could be part of the process, but in order to make the measure reasonable, companies would need to know how many hours each hourly-paid worker actually worked and for what portion of the year salaried workers were employed.

The interpretive guidance makes clear that in determining the median employee, the population may be evaluated using any date within 3 months of the end of its fiscal year. Once the population as of that date is selected, the employer can go through this process:

  • Identify the median employee using either annual total compensation or a CACM ... by
  • Selecting a period over which to determine that CACM (the period need not include the selected date so long as based on the facts and circumstances indicate that there will be no significant changes (undefined term, of course) between compensation used and actual compensation for the fiscal year)
It is up to employers to determine, again based on all the facts and circumstances whether furloughed employees should be considered in the population. Employees who were hired during the year or who worked less than the full year due to a leave of absence may have their pay annualized. But, part-time and seasonal employees may not have their pay annualized.

And, finally, the staff weighed in on how to determine who might be or not be an employee for purposes of the pay ratio. Essentially, the determination of whether a worker who is not a common-law employee of the employer should be considered an employee for these purposes is based on, you guessed it, all the underlying facts and circumstances. Primarily, the employer should look to whether it sets the compensation of, for example, contract workers, or if that pay is set by someone else.

So, for example, if the company advertises that it will pay contract telephone callers $15 per hour, then they would be employees for these purposes even if they are not employees for tax purposes. On the other hand, a worker who is brought on board through a temporary staffing agency or for a specific contract is likely not a worker.

Well, this clears it up for you, doesn't it? Okay, I thought not. Continue to follow me here for more updates as they come rolling in. Or, let me know if you have questions.

Thursday, October 27, 2016

Analytics and Hiring

Can you use analytics to help you in your hiring process? The conventional wisdom says no. The big data proponents say yes.

Let's consider how this might work at a larger (undefined term) company. Suppose you asked each manager to list all of the characteristics of their best employees. Have them do it with no limits. They tend to be of a particular height, have a particular eye color, and speak loudly. Perhaps they tended to graduate from larger primary state colleges. And, they tended to major in one of three disciplines.

Among the key questions then becomes whether those particular data points are predictive or not. If they are, then depending on what they are, then either before an interview or after an interview, you should be able to put the characteristics of an applicant into your model and determine whether they would be a good hire for you.

You don't think it works, do you?

Let me challenge that. Is professional baseball a job? If you read or watched "Moneyball", you know that one of the early adopters of analytics (they call it sabermetrics in baseball) were the Oakland As under the leadership of their GM Billy Beane. Perhaps his leading disciple was Theo Epstein. Epstein is fairly unique in being the General Manager of the Red Sox who broke the curse of the Bambino and may turn out to be the Cubs GM who breaks the curse of the goat. In any event, Epstein has made highly controversial moves and made two struggling franchises into winners.

I know; that's baseball; it doesn't work in real jobs. Or does it?

Frankly, I don't know. I haven't tried it. But I know people with expertise who think it does.

Try it in your company.

Let me know how it goes.

Friday, September 23, 2016

More on the Public Pension Controversy

The media has fallen in love with the ongoing controversy over public pensions. In the last few weeks, article after article has appeared in major print and electronic media mostly discussing how poorly funded the majority of public pension funds are and placing blame everywhere they can. This is not to say that there are not problems and it's also not to say that there's not plenty of blame to go around, but as in most any controversy, there's more than one side to this issue.

Before delving into it, let me provide some background for those who may not be particularly familiar with public pensions.

Virtually all public pension plans are traditional defined benefit (DB) pension plans in which most, if not all, of the benefit is provided through contributions from the sponsoring governmental entity (some do require significant participant contributions in order to get that benefit). The benefit is typically related to final year's (or the average of the last three or five years) compensation. As a result, spikes in compensation in the final year or years of a career produce much larger pensions. And, when overtime pay is included in those amounts, workers are smart enough to know that their pensions can easily be boosted by getting as much overtime as possible.

As I said, most of these pensions are funded largely through contributions from the governmental entities. Where do those contributions come from? Well, for most of those entities, the very large majority of their budgets come from tax dollars. So, if the recommended, or even legally mandated contributions get too large, there are only two choices -- ignore those requirements or raise taxes (of course in most jurisdictions, future benefits can be reduced prospectively, but that's a different story for a different day).

The current debate centers on public plans in California. What we have recently learned is that the California Public Employers Retirement System (CalPers) values pension liabilities in two ways -- one using what the New York Times referred to as the actuarial value and another referring to it as a market value.

The next two paragraphs briefly discuss a rationale for each basis. For the sake of both simplicity and brevity, both are oversimplified and should not be taken as a precise rationale for either.

The actuarial value discounts obligations using a discount rate at the expected long-term rate of return on plan assets. Proponents argue that this is correct because plans are expected to have a degree of permanence and as assets are invested for the long haul, the obligations that they support should be discounted on that same basis.

Market value discounts obligations using a current settlement rate; roughly speaking, that is the rate at which you could go out to the insurance market to settle those obligations. Proponents argue that in an efficient market, there is no risk premium in investments and therefore, this is the only appropriate basis on which to discount.

What we have read about in the news is that governments that thought that the plans that they sponsor were well funded and that wanted to pull out of the system are learning that to do so will cost them money that they will likely never have.

So, which method is correct? I suppose I could argue that it depends upon which media piece you read. You see, what is happening is that most of the articles have interviewed experts (or self-proclaimed experts) on only one side of the debate. So, they present that side.

The reality is that neither side is correct. It's not as simple a question as the strong proponents on either side would have you believe.

So, here's my take (you knew I would get to it eventually).

Public plan trustees need to understand the true costs of the plans they sponsor. On average, when an employee retires, their pension should be fully funded. This is often not happening. In years when investment returns are good, they use them to reduce contribution requirements. In years when investment returns are poor, they say they can't afford to make the appropriate contributions. It doesn't take an experienced actuary to tell you this is a problem.

I would urge that governments embark on prudent funding policies that build up surpluses in strong years in order to pay for shortfalls in lean years. Doing so will have only minimal effect on the tax base. Studies to understand these issues should be par for the course.

I also urge the popular media to realize that this is not a one-sided issue. While it may make for a great read to tell of the sad tale of a small Citrus District pension plan that is woefully underfunded, it's a small part of the story.

Within the Conference of Consulting Actuaries (yes, I am biased, I serve on the Board of Directors), there is a Public Plans Community that regularly discusses issues such as this. For those who are interested in a view of the problem from people who understand the issues, it's an excellent read.

Monday, September 19, 2016

Lessons From California Public Pensions

Over the last few days, the print media (at least we used to call it print media) has hit hard on public pensions in the State of California. The New York Times hit hard on the differences between the "actuarial approach" and the "market approach." The Los Angeles Times took on a pension deal from the late 90s. Both of these are symptomatic of the issues that all of taxpayers, legislators, workers, and actuaries face in the public pension world.

Let's take a step back. Some of the most generous of all public pensions are those available to public safety officers primarily police and fire. I could give you lots of reasons why this approach is correct and why it's not. You might disagree with my analysis on all of them, but that's not what's important here.

Historically, people who have chosen careers in police and fire have thought of their careers differently than people in most other professions. Those careers are very risky and they are physically demanding. Many in those professions would tell you and me that lasting more than 30 years or so is just not practical. And, if we take that as a correct statement (I do), then it is reasonable that such public safety officers be eligible to retire from that career earlier than we would expect in most other careers. After all, if you were trapped in a burning building, would you be happy if the people trying to save you were just trying to hang on until normal retirement age at 65, but weren't really physically capable of handling such a demanding task?

Over time, states, cities, towns, and other governmental organizations found the answer. Provide those public safety officers with a significant incentive to retire early (compared to other careers) and if you do that, you don't have to pay them all that much. So, what that has historically achieved is that costs for current public safety employees have been relatively lower and costs have been deferred into their retirements.

That's a problem. It doesn't need to occur. The correct answer for a governmental employer, or other employer, is to realize that deferred compensation (that's what a pension is) is earned during a employee's working lifetime. Therefore, it should be paid for during that working lifetime. After all, once an individual in any profession retires, they no longer provide a benefit to the organization that they previously worked for. Further, the burden to pay for those pensions should not be passed on to future generations of taxpayers.

In the past, I have commented about various actuarial cost methods. An actuarial cost method is a technique for allocating costs to the past, the present, and the future. Looking at things as any of a taxpayer, legislator, employer, or employee (I happen to not be all of those, but even so, I can put myself in the shoes of those that I am not), the correct answer has the following characteristics:

  • An employee's pension is paid for (funded) over their working lifetime. Once they retire, the cost of providing their benefit is over. (Understand that actuarial gains and losses make this an inexact science, but we should be close.)
  • The cost of providing that employee's pension should be level. That is, it should either be a constant percentage of their pay or a constant dollar amount. As an employer, I can budget for that. 
Let's consider an example of that second bullet. Suppose I pay a public safety officer $60,000 per year (I know -- in some jurisdictions that seems high and in others it seems low) in salary. Further suppose that their deferred compensation costs me 10% of pay annually. Then when I am budgeting for that person, I know how to budget every year. If their pay goes up by 5%, so does the cost of their pension, roughly. This year, I budget $66,000 for current plus deferred compensation. Next year, with that 5% budgeted increase, I budget $69,300 for current plus deferred compensation.
There is an actuarial cost method that does exactly this. It's called Entry Age Normal (EAN). When I entered the actuarial profession back during the days when we used green accounting paper rather than spreadsheets, in my experience, EAN was the actuarial cost method of choice. But, it had its downsides. 
  • Neither the accounting profession nor the federal legislators accepted it as the method of choice.
  • Employers were advised that their current cash cost would be lower using a different actuarial cost method. It's easy to say you will fix that problem later on.
  • Observers understand a method where you pay for benefits as they accrue, but nor one in which you pay for benefits as they are allocated by actuaries.
So, now we have come to a crossroads. Many of the largest public pension plans are horribly underfunded regardless of how you determine funding levels (some have been funded responsibly; others have not). Getting them well funded requires cash which can only come from increasing taxes or from taking money from elsewhere in the budget (dream on). Legislators want to get re-elected which means you don't raise taxes. 

Hmm, I see a problem here.

The problem extends to private pensions as well, but there are  good solutions there. Since EAN is not available as an actuarial cost method anymore (we could choose to have our valuation done using the legally prescribed Unit Credit actuarial cost method, but fund not less than the EAN cost although that is very rarely done), we need to look in other places. 

Plan design is an excellent lever in this regard. Suppose we had a plan design  that even under a Unit Credit cost method allowed us to achieve exactly what we are talking about here. And, suppose that design allowed for all the benefits of defined benefit plans (DB) including market-priced with no built-in profits annuity options, professional investing, no leakage, portability, and virtually no cost volatility. Wouldn't that be an ideal world?

Thursday, September 15, 2016

It's Your Plan's Money They are Wasting

You're a defined benefit plan sponsor. That means that you have to hire an Enrolled Actuary (EA). No, you don't have to have one on staff, but you must have an Enrolled Actuary provide an annual actuarial valuation for the plan.

You know that your EA is providing great service and making smart decisions on your behalf, don't you?

If you are a prudent sponsor, you will periodically bid that work. In other words, you will put out a request for proposal to ensure that your current EA and his or her firm are providing you with excellent service at a fair price.

Fair is in the eye of the beholder. If what you are looking for is a cheaper price, you can almost always find one. There's usually someone out there who will do the work for less money. That doesn't necessarily mean that engaging them will be a good decision.

Suppose I pointed out to you, however, that your plan's EA was making bad decisions on your behalf. Perhaps those decisions are costing your plan more money than you are spending on the services for that EA. You probably think that can't be your plan. But, it could be.

Suppose I told you that I could educate you as to those decisions for your plan. I know, you don't have the time to give me all the information that I'll need. Well, suppose I told you that I don't need your time for that. I just want to be able show you what I've learned.

Would you be interested then?

Send me a note or call me at 770-235-8566. You'll never know unless you do.

Thursday, September 8, 2016

Laws Affecting Benefits and Compensation Nearly Always Failures

I suspect that the authors of every law that affects employee benefits and compensation have good intentions when they draft those laws. As T.S. Eliot said however, "Most of the evil in this world is done by people with good intentions."

Where do these laws go wrong? To understand this, it's helpful to understand the process.

Usually, bills are drafted by Congressional staffers perhaps with the assistance of outside experts, often lobbyists. From there, bills are introduced and then haggled over by 435 people with no subject matter expertise in one chamber of Congress and then by 100 people with a similar lack of subject matter expertise in the other chamber. Once the sausage has been ground sufficiently, a bill may be approved and passed to the President for signature.

What could possibly go wrong?

Assuming that nothing could go wrong up until that point, these bills that by this point in the process have become laws leave it up to the various government agencies to create regulations that help to implement these laws. Some of the regulations make sense, and then there are the others.

Looking at this as someone who doesn't work for one of those agencies, it strikes me that each of them seeks to assert their power where possible. After all, if a government agency cannot show that it has power, why should it not simply cease to exist?

Further, if between Congress and the various government agencies, a bill and then law has not been messed up, there is still the court system to fall back on.

As an example, let's consider Internal Revenue Code Section 401(k). Essentially, it was added to the Code by the Revenue Act of 1978. And, while it was a throw-in, as we all know, once 401(k) plans were truly discovered, they took off in their popularity.

There are several things that we know about 401(k) plans. They are qualified retirement plans, thus governed by ERISA. They provide tax deductions and are thus also governed by the Internal Revenue Code. They have become very popular, so the amount of plan assets in many 401(k) plans is massive.

So now, let's look at the evolution of a current nightmare.

401(k) plans were created by the Revenue Act of 1978. They provided employees with an opportunity to save money for retirement on a tax-favored basis. Employers have the ability to match those employee deferrals and receive a tax deduction for those matching contributions. The Investment Committee (or some similar name) for the plan or its designee is responsible for selecting and monitoring investments in the plan. In that role, the Committee must act in the best interests of plan participants and in a fiduciary manner.

What does that mean?

The old regulations were very vague. Vagary has led to different courts imparting their wisdom in different ways. To be acting in the BEST interest of plan participants, what does a committee need to do? Does it need to find the LEAST expensive investment options? Does it need to find the HIGHEST returning investment options? If not, then how close to that optimum? Where is the bright line?

So, now we have new Department of Labor (DOL) fiduciary regulations. What they do more of than anything else is make more people fiduciaries of the plans than were before. Or, if they don't, then they certainly make clearer who the fiduciaries are and establish that there are, in fact, a lot of fiduciaries out there. Does this mean that more people will  be sued for fiduciary breaches?

Looking back, Section 401(k) should have been a great addition to the Code. And, weighing everything, perhaps it was (although regular readers of this blog will know my opinion that the addition of Section 401(k), more than anything else, probably ruined the American retirement system). But, over time, through this process, the 401(k) plan has become a mess. Each government agency thinks it has turf to protect. Employers feel that they have to offer a 401(k) plan, but few are equipped to handle one according to the current state of regulation and litigation.

The good news is that 401(k) plans through the Revenue Act of 1978 don't represent the only benefits or compensation law that is broken. Yes, that's also the bad news.

Consider these:

  • The Pension Protection Act of 1987 and the Pension Protection Act of 2006 have probably done more to drive down the number of US pension plans than any other laws.
  • A provision in the Multiemployer Pension Reform Act of 2014  that was intended to address the problem of serious underfunding in plans such as the Central States Teamsters Plan was dealt its first major setback specifically with respect to the Central States Teamsters Plan.
  • The million dollar pay cap in Code Section 162(m) that was designed to limit executive compensation has done more to increase executive compensation than probably all other legislation combined.
  • The Affordable Care Act of 2010 as we are seeing with announcements of 2017 exchange premiums is making health care anything but affordable.
  • The Pension Benefits Guaranty Corporation's (PBGC) shortsightedness in addressing its self-determined shortfall has taken millions of participants out of the pension system thus increasing the PBGC's shortfall.
I could go, but you get the picture.

Tuesday, August 9, 2016

409A Audit Could Be Coming to Your Company

All the way back in 2004, Congress passed and President George W. Bush signed into law the American Jobs Creation Act (Jobs Act). While it does not appear to have created many jobs, the Jobs Act added Section 409A to the Internal Revenue Code. The reasons were twofold -- first, to ensure that participants in nonqualified deferred compensation plans (NQDC) would never be advantaged over those in qualified plans; and second, to raise revenue for the federal government.

Thus far, the addition of 409A has done a pretty good job at the first of those goals by imposing a very strict set of rules on participants, usually executives, in NQDC arrangements. With regard to raising revenue, however, 409A has been fairly impotent to date.

Several years ago, the IRS rolled out an audit initiative of 409A plans. It had some teeth, but mostly with regard to larger plans (more participants) of larger companies. While there were exceptions, for the most part, if your company has less than about 5,000 employees or if your NQDC plans in total have less than about 100 covered participants, you've been mostly immune from this audit initiative.

Reports are now that the IRS has stepped up their audits. They are doing more of them and they are investigating more and more plans of companies that did seem immune in the early years of the program. In fact, I heard from an NQDC recordkeeper that a client of theirs with only 19 NQDC participants is currently under a 409A audit. I spoke with that recordkeeper, but between us, we couldn't determine what the pattern of companies that have recently come under 409A audit has been. That recordkeeper's anecdotal evidence, though, suggests that in other than very large companies, the primary target plans have been in order:

  • Nonqualified defined benefit pension plans that do not have the same formula as a broad-based DB plan in which the covered executives also participate;
  • Other nonqualified DB plans that simply make up for IRS limits (415 and 401(a)(17));
  • Deferred compensation plans that look different from the company's 401(k) plans; and
  • 401(k) mirror plans.
In other words, the target seems to be executive retirement plans.

To understand what the solutions might be, your first need to understand the problems. Generally, there are two ways that you can violate 409A -- either by failing to have or failing to have an appropriate written plan document, or by failing to follow both the plan document and the law and regulations.

In either case, the penalties are severe. But, those penalties are not imposed on the company. Instead, they are imposed on the executive, even if he had neither influence on nor knowledge of the defect from which that penalty will arise.

How bad is the penalty? It's this bad:
  • An additional 20% income surtax on the amounts deferred and not compliant for all taxable years in which that was the case; plus
  • Interest on previously unpaid taxes (due to failure to include the deferred amounts in income in the year in which they were deferred) at the Federal Underpayment Rate plus 1%.
And, that's in addition to ordinary income (and other) taxes that would be owed on those amounts. They add up quickly.

For most 409A defects, however, there are correction methods, structured somewhat analogously to those under the EPCRS program for qualified plans.

Many of you will seek help from counsel and from tax advisers. That may be a good solution for you. A problem that can occur in either case, though, is that it's very possible that neither has significant experience with determination of 409A benefits or with the administration of those benefits.If they do, that's great. But, if they don't, you probably need to look for additional expertise.

Thursday, August 4, 2016

Thinking About Compensation -- Cash and Otherwise

Suppose someone asks you how much you get paid. Probably the first thought that comes to mind for you is something like that your base pay is some amount of money per year or that you earn some amount per hour. You might include bonuses in your thoughts, or if you are hourly paid, you might include some overtime that you typically get. Let's just say, hypothetically, and because it's an easy number to work with, that your base pay is $100,000 per year and that you are not bonus eligible.

You're pretty happy in your job, but one evening, you get a call out of the blue from a recruiter or headhunter, if you prefer, who tells you that she would like to talk to you about a job in your field that has a budget of $110,000 per year. My question for you would be whether relative to your $100,000, is that $110,000 a good deal?

It seems obvious, doesn't it? You'd be getting a raise. But, it's not really that simple. Your current employer has a defined benefit pension plan and a 401(k) plan. They also provide you with a good health care program, four weeks of vacation per year, and some other benefits that probably don't seem like they will make a difference to you. Your potential new employer just has pretty basic health care and a garden variety 401(k) plan. They will start you at two weeks of vacation, but you work your way up to four weeks after ten years with the new company.

What should you do?

To people who often read my blog, the analysis is pretty simple, but to the average person, it's not. They often don't understand the value of these various benefits. And, that's why they tend to look at pay alone and perhaps the amount of vacation time that they are getting and whether or not their work schedule or work site (office versus home) will have any flexibility. That's work in 2016.

Suppose you are the employer and you happen to be the employer that offers good benefits, but doesn't pay quite as much as some of the employers against whom you compete for talent. I have an idea for you. Suppose you created a tool, or model if you prefer, to help prospective employees to compare what they are currently receiving with what you are offering them. It sounds like you've already made the commitment that you're not going to win on pay alone, so you have to find a way to make them understand the value.

Let them input all these various components side-by-side and see which one is the winner, especially if the pay you are offering is sufficient for them to live on. If you want to get even more sophisticated, you could tax-effect it.

Interestingly, the same concept works in executive compensation.

A company recently asked me to benchmark their executive retirement benefits (of course, those benefits are pay related). So, if their plans are 50th percentile, but their pay is only 40th percentile, then in reality, their plans fall short (50th percentile applies to 40th percentile gets you to somewhere less than 50th percentile retirement value), and conversely if you pay above the 50th percentile and provide 50th percentile retirement benefits.

It's surprising to me how often looking at things this way is a revelation. Perhaps you need that revelation.

Wednesday, July 27, 2016

Doing Your Due Diligence on Advisers and Actuaries

I read an interesting article this morning. In it, I read about a company that had used the same retirement plan adviser for quite a long time and developed a good relationship with them. After 13 years of this adviser assisting them with investment monitory, a fiduciary policy, and an investment policy, as well as manager searches, the company in question decided that just as part of due diligence, even though they figured there would only be about a 10% of chance of changing advisers to go through that due diligence process and bid those services out as well.

What the company, Dot Foods, found was that it was being charged perhaps more than a market competitive price and getting less than market competitive level of service. It was time for a change.

We could draw an analogy to lots of different kinds of services, but as consultants like to say, I'm going to drill down a little bit (I can't believe I used that term as hearing it always makes me hear a dentist's drill).

Let's put this in the context of a decent-sized, but not enormous defined benefit pension plan. To give some context, let's say that the plan has between $50 million and $1 billion in plan assets and let's assume that the plan is frozen (this is not an uncommon situation).

Now consider your plan advisers, particularly your actuary. Ask yourself these questions:

  • How long have you been working with your current actuarial firm?
  • Over that time, how many fresh ideas or analyses have they brought you with respect to your plan? When was the last time they brought you one that they didn't charge you for?
  • Reflecting the fact that your plan was frozen and that some of the work behind the actuarial valuation would be much simpler, did they voluntarily reduce your actuarial fees the year after you froze your plan?
  • Do you get as much attention from them as you did before your plan was frozen?
  • Have they given you a strategic plan to get to termination of your plan? Or, have they just told you that interest rates are too low now and you'll have to wait it out?
  • If they have given you a plan, was it provided in the context of your business or was it just their standard template?
You can pretty easily tell what the so-called best practice answers to all of these questions are. And, for your sake, I hope that after reflecting on your answers that you are able to tell yourself and your colleagues that most or all of those answers are what you would like them to be.

Suppose they're not. 

I know. You have a frozen plan and you think you are in set it and forget it mode. You don't really want to spend time both in the due diligence or RFP process to do this check and you certainly don't want to invest the time and effort that you think will be necessary during transition. 

Consider this scenario. You are able through that process to identify enough hard savings and soft savings that hiring a contractor or temporary employee to help with the transition would be a drop in the bucket in terms of cost compared to what you will be saving. During the RFP process, you get a freebie of some ideas that will help you to meet your strategic objectives with a promise of more to come. You learn that your actuary had gotten lazy and was delivering sub-optimal consulting.

Hmm ... there's an interesting term. What in the world is sub-optimal consulting

Sub-optimal consulting is a fancy way of saying that your actuary is just going through the motions. Everything they are providing you is correct, but none of it is the best correct answer.

I'm not implying here that your actuary should be doing anything underhanded or unethical. Quite to the contrary, your actuary should be following the law and Actuarial Standards of Practice to a tee. Oftentimes, however, within those constraints, there are a range of potential answers. Some are far more conducive to your business than others.

Consider this recent real example. A company, now a client, didn't like the news it was consistently getting from its actuary. That company didn't know if that news was the only way or if there was a better way. So, they asked. 

What they learned was that if their actuary did take the time to understand the interrelationship between their plan and their business that there was better news that they could be getting. The company came back to us and asked, "Can you save us money?" The answer was that there were hard dollar savings (fees) that would be small and other savings that would be significant. 

Perhaps you are the company that is getting great service and perhaps you maintain the plan for which everything is being done properly.

Tuesday, July 26, 2016

Save Our Social Security Act

What a novel idea -- Congressman Reid Ribble (R-WI) who I was completely unfamiliar with previous to today, has introduced into the House of Representatives a bill that incorporates ideas espoused by both parties. That's right, it's somewhat of a compromise bill designed to save our Social Security system by adding some burden to high earners while also increasing retirement ages.

The sad part is that I think that most people will look at this bill and focus on the parts that they, philosophically, don't like rather than emphasizing that it represents an excellent effort at potential bipartisan compromise. I hope I'm wrong.

What's in the bill?

  • The Social Security Wage Base, that is the amount subject to the 6.2% OASDI tax that is currently at $118,500, will increase as follows:
    • $156,550 in 2017
    • $194,600 in 2018
    • $232,650 in 2019
    • $270,700 in 2020
    • $308,750 in 2021
    • after 2021, to be determined by the Secretary of the Treasury to capture 90% of all FICA-covered wages
  • Change the current 3-band formula for calculating Social Security benefits to a 4-band formula thus allowing that all compensation considered for purposes of Social Security taxes also be considered for Social Security benefits, but not increasing Social Security benefits for the highest earners.
  • Beginning in 2022, the Social Security Normal Retirement Age (SSNRA) would again begin to gradually increase. This would have little, if any, effect on people currently close to SSNRA, but would reflect longer work spans and life spans for younger workers. This piece of the bill would be reexamined by actuaries every 10 years to study the effects of mortality improvements.
  • Change the basis for calculating the annual COLA for current SS beneficiaries by putting more weight on, for example, food, clothing, and transportation, and by putting relatively lower weight on housing, medical care, and recreation. The intent is to more closely mirror the necessary spending of a senior citizen as compared to that of an average urban wage earner.
  • Create a minimum benefit at 125% of the poverty level
  • Increase the benefit amount (I can't quite determine how this will work) after a person has been eligible to have been in pay status for 20 years
  • Base the SS benefit on 38 years of SS wages rather than 35
  • No legislation can be considered that would temporarily lower SS revenue for a year
Is this what I think is the best solution for Social Security? Probably not.

On the other hand, is this the best solution that I have seen that has a chance of passing Congress and being signed into law by the President? In my opinion, it has the best chance since 1983.

Let's see where it goes.

Monday, July 25, 2016

The Plight of Retirement And It's No-Mention Status in the Election

We have a Presidential election coming up. We have 34 US Senate seats that need to be filled this year and 435 seats in the House of Representatives. I've looked pretty closely. I've not see a single comment from an individual running for one of those offices that mentions retirement policy or retirement plans. That, while a majority of working Americans either worry daily about the prospects of retirement or would and should have that worry if they came out from under that rock they have hidden under.

There has been far more emphasis on other areas of workers' rewards packages and frankly, that emphasis has not had a major positive effect on the bulk of those American workers. Perhaps you have seen differently, but the three things that have gotten lots of focus ordered only by the way that I choose to type them have been:

  • Health care (primarily the Affordable Care Act)
  • The need (according to many to reduce executive compensation
  • The hourly minimum wage
Let's assume for the moment that if you are reading this that you are over the age of 25 (if you're under 25 and you have an interest in what I write here, I expect that you will have a successful future) and that you have some useful skill set. If that's the case, then there is a good chance that you are employed, employable, and looking for work, not working by choice, or retired. 

If you are working and you fall into those categories, there is a very good chance that you have access to decent health care benefits and, in fact, you probably had them or would have had them had you been similarly situated, before the effective date of the Affordable Care Act. So, while the ACA may have made some changes to your health benefits, it's not likely that those differences were life-changing for you (yes, I understand that uncapping the lifetime maximum and allowing your kids up to age 26 on your policy could have had that big a difference for you).

Similarly, most of us are not executives and certainly not of the classification whose compensation draws the significant ire of others. As individuals, we might have opinions on levels of executive compensation or we might not, but most of us know that even reducing our CEO's pay by 75% would not change our compensation one iota. We are compensated roughly on our value in the marketplace. Our value does not change merely because our CEO takes a pay cut.

Finally, there is the hourly minimum wage. I could be wrong, but my observation is that there just aren't a whole lot of people earning less than $15 an hour (unless they are currently in school) who read this blog. So, for you, the hourly minimum wage probably doesn't make much of a personal difference (I understand that you may have very strong opinions on it, but those are from the standpoint of what's right and what's wrong).

Where is poor little retirement? Social Security gets debated. But, we all know that you just can't retire on Social Security. 

I'm not going to spout statistics here because I don't have them at my fingertips. But, my observation is that a generation ago, far more employees than not were covered by meaningful employer-provided defined benefit (DB) plans. And, among those who were not, likely the majority of the rest were in often generous money purchase or profit sharing plans. 401(k) plans were in their infancy. As I've written many times here, 401(k) plans were never intended to be a primary means of retirement savings. 

That was the way of the mid 70s through mid 80s. 

Today, as we know, more employees than not, have a 401(k) plan as their only employer-sponsored retirement plan. Many of them are not generous. Many are poorly invested. In a perfect world, the employees in many of those plans will find it difficult to retire with anywhere near the standards of living they are used to. 

It gets worse, of course. Many of us will have or have had work interruptions or, at the very least, periods where we need to reduce or even cease our 401(k) contributions.  

We have a crisis. 

There, I said it. I believe it. 

In fact, it affects and will affect more Americans more profoundly than most of the issues being hotly debated. It certainly affects us more than does knowledge about Hillary Clinton's emails or Donald Trump's tax returns.

Yet, the candidates remain silent.

So very sad.

Tuesday, July 19, 2016

Opinion: American Workers Need Pensions and They Should Look Like This

Since I last blogged, I've seen a lot of survey data. Among the very compelling themes has been that Americans are afraid that they will not have enough money with which to retire. Those fears are well founded for many.

As I've written here many times, the 401(k) plan was never intended to be the primary retirement source of retirement income for American workers. Neither was Social Security. Rather, Social Security was intended to be a supplement to bridge people for what was usually just a few years of retirement before death. Section 401(k) was a throw-in in a late 70s tax law that was suddenly discovered. It was intended to give companies a way to help their employees to save more tax effectively. And, remember, in the late 70s, the norm was that whatever company employed you at age 35 was likely to be your last full-time employer. ERISA had recently become law and most American workers had defined benefit pensions. These plans were designed to assist employers in recruiting and retaining employees.

Then, again, as I've written many times, along came change through the government and through quasi-governmental organizations. Employers didn't like the mismatch between cash flow requirements and financial accounting charges. New pension funding laws, beginning in 1987, were designed not to ensure responsible funding of pension plans, but to provide an offset to tax expenditures (a fancy name for tax breaks and government overspending). Looking at it from the standpoint of someone in Congress trying to decrease tax expenditures, if you can decrease required company contributions, you decrease their tax deductions, and thus cut those evil tax expenditures.

Nearly 30 years later, pensions have tried hard to go the way of the dinosaur. The fact is, however, that there are still lots of defined benefit pension plans out there. But, they don't look the same as they did 30 years ago. The laws have changed, creative minds have been at work, and new and better designs have emerged.

American workers generally should have employer-provided defined benefit pension plans. But, since these creative minds have been at work, what exactly should these new plans look like?

  • While they offer a sense of stability in retirement, annuity payments do not appeal to many Americans and they do not necessarily understand them. So, while all defined benefit plans must have annuity options, they should also have lump sum options.
  • The plans should not be "back-loaded" (a term that means that most of your accruals and therefore cost to your employer emerges late in your career). The typical final average pay plan of yesteryear was designed so that most of your accruals occurred close to or after you were eligible to retire. This made some sense when you spent your whole career with one employer. But, in 2016, that very rarely happens. So, plans should accrue benefits fairly ratably.
  • Benefits should be portable. That is, you should be able to take them with you either to an IRA or to another employer. This works best if there is a lump sum option through which you can take a direct rollover and maintain the tax-deferred status.
  • Employer costs should be predictable and stable. This can be achieved when there is no longer a mismatch between assets and liabilities in a plan.
  • Employers should see that plan assets are professionally managed, but fluctuations in asset returns from those that are expected can be borne by plan participants.
This sounds like pension nirvana, doesn't it? Such plans and designs can't possibly exist.

Well, they do. 

The plan design that accomplishes this is often known as a Market Return Cash Balance Plan (MRCB).

While an MRCB carries with it all of the required characteristics of defined benefit plan and it looks a lot like a 401(k) or other defined contribution plan, it brings with it additional benefits. It satisfies all of the bullets I've outlined above. Budgeting gets easy and predictable. There is no "leakage" due to sudden expenses when a participant's car decides to break down or an unexpected flood ravages their house.

An MRCB is very suitable to be a primary retirement plan. You want to save a bit extra? That's what your 401(k) plan is for. 

If you are an employer and you're reading this, you really need to know more, don't you?

Thursday, June 2, 2016

The Easy Benefits Answer May be Compliance

I ran into an interesting situation the other day. I can't disclose enough of the details for reasons of confidentiality to use that as a case study. The point of the exercise, though, was that a client was looking for a loophole to escape the claws of what it was told is a horrible provision of the Internal Revenue Code. After analysis, however, I was able to determine that the loophole, as they put it, just doesn't work for them.

There, was a better and simpler solution, though. Just follow the law (without regard to the loophole).

While I can't use this week's example, it harkens back to the late 80s and early 90s (yes, I was doing similar work even then). Readers in their 50s or older may recall that the first Tax Reform Act of 1986 (TRA86) regulations to come out were the proposed 401(l) regulations that graced the pages of the Federal Register in late 1988. Lawyers, consultants, and actuaries (me among them) raced to digest those regulations and to be the first to tell their clients and prospects how to comply.

I digress for a moment to explain why this could have been so important. 401(l) explained how to integrate certain qualified retirement plans with Social Security in order for those plans to be exempt from the general test for nondiscrimination under Code Section 401(a)(4). Prior to TRA86, permissible integration was determined under Revenue Ruling 71-446, and whether or not a group of plans was discriminatory in nature was determined under the comparability rules of Revenue Ruling 81-202. What was different, though, was that if you had an integrated plan and you couldn't prove that it was properly integrated per RR 71-446, you risked your qualified status. Under TRA86, proper integration was more of a convenience.

Returning to the main plot, we all rushed out to our clients and many with defined benefit (DB) plans redesigned them to be properly integrated making them safe harbor. Those clients then needed to deal with transition rules under Notice 88-131. Some with good memories will remember racking our brains over choices between Options II and III and Alternative II-D.

Other sponsors made a different decision. They chose to not redesign their plans. That meant that they had to comply with the general test for nondiscrimination.

Well, for most, that turned out not to be such a big deal. It meant that every year or two years or three years, they had to engage their actuary to perform a test that was usually pretty easy to pass. What they got in return was a lack of disruption. For them, the easiest answer was not to find a way out of testing, but simply to pass a test that they could easily pass.

Returning finally to my initial point from this post, the client in question was trying to get out of a rule that counsel had told them was pretty horrible. And, it's true, it can be a horrible rule. But, in this specific case, the compliance burden associated with this rule will be minimal.

And, that means that what is perhaps the optimal solution will be simple.

Sometimes, the right answer has nothing to do with loopholes. Sometimes, the easiest (and best) answer is compliance.

Tuesday, May 24, 2016

The Truth About Actuarial Valuations of Pension Plans

I've heard the same comments for years. I've heard that a company loves its actuary, but they can't give you one reason why. I've heard that actuarial work is a commodity and that everyone produces the same numbers, so you might as well go with the lowest bidder. There's more; there's lots more.

I'm here to tell you that it's all wrong and it's wrong now more than ever.

Let's revisit history a little bit. In the beginning (well, not quite the beginning), there was ERISA. And, Congress saw that it was good ... for a while.

ERISA brought us rules and choices. The rules said that plan sponsors had to fund the sum of the annual cost of benefits that were accruing (normal cost) plus a portion of the amount by which the plan was underfunded using some fairly complex formulas. But, those calculations were pretty malleable. In fact, there were many methods by which to calculate those numbers and if you couldn't find the methods to get you the answers you wanted, you could likely talk your actuary into selecting assumptions to get you to those numbers. That's the way the game was played from the mid-70s through the mid-80s.

Then, the rules began to change. Congress saw that corporate tax deductions for funding pensions were a significant drag on the federal budget. So, Congress sought to limit those deductions by bringing in multiple funding regimes. So, was passed the Pension Protection Act of 1987 as part of the Omnibus Budget Reconciliation Act of 1987. And, Congress saw that is was good ... for a while.

Multiple funding regimes theoretically brought multiple choices, but with the 90s came the era of full funding. With the use of high discount rates tied to assumed rates of returns on plan assets, those assets exceeded the calculated liabilities of the plan. More plans than not had no required contributions. Pensions were cheap.

And, then came the perfect storm. Interest rates fell, asset values fell, and Congress had to do something. In 2006, Congress passed another Pension Protection Act (PPA). And, Congress saw that it was good.

But, there was something different about PPA. It severely limited flexibility in calculating the actuarial liabilities of a pension plan. In fact, with very limited exceptions, without any knowledge of the actuarial assumptions being selected, another actuary could fairly well reproduce that calculation of actuarial liabilities (at least within in a few percent).

But, what we have now is a tangled web. There are so many liabilities and percentages. Every single one of them affects the cost of your plan. There is the funding target, the plan termination liability, the liability for purposes of calculating PBGC premiums. There's the FTAP, the AFTAP, and various other funding percentages.

While each individual calculation is simple, getting to the correct answer is not.

And, that's why your choice of actuary for your plan is actually far more important today than it used to be.

Suppose I told you that your actuary's lack of attention to your plan as compared to the rules was costing you more money annually than you pay in actuarial fees.

Suppose I told you that your actuary's not focusing on your business's cash flow needs was forcing you to borrow unnecessarily.

Suppose I told you that that renegotiation of a loan covenant that you just went through because your pension plan had too low a funded percentage could have been avoided.

The scary thing is that I have told companies all of those things. We're in an era now where calculation is easy, but strategy is difficult. In fact, more plans than not are using a suboptimal strategy. Don't you need to know if you are spending more money than you need to or if you are spending it inefficiently?

Monday, May 9, 2016

Multiemployer Law Fails to Work for the Plan it was Most Likely Developed For

In mid-2014, Congress enacted and the President signed into law the Multiemployer Pension Reform Act (MPRA) sometimes known as the Kline-Miller Act (for its original sponsors). MPRA was unique in modern political circles as it was sponsored by John Kline, a Republican from Minnesota and George Miller, a Democrat from California. It was also unique in that it had support from unions, from companies that employ union workers, from affected government agencies and from industry groups specializing in multiemployer plans.

All that makes it sound like a law that was practically perfect.

Some background for those who don't spend their days in the multiemployer plan world is useful. Generally, multiemployer plans exist in industries where an individual working in that industry may provide services to many different employers. In the Teamsters Unions (primarily truck drivers), for example, drivers may drive on behalf of many different employers. Each employer agrees to contribute an amount to the plan based on the amount of service provided to it by each worker under the agreement. So, for example, in the case of a Teamsters Union, contributions could be set at some number of dollars per thousand miles driven. Retirement benefits are set based on the levels that the trust can support.

Benefits under multiemployer plans are insured (to some extent) by the Pension Benefit Guaranty Corporation (PBGC). One of the reasons for the passage of MPRA was to protect the PBGC. This was to be accomplished by allowing plans that met a set of requirements (more later) to reduce benefits that had already accrued. As many of the industries often covered by multiemployer plans dwindle, the plans themselves are unable to support the levels of benefits that had been promised. There are just not enough dollars coming into the plans.

Based on data published initially by the Center for Retirement Research at Boston College, the single plan that was viewed as potentially most problematic was the Central States, Southeast, and Southwest Areas Pension Plan. With more than 400,000 member, a funded ratio just barely above 50%, and nearly 5 times as many inactives as actives (all as of 2012), the plan was estimated to become insolvent in 12 years. Many plans were projected to become insolvent sooner, but not represented nearly the liability of the Central States Plan.

As MPRA should have, it placed a strict set of conditions (see Code Section 432(e)(9)) on such suspensions. Cutting back retirement benefits had essentially never been permitted in an ERISA plan. Such a cutback needed to be in everyone's best interests.

The process for determining that was generally to be that the Trustees of a Plan would apply to the Treasury Department for such a suspension (the technical term for such a reduction). The application would need to demonstrate that the suspension met all of the conditions referenced above.

In the case of the Central States application, Special Master Ken Feinberg determined that some of those conditions were not met.


  • The suspension must be reasonably estimated to avoid insolvency
    • In making its projections, the Trustees or the outside consultants used by the Trustees assumed a rate of return on plan assets that for every asset class in the plan exceeded the 75th percentile (according to survey data) for that class
    • The entry age for new participants under the plan was assumed to be 32. While data shows that 32 is the average age, that is misleading because a group of new entrants at age 32 would have no new retirees in the next 20 years. On the other hand, a group with average age 32, including some who are much older, would have new retirees representing cash outflow from the plan far sooner than that.
  • The suspension of benefits must be equitably distributed meaning that a particular class of participants is not adversely affected more than other classes
    • The Trustees sought to make use of participants who are or were UPS employees under the plan. UPS had completely withdrawn from the plan and made withdrawal liability payments under the plan. In doing so, UPS had fulfilled its obligations with respect to the plan.
    • But, UPS made those participants whole under a different plan. In its application, the Trustees considered only the portion of UPS benefits attributable to the make-whole agreement. This was judged not to be an equitable distribution.
  • Upon application for suspension of benefits, notices must be distributed to participants explaining the suspension and the reasons for it
    • The notices must be understandable by the typical participant, but in fact contained lots of technical jargon.
    • In the notice's worst blemish, it contains a 98-word sentence with 4 technical terms not defined anywhere in the notice.
For all these reasons, the application was denied.

What does this do?

It leaves the Central States Plan in a position where it is likely within roughly 7 or 8 years of becoming insolvent. This means that the PBGC will become responsible for an extremely large liability for which its multiemployer fund does not have sufficient assets.

Who wins? Nobody.

Who loses? The PBGC, the plan participants, and the multiemployer system.

We might as well say that Americans are the losers.

Friday, April 15, 2016

IRS Withdraws Troubling Provision of Proposed Nondiscrimination Regulations

Yesterday, the IRS released Announcement 2016-16 withdrawing parts of the nondiscrimination regulations it proposed at the end of January. Those proposed regulations had troubled many in the defined benefit industry since their proposal for a number of reasons (more below). From the standpoint of the IRS, the troubling part of the proposal addressed some serious abuses by practitioners and the sponsors they consult to. From the standpoint of practitioners, the proposed regulations took an objective test that has been around for quite a while and essentially changed the rules of the game.

I'm going to have to get a little bit technical here before I bring you back to reality. What the proposed regulations would have done was to make retirement plans with multiple formulas show that each formula applied to reasonable business classifications of employees or to pass a more difficult test.

Under regulations that were finalized in 1993 and then amended for cross-tested plans in the late 90s, a rate group in the testing population must have a coverage ratio at least equal to either

  • 70% if the plan uses the Ratio Percentage Test to pass minimum coverage tests or
  • The midpoint of the safe harbor and unsafe harbor (the midpoint is typically in the 25% to 40% range, but is determined through a somewhat convoluted formula) if the plan uses the Average Benefit Test to satisfy minimum coverage
It is far easier for a rate group to satisfy a lower minimum coverage ratio than a higher one. And, many plans had been designed around satisfying the lower threshold. While the preamble to the proposed regulation said that it was targeting QSERPs, practitioners found that they also were potentially problematic for many plans of small businesses and plans of professional service firms. 

Why would this be troubling? Certainly, among larger corporations, the prevalence of ongoing defined benefit plans has dropped precipitously, but many small businesses and professional service firms have adopted new defined benefit plans (DB) over the last 15 years or so and many of these plans would have found it more difficult or perhaps impossible to pass these proposed rules.

This doesn't mean that DB plans of this sort are out of the woods yet, so to speak. Clearly, the current Treasury Department views that plans of this sort may be abusive in their application of the nondiscrimination regulations, so we could see another effort from the IRS to make the regulations a bit less QSERP-friendly. 

In the meantime, there are some great DB designs that exist for companies that wish to provide meaningful retirement benefits to their rank and file employees. You can learn more about them here.

Tuesday, April 12, 2016

The Quandaries of Being A Retirement Plan Fiduciary

Last week, the Department of Labor issued its final rule on what it means to be a fiduciary and on conflicts of interest. Virtually everyone in the retirement plan industry has been scurrying about to determine what the effect of the rule is. Some, including the US Chamber of Commerce, say it will lead to unnecessary litigation. Others say it will drive unknowledgeable advisers out of the retirement plan business.

If you're interested in the details of that regulation, every large consulting firm, law firm, and recordkeeper either has or will be publishing their take on it. Here, however, I want to address a different issue.

If you sit on the committee that oversees a retirement plan whether its called the Benefits Committee, the Investment Committee, or the Committee for All Things Good Not Evil, by virtue of that role, it is probable that you are a fiduciary. That means that both individually and as a member of that committee, when making decisions related to the plan (not your own account in the plan, but the plan generally), you have a requirement to act in a fiduciary manner and in the best interest of plan participants.

That's not a low bar.

Instead of bringing up situations that arise from the new final regulations (the other articles will present you with all of those that you need), let's instead consider an age old problem. Suppose your company sponsors a defined benefit plan and you are on the committee that oversees the plan. Let's complicate the situation a bit by adding in the following fact pattern:

  • The plan is covered by the PBGC (Title IV of ERISA)
  • The plan is frozen and the committee's minutes show that the intent of the committee is to terminate the plan whenever it becomes well enough funded
  • Your company is subject to US GAAP; in other words, you account for the plan under ASC 715 (previously FAS 87).
  • Your own personal incentive compensation is affected by corporate financial performance measured under US GAAP
  • Over time, you have received a material amount of equity compensation from your employer meaning that you now hold a combination of shares of stock, stock options, and restricted stock in your employer
Your actuary comes to a meeting with your committee and informs you that you have three options related to a funding strategy:
  • Option #1 will keep the ASC 715 pension expense down and will not result in a settlement (that would be a loss currently), but will result in the plan being less well funded
  • Option #2 will produce a settlement loss, but will get the plan closer to termination and leave it currently better funded for remaining plan participants
  • Option #3 will reduce ASC 715 pension expense and get the plan better funded and therefore closer to termination, but will have a material effect on the corporate balance sheet and could cause the company to violate certain loan covenants
You do have a quandary, don't you? Only Option #1 will help you to maximize your incentive pay. In my personal experience, in days gone by, for that particular reason, Option #1 would have gotten some votes. If you vote for Option #1, are you fulfilling your responsibilities as a fiduciary?

I'm not an attorney, so I'm not going to answer that question, but I'm sure you can find many who would be happy to weigh in.

Option #2 looks like it could be better for plan participants. Of course, that depends a little bit on what better means in this context. But, if the committee goes with Option #2, you know that your incentive payout could be smaller. If you vote against Option #2 (another question for the attorneys), are you fulfilling your fiduciary requirements?

And, then there's Option #3. How far do you have to go to fulfill your fiduciary requirements? Do you have to make decisions that are clearly not in the best interest of the company, but that may be in the best interests of plan participants? 

It's tricky, isn't it?

Now, let's consider a different situation that may not affect your personal compensation. Using Strategy #1, your company will pay PBGC premiums equal to about 10% of its free cash flow. Using Strategy #2, those same premiums will be reduced to about 3% of free cash flow. But, your actuary isn't familiar with Strategy #2. And, you do have a really good relationship with him. But, the people who brought you Strategy #2 say you can only implement it by using them.

Thursday, March 31, 2016

The Private Equity Multiemployer Plan Problem ... Litigated

For years, private equity funds have managed to do a good job of using the controlled group rules of Internal Revenue Code Section 1563 to avoid some of the complexities associated with them. In fact, where a single private equity group maintains multiple funds, it has typically ensured not having to deal with these rules by divvying up the ownership of any company among its funds. However, the United States District Court for Massachusetts may have dealt a serious blow to these strategies.

Section 1563(a) contains the key language specific to controlled groups.

(a)Controlled group of corporations For purposes of this part, the term “controlled group of corporations” means any group of—
(1)Parent-subsidiary controlled group One or more chains of corporations connected through stock ownership with a common parent corporation if—
stock possessing at least 80 percent of the total combined voting power of all classes of stock entitled to vote or at least 80 percent of the total value of shares of all classes of stock of each of the corporations, except the common parent corporation, is owned (within the meaning of subsection (d)(1)) by one or more of the other corporations; and
the common parent corporation owns (within the meaning of subsection (d)(1)) stock possessing at least 80 percent of the total combined voting power of all classes of stock entitled to vote or at least 80 percent of the total value of shares of all classes of stock of at least one of the other corporations, excluding, in computing such voting power or value, stock owned directly by such other corporations.
Long time followers of this blog may recall that Scott Brass has been fodder for issues specific to private equity funds in the past. Once again, we deal with Sun Capital Partners, here known by Sun Capital Partners III, III QP, and IV.

Scott Brass, Inc. was a bankrupt company essentially held 30% by Sun Capital III and 70% by Sun Capital IV. After going bankrupt, Scott Brass stopped contributing to the New England Teamsters pension fund and was assessed a withdrawal liability by the multiemployer plan.

Under the Multiemployer Pension Plan Amendments Act of 1980 (MPPAA), members of a controlled group may be jointly and severably liable for withdrawal liability payments. But, Sun Capital argued that Scott Brass was neither part of a controlled group with parent Sun Capital III nor one with parent Sun Capital IV.

The courts thought differently. Relying on ERISA Section 4001, in which we see outlined the PBGC's definition of controlled group, the courts in this case looked at substance over form. That is, the courts saw that there is, in fact, a single entity that owns Scott Brass, Inc,, despite the complex legal structure that was developed surrounding the company. In fact, the Managing Partners of Sun Capital freely admitted that the structure that they created was largely to avoid the possibility of joint and several liability for withdrawal liability.

The court ruled in favor of the Teamsters Fund. While this will surely be appealed to the First Circuit and perhaps to the Supreme Court if the First Circuit fails to overturn, this case provides an avenue by which multiemployer plans may seek payments of withdrawal liability that have previously not been available to them.

Private equity funds in similar situation should consider these potential liabilities both in due diligence and in their ongoing risk management assessments.

Thursday, March 24, 2016

The Pension Tale of the Cash and the Calendar

Once upon a time, there was a defined benefit (DB) pension plan. And, the plan was fully funded. And, that was good.

Well, at least, the plan's actuary told the plan sponsor that the plan was fully funded. And, then he said something else after that -- something about a HATFA basis. Oh, but it couldn't matter. That was clearly some foreign word. After all, the sponsor knew that the actuary was a really smart and he probably lapsed into foreign tongues once in a while. All that actuarial gibberish is pretty much a foreign language, anyway.

So, the plan sponsor, in this case represented by the Benefits Manager (Bob) and the Controller (Cliff), armed with the knowledge that its frozen plan was fully funded gleefully went off to see the CFO (Charlotte). It was time to tell her that the plan was fully funded and that the plan could be terminated.

Those of who work in the pension world know that this little story didn't end well. For those who don't work in that world, let's just say that being fully funded at the beginning of 2016 on a HATFA basis may mean that on a plan termination basis, assets may only be very roughly 2/3 of liabilities.

Our story goes on.

After understanding that they couldn't terminate the plan, the sponsor Craters R Yours (CRY), the world's largest manufacturer of inflatable moonwalks set about to continue managing their frozen DB plan. CRY had initially assumed that freezing the plan was an end to its pension worries, but it soon learned that was not the case.

They learned that frozen plan management can be a tale of volatility caused by cliffs and calendars. In year 1, we get funding relief. In year 2, it's gone and we revert to the old rules. We're 80.01% funded; all is well. We're 79.99% funded; life gets really tough. We make a contribution on March 31; a ratio gets better. We make it on April 2; there are things we have to tell the government.

Bob and Cliff learned that their jobs had become really difficult. Charlotte had roundly praised them when they found a new and inexpensive actuary, Numbers For Cheap. And, NFC always provided legally correct numbers. But, there was no strategy. NFC didn't tell Bob and Cliff that contributing $1,000,001 on March 31 was going to be much more valuable in the long run than contributing $999,999 on April 2. Because NFC really had no clue, CRY would up doing a lot of crying.

Bob and Cliff, and Charlotte, for that matter had been sure that when they froze CRY's pension plan that the actuarial work was a pure commodity. All the strategy was done. All that was left was to hire the cheapest actuary and get the plan terminated.

The moral of the story, of course, is that pension funding strategy doesn't end until the plan is gone. Until then, there is a difference, and you, as a plan sponsor need someone who can help you to find that optimal strategy. Let us help.

Wednesday, March 16, 2016

Is Your Executive Plan Top-Hat?

Most larger companies and some smaller ones provide many of their higher paid employees the opportunity to participate in a nonqualified retirement plan often referred to as a Supplemental Executive Retirement Plan or SERP. The rationale for having such a plan is spelled out in ERISA. The regulations specifically grants "top-hat" status to plans that are limited to a select group of management or highly compensated employees. The plan must also be unfunded (and for those people who say that lots of top-hat plans have assets set aside, that is informal funding in a rabbi trust or through insurance products or some other means).

Before going further, I'd be remiss if I did not mention that my motivation for posting this is a recent series on top-hat plan litigation in Mike Melbinger's blog.

So why should an employer or employee care if their plan is a top-hat plan or not? According to regulations under ERISA Section 104, top-hat plans are exempt from the participation, funding, vesting, and fiduciary rules under ERISA. As we shall see, this can be critically important, especially in the current statutory environment.

Backpedaling just a bit because this will help the less knowledgeable reader to understand why top-hat plans exist, let's consider what it could mean to be in a top-hat group. ERISA was enacted in 1974 to provide certain protections for employees in retirement and certain welfare benefit plans. When a plan is exempt from some of the key provisions of ERISA, it fails to provide those protections. So, being in a top-hat plan could alert a participant that he or she might not need those protections.

As some authors, mostly attorneys, have pointed out, the last year or two has seen more than the usual amount of litigation related to top-hat plans. In the typical situation, either an individual thinks that they were improperly excluded from a top-hat plan (in my completely non-legal view, this would be a tough claim to make) or because they were in a plan that was treated by their employer as being a top-hat plan, but they thought that it did not satisfy the criteria for being top-hat.

Depending on your viewpoint, the latter is either an easy claim or a difficult claim to make. Why is that? It's been more than 40 years since the passage of ERISA and we still don't have formal DOL guidance telling us what a top-hat group is. Some have argued that an individual may properly be in a top-hat group by being either management or highly compensated or both. Despite the current definition of highly compensated (Internal Revenue Code Section 414(q)) not existing until late 1986, some have argued that satisfying that criterion is sufficient. Many years ago, the DOL floated a concept that a person should be eligible for a top-hat group that a person would be eligible if their compensation was at least two times (three times in a separate informally floated concept) the Social Security Wage Base. And, finally, there is the concept that a person may rightfully be in a top-hat group if by the nature of their position, they have the ability to influence the design and amount of their compensation and benefits package.

So, knowing that we currently don't know what a top-hat group actually is, why do we care?

Suppose your company sponsors what it believes to be a top-hat plan and it turns out that it's not top-hat. Then, it's going to be subject to some fairly onerous provisions that could create massive current costs in some cases and unsolvable compliance issues in others.

Consider the following scenario.

Suppose you have a DB SERP with 20 participants. Further suppose that for whatever reason, this plan is found to not be a top-hat plan. Assuming that the company is large enough, then the plan will fail the minimum participation rules and it will necessarily (unless the company has only highly compensated employees) fail the minimum coverage tests. Full vesting must occur generally within 5 years of entry and that entry must occur not later than age 21 with 1 year of service. The plan must be funded according to ERISA's minimum funding rules. And, those plan assets must be invested according to ERISA's fiduciary standards. But, the plan will still not be a qualified plan as it doesn't meet all of the Internal Revenue Code's standards under Section 401(a).

If the plan is not qualified, it must be a nonqualified plan of deferred compensation. That makes the plan subject to Code Section 409A. So, let's throw in one more wrinkle. Let's suppose the company also sponsors a qualified DB plan and let's suppose that the qualified plan is less than 80% funded. Now, you are between a rock and a hard place. Setting aside assets (funding) for the nonqualified plan will violate Code Section 409A which will subject participants to a very large unplanned additional tax liability. (By the way, those participant will likely have to find a way to pay those taxes perhaps without having access to the deferred compensation assets in order to pay them.) Not funding the SERP will cause the plan to fail to meet minimum funding standards which will result in excise taxes under IRC 4971.


What should an employer do?

I've been told by more than one attorney that it is unlikely that you can get a formal legal opinion that your top-hat group is, in fact, a bona fide top hat group.

If you can't get a formal legal opinion, perhaps the best way to get comfort is to get an outsider with expertise in this area to assist with an independent analysis.

Looking at a history of case law and DOL opinion on the topic, one might consider these elements:

  • The percentage of the workforce in the top-hat group
  • The relative pay of the top-hat group as compared to the pay of those people not in the top-hat group
  • Whether the top-hat group was selected by the Board as compared to being, for example, any employee with the title Vice President or higher
  • Whether individuals in the top-hat group, especially those among the lower-paid in the group, have significant management responsibilities
  • Whether individuals in the group need the protection of ERISA
Nobody really knows. But, having an independent analysis might show that an employer is acting in good faith in determining the group. Given the downside of getting it wrong, it may just be worth it to find out.

Finally, I want to reiterate that I am not an attorney and I have no qualifications to provide legal advice. As such, nothing in this post or anything else that I write should be construed as legal advice or as the practice of law.