The Social Security Tax Cut May Not Apply to You

Congress has reached a new level of confusing the American public. We have the new 2-month Social Security tax cut. And, it applies to all working Americans (except those like Senators and Representatives whose wages as elected officials I think are exempted from Social Security). So, for the months of January and February, we all get a decrease of 2% in our Social Security taxes. Fantastic!

Now, for some explanation. Generally, a person pays into the Social Security system at the rate of 7.65% of pay up to the Social Security Wage Base (I believe that is $110,100 for 2012). Above that level of wages, a person pays in at the rate of 1.45% of pay. And, for each dollar that a person pays in, their employer pays in an equal amount. If you are self-employed, you are both the employer and the employee, so you pay both parts.

Now, that sounds unfair, doesn't it, that you stop paying in the Old-Age, Survivor and Disability Insurance part (the first 6.2%) after your pay reaches the wage base? Well, you do need to consider that any pay that you receive that is above the wage base is not used in computing your eventual Social Security benefit. For those who are still with me, the other 1.45% is used for Health Insurance, i.e., Medicare.

Here is the good and fair news -- we all get that that cut in our OASDI (the 6.2% piece) during the months of January and February 2012 from 6.2% to 4.2%. But, some of us are deemed to apparently have no need for the extra 2%, so we have the honor of getting to pay a recapture tax, an increase to your federal income tax.

Yeehaw, gotta love it, a recapture tax. I know, what in the world is a recapture tax. Read on, poor reader.

Start by dividing $110,100 (the wage base) by 12 (to get a monthly rate) and you get $9,175. Double that to get a two-month rate and you are up to $18,350.

Now, suppose your Social Security wages for January and February are more than $18,350. [For those who aren't sure, Social Security wages look a lot like your gross pay before taxes are taken out. If you pay for certain welfare benefits on a pre-tax basis, they get taken out. And, if you defer compensation to a 401(k) or similar plan or even to a nonqualified deferred compensation plan to the extent that the amount is vested, those get included.]

If you are fortunate enough to still have your Social Security wages for that two-month period exceed $18,350, then you have the honor of paying a recapture tax calculated as follows:

1. Subtract $18,350 from your Social Security wages for the months of January and February combined. If the answer is 0 or less, then this doesn't apply to you. If the answer is greater than $18,350, then call it $18,350.
2. Take the result from step 1 and multiply it by 2%
3. This is the additional income tax that you will owe for 2012 and it is called a recapture tax.

Think of the scenarios. Lots of companies pay bonuses for your performance during the previous year (2011, in this case) during January or February. For people with base pay less than $110,100, your bonus could put you into recapture territory. Maybe you are fortunate enough to be entitled to a really big bonus for 2011 paid during January or February 2012. It might run through recapture territory into I-Don't-Owe-Recapture-Taxes-On-This Territory. And, then, there are the people whose bonuses will get paid during the first half of March. They get the old-fashioned treatment.

Got it? Good!

Now, think about your paycheck. If you are like lots of Americans, the payroll of your company gets handled by an outside provider. And, miraculously, once a week, once every two weeks, once or twice every month, the right amount of pay gets deposited electronically into your checking (or savings) account. Hmm, do you think that will happen now?

The IRS thinks that it may not. In fact, they have already published rules for companies and individuals that mess this up. Doesn't that just build up your confidence?

So, why do we have this nonsense? In my opinion, it's all because our government no longer chooses to govern. Instead, the two major parties wage a constant battle to see which can find a way to embarrass the other. Does it matter if a law is a good law? Of course not. Does it matter if the law can be administered? Of  course not. Does it matter if the law says what it is purported to say? Of course not.

The Democrats appear to have won this game of shame. It's not their first win. But, Republican lovers shouldn't feel left out. They have won the shame game about the same number of times.

So, now we have a middle-class tax cut ... unless your bonus gets paid at the wrong time, or unless you make too much overtime during January and February, or unless ...

To LDI or not to LDI

I saw an interesting article today. It said that 63% of pension execs (whatever execs represents in this case) are now using an LDI approach for pension funding. I saw an article on the same site that asked the question, "If LDI is so great, how come more funds aren't doing it?"

"I see", said the blind man who knows that LDI stands for Liability Driven Investing. In a nutshell, pension funds that employ this technique seek to mitigate funded status volatility by having a portfolio of assets that varies with moving interest rates in essentially the same way as the plan obligations move.

I first discussed LDI with a client in (I think this is the correct year) 1998. At the time, this company's US pension funds had an overall funded status well in excess of 125% on any measure. The technique that I discussed with them didn't have such a catchy name though. I think we called it duration modeling (doesn't sound too catchy, does it). The good news -- that company adopted what came to be known as an LDI strategy and never fell into the morass of underfunding suffered my most US pension plans. The bad news (for participants anyway) -- the company eventually froze their plans to save money.

Back in the very late 90s and early 2000s, I gave some speeches on the topic. I always heard the same response from the naysayers -- roughly, do you mean to tell me that you think interest rates are going to go down? These naysayers were generally the absolute return people. Despite all the logic, they didn't seem to understand that even if you thought that interest rates would go up (they didn't over the next 10 years or so), probabilistic or stochastic analysis showed that for most plans, you would be doing a far better job of risk management by matching assets with liabilities.

Let's consider. Suppose that in 75% of all cases, you thought interest rates would go up and in 25%, they would go down (let's assume that in very few would they stay the same and we will just split them evenly between the two groups). Unfortunately, especially under the new PPA funding regimes, the worst possible scenarios for plan sponsors -- the ones that might put them out of business -- all occurred where interest rates fell and the plan sponsor chose to not match assets to liabilities. In the more positive (return) cases, the group that matched didn't do as well as the group that bet that interest rates would go up, but even so, they should have been able to sleep better.

You see, the matching, or immunizing, group, was coming close to ensuring that their required contributions would not be enough to cause corporate financial ruin. Yes, they were taking away some of their upside potential, but isn't that what risk management and insurance are all about? When you insure your home, for example, you know that you probably won't have a large claim. So, you are spending money on insurance that you probably won't recover (essentially decreasing your upside potential). On the other hand, if you do have that large claim, you'll be glad that you had that insurance, and that's what LDI is all about.

Sadly, so many companies that knew this was the correct approach for them resisted and many of them either had to reduce benefits, or in some particularly severe cases, were essentially put out of business by their pension plans.

It's not worth all that. If you still have a US defined benefit plan, at least consider your risks and see what you might do to mitigate them.

Things I Learned on the Road

I know, I haven't blogged much lately. But, I have an excuse. It's tough to blog when either you can't stop coughing or when you are spending your whole day driving around town. That's two excuses -- take them or leave them -- but they are the truth.

In any event, while I've been out there, I ran across a few consistent themes. Here is a summary:

• There are a lot of 401(k) plans out there in America, but many of them are pretty darn small.
• Some of these plans have average account balances of less than $5,000 and they are not brand new plans. That frightens me.
• Among much of the advisor community, there are three types of retirement plans: defined contribution (primarily 401(k)), defined benefit (mostly frozen of one type freeze or another), and cash balance
• Notably, cash balance appears to be a new concept primarily for doctors and lawyers (I found this interesting)
• Many people in the retirement plan advisor community speak in code, or should I say Code. They discuss the distinction between being a three thirty-eight (that's actually 3(38)) and being a three twenty-one (3(21)). It must make for interesting discussion over drinks when the question they are considering is whether to take on responsibility for investment decisions or not.
• Another word that gets tossed around is fouroheightbeetwoo. That's 408b2 or more precisely, the fee regulations under ERISA Section 408(b)(2).

I had always heard that actuaries spoke their own language and that they couldn't (or wouldn't) translate it into English. For some of us, that's very true, but many of us use common everyday language as often as is practical. We only revert into technospeak when we have no other alternative (or when we are sufficiently language-deficient that we are incapable of using our lack of mastery of the language to find a suitable alternative).

To look at the other side of things, though, these advisors are pretty much the everything on retirement plans to small (and nearly small) business owners. They have to know the participant side, the employer side, the recordkeeping side, the investment side. It's not easy to know all that stuff, and to stay on top of it. And, some of those people are really good at it.

The next time I write, I'll try to give you something of more substance. In the meantime, for those of you are celebrating holidays before you see my words again, I wish you the merriest of Christmases, the happiest of Chanukkahs, and a wonderful end to 2011 and start to 2012.

Be safe and be well.

Nondiscrimination Testing Revisited

Yesterday, I read an article written by David Godofsky of Alston & Bird (a large law firm headquartered in Atlanta) on nondiscrimination testing in 401(k) plans. If you are interested in this topic, I would commend you to read it. It is very well written. It's almost interesting. And, like very few pieces that I have seen on this topic that has been written by an attorney, David gets it right, even the math.

You see, David has an unfair advantage. I'm not sure when he became an attorney, but I do know that he has been an actuary for a really long time. So, unlike most attorneys that I know, he gets the numbers. And, unlike many actuaries, he gets the law.

So much for praise of an attorney. While he gets the technical stuff right and keeps it interesting, I am going to explain to you where David goes wrong. He compares testing to a peanut butter and jelly sandwich, and puts that sandwich in a positive light. I know this will be anathema to many, but peanut butter is the single worst food ever created. It smells bad, it tastes bad, and it has a bad texture. That, by the way, is either opinion or fact, and the early voting returns say it is fact, although I am afraid that opinion may come on strong. In any event, to add to the problem, he doesn't even serve anything to drink with his abomination.

Retirement plan nondiscrimination is clearly more elegant than that which applies only to 401(k) and similar plans. If Mr. Godofsky is serving PB&J with his testing, the testing that I refer to is more suited to foie gras served with sauternes.

You get the picture? His is packed in a metal lunchbox with Fred and Wilma staring at you. Mine is presented by a trained server and is only for the most discriminating among us. And, oh yeah, mine costs more than his.

Before I move forward, though, I need to warn you that just like foie gras and sauternes, neither most actuaries nor most attorneys understand nondiscrimination testing. I taught this lovely topic for more than ten years, so I saw the misconceptions.

Now, we get technical and explain to you why this process should not be left to the sous chef and the apprentice sommelier, but rather to the masters. While I am not going to go into the really gory details, this is probably about to become the single most technical topic (although I prefer to think of it as elegant) that has ever appeared in this blog.

It all started with Internal Revenue Code Section 401(a)(4) which spells out one of the requirements that a trust that forms part of a retirement plan be qualified (exempt from tax): "[I]f the contributions or benefit provided under the plan do not discriminate in favor of highly compensated employees (within the meaning of section 414(q)). For purposes of this paragraph, there shall be excluded from consideration employees described in section 410(b)(3)(A) and (C)."

That sounds pretty simple doesn't it? You wonder what nondiscriminatory means in this context, don't you?

I'm so glad you asked. You see, without explaining everything, there are two ways that a plan can be nondiscriminatory in the amount of benefits or contributions that are provided:

1. Have a safe harbor design
2. Prove it

Let's suppose that we choose to prove it. In the simple case, we will consider each employee in the controlled group. And, then for each one, we will calculate both that employee's normal and most valuable rate of accrual. Normal generally means life annuity at normal retirement age. Most valuable generally means qualified joint and survivor at the age at which it has the greatest actuarial value. This is not a simple determination. 

Then we take the employees and we put every one of them on a grid defined by his or her normal and most valuable accrual rates (by the way, if you think this is too easy so far, there are multiple measurement periods that can be used to do these calculations, and we can choose to impute permitted disparity or not). Let's assume that in our grid, the highest rates are in the upper left or northwest corner. We get to take people with similar accrual rates and group them. Then, we define a rate group for every highly compensated employee (or group of highly compensated employees). A rate group consists of every employee who sits neither south nor east in our grid of the rate group in question. Once we have done that, we determine a ration percentage for that rate group defined loosely as the ratio of 1 to 2 divided by the ratio of 3 to 4 where 1, 2, 3, and 4 are as defined here:

1. the number of nonhighly compensated employees (NHCE) in the rate group
2. the number of nonexcludable nonhighly compensated employees in the controlled group
3. the number of highly compensated employees (HCE) in the rate group
4. the number of nonexcludable highly compensated employees in the controlled group

So, now we have a percentage for a rate group. We need to get a percentage for every rate group. And, then we need to take the minimum of all those percentages. And, after that, we need to compare that minimum to the threshold percentage for the coverage test that we used and if our minimum is above that threshold percentage, then we pass.

Hold on, what's all this about coverage percentages?

Well, you see, a plan also needs to satisfy the minimum coverage requirements of Internal Revenue Code Section 410(b). And, this section has two tests (you only need to pass one). But, the tests have different threshold percentages.

Let's look at them. Under the ratio percentage test, you again take the ratio of 1 to 2 and divide it by the ratio of 3 to 4 like we did above, except that now in the numerators, we have numbers benefiting under the plan. To pass the ratio percentage test, your threshold is generally 70%, unless you are using snapshot data which is a subject for a comparison of restaurants rather than foods (snapshot data looks like fast food while complete data looks like fine dining). But, suppose you fail the ratio percentage test, or when you are doing your nondiscrimination testing, your rate groups don't clear the 70% hurdle. Then, you will want to use the average benefit test.

It's a nice little test. It has two parts, the average benefit percentage test (ABPT) and the nondiscriminatory classification test (NDCT). And, the NDCT has two parts. To run the ABPT, you combine generally all plans of the employer and determine an accrual rate (or contribution rate) much like we did above for each employee in the controlled group. Then, you take the average over all the NHCEs and divide it by the average over all the HCEs and take the average for the NHCEs and divide it by the average for the HCEs. If it's at least 70%, you pass this part.

On to the NDCT. One part of it is that the group of people covered by the plan has to be a nondiscriminatory classification. It's hard to know exactly what this means, but two examples may help. A plan that covers all the employees working in Grand Fenwick probably has a nondiscriminatory classification. A plan that covers all the employees with purple hair and orange eyes may fail to be nondiscriminatory.

The other part is a version of the ratio percentage test, but with a lower passing threshold. What is that threshold? I'm so glad you asked because you have to figure it out. Just follow these simple steps:

1. Determine the percentage of employees in your controlled group who are NHCEs. Call this the NHCE Concentration Percentage (NHCECP). 
2. Round down to the next lower integral percentage unless you are already at an integral percentage.
3. Subtract that answer from 100.
4. Multiply that answer by 0.75.
5. Add that answer to 20, but don't let your new answer go above 50.
6. This is your safe harbor percentage.
7. Subract 10, but don't let this answer go below 20.
8. This is your unsafe harbor percentage.
9. Halfway in between the two is your midpoint.
10. If your ratio percentage is at least equal to the safe harbor percentage, you pass.
11. If your ratio percentage is less than your unsafe harbor percentage, you fail.
12. If you are between the two harbors, you are in the Sea of Facts and Circumstances and only the IRS can tell you if you pass or fail.
13. The midpoint is generally the threshold for your rate groups.

That sure was fun, wasn't it?

Well, sometimes after you have done all that, you still don't pass. And, that's when you really need to rely on tricks of the trade.

Don't do it yourself. This is dangerous stuff. Talk to the master.

.

Are You Sleeping? Who is Managing the Compensation Risk?

Risk management used to be viewed with a somewhat jaundiced eye. It was something that the geeks did. I know, at your company, you just didn't need it because you understood your business better than some guy with a fancy degree, a pocket protector, and an HP-12C.

While companies had full-time risk managers and even risk management departments before then, this mad science really came to the forefront in the early 2000s. Suddenly, companies were seeing that risks that they had taken, especially in the area of leveraging themselves perhaps a bit too much, were starting to bite them in their proverbial hind quarters.

With that, the CRO or Chief Risk Officer, became the new sought after geek. Here was a person with specialized training who could look after the store, so to speak. If the CRO approved, then the CEO and CFO had a special comfort that all would be well.

Yes, CROs, as a group, do have specialized training. They tend to be smart people who can model the risks of a veritable cornucopia of corporate transactions. But, even the smartest person doesn't have the capacity to consider every possible risk. Sometimes, they are just not aware of certain risks. Sometimes, the other departments take actions without consulting the CRO and his staff because they just don't think the particular decisions has a risk potential that hits that threshold.

Perhaps that department was Human Resources. I know, you think I am wrong; by the early 2000s, the Risk Management Department was heavily involved in working with pension plans. Well, I am focused on a different part of Human Resources here, the part that develops compensation programs.

Way back when, you know, about 25 years ago, a typical bonus program worked something like this. Everyone in the program had a target bonus -- some percentage of their base pay. To go with that target bonus, you had a set of goals. They were, in theory, set up so that you had a roughly equal chance of exceeding your goals or of falling short. And, your bonus was typically capped, on the upside at twice your target and on the downside at zero.

Ah, theory, what a wonderful concept.

Picture yourself as a manager. You have three employees to review for their performance in 2011. Let's call them Larry, Moe, and Curly. Larry has always been a star performer. Each year, he has exceeded expectations. But, in 2011, Larry did not have a good year. He fell short of every goal. But, somewhere in your mind, although you can't quite put your finger on the exact cause, you think there must have been extenuating circumstances. You are sure that Larry will have a good year in 2012, and what's more, you don't want to lose him to a competitor. So, on your 1 to 5 scale with 5 being the best, you grade Larry as a 3.5. You tell him that he is being rewarded for a prolonged period of high performance, but that he needs to step it up in 2012.

Moe has always been your man in the middle. He's been a consistent performer, always meeting goals, but rarely exceeding them. But, Moe has those intangibles. They are not in his goals, but you just have to reward him because he makes everyone around him better. In 2011, Moe exactly met his goals, but because of that special something, you gave him a rating of 3.5.

Curly has been your problem child. Each year, he has been the laggard of the three, but you have kept him around both because the team has been meeting its goals (due mostly to Larry) and because of his wonderful sense of humor. Curly keeps you laughing and he is just so likable. Finally, for the first time, in 2011, Curly beat his goals. You gave him a rating of 3.5

Let's look at what happened. Your team exactly met its goals. Yet, you awarded each team member with a rating that gets them a bonus of 125% of target. Hmm?

And, then in another year, business was really good. You find out that the bonus pool is going to be really big. Curly had another very good year. You give him a rating of 4.5. Moe had a better year than Curly, and you know that somehow, Moe also contributed to Larry's success this year, so you give him a 4.9. But, Larry, oh Larry, had the year of a lifetime. If Moe got a 4.9, there is no rating that does Larry's year justice, so you take it up the line to get Larry a bonus of 3 times target. And, because business was so good, it gets approved.

But, the next year, the economy goes into the tank. Nobody meets their goals, and in fact, the company lost money. It would like to have a negative bonus pool, but that can't happen. And, all of your employees tried really hard, so you want to give them something. You beg to your superiors just as every manager is doing, but where will the money come from?

As time went by, companies survived this strange concept where everyone got a bigger bonus than they really deserved. So, it became accepted that there was really no upside limit to bonuses, at least not for the top producers.

But, I digress for a brief commercial. If you haven't read Michael Lewis's book, The Big Short, then you should. To a large extent, it shows how having no upside limits to incentive payouts encourages absolutely ridiculous risk-taking. Without giving away the whole book, people were making and taking 12-figure risks on bets that they didn't understand. Hmm?

And, they were being rewarded for it. People who had budgeted incentive payouts in the range of several hundred thousand dollars were suddenly getting 8-figure payouts. They were betting on these wonderful instruments known as credit default swaps, and most of them were taking what turned out to be the wrong side of the bet. But, the risk management people didn't understand them either. In fact, very few people did.

So, now we are really in 2011, very close to the end of it, in fact. Managers with explicit incentive compensation plans will be facing the same issues all over again. Far more visibly, Compensation Committees will be facing the same issues all over again.

Let's peek in at a deliberation as the Compensation Committee decides how much of an incentive payout to give to CEO Lou Abbott and CFO Bud Costello. The company didn't have a great year, but neither did any of their competitors. And, Abbott and Costello, everyone knows, are legends in the industry. We really can't afford to lose either one of them. Last year wasn't too good either. We really can't risk losing them over a bad incentive payout. Let's give them something extra this year and we'll go harsher on them the next time their scheduled payout would be huge. [Hopefully, this behavior isn't occurring in any real Compensation Committees, but you never know.]

Do you think the Compensation Committee will remember?

So, here's the deal. In a bad year, bonuses in total may be more than the company can afford because they can't afford to pay out that little and risk losing people over it. In a mediocre year, bonuses in total may be more than the company can afford because everybody had something positive about their year. And, in a great year, the risk-takers won and they will get bonuses so big that the company will pay out more than it can afford.

And where is the Risk Management Department to ask who is managing the compensation risk?

CBO, We Have A Problem

Sometime back, I wrote, not with admiration, about the Congressional Budget Office (CBO) and the 'scoring' rules that our Congress has burdened it with. Essentially, they don't adjust for inflation and they don't do dynamic scoring. Or, said differently, they are required to treat each bill as its own micro-economy, forecast for only 10 years, and  generally not reflect inflation. This approach allows the Congress to manipulate bills so as to score them as cost-neutral, or even as cost-savers, when in reality, everyone, including both Congress and the CBO, know that they are going to cost us a lot of money.

How much money? Does the number 15 trillion mean anything to you? The federal debt, according to the debt clock is now just above that number. It's a big number. It has 12 zeroes in it. It also has two other digits to the left of those zeroes.

I would posit that these rules and Congress' manipulation of these rules are responsible for a significant portion of that 15 trillion. In fact, and I'm just guessing (no calculator or spreadsheet in action here, not even any mental math), if I had to choose an over/under amount, more than half of that 15 trillion in debt has accumulated from flawed scoring.

I'm not saying that the CBO does poor math, in fact, they are very good at it. What I am saying is that the constraints that they are required to follow have caused the United States to underprice the costs of various bills by a really big number and I am guessing (that means that I don't know, but my brain now fully caffeinated for the day has estimated) that this number in the aggregate is more than half of 15 trillion dollars!

When I try to hide my political biases, I usually work in alphabetical order and I'm going to do that here. In this case, the Democrats are incredibly guilty of having gamed this system ... and they know it. In this case, the Republicans are incredibly guilty of having gamed this system ... and they know it. Most of the public doesn't know it. There has never been a public outcry. There should be.

So, what does this have to do with employee benefits? The good folks at the Employee Benefits Research Institute (EBRI) have a nice little chart (actually it's not so little) that they call Employee Benefit Tax Expenditures -- White House Fiscal Year 2011 Budget Estimates. It shows that the tax expenditure (that's a fancy name for the amount of deductions that people and corporations get on their taxes, either through deductions or through tax exemptions) for employer contributions for health care benefits in FY 2011 is in the neighborhood of $175 billion and  similarly, for employment based retirement plans, it's about $110 billion. That's $285 billion in total. The mortgage interest deduction for the same year is about $105 billion. So, employee benefits are a really big culprit.

I bet my readers know that those numbers go up every year. Of course, they do, inflation makes them go up, doesn't it? Suppose we adjust for inflation. Then, what happens? Well, EBRI can help us out with that as well. Here is the url for a spreadsheet (http://www.ebri.org/pdf/publications/books/databook/Table 5.2 Inflation Adjust.xls), and you'll have to copy and paste this one, that shows what happens when we adjust for inflation. Look at the spreadsheet. Find me a major element that decreases on an inflation-adjusted basis. You can't do it, can you? And, therein lies a problem of just enormous proportions.

The 10-year cost of many of these bills is understated because the CBO isn't allowed to use assumptions that faithfully project the cost. And, because cost increases tend to (read that as virtually always) significantly outstrip inflation, using virtually any 10-year cost projections for a bill that is expected to last for a long time (think Social Security or Medicare, for example) represents among the most significant frauds ever perpetuated on the American taxpayers.

Yes, I said it. It's a fraud.

It's time for the taxpayers to stand up to Congress.

I haven't used song lyrics in this blog for a while, but I'm going to go back to the Vietnam War era for this one. With thanks to Jefferson Airplane,

got a revolution got to revolution 
Who will take it from you 
We will and who are we 
We are volunteers of america

Change volunteers to taxpayers and ...

Another Survey Says

The benefits community in the US loves surveys. Large consulting firms love to do surveys. Presumably, their clients like this information, or at least someone thinks they do. The benefits news consolidators (you know, the publications that scour the internet for benefits news for a daily newsletter) love to tell us about these survey results.

This is all good. Or, at least, this could all be good. These surveys, though, have their problems.

• Questions are often poorly worded
• Possible answers either cover too much territory or not enough territory
• Press releases summarizing survey results seem to disassociate cause and effect
• Survey populations may not be unbiased
• Surveys inevitably are constructed to produce the findings that the surveyors think should be produced

Questions are often poorly worded

This is a no-brainer, but the world at-large doesn't seem to mind. I saw a survey question recently (the group had not been bifurcated yet into people who liked versus those who disliked their consumer-driven health plan (CDHP)) that asked "What do you like best about your consumer-driven health plan?" The possible answers were something like:

     a. my quality of care is higher
     b. it costs me less
     c. I can choose my own physician
     d. it promotes a culture of wellness

My immediate reaction is to ask where is e: none of the above? Let's look at the possible answers. Anybody who says that their quality of care is higher under a CDHP must be hallucinating. What would make it higher? If you can choose your own physician, why would they provide better care when you are in a CDHP than they would under a traditional health plan?

If you say that it costs you less, I would ask you less than what. Yes, the premiums are lower than they would be in an HMO, for example. On the other hand, they are higher than they would be if you had no insurance at all. Isn't this like having a deductible on an automobile insurance policy? If you choose a higher deductible, your policy costs less. But, in the health care policy, you usually don't get to choose your deductible. And, in the case of high-deductible health plans (HDHP) which are typically the cornerstone of CDHPs, the deductible is typically higher than most people can effectively budget for.

If you say that you can choose your own physician under a CDHP, that is true, but can't you choose your own physician under any health plan? It's true that your care may not be covered by the plan, but for many people, if that is really the reason they are in a CDHP, I would say that they are quite misguided.

Do you really think that CDHPs promote a culture of wellness? If I were texting, I would reply "lol." According to a recent Aon Hewitt survey (oops, now I am citing a survey), 35% of participants in CDHPs are sacrificing medical care because they cannot afford their part of the cost under these plans and 28% are postponing it for financial reasons. FACT: that is not indicative of a culture of wellness.

Suppose I think the CDHP that I have been forced into just plain sucks. How do I answer this question?

Answers cover too much or not enough territory


In the last section, I managed to deal with answers that don't cover enough territory. Sometimes, they go the other way and cover too much.

I took a survey recently about automobiles. The survey asked me a series of questions. For each question, I was supposed to answer on a scale of 1-13, with 1 meaning I strongly disagreed and 13 meaning I strongly agreed. Come on, people, 1-13? Do they really think that ten minutes into a survey, I can rate things on that fine a scale. They asked me if I would consider buying a Lexus when I next purchase a vehicle. So, perhaps I went through a train of thought like this. Lexus makes a very good car. They are stylish, safe, high-performing, and dependable. They are also expensive. Would I consider buying one? Yes, I would probably consider it, but I really don't want to spend that much money on a car, so how strongly would I consider it? Hmm, is that a 5 or a 6 or a 7 or an 8 or a 9 or a 10? I don't know. If it was on a 1-5 scale, I could probably happily fill in the little button for a 3. But on a 1-13 scale, that would be equivalent to a 7 and I just don't know if I'm a 7 or not.

Press releases ignore cause and effect


I saw another survey (if I could find the actual survey again, I would cite it here) recently that said that fewer companies were funding (informally) their nonqualified deferred compensation (NQDC) plans. The headline said something about recent guidance on corporate-owned life insurance (COLI) being the reason for this. Hmm, the survey had no questions in it about why fewer companies were funding their NQDCs. And, further, I'm not sure what recent is, but I can't find any recent COLI guidance that would affect funding of NQDC plans. Perhaps the authors of the surevy had a bias?

Survey populations may not be unbiased


Suppose a large consulting firm does a survey. In my experience, they send the survey to a nice cross-section of large companies. Perhaps it looks something like the Fortune 200 plus all of that firms clients not in the Fortune 200 that generate at least $1 million in annual revenue for the firm. Of the companies surveyed, who do you think are the most likely to answer the survey? Could it be the consulting firm's large clients? Aren't they the ones most likely to actually open the survey? Who are least likely to answer the survey? Could it be the companies that have recently fired that large consulting firm?

Do you think that the results of this survey might be a little bit skewed? Do you care? I do.

Surveys inevitably are constructed to produce the findings that the surveyors think should be produced


Suppose you ran the health care consulting practice at a large consulting firm. Further suppose that you are a big proponent of consumerism. In fact, you have built your consulting firms health care consulting practice around CDHPs. You ask your survey group to do a survey around health care plans. You want to be able to make a bold statement in a press release that shows how wonderful CDHPs are and for all the reasons that you have been touting.

Do you think you will make sure that the questions have at least a small bias that will lead to your desired result? If the findings come back differently than you had hoped, do you think you will publish the results as is, or will you find a way to tweak the results? Will you tout the portion of the results that support your practice or will you be unbiased in how you release the survey results?

I don't need to answer those questions for you. You don't need to answer them either. We all know the reality.

These surveys ... they do have their problems.

The Cynic In Me Says Watch Out For the Health Insurance Industry

Yesterday, I attended the Traveling Seminar in Atlanta put on by the Conference of Consulting Actuaries. Well, actually, I instructed for part of the day and attended for part of the day. It's a really good day of continuing education and I would highly recommend it even if I am one of the instructors. You can read more about here so that you can see why perhaps you should attend a Traveling Seminar next year.

But, that's not my point in this post. I'll get to that in a second. One of the four sessions yesterday was on health care in the US, essentially health care reform, PPACA, or whatever glorious name you might choose to attach to it. As I listened, I noticed some analogues between the Dodd-Frank Act that was intended to keep the financial services industry in check and PPACA which among other things appears intended to keep the health insurance industry in check.

So, I digress. Dodd-Frank created lots of new rules. In fact, 2800 pages or so of legislation has a tendency to do this. Among other things, it restricted some of the practices of the banking industry that lawmakers had judged were pretty nefarious. The banking industry saw that its profits, especially on the retail side were declining. So, what did the banks do? They started to put more and different fees in place. Some of them, such as the $5 per month (that was usually the number, I think) fee for using your debit card even once, faced public uproar and outrage and were repealed. But, they are finding other ways that will not be so in your face. If you ever find out about them, you won't like them, but chances are that you can't find out whether they are in your bank's disclosures or not.

So, what does that have to do with PPACA? Well, the more I listened to yesterday's presentation, the more I heard about health insurers losing some of their margins. And, many of them have shareholders to report to. And, those shareholders expect profits. And, the profits may be ready to decline. So, my message to you is that since the health insurers can't easily deal with declines in their profits, they'll have to get them back somewhere ... somehow.

So, ladies and gentlemen, I don't know how they will do it. But, hold onto your wallets. The insurers need their profits. They are in business, after all, to make money.

Thank You

Tuesday, November 15 will mark one year since I started this blog. In the immortal words of Casey Stengel, "You could look it up." Since I will not have the opportunity on Tuesday, I thought that I would reflect a bit this morning on my first year as a blogger.

Frankly, I don't recall why I started. I do know, though, that I was really excited when I found out that someone who was neither my wife nor my child had read what I had written. Now, one year later, I have nearly 12,000 hits. People that I have never heard of have e-mailed about things I have written and none of them have been death threats. People that I do know have written me and have been very complimentary.

When I first started, I had some thoughts about what I would blog about. I was going to have a heavy focus on analyzing new laws and new regulations. Well, the lovely folks at Treasury and Labor didn't read my mind. They forgot to give us much in the way of new regulation. And, Congress, they can't get anything passed, so expecting to see new laws to analyze was nothing more than a pipe dream

So, I have evolved. I have done a lot of observational writing, perhaps patterned more after Freakonomics than the Harvard Law Review. Well, in all honesty, it's been neither, but I have tried my best to inform and to entertain, but perhaps most of all, to make you think.

It's been fun. I like to think that I am not the traditional math geek in that I can construct a proper sentence or even paragraph when I choose to. So, writing is often relaxing. Yet, at the same time, some of my thought pieces make me think as well.

And, no I'm not quitting this blog (or my other one either). It's not easy every week, though, to come up with two or three blog posts with which to entertain myself and hopefully be worth reading for at least a few of my readers. So, as I thank everyone who has taken the time to stop by to see what in the world my most recent ramble is about, I beg for these things:

• Keep reading. I love my readers.
• Comment some. It's not hard and it doesn't take much time. I'd like to know what you think.
• Give me blog post ideas. 
• Figure out why mass distribution newsletters such as NewsDash and BenefitsLink don't pick up my posts (I've tried) and convince them to do so once in a while. I know that my drivel is more worthwhile than some of what they do circulate.
• Refer your friends to my blog. I'll even settle for referrals to your pets.

Thanks again for reading.

Public Pensions Are Not the Problem

I hear it all the time: public pensions are a big problem. On TV, I hear that "we" just have a 401(k) plan, why should government workers have a pension plan? I'll answer that question and talk about the real problem that public pensions have been made to become.

Understand as I write this that I am a fiscal conservative by nature. While there is a place for some benefits that are more socialized than some others might think, I don't, for example, espouse that our employers, public or private, should be responsible for our entire welfare.

That having been said, let's consider a young potential worker, Kelly (I figured I would use an androgynous name because I haven't decided yet if I want to make Kelly male or female, or if I even care). Kelly is considering two job offers, one with a private employer and one with a public employer. This may not be an unusual scenario.

The private employer offers Kelly a nice package to start with. It includes all this:

• $60,000 base pay
• 2 weeks paid vacation and 10 paid holidays
• A consumer driven health plan (Kelly doesn't know what that means, but does know that it is a health plan) where the employer pays 75% of the total cost
• A 401(k) plan with a match of 50 cents on the dollar for the first 6% of pay that Kelly contributes

Assuming that she (I decided to make Kelly female) elects the health plan and defers at least 6% of her pay to her 401(k) plan, the total annual employer cost of the package being offered to Kelly is approximately $60,000 (base pay) + $4,615 (paid time off) + $4,500 (health plan) + $1,800 (401(k)) = $70,915.

The public employer offers Kelly a very different package. It includes all this:

• $50,000 base pay
• 3 weeks paid vacation and 15 paid holidays
• A traditional indemnity health plan for which the employer pays 90% of the total cost
• A defined benefit pension plan that if funded ratably over a full career for Kelly will cost the employer (on average) about 5% of pay

Again, assuming that she elects the health plan, the total annual employer cost of the package is about $45,000 (base pay) + $5,769 (paid time off) + $9,720 (health plan) + $2,500 (pension plan) = $67,989.

NOTE: I have taken fairly wild guesses on the costs of the health plan. They should not be used as representative of any particular plans nor should the be used as representative of the costs of any particular plans.

The values of the two packages are close enough that Kelly may have some career and lifestyle choices to make. But, we will leave Kelly for the moment as her career decision does not really matter to us.

The first thing that does matter, however, is that the two potential employers have similar costs of employment, however, they choose to allocate those costs very differently. The second thing that matters is the pension plan. Note that I said that the public employer was going to fund that benefit ratably over a full career. When this is done on a percentage of pay basis, it typically comes from an actuarial cost method known as (Individual) Entry Age Normal. In this case, the 5% of pay is what is known as the normal cost, or the annual cost of the benefits being allocated to the present year.

Wow, that was an earful. I'll slow down the technical stuff.

My point is that a public pension plan, at least in every jurisdiction of which I am aware, can be funded rationally. As part of that rational funding, the plan sponsor (whoever represents the sponsor) must first allow the plan's actuary to choose reasonable actuarial assumptions, including those for discount rate, salary increase rate, rates of termination, disability, retirement, and death, and any others that are appropriate to the plan and its population. Second, the plan must be funded using an actuarial cost method that takes into account future pay increases and is reasonable in its allocation of benefits to an employee's past service, current service, and future service with the employer. Third, regardless of the leeway allowed by the law, the sponsor must ensure that the plan is funded rationally every year. The cost is the cost. You don't take a year off from funding so that you can build a new skate park, especially since the mayor's son is a competitive skateboarder. 

The problem is that most public plan sponsors have not taken this approach. They have been neither reasonable nor rational. Much like the US government, especially under the last two presidents, public plan sponsors have taken the approach of running up obligations that perhaps could have been paid for as they were accrued, but were instead left for a future generation.

Therein lies the problem. The public pension is only its face.

And the Survey Says ...

I read the results of a survey on defined contribution (DC) plans this morning. Among its findings was that participants understand what the number/date in the name of a target date fund (TDF) means. I don't want to call out the name or author of the survey here because it did have some good information. What I do want to cite is that the conclusions may not be as valid as the authors suggest.

I'll bet you want to know how I can say such a thing. Even if you don't, I am going to tell you. Roughly what happened was that survey participants were contacted by telephone and asked a series of questions. One of those questions was (approximately) asking what the 2030 means in the term Retirement 2030 Fund. Again, approximately, the choices were:

1. The approximate date at which a participant expects to retire and begin drawing down the account balance for retirement income.
2. The approximate date at which a participant expects to retire and roll over the account balance to an IRA.
3. The approximate date at which the participant wants to spend the money freely.
4. I don't know.

Frankly, two of these (1 and 2) sound like good choices. The other two do not. That person could somehow divine one of the two correct answers (1 and 2) from the four choices given does not suggest much about the person. The survey authors seem to think it does.

I think I could have authored the survey in a way that would have shown that nearly 100% of respondents understand what the 2030 means. That's right, nearly 100%. 

I want to change the choices. I'll keep #s 1 and 2 as they are. But, I am going to change #s 3 and 4 to be these:

• The next year that the Cubs will win the World Series.
• The next year that NBC will win the ratings battle against ABC, CBS, and Fox.

See how silly it can get. Everyone knows that the Cubs just don't get to win the World Series. There is a curse, and it is stronger than the one that plagued the Red Sox. And, clearly, NBC is more likely to finish 5th in a 4-horse race than it is to win the ratings battle. 

Or, I could make these choices 3 and 4:

• The year at which a participant will have enough money in their account to retire comfortably.
• The year at which the fund will convert from an account balance to a level annual retirement payout.

Now, my guess is that between 50% and 60% of respondents would get this one right. And, remember, if choices were chosen randomly, 50% would choose either 1 or 2. So, I don't think that respondents really get it.

There is much education still to be done.

Final DOL Investment Advice Regulations

On October 25, the Department of Labor (DOL) published final regulations on the provision of investment advice to individual account plan (generally defined contribution or DC plan) participants and beneficiaries. You can read those regulations yourself on the DOL website, you can get a highly technical explanation on the website of most law firms that have an ERISA practice, or you can read about them here. I know which one will be the easiest read for you.

These regulations have an interesting genealogy. They implement provisions of the Pension Protection Act of 2006 (PPA). Proposed regulations were first issued under the Bush administration in 2008, withdrawn and reproposed under the Obama administration in 2010 and have now been finalized.

In discussing this final regulation, I am going to refer to the 2010 proposed regulations as a starting point. For those who are not familiar with the proposed regulations, I would love to refer you to an earlier blog post, but I wasn't blogging then. In any event, I think you'll get the gist as you go along.

Generally, providing advice of this type to plan participants [or beneficiaries] would be a prohibited transaction under ERISA (from here forward in this post, when I refer to participants, that term will include beneficiaries unless I say otherwise). However, PPA provided an exemption for two specific types of advice -- model-driven and flat-fee. The final regulations make two noteworthy changes (a few readers may not agree that the second one is a change, but just a re-interpretation) for model-driven advice.

• To the extent that employer securities are an investment option, they must be included in the model unless the participant directs otherwise. I'm not sure how this can be effectively implemented.
• The proposed regulations indicated, at least to me, that a model could not consider historical returns. Again, to me, this would have directed a bias toward index funds. While index funds may be very appropriate, a regulated bias to them seems inappropriate. The final regulations change the language so that any "generally accepted investment theories" may be used. Presumably, this would include a reference to historical returns.

Again, the statute and regulations under PPA allow for two types of what I have referred to as conflicted advice. That is, it is advice that would be provided by someone who may not be an independent third party. The exemption for flat-fee advice is largely what it seems. To qualify, it must satisfy four pretty simple criteria:

• At a minimum, it uses generally accepted investment theory to take into account historic risk and returns of various asset classes over defined periods of time.
• It takes into account fees and expenses associated with the investments.
• The adviser must solicit pertinent information from the participant and the participant must provide that information. At a minimum, that information includes:
• age
• information that could relate to life expectancy
• current investment options
• tolerance for risk
• investment style or preferences
• other assets and sources of income
• other information that seems relevant
• The adviser receives no direct or indirect compensation for this advice other than a fixed fee from the participant.

A computer model in order to qualify must satisfy seven basic criteria:

• At a minimum, it uses generally accepted investment theory to take into account historic risk and returns of various asset classes over defined periods of time.
• It takes into account fees and expenses associated with the investments.
• Weight the factors 'appropriately' (whatever that means) used to estimate future returns of the various investment options under the plan.
• The adviser must solicit pertinent information from the participant and the participant must provide that information. At a minimum, that information includes:
• age
• information that could relate to life expectancy
• current investment options
• tolerance for risk
• investment style or preferences
• other assets and sources of income
• other information that seems relevant
• Use appropriate (undefined term) criteria to develop portfolios of available investment options under the plan.
• Ensure that there is no bias to recommending investment options that may financially favor the financial adviser or an affiliate.
• Consider all investment options under the plan [including company stock] unless the participant asks that particular options be excluded from consideration.

Because the final regulations require model-driven advice to consider all available investment options under the plan (unless the participant requests otherwise), I would read this to include all employer securities and target date funds (TDFs). In fact, the regulations say that "The Department [of Labor] believes that it is feasible to develop a computer model capable of addressing investments in qualifying employer securities, and that plan participants may significantly benefit from this advice. The Department also believes that participants who seek investment advice as they manage their plan investments would benefit from advice that takes into account asset allocation funds, if available under the plan. Based on recent experience in examining target date funds and similar investments, the Department believes it is feasible to design computer models with this capability."

I am glad that the DOL finds this to be feasible.

Finally, the producer of a computer model to be used to provide investment advice must receive a written certification that the model meets all of the applicable requirements from an independent (independence was not in the proposed regulation) eligible investment expert. Such expert must have the requisite technical training or experience and proficiency to make such certification. [I have no idea who makes the decision on whether or not the expert has these amorphous qualifications.]

Such certification (not a fiduciary act according to the regulation) must include the following:

• Identification of the methodology(ies) used to determine that the model meets the applicable requirements.
• An explanation of how those methodologies show that the model meets those requirements.
• An explanation of limitations, if any, that were placed on the eligible expert in making his or her determination.
• A representation that the expert has the requisite training or experience and proficiency to make such determination.
• A statement that the expert has determined that the model meets all of the applicable requirements.

In jest, perhaps an expert is anyone who can figure out how to do an appropriate certification.

To qualify for either exemption, advice must meet a five-prong test:

1. It must be authorized by a plan fiduciary not related to the adviser
2. It must be independently audited annually with the audit results issued to the adviser and the plan fiduciary. The fiduciary adviser selects the adviser who notifies the authorizing fiduciary of the audit requirements.
3. The fiduciary adviser must provide appropriate disclosures to comply with all securities laws.
4. The transaction must occur at the sole discretion of the requestor.
5. Compensation must be reasonable and no less favorable to the plan than an arm's length transaction.

The regulations also specify a plethora of requirements related to disclosure and record maintenance. So, once again, a participant being advised under one of these exemptions will be given a host of forms to [just] sign before being given advice. Perhaps more useful would be the adviser having a discussion about this information with the participant and the participant making an affirmative statement in writing that such conversation had taken place, but I don't write the regulations.

Failure to comply with these regulations would result in an excise tax of 15% of the amount of the prohibited transaction. The DOL views this as putting significant teeth in the regulation. I am less than convinced. 

In any event, the regulations are effective 60 days after publication in the Federal Register. I have yet to see people lined up waiting to use them.

I Wish I Had Such an Investing Mirror

Everyone seems to be coming out with new and groundbreaking research these days. Well, maybe not. Everyone is coming out with research, but perhaps it is neither new nor groundbreaking. I did read a different take on defined contribution (DC) investing at Wellington Management's website.

The summary of their piece suggests that an additional percentage point of investment return at age 55 is nearly 4 times more powerful than at age 30 because of the increased asset base. It further suggests that "[P]lan sponsors should be thinking about how to construct a robust menu of investment choices that will facilitate an improved investing experience and outcome."

Wow!

There are some great phrases in there. I hate to disparage this summary more than others, but take a look at those words: "facilitate an improved investing experience and outcome." Isn't that really the same as saying that plan sponsors should have a fund menu that produces better returns on investment?

Duh!

Back to the whole point of this blog post, though, and I may get fairly technical for a moment, generally, when a pool of assets is invested in such a way as to increase the likelihood of generating higher investment returns, this is done by taking on more risk. At older ages, this goes against conventional wisdom which says to take less risk. Let's take a more geeky look.

For years, much of portfolio analysis has been done, oversimplifying somewhat, using a normal distribution (bell curve) of occurrences, or if you prefer, a mean-variance model. By way of example, this suggests that if you have an investment with a mean rate of return of 7% per year with a standard deviation (square root of variance) of 9%, then your average (and most likely) rate of return is 7% and that roughly 70% of the time, your annual rates of return will fall between -2% and 16% (+/- 1 standard deviation). Suppose you take on more risk for more return so that your mean is now 8% and your standard deviation 11%, then roughly 70% of the time, your annual rates of return will fall between -3% and 19%.

I want to look at three concepts now that perhaps direct added risk to the higher return portfolio (beware, these may not be for the faint of math):

• Geometric versus arithmetic returns
• non-normal distributions
• fat left tails

Geometric versus arithmetic returns

Let's consider three sets of annual rates of return, all of which average out to 7% per year (add up the 10 years and divide by 10) on an account balance of $100 (no new money coming in):

1. .07, .07, .07, .07, .07, .07, .07, .07, .07, .07
2. .115, .105. 095, .085, .075, .065, .055, .045, .035, .025
3. .025, .035, .045, .055, .065, .075, .085, .095, .105, .115

In case 1, we wind up with an account balance of 196.72. In cases 2 and 3, we wind up with an account balance of 196.01. This is equivalent to an annual return of approximately 6.9614% which is less than 7.00%.

Suppose we add in annual contributions of $10 per year on the last day of that year. Let's see what happens then. Now, case 1 leaves us with an account balance of 265.80, case 2 with an account balance of 259.76, and case 3 with an account balance of 270.69. The average of cases 2 and 3 is an account balance of 265.23. From this, we can learn two things: 1) the additional risk decreases our expected final account balance; and 2) Wellington is correct that more leverage is attained from later investment returns, whether that leverage is positive or negative.

Non-normal distributions

So, you think I've been pretty geeky thus far. It's about to get more geeky. 

Perhaps there have been two reasons that we have historically assumed that investment returns have been distributed normally; that is, they follow a normal distribution. First, it's simple. Second, and far more technically, there is this wondrous concept in probability called the Central Limit Theorem. Oversimplifying a whole bunch, it says that a probability distribution of a number of random occurrences that is really, really big (apologies to Ed Sullivan) will revert to a normal distribution. Hold on, occurrences of investment returns are not random. They have outside influences. 

Fat left tails

So, if these returns are not normally distributed, how are they distributed? Well, we don't have an infinite number of occurrences to look at just yet, but real data suggests that the mode is somewhat right of center (the most common occurrence is a return higher than the mean), but that there are fat left tails (there are a significant number of occurrences (way more than 5%) that fall in the range that we would have expected under a normal distribution to be in the worst 5% of all annual returns.

So, if we return to our cases 1, 2, and 3 from above, there is probably more downside risk than our earlier calculations had demonstrated (I'm not going to re-do the math, just trust me on this one if you can't envision it). This implies that chasing higher returns later in life will give you a greater chance of retiring with a really big account balance, but on average, that same account balance will be lower. In fact, on average, it will be much lower.

Back to common sense

At the end of the day, you need to make your own investment decisions. If you think that you can increase your returns by taking on only tolerable additional amounts of risk, then this may be a good strategy. But, unless you really understand the risks that you are taking, don't go chasing after these additional returns late in your career just because you think you have a robust menu of investment choices that will facilitate an improved investing experience and outcome ... whatever that means.

If It Wasn't Broke, Why Did You Try to Fix It?

I just returned from the Conference of Consulting Actuaries Annual Meeting (well, I haven't quite returned and I took some personal time in between). As usual, the meeting had some outstanding sessions with great learning opportunities. But, there is one theme that bothers me, and this is not a reflection on the meeting, but on the consulting profession -- too often, when something is working just fine, we have to try to fix it.

More on that in a minute, but first, for my regular readers (and I know that I am bold in putting an s at the end of reader), I apologize for the hiatus. The Annual Meeting was a busy place and time ... and then there was vacation, and while my mind was filled with lots of thoughts, this blog was not one of them.

Returning to my theme, however, I learned about some new (or maybe really old) designs for defined benefit plans. They were intended to be THE SOLUTION. We saw some illustrations. They produced very slightly different results than plans that were already popular. The new ones will be difficult to administer, and, even compared to DB plans of days past, these are designs that no participants will understand.

What's the point?

I also heard about companies that were doing more aggressive cost-sharing in their health care plans. What a wonderful euphemism -- cost-sharing. Isn't that just another name for, you as the employee are going to pay a lot more while we as the employer try to hold our costs down. 

Here is the situation where I find this to be the most laughable. Consider a company that touts its wellness programs. And, it wants to make sure that its employees are healthy and stay healthy (at least that's the propaganda). So, they offer you one regular checkup per year. And, they pay for it ... all of it. But, here's the catch. Suppose you need maintenance medication. Perhaps you have nothing but healthy lifestyle habits. But, your family has a history of high cholesterol. You are burdened with it, too. The longest prescription you can get is 180 days. To get your next refill, you have to go back and see your doctor for blood work (so, that's labs and an office visit). And, in your effort to stay well, neither of them is covered. 

This is the new design that is being touted. 

I liked the old system better. It wasn't broken. Now, it's fixed, and the new system IS broken.

"I see," said the blind man.

Pension Limits for 2012

The IRS has announced retirement plan limits for 2012. You can see them at the IRS website or see the text below:

• The elective deferral (contribution) limit for employees who participate in 401(k), 403(b), most 457 plans, and the federal government’s Thrift Savings Plan is increased from $16,500 to $17,000.
• The catch-up contribution limit for those aged 50 and over remains unchanged at $5,500.
• The deduction for taxpayers making contributions to a traditional IRA is phased out for singles and heads of household who are covered by a workplace retirement plan and have modified adjusted gross incomes (AGI) between $58,000 and $68,000, up from $56,000 and $66,000 in 2011.  For married couples filing jointly, in which the spouse who makes the IRA contribution is covered by a workplace retirement plan, the income phase-out range is $92,000 to $112,000, up from $90,000 to $110,000.  For an IRA contributor who is not covered by a workplace retirement plan and is married to someone who is covered, the deduction is phased out if the couple’s income is between $173,000 and $183,000, up from $169,000 and $179,000.
• The AGI phase-out range for taxpayers making contributions to a Roth IRA is $173,000 to $183,000 for married couples filing jointly, up from $169,000 to $179,000 in 2011.  For singles and heads of household, the income phase-out range is $110,000 to $125,000, up from $107,000 to $122,000.  For a married individual filing a separate return who is covered by a retirement plan at work, the phase-out range remains $0 to $10,000.
• The AGI limit for the saver’s credit (also known as the retirement savings contributions credit) for low-and moderate-income workers is $57,500 for married couples filing jointly, up from $56,500 in 2011; $43,125 for heads of household, up from $42,375; and $28,750 for married individuals filing separately and for singles, up from $28,250.

Below are details on both the unchanged and adjusted limitations.

Section 415 of the Internal Revenue Code provides for dollar limitations on benefits and contributions under qualified retirement plans.  Section 415(d) requires that the Commissioner annually adjust these limits for cost of living increases.  Other limitations applicable to deferred compensation plans are also affected by these adjustments under Section 415.  Under Section 415(d), the adjustments are to be made pursuant to adjustment procedures which are similar to those used to adjust benefit amounts under Section 215(i)(2)(A) of the Social Security Act.

The limitations that are adjusted by reference to Section 415(d) generally will change for 2012 because the increase in the cost-of-living index met the statutory thresholds that trigger their adjustment.  For example, the limitation under Section 402(g)(1) on the exclusion for elective deferrals described in Section 402(g)(3) will increase from $16,500 to $17,000 for 2012.  This limitation affects elective deferrals to Section 401(k) plans, Section 403(b) plans, and the Federal Government’s Thrift Savings Plan.

Effective January 1, 2012, the limitation on the annual benefit under a defined benefit plan under section 415(b)(1)(A) is increased from $195,000 to $200,000.

Under section 1.415(d)-1(a)(2)(ii) of the Income Tax Regulations, the adjustment to the limitation under a defined benefit plan under section 415(b)(1)(B) is determined using a special rule.  This special rule takes into account the following recent history of changes in the cost-of-living indexes:  (1) the cost-of-living index for the quarter ended September 30, 2009, was less than the cost-of-living index for the quarter ended September 30, 2008; (2) the cost-of-living index for the quarter ended September 30, 2010, was greater than the cost-of-living index for the quarter ended September 30, 2009, but less than the cost-of-living index for the quarter ended September 30, 2008; and (3) the cost-of-living index for the quarter ended September 30, 2011, was greater than the cost-of-living indexes for all prior periods.

For a participant who separated from service before January 1, 2010, the limitation under a defined benefit plan under Section 415(b)(1)(B) for 2012 is computed by multiplying the participant's 2011 compensation limitation by 1.0327 in order to reflect changes in the cost-of-living index from the quarter ended September 30, 2008, to the quarter ended September 30, 2011.  For a participant who separated from service during 2010 or 2011, the limitation under a defined benefit plan under Section 415(b)(1)(B) for 2012 is computed by multiplying the participant's 2011 compensation limitation by 1.0376 in order to reflect changes in the cost-of-living index from the quarter ended September 30, 2010, to the quarter ended September 30, 2011.

The limitation for defined contribution plans under Section 415(c)(1)(A) is increased in 2012 from $49,000 to $50,000.

The Code provides that various other dollar amounts are to be adjusted at the same time and in the same manner as the dollar limitation of Section 415(b)(1)(A).  After taking into account the applicable rounding rules, the amounts for 2012 are as follows:

The limitation under Section 402(g)(1) on the exclusion for elective deferrals described in Section 402(g)(3) is increased from $16,500 to $17,000.

The annual compensation limit under Sections 401(a)(17), 404(l), 408(k)(3)(C), and 408(k)(6)(D)(ii) is increased from $245,000 to $250,000.

The dollar limitation under Section 416(i)(1)(A)(i) concerning the definition of key employee in a top-heavy plan is increased from $160,000 to $165,000.

The dollar amount under Section 409(o)(1)(C)(ii) for determining the maximum account balance in an employee stock ownership plan subject to a 5 year distribution period is increased from $985,000 to $1,015,000, while the dollar amount used to determine the lengthening of the 5 year distribution period is increased from $195,000 to $200,000.

The limitation used in the definition of highly compensated employee under Section 414(q)(1)(B) is increased from $110,000 to $115,000.

The dollar limitation under Section 414(v)(2)(B)(i) for catch-up contributions to an applicable employer plan other than a plan described in Section 401(k)(11) or Section 408(p) for individuals aged 50 or over remains unchanged at $5,500.  The dollar limitation under Section 414(v)(2)(B)(ii) for catch-up contributions to an applicable employer plan described in Section 401(k)(11) or Section 408(p) for individuals aged 50 or over remains unchanged at $2,500.

The annual compensation limitation under Section 401(a)(17) for eligible participants in certain governmental plans that, under the plan as in effect on July 1, 1993, allowed cost of living adjustments to the compensation limitation under the plan under Section 401(a)(17) to be taken into account, is increased from $360,000 to $375,000.

The compensation amount under Section 408(k)(2)(C) regarding simplified employee pensions (SEPs) remains unchanged at $550.

The limitation under Section 408(p)(2)(E) regarding SIMPLE retirement accounts remains unchanged at $11,500.

The limitation on deferrals under Section 457(e)(15) concerning deferred compensation plans of state and local governments and tax-exempt organizations is increased from $16,500 to $17,000.

The compensation amounts under Section 1.61 21(f)(5)(i) of the Income Tax Regulations concerning the definition of “control employee” for fringe benefit valuation purposes is increased from $95,000 to $100,000.  The compensation amount under Section 1.61 21(f)(5)(iii) is increased from $195,000 to $205,000.

The Code also provides that several pension-related amounts are to be adjusted using the cost-of-living adjustment under Section 1(f)(3).  After taking the applicable rounding rules into account, the amounts for 2012 are as follows:

The adjusted gross income limitation under Section 25B(b)(1)(A) for determining the retirement savings contribution credit for married taxpayers filing a joint return is increased from $34,000 to $34,500; the limitation under Section 25B(b)(1)(B) is increased from $36,500 to $37,500; and the limitation under Sections 25B(b)(1)(C) and 25B(b)(1)(D), is increased from $56,500 to $57,500.

The adjusted gross income limitation under Section 25B(b)(1)(A) for determining the retirement savings contribution credit for taxpayers filing as head of household is increased from $25,500 to $25,875; the limitation under Section 25B(b)(1)(B) is increased from $27,375 to $28,125; and the limitation under Sections 25B(b)(1)(C) and 25B(b)(1)(D), is increased from $42,375 to $43,125.

The adjusted gross income limitation under Section 25B(b)(1)(A) for determining the retirement savings contribution credit for all other taxpayers is increased from $17,000 to $17,250; the limitation under Section 25B(b)(1)(B) is increased from $18,250 to $18,750; and the limitation under Sections 25B(b)(1)(C) and 25B(b)(1)(D), is increased from $28,250 to $28,750.

The deductible amount under § 219(b)(5)(A) for an individual making qualified retirement contributions remains unchanged at $5,000.

The applicable dollar amount under Section 219(g)(3)(B)(i) for determining the deductible amount of an IRA contribution for taxpayers who are active participants filing a joint return or as a qualifying widow(er) is increased from $90,000 to $92,000.  The applicable dollar amount under Section 219(g)(3)(B)(ii) for all other taxpayers (other than married taxpayers filing separate returns) is increased from $56,000 to $58,000.  The applicable dollar amount under Section 219(g)(7)(A) for a taxpayer who is not an active participant but whose spouse is an active participant is increased from $169,000 to $173,000.

The adjusted gross income limitation under Section 408A(c)(3)(C)(ii)(I) for determining the maximum Roth IRA contribution for married taxpayers filing a joint return or for taxpayers filing as a qualifying widow(er) is increased from $169,000 to $173,000.  The adjusted gross income limitation under Section 408A(c)(3)(C)(ii)(II) for all other taxpayers (other than married taxpayers filing separate returns) is increased from $107,000 to $110,000.

The dollar amount under Section 430(c)(7)(D)(i)(II) used to determine excess employee compensation with respect to a single-employer defined benefit pension plan for which the special election under section 430(c)(2)(D) has been made is increased from $1,014,000 to $1,039,000.

More on CEO Pay -- Whose Fault Is It?

OK, I'll say it -- US Chief Executive Officers, as a group, get paid a lot of money. There! Are they worth what they get paid? Some are, some are not. Gee, you're not surprised yet by anything I've said?

My question to you or to anyone else is how did this happen. I heard somewhere this week that back in the 80s, US CEOs had pay roughly equal to 30 times the median pay for US workers. The same person said that multiple is now in the 300s or 400s. Assuming that you think that is too much on average (and I do think it is), is it my fault that it got that way? Is it yours?

Times have changed. Compensation packages have changed. Some executive compensation consultancies found for a while that the best way to get hired was to be able to show that they could get the executives the most money. There was no independence of compensation committees back then, at least it wasn't particularly required.

Again, back in the 80s, how were CEOs paid? For most, they got a base pay and they got a bonus. Some received equity awards or grants, but that was nowhere near as common.

Three things happened:

1. Companies started giving mega-grants.
2. The country at large and the politicians decided CEO and other executive compensation was too high.
3. Congress was smart enough or not to put Section 162(m) (the million pay cap for deductibility) into the Code.

My memory isn't perfect on this one, but this is my blog, so I can write as if it is. The first mega-grant that I remember was paid by The Coca-Cola Company. Mr. Goizueta became the CEO of Coca-Cola in 1980 at the age of 48 and he was a superstar. The Board thought so, the Compensation Committee thought so, shareholders thought so, Wall Street thought so, and competitors thought so. Coca-Cola wanted to lock Mr. Goizueta in and to do so, they gave him an award of 1,000,000 restricted shares. What this meant, roughly speaking, was that if he stuck around for 10 years, he would get one million shares of KO stock which traded around $83 per share at the time. 

That was a lot of money. Wall Street thought that Coca-Cola had made a great decision.  

So, other companies followed suit. Executive compensation consultancies and practices within larger consulting firms actively trained their people on the intricacies of mega-grants. 

Two things happened. The economy plummeted as it does from time to time, and as often happens when the economy plummets, people think that executives make too much money (oftentimes they do). So, Congress "solved" the problem. 

The Fools on the Hill (Capitol Hill) added Section 162(m) to the Code saying that pay for the top five executives in excess of $1 million in a year was generally not deductible on the corporate tax return. But, they put in an exception for certain performance based pay. 

Ah, a loophole! Who woulda thunk it?

In the Internal Revenue Code, where there's a loophole, there's a loop to put through it, and virtually everyone could find this loop. So, CEOs of large companies everywhere suddenly had base pay at or below $1 million and complex performance clauses that could pay them lots of money, especially when the stock market was heading up. 

Finally, the SEC entered the picture. As they refined and further refined the proxy rules for registrant companies, the SEC decided how pay should be defined. So, now, where CEO compensation can decrease significantly if interest rates are high and the stock market is low on the last day of the company's fiscal year, or conversely, compensation can increase because interest rates plummet on December 31 while the stock market hits new highs, different groups have the opportunity to cherry-pick their data.

In any event, according to the data I heard this week, CEO pay is now a multiple of 400 or so of the median worker pay. I don't know where the number came from. I'm not sure that I care because I know that the number is a contrived one. On the other hand, that multiple is too high by anyone's standards.

It's not my fault, though. Is it yours?

On the Origin of Species - Retirement Plan Style

It's been about 150 years since Charles Darwin wrote about his theory of evolution. He also, as we know, discussed Spencer's phrase "survival of the fittest." This seems to work pretty well in the worlds of zoology, botany, and ecology. But, does it work with regard to retirement plans?

I guess that part of the premise would need to include what exactly is a fit retirement plan. Is it a plan that allows people to retire? The terminology alone would seem to suggest that. Is it a plan which might assist people in their goal of retiring, but doesn't cost an employer very much? Is it a plan, jury rigged over the years, to assist politicians in their never ending goal of changing stuff to help them get re-elected?

I'd like to believe that a fit retirement plan or retirement system will allow participants to retire after a normal working lifetime. 30 years ago, we had such a system, and it existed without 401(k) plans. But, I guess I must be mistaken, as clearly, that system has not survived. But, it's not been without outside influence -- largely Congress. You see, every year or two for the last 30, when it's come time to develop a budget for the upcoming fiscal year and the country has needed some revenue enhancers, Congress looks to the retirement system. And, it's a really cool solution, too, because nobody understands what Congress is doing (and that includes Congress), but it doesn't affect Congressional retirement benefits.

In his Origin of the Species, Mr. Darwin did not have to consider Congress, or even Parliament.

The 401(k) system cannot be the correct answer. It has too many rules. And, many of the rules and goals conflict with each other. Consider a system containing all of these features.

• If your low-paid don't participate to a great enough extent, your high-paid aren't allowed to.
• If you don't communicate the plan and its benefits to the low-paid, they won't participate to a great extent.
• If you do communicate the plan and its benefits to the low-paid, then the plan is useful to the high-paid, but it costs the company more, cutting into profits.
• Cutting into profits competes with the goals of the management team.
• This affects dividends paid to shareholders which, in theory, is the reason a person holds shares in a company.

And, this is now the primary retirement vehicle for the majority of US companies.

But, wait, we have a Presidential election coming up in just over a year. And, with that, 33 or 34 Senate seats are up for grabs as well as 435 seats (actually a bunch of them are not contested) in the House of Representatives. With those elections will come a bunch of new allegiances. Will your Congressman or Congresswomen be aligned to the Occupy movement, the Tea Party, the Green, the Libertarians or some other group? How about the others? I'm not smart enough to tell you. But, I am smart enough to know that the allegiances of the new group will be different than those of the existing group. So, with this new group will come retirement plan change. 

Maybe this change will be 401(k) biased. Maybe it will revolutionize retirement plans. But in any event, it will do something.

And, you heard it here first, my bet is that they will do something stupid.

If we look at the way things are now, though, people in the workforce are just not going to be able to retire. Yes, some will, but most won't. Certainly, they won't be able to by age 65. What's so special about age 65? It's been a retirement age for a long time. When it first came about, those who were fortunate enough to outlive that age usually didn't do it by too much. Now they do. So many argue that the working lifetime should be extended. But companies don't want to keep the post-65ers employed. These days, they seem to prefer that with the post-55ers as well. And, for that matter, by the time people hit age 65, most of them are just worn out from full-time work.

The 401(k) isn't going to fix it. Maybe we need a fitter plan.

A New Take on Just How Much You Need to Retire

I was part of an interesting conversation last Friday. Since I didn't ask if I could attribute to the specific individual, I'll leave his name out. The general topic in this part of the conversation was how much money do you need to retire.

I know -- you've heard it before. 10 times pay, 15 times pay, some other number times pay. But, last Friday, I heard a different answer. Suppose you look at things based on health factors. You've probably thought about that, but I don't think you have thought about it the way this gentleman has (I am going to deviate from what he said, but am using his basic premise).

Suppose we break the population into 4 quadrants. On the vertical axis, put your estimated health care costs compared to a typical person without regard to life expectancy. On the horizontal axis, put your life expectancy based on your family history and your health. I realize that you can't be exact, but you have a pretty good idea if you expect to outlive the norm or not.

When we look at the center of the chart (average life expectancy, average health care costs), perhaps you will need 16 times final pay to live happily in retirement. Consider the other four quadrants (using map directions):

• Northeast -- long life with high medical expenses requires high multiple
• Southeast -- long life with low medical expenses requires medium multiple
• Northwest -- short life with high medical expenses requires medium multiple
• Southwest -- short life with low medical expenses requires low multiple

It's so simple, yet so elegant. And, I've never seen it put this way before. 

The particular individual cited in this article is doing research. He plans to release a publication with tremendous detail on this topic. Saying much more would steal his thunder, but it was such an interesting yet simple concept that I felt the need to say something. 

Stay tuned.

How Much Should a CEO Be Paid?

That sure sounds like a simple question. It has no difficult words. It's not a compound question. It's the type that if an attorney asked a witness on cross-examination, there would be no objection as to form.

I've noticed the Occupy [Wall Street] movement and one of their major beefs is how much CEOs of US companies are being paid. On Facebook, I have seen a chart suggesting that US CEOs make on average 475 times as much as the median US worker (the data being used suggests that the median worker earns $33,840 per year) which suggests that the average CEO makes somewhere in the neighborhood of $15 to 16 million per year. That's a lot of money, but there are not a whole lot of CEOs that actually make that much. And, when the people who put together that chart did their homework, so to speak, they used compensation from proxy disclosures.

Executive compensation (and related topics) practitioners will know that this is not an apples to apples comparison. While many of the components of CEO pay do not apply to the median worker, note that CEO pay includes the value of retirement plans, for example, while median worker pay does not. Further, in the years where CEO pay, relative to the median worker is highest, this is significantly a function of prevailing interest rates on corporate high grade bonds. I'm not saying that this is the right way or the wrong way to do this, I'm just saying that this is the way it is.

But, we still haven't approached the answer of how much a CEO should be paid. So, I asked a few people who have been objecting quite strenuously to CEO compensation. They don't know either. But, the only answer that I got more than once was "less than 10 times what the average worker makes."

You know what. I know a few corporate CEOs (not real well, but in passing). And, not a single one of them would do their job if their pay was limited to less than 10 times what the average worker makes. A good CEO delivers value to a company. How much value? I don't know. Perhaps we will see as we watch Apple over the next couple of years in the post-Steve Jobs era.

Should a CEO earn more than 'talent'? In my opinion, generally a good CEO should earn more. They have larger responsibilities. While talent can swing earnings significantly for a segment of a business, the CEO sets the direction for the business.

So, I asked one of these people who thought that CEOs should less than 10 times what the average worker makes how much they thought that talent should make. I asked them if Lady Gaga should have made upwards of $50 million in 2010. They answered probably not. PROBABLY not! That means that there is a chance that she should earn that much, but the person who is responsible for having a recording contract shouldn't earn more than about $340,000. How about Peyton Manning. I think his football earnings for 2011 are between $10 and 20 million. Add that to his endorsement earnings and he is pretty well compensated. Is he earning that much in 2011? Does he deserve it? He's had a pretty good career, far better than most, but if he were a CEO in 2011, his compensation would be hit a lot more by his inability to do his job this year.

I know. CEOs don't get career-limiting injuries. But, in any case, it's a tough comparison to make. I don't know how much a good CEO or a bad CEO should make, but neither do the protesters. Perhaps, though, they should get a few facts straight before they present them.

9 9 9 or Nein Nein Nein

If you haven't been under a rock, you have at least heard an inkling about Herman Cain's "9 9 9 Plan." If you like, you can read about it on his website (hermancain.com) or you can get the whole plan hear in just a few bullet points:

• Eliminate the Internal Revenue Code (the Tax Code or the Code)
• Impose a flat 9% personal income tax on all income, apparently excluding bonafide charitable contributions
• Impose a flat business income tax at a rate of 9%, eliminating all deductions (the media and the activists on both sides and in the center usually call these loopholes)
• Impose a 9% sales tax on, as I understand it, the purchase of all new (not pre-owned) end products

Mr. Cain says that it is revenue neutral, or better. I have not had a chance to review either his math or his assumptions, so I can't vouch for him, or dispute his claims.

I have to give credit to Jay Leno for the second part of my blog post title. Mr. Cain was a guest on the Tonight Show the other night and Leno talked about Republican Presidential candidates being fluent in foreign languages: Romney in French, Huntsman in Mandarin and Cain in German as nein, nein, nein translates to no, no, no.

But, back to the point of the post, look at that first bullet. Eliminate the Internal Revenue Code. If you are an average American, or even a not so average American, you probably think that's great. But, there are complications. And, if we are pointing them out here, they probably relate somehow to benefits or compensation.

Do you participate in a 401(k) plan? You do, now there's a shocker. The fact is that the large majority of working Americans either participate in a 401(k) plan, or are at least eligible to. And, why is it called a 401(k) plan? Well, duh, it's sanctioned by Section 401(k) of the Internal Revenue Code. That's why you as a participant have the opportunity to make deferrals on a pre-tax basis and not pay any tax on the money until you take a distribution. And, there are rules in the Code related to those distributions. Those would all go away. When would your distribution be taxed? Well, I don't know. Since the build-up in your account is exempt from taxes under Code Section 501(a) until you take the money, would it no longer be exempt from taxes if there ceased to be a Section 501(a) of the Code? I don't know.

Suppose you made Roth contributions. That means the money was taxed in the year that you contributed it, but would not be taxed upon distribution. So, it's already been taxed, but with no tax exemption, would it be taxed again? I don't know. 

How about life insurance that you may be the beneficiary of? Suppose your parent took out a $1 million policy on their own life and made you the beneficiary. Currently, if that parent were to die, that $1 million would be exempt from income taxation (it would be subject to estate taxation) because the Code exempts it.  What would happen under 9 9 9? I don't know.

And, you were one of those parents who chose to save for your child's college education using a 529 Savings Plan. Why is it called a 529 plan? It's sanctioned under Section 529 of the Internal Revenue Code. Would it lose its tax effectiveness? I don't know.

You would think that Donald Rumsfeld was my role model.

With regard to 9 9 9, you may like it or you may not. But, there are known knowns; there are things we know we know. We also know there are known unknowns; that is to say we know there are some things we do not know. But there are also unknown unknowns -- the ones we don't know we don't know.

I don't know, do you?