The Big Surprise Gotcha in the Million Dollar Pay Cap

Even those of us who have been hiding under rocks know that late last year, the President signed into law the Tax Cuts and Jobs Act. And, as part of that Act, there was language that amended Code Section 162(m) also known as the million dollar pay cap. After Treasury gave us guidance on those changes in Notice 2018-68, some observers were surprised by a few of the interpretations that the regulators took. One in particular, however, that they didn't quite spell out, meets my criteria for a big surprise gotcha.

I'll come back to that and consider how an employer might get around it, but first some background. Under the old 162(m), deductions for reasonable compensation under Section 162 were limited to $1,000,000 per year for the CEO and the four other highest compensated employees of, generally speaking, publicly traded companies. However, most performance-based compensation was exempt from that calculation and was deductible as it would have been before the cap came into being.

Under the new 162(m), the definition of covered employee has been changed to be the CEO, CFO, and the three other highest paid employees. But, once you become a covered employee, you remain a covered employee. So, by 2030, for example, a company could easily have 25 covered employees. [Hats off to the cynics who know this is a silly example because no law stays in place unchanged for 13 years anymore.] Further, performance-based compensation is no longer exempt.

Like most law changes that affect compensation and benefits, this one, too, has a grandfather provision. Here, the new rules are not to apply to remuneration paid pursuant to a binding contract that was in effect on November 2, 2017, and which has not been materially modified after that date. The keys then relate to what is compensation for these purposes, what sort of modifications might be material, and what constitutes a binding contract.

Compensation is essentially any compensation that would be deductible were it not for the million dollar pay cap. Whether a modification is material remains a bit subjective, but the guidance does specify that cost-of-living increases in compensation are not material, but that those that meaningfully exceed cost-of-living are.

The binding contract issue is the really sneaky one. Your read and your counsel's read may be different, but my read is that if the employer has the ability to unilaterally change the contract, it's not binding. That is problematic.

Consider a nonqualified retirement plan be it a defined benefit (DB) SERP or a traditional nonqualified deferred compensation (NQDC) plan. In my experience, it's fairly common (completely undefined term) to see language that gives an employer the unilateral right to amend said plan, subject to any employment agreements that may overrule. Well, if the company can amend the plan, there would seem to be no binding agreement. And, that means that when that nonqualified plan is paid out to the employee, perhaps none of a large payout will be deductible for the employer. I'm aware of some payouts well into nine figures.

When it's a nine-figure payout, there really aren't great solutions. But, for the typical nonqualified plan, whether it's DB or DC, qualifying some of the benefits changes the treatment. If the benefits can be qualified in a DB plan using a QSERP device, employer funding will be deductible if it is deductible under Section 404. That's far more forgiving and, in fact, it is not at all unlikely that the deductions will already have been taken before the covered employee retires.

Yes, it's still a big surprise gotcha, but don't you prefer a surprise gotcha when it has a surprise solution.

Time to Revisit the Work Relationship

I read an article the other day highlighting some findings from a Willis Towers Watson survey. Quoting from the article:

Yet only 25% rank contributing to a health savings account (HSA) as a top current financial priority, falling below saving for retirement in a 401(k), paying for essential day-to-day expenses and paying off debt. The survey found the majority of employees (69%) who didn't enroll in an HSA said they chose not to because they didn't see the benefit, understand HSAs, or take the time to understand them.

Let's think about the hidden part of what is being said there. The relationship between employers and employees has changed. As two factions battle for dominance in what that relationship should look like -- those who preach self-reliance think that employers should provide availability of savings options only and those who preach mandated pay and benefits think that the only differentiators should be things like office gyms and juice bars -- we are left in a world where creativity is encouraged, but not in any determination of how employees are rewarded.

If you were to take a survey of which benefits employees find the most important (many have, but I can't put my hands on one right now), I suspect that numbers one and two would be their health benefits and their 401(k). Why? The data that I cite above shows that most don't understand their health benefits and having worked in the retirement space for more than half my life, I can tell you that the large majority don't understand their 401(k) either. Many understand what it is, but relatively few understand what it's not.

So much for the people who preach self-reliance as in 2018, those are two benefit types that are the epitome of self-reliance.

Let's turn for a moment to another side of the equation -- pay. The other side of the spectrum would have us believe that as an employer, you are not particularly entitled to differentiate between employees based on much of anything because if the data suggests that any two employees are paid any differently from each other and it is even remotely possible that maybe someone in their wildest dreams could divine that those differences in pay are based on something that the law doesn't or shouldn't, in their opinion, allow, the company is in trouble.

Suppose we were to scrap the current system. Suppose different companies offered different benefits that their employees could understand. Suppose they paid employees based on the value they brought to those companies (yes, I know that value is nigh impossible to measure).

In the thought to be antiquated employer-employee relationship that existed 30-35 years ago, consider what we had:

• Companies were generally nicely profitable;
• Employees tended to stay with the companies that they worked for at age 35 until they retired;
• Those employees, generally speaking, lived as well as or better in retirement than they did while they were working;
• Health benefits were such that employees didn't go into debt to pay their share of them from every paychecks; and 
• Neither the country nor its citizens were reeling in debt.

I also see data that tells me that more than half (usually about 55%) are on track to retire. Translated, that means that nearly half are woefully behind. That's not a success. That is an utter failure.

The experiments of employee self-reliance and of paying everyone the same because you're not allowed to pay them differently have been failures. More likely than not, they will remain failures. 

Perhaps it's time to see what was right about the employer-employee relationship in the 80s and bring it back. Let's aim for 100% of employees being on track to retire. Let's aim for benefits that employees use because they do understand them. Let's pay people that deliver value in the workplace. It is time to revisit the work relationship.

As President of the Conference of Consulting Actuaries

I have had the honor and privilege to serve my profession and the members of the Conference of Consulting Actuaries (CCA) for almost a year now. My term will come to an end at the close of our Annual Meeting on October 24.

Last Thursday, I received a phone call and later an emailed letter from the President of the American Academy of Actuaries. The Academy later notified its membership with a similar communication.

Here is a paragraph from the Academy's communication to its members:

• The Board believes that ACOPA and CCA perform important functions for their members. Those functions, which include advocating for the commercial interests of their members and their members’ clients, are highly valued by many in the profession. They are, however, incompatible with maintaining the independence and objectivity of the ASB and ABCD. Preserving this independence is vital to the public’s confidence in the U.S. actuarial profession’s ability to regulate itself.

None of the functions of the CCA is advocating for the commercial interests of our members and our members' clients. In fact, the CCA is not a lobbying organization. We do not currently and to my knowledge, never have had a presence on Capitol Hill.

The Academy does.

Of the five major US-based actuarial organizations, the CCA was the first to impose upon its members formal standards for continuing professional education. Later, the Academy and others adopted ours.

In 2006, in response to a crisis within the actuarial profession in the UK, a specially appointed task force of the US-based actuarial organizations released the final CRUSAP report (Critical Review of the US Actuarial Profession) outlining a series of recommendations to keep the independence of the US actuarial profession intact. To my knowledge, the last remaining remnant of CRUSAP had been the Joint Discipline Council (JDC), a group and function whose role was to jointly recommend discipline for violations of the Code of Professional Conduct. Leadership of the CCA took perhaps the largest role in seeing that the JDC came to fruition. All five major US-based actuarial organizations were signatories to it. Last fall, the Academy withdrew causing the JDC to be disbanded.

It's not up to me to be the arbiter of right and wrong.

I've laid out facts.

You decide.

Using Cash Balance to Improve Outcomes for Sponsors and Participants

In a recent Cash Balance survey from October Three, the focus to a large extent was on interest crediting rates used by plan sponsors in corporate cash balance plans. In large part, the study shows that those methods are mostly unchanged over the past 20 years or so, this, despite the passage of the Pension Protection Act of 2006 (PPA) that gave statutory blessing to a new and more innovative design. I look briefly at what that design is and why it is preferable for plan sponsors.

Prior to the passage of PPA, some practitioners and plan sponsors had looked at the idea of using market-based interest crediting rates to cash balance plans. But, while it seemed legal, most shied away, one would think, due to both statutory and regulatory uncertainty as to whether such designs could be used in qualified plans.

With the passage of PPA, however, we now know that such designs, within fairly broad limits, are, in fact allowed by both statute and regulation. That said, very few corporate plan sponsors have adopted them despite extremely compelling arguments as to why they should be preferable.

Why are they preferable?

For roughly 20 years, the holy grail for defined benefit plan, including cash balance plan, sponsors has been reducing volatility and therefore risk. As a result, many have adopted what are known as liability driven investment (LDI) strategies. In a nutshell, as many readers will know, these strategies seek to match the duration of the investment portfolio to the duration of the underlying assets. Frankly, this is a tail wagging the dog type strategy. It forces the plan sponsor into conservative investments to match those liabilities.

Better is the strategy where liabilities match assets. We sometimes refer to that as investment driven liabilities (IDL). In such a strategy, if assets are invested aggressively, liabilities will track those aggressive investments. It’s derisking while availing the plan of opportunities for excellent investment returns.

How exactly does this work?

I alluded to the new design that was blessed by PPA. It is usually referred to as market-return cash balance (MRCB). In an MRCB design, with only minor adjustments necessitated by the law, the interest crediting rates are equal to the returns on plan assets (or the returns with a minor downward tweak). That means that liabilities track assets. However the assets move, the liabilities move with them meaning that volatility is negligible, and, in turn, risk to the plan sponsor is negligible. Yet, because this is a defined benefit plan, participants retain the option for lifetime income that so many complain is not there in today’s ubiquitous defined contribution world. (We realize that some DC plans do offer lifetime income options, but only after paying profits and administrative expenses to insurers (a retail solution) as compared to a wholesale solution in DB plans.)

When asked, many CFOs will tell you that their companies exited the defined benefit market because of the inherent volatility of the plans. While they loved them in the early 90s when required contributions were mostly zero, falling interest rates and several very significant bear markets led to those same sponsors having to make contributions they had not budgeted for. The obvious response was to freeze those plans and to terminate them if they could although more than not remain frozen, but not yet terminated.

Would those sponsors consider reopening them if the volatility were gone? What would be all of the boxes that would need to be checked before they would do so?

Plan sponsors and, because of the IDL strategies, participants now can get the benefits of professionally and potentially aggressively invested asset portfolios. So, what we have is a win-win scenario: very limited volatility for sponsors with participants having upside return potential, portability, and wholesale priced lifetime income options.

The survey, as well as others that I have seen that focus on participant outcomes and desires, tells us that this strategy checks all the boxes. Now is the time to learn how 2018’s designs are winnersfor plans sponsors and participants alike.

Imagining Retirement Plans Through the Eyes of a Child

Imagine retirement plans. Imagine retirement plans through the eyes of a child (gratuitous Moody Blues reference for readers in my age range).

I know, this sounds really strange. Of all the people who are not thinking about retirement, kids are at the top of that list. Bear with me though. I will bring you back.

Before I do, however, think back to when you were a child. You probably either lived in a house on a street where there were other kids or in an apartment where there were other kids around or went to school where there were other kids. One way or another, most of us found ourselves around other children.

Now, think about what really made you beam with pride and joy. There were lots of things -- good grades, winning a game or a race, and being the first kid on the block to have something that every kid wanted. It didn't have to be something big. But, if you had it first, every kid wanted to be you.

I promised that I would bring you back and I'm going to start now. Take yourself out of the mind of a child. At least do that a little bit, but we're going to be meandering back and forth a bit on this short journey.

Think about the employer-employee relationship. Some employees want a job; others want a career. Some employees want a paycheck; others want to be somewhere where they want to come to work. Some employers want to have employees who collect a paycheck and perhaps as small a paycheck as the employer can get away with; others want to be employers of choice.

From an excellent article in Fast Company, "[O]ne of the top factors most likely to keep professionals at their company for 5+ years ... is having strong workplace benefits ... ." The article continued, "[I]n comparison, the least enticing factor for keeping professionals at their current companies is having in-office perks such as food, game rooms, and gyms."

Employers that want to be employers of choice will care about this stuff. And, so will employees. And, many of these employees actually do remember being children. Just as I do, they remember things like spending a nickel on a stick of Topps bubble gum that came with five baseball cards and upon opening the pack seeing that they were the first kid they knew of to get a Mickey Mantle. You really do have something special then.

Often times, employers that want to be employers of choice want that because they know that the cost of unwanted employee turnover is so high. In fact, when companies are counting their beans, if they use 150% of one year's pay as a proxy for the cost of an unplanned and unwanted turnover of a professional employee, then 1) they are likely pretty close, and 2) they will realize that the cost of benefits probably pales in comparison to the cost of turnover.

One of those benefits that we mentioned is a retirement program (note that I talk about a program not an individual plan). Most companies, or certainly many if not most, have 401(k) plans. Their employees don't really know what they are, but everybody thinks they are important, and, in fact, they are. So, giving an employee a 401(k) plan doesn't make her feel special when she looks at it through her eyes of a child.

But, suppose I told her that I had a special plan for her. We don't have to give that plan a name. Suppose I told her that I, her employer, value my employees and that I was going to give her something like a match, but that it was better. Suppose I told her that I was going to auto-enroll her in our 401(k) plan because everybody says auto-enrollment is a best practice, but even if a year came where she had to stop deferring to the 401(k) plan, I was still going to contribute the same 5% of pay to her retirement account. And, by the way, those assets that accumulated from those over and over again five percents were going to grow based on professional investments. And, someday when she retires, she'll be able to take her benefit as a lump sum, or as an annuity, or as some combination of the two.

Imagine how a child thinks about that.

The child's eyes light up.

She is the first kid on her block to have this special benefit.

She is special.

District Court Affirms Withdrawal Liability Calculations, But Appears to Leave an Opening

Working right before the holiday, New Jersey District Court Judge Kevin McNulty issued a lengthy opinion late on July 3 in Manhattan Ford Lincoln, Inc. v UAW Local 259 Pension Fund. The case concerns the withdrawal liability assessed against Manhattan Ford, a withdrawing employer from a multiemployer pension plan and the actuarial assumptions used for the calculations. While this is far from the first case on this topic, it may be instructive to contributing employers who are considering withdrawing from multiemployer plans and for consultants and actuaries who work with these plans.

Before diving too deeply into the case, we need some background for readers who do not work in the multiemployer plan world on a daily basis. As the background is geared toward the more casual reader than to the multiemployer expert, we've intentionally omitted some details.

In 1980, Congress passed and President Carter signed into law the Multiemployer Pension Plans Amendments Act (MPPAA). In part, MPPAA established the concept of withdrawal liability as a means of ensuring that employers who choose to leave those plans pay their fair share of any unfunded liabilities.

For years, one of the frustrations of many who are involved with multiemployer plans has been the lack of guidance on actuarial assumptions particularly the discount rate to be used in determining the vested benefit liability (VBL) under a plan. That said, the statutory language that provides much of the guidance that we have in this arena and the language that the fund's actuary looks to in determining the discount rate to be used in annual actuarial valuations are somewhat instructive.

Quoting from a footnote in Judge McNulty's opinion, "The main upshot, for our purposes, is that under current law, 'each' actuarial assumption must be reasonable for the purpose of minimum funding, whereas they must be reasonable 'in the aggregate' for purposes of withdrawal liability." The language here is strikingly similar yet as we will discuss later, the calculations are often very far apart.

In this particular case, the plan's Enrolled Actuary (EA) used the Segal Blend (a method developed by the Segal Company in the early days of MPPAA) as a means of discounting in order to determine the fund's VBL and therefore the unfunded vested benefits (UVB) as well. To understand this case and the distinctions we will make later, we'll have to get hypertechnical (yet still oversimplified) for a moment to explain the Segal Blend. The Segal Blend essentially does two calculations and blends them. It considers that liabilities that can be settled by plan assets are assumed to have their risk transferred and therefore use PBGC rates (the rates inherent in insurance company annuity settlements) to discount the liabilities. But, for the portion of the liabilities not covered by plan assets, it acknowledges a risk premium and uses the funding interest rate (the EA's best estimate of future investment returns).

In Manhattan Ford, the fund's calculation performed by the EA showed that the withdrawing employer owed a roughly $2.5 million withdrawal liability based on the Segal Blend. The employer challenged the calculation and an arbitrator found in favor of the fund. Manhattan Ford appealed to the District Court.

Judge McNulty found that two essential questions were raised [quoting]:

1. As a matter of ERISA law, must a pension plan's actuary use identical actuarial assumptions to calculate the plan's satisfaction of minimum funding requirements and its unfunded vested benefits ("UVB") for withdrawal liability?
2. Assuming the answer to question 1 is "no," did the Arbitrator err in this case when he found that the discount rate applied by the Pension Fund's actuary to determine Manhattan Ford's withdrawal liability, the Segal Blend, did not render the actuarial assumptions "in the aggregate, unreasonable (taking into account the experience of the plan and reasonable expectations)"?

The Judge found that answer to both questions to be "no" and granted summary judgment to the Pension Fund. Summary judgment is granted only when the Court finds that the movant shows that there is no genuine dispute as to any material fact and the movant is entitled to judgment as a matter of law. Stated differently and from an extremely non-legal perspective, the Court found that even if all of the facts claimed by Manhattan Ford were true, it still had no valid case.

Thinking about this as a consulting actuary or even putting us in the lens of a withdrawing employer, this would appear to leave little room. And, this would appear that based on the fact pattern in this case that at least in the District of New Jersey that the Segal Blend produces results that are not unreasonable (note that the burden of proof here by statute is on the withdrawing employer).

What this opinion specifically does not say, however, is that the EA's judgment is infallible or indisputable. While the opinion did not address this, that the statute gives withdrawing employers the ability to challenge withdrawal liability calculations suggests that ERISA contemplates that there are, in fact, valid challenges.

What might they be?

We've seen a number of calculations of withdrawal liability where all of the discounting is done using PBGC rates. To understand the significance of this, note that in recent years, PBGC rates for this purpose have often been less than 3% while funding interest rates are often in the vicinity of 8%. Conservatively, changing the discount rate from 8% to 3% could increase liabilities by anywhere from 40% to more than 100% depending on the demographics of plan participants. For purposes of an example, let's use 60% and further, for extreme simplicity, let's assume that all liabilities of our hypothetical multiemployer plan are vested.

Suppose our plan has assets of $1 billion and liabilities discounted at 8% of $1 billion. Then, the unfunded liability at 8% is $0. However, decreasing our discount rate to 3% increases our liabilities to $1.6 billion and increases our unfunded liability from $0 to $600 million. That helps us to illustrate the extreme leverage inherent in many of these calculations.

So, to return to some of the questions at hand, let's suppose that the 8% discount rate applied in the annual valuation of the plan is the EA's actuarial assumption. In fact, when he has put it on the Schedule MB to Form 5500, he has asserted under penalty of perjury that it is reasonable. And, he has similarly asserted under penalty of perjury that each of his other assumptions is reasonable. Finally, he has asserted that, in combination, these assumptions offer his best estimate of expected future experience under the plan.

Now, the EA is asked to perform a withdrawal liability calculation. In performing that calculation, he keeps all assumptions except for the discount rate the same as they were for minimum funding. But, he changes the discount rate from 8% to 3%.

If each assumption is individually reasonable, one can extrapolate that the set of assumptions, in the aggregate, is reasonable. 

Given that the unfunded liability has increased from $0 to $600 million and even conceding that the purpose of the measurement is different, this begs the question as to how the revised assumptions (only one is revised), in the aggregate, can also be reasonable.

Withdrawing and potentially withdrawing employers should weigh these issues carefully when withdrawing. In combination with counsel and with other experts including actuaries, they should also weigh these issues when appealing a determination of withdrawal liability.

How Ready are Americans for a Successful Retirement

Every weekday morning, one of the first blasts that glamorizes my inbox is the Plan Sponsor News Dash. If you don't subscribe already, you should probably remedy that situation. It's free and it's pretty unobtrusive, and once in a while even features my wisdom or lack thereof. But, this morning, I read an article from the News Dash that struck my mathematical, actuarial, and consulting senses a bit funny.

This article told me that according to a study by the Employee Benefit Research Institute,  57.4% of U.S. households are on track to be able to cover 100% of expenses in retirement, but if long-term care costs are removed from the equation, the percentage jumps to 75.5%. Then it goes on to tell me how much rosier the picture gets if they only have to cover 90% of their household expenses, or even 80%, or finally even 100% if you also remove long-term care costs.

Holy Symmetry, Batman!

What happened to the scenario where expenses go up more than we are anticipating? I've not been able to find the EBRI research, so perhaps the article is explaining everything that the research actually does present.

According to the article, the research goes on to suggest that if we auto-enrolled all workers at 6% in an automatic DC plan that the retirement crisis would virtually disappear. 

From a policy standpoint, this just feels so wrong. If you look at your pay stub today, unless your compensation for the year has already gone above $128,400, you'll see that 6.2% of it is going to the government in the form of FICA tax. For those that don't know the terminology, that's the old age part of Social Security. In addition, regardless of how much you have made thus far this year, an additional 1.45% is going to the Social Security Administration to support the Medicare system. So, what this proposal is telling me is that it wants to, right off the top, direct 13.65% of my pay towards my retirement and the retirements of others. That's almost one dollar in seven of what most Americans earn. We would have no say. In fact, if you add that to federal, state, and local income taxes, it feels like the policymakers are directing more of what I make than I am.

Think about that.

But, returning to the original topic, how ready are Americans for a successful retirement? It doesn't seem likely to me that covering 80% of ones projected expenses is going to be sufficient. But, if we focus on the analysis in which we are supposed to cover 100%, 3 in 7 American households can't do it. Were we to bump that to 110% (inflation increases), we probably get to the point where more than half of those households cannot sustain retirement.

Why?

The 401(k) as the cornerstone of American retirement system does not work. Remember, this study was done after some huge run-ups in equity markets. What happens if we have a significant correction? What happens if we are in a bubble?

You want a policy solution? Reinvent the pension plan in ways that offer some degree of lifetime income, longevity protection, and inflation protection. Design it so that costs are stable (that's really easy by the way) while still providing for consistent and responsible funding. Let employees use the 401(k) as it was intended -- as a supplemental savings program.

Households will be ready for a successful retirement.