The US Retirement System is a Success?

I read a white paper from the Investment Company Institute (ICI) entitled "The US Retirement System is a Success." You can read it here if you like.

I beg to differ. Among the positions that ICI has taken is that the number of people actively saving for retirement and the amounts they are earmarking for retirement are increasing. Both of these may be true, but then again, it may be the way the questions are being asked today and were being asked in the past.

ICI uses 1985 as a reference point for a generation earlier. Interestingly, that's the year that I started in the actuarial consulting world. My perception is that we didn't see many people specifically saving for retirement back then. Most companies didn't have 401(k) plans. However, my memory tells me that the vast majority of American workers were covered by defined benefit plans. And, it was fairly likely that the company that you worked for at age 35 was the company you were going to retire from. Workers just knew that their pensions combined with Social Security would provide for their retirement.

Did it work? In a lot of cases, it did. When I got into this business, most times that a company did a plan design study, they looked at replacement ratios at various retirement ages. They looked at winners and losers. It was not unusual for a typical worker's replacement ratio from just a pension and Social Security to exceed 75% of their final pay as a worker.

ICI says that more recent retirees have higher levels of resources to draw on then prior generations. This may be true. But, focus on the words "recent retirees." More people in 2012 are working to older ages than in previous generations because they can't afford to retire. Many of those who have retired recently got their retirement savings during the dot com boom in the 1990s. Those who missed out on that may, in many cases, never be able to retire.

I've implied it many times in this blog that data is a funny thing. Give people data and an agenda and they can do with that data what their agenda asks them to do. I fear that the ICI has done this.

Suppose the Actuarial Code of Conduct Applied to Congress

Suppose the Code of Conduct that applies to the actuarial profession in the US applied to Congress. Just suppose. What would happen?

Let's consider Precept 8. Quoting directly,

An Actuary who performs Actuarial Services shall take reasonable steps to ensure that such services are not used to mislead other parties.

I guess that, in theory, anyway, Congress does provide services to its constituency.

Today, I am going back to an old target of mine, the rules under which the Congressional Budget Office (CBO) is required to operate. Now, understand, I don't hate the CBO. It's made up of some pretty smart people. And, as far as I know, they are also very honest people.

But, they don't set their own rules. You see, when the CBO "scores" a bill, that is when the CBO determines the cost of a bill that is introduced into a house of Congress, it is required by Congress to determine that cost over a 10-year period without regard to a dynamic economy. In other words, there is to be no inflation considered, no growth -- just whatever we have right now is what we are assumed to continue to have.

Quoting directly from President Lincoln in his famous Gettysburg Address:

Now we are engaged in a great civil war, testing whether that nation, or any nation so conceived and dedicated, can long endure. We are met on a great battle-field of that war. 

Surely, it's not what the President intended, but the so-called fiscal cliff negotiations going on right now feel like some sort of great civil war. People are not perishing from it, but jobs may. And, leaders of both parties are acting like babies.

From what I have read in major print media and heard on major broadcast media, proposals include

• no increases in tax rates for anyone
• increases in tax rates only for the "wealthiest 2%"
• no spending cuts for the first 4 years of the 10-year period that the CBO would be considering (this is to be balanced by generally as yet undetermined spending cuts to occur beginning in 2017)
• continued reductions in FICA taxes

People, we have an 'official federal debt' of approximately $16.3 trillion. Through the magic of the way the CBO is required to do its calculations, the bulk of the savings from these proposals is not likely to ever come about. If a credentialed US actuary performed calculations in the manner that Congress requires, he or she would be required to also do the calculations on a reasonable basis or to at the very least estimate the difference in results if the calculations were done on a reasonable basis. Failure to do so might subject said actuary to any number of disciplinary options including expulsion from actuarial organizations.

What would it take to discipline most of Congress in such a manner.

FULL DISCLOSURE: If the actuary disclosed that calculations were being performed using assumptions chosen by the Principal (Congress in this case with respect to the CBO) and that the actuary did not agree with the assumptions and further disclosed that said calculations could only be used for the specific purpose for which they were intended, the actuary would likely be compliant. But in that case, at least the user would know that the actuary disavowed the results.

Does Your Plan Have Undue Risk?

An actuary friend of mine was complaining about upcoming end-of-year DB disclosures and the fact that his clients had funding calculations coming up that were going to be based on low interest rates and equity markets that have plummeted since the election. I further heard that the underfunded plans that he works with were overfunded as recently as September 1.

I asked him about de-risking, liability matching and things like that. He said that his clients give up too much upside return by doing that. I guess they would rather have underfunded plans.

In about 2002, I gave a speech to a bunch of pension investment professionals. In it, I espoused long duration fixed income investments in DB plans despite that everyone knew that interest rates couldn't go any lower. Of course, they also knew that this would take interest rate risk out of the equation, but people treated me as if I had some sort of strange disease.

I know of a few plan sponsors who did what I said. They are the ones with well-funded plans now. I don't know about you, but I'm not smart enough to know where interest rates are headed on any particular day. Frankly, I have expected them to be headed upward for that entire 10-year period, but that's not the point. The point is that there are a number of risks inherent in DB plans in the US. Some are outside of the sponsor's control, but others fall within it.

Shouldn't a sponsor consider controlling the ones that they can.

The Election Happened, Now What?

As the politicians like to say, the people have spoken. Now what?

There are lots of things I could say here about the policies of either side and what I think is right, wrong, or beyond comprehension, but that would be as worthless as much of the blather that occurs inside the Beltway.

What we have now is the same President that we have had for the past four years, roughly the same makeup of the Senate, albeit very slightly more left-leaning it appears and the same House of Representatives although perhaps slightly more right-leaning in its ideology. What we also have is an Administration which no longer needs to be in campaign mode. This means that policies and regulatory agendas which perhaps were on hold for political or non-political reasons may move forward.

Before moving forward, I caution you that what I am about to write is nobody's opinion but my own and that it is only my opinion on the morning of November 7, 2012. It may be different this afternoon, tomorrow, or some other day, but I hope that it doesn't change too much.

PPACA (health care reform or ObamaCare if you prefer) remains the law and it will remain. Whether they like the law or not, companies must prepare for 2014 when many of the key provisions of the law will take full effect. As an American, I hope that most employers do not make the decision to convert many employees from full-time to less than 30 hours for the sole purpose of excluding those employees from semi-mandatory coverage, but that is a decision that some will make.

The President is a strong believer in nationalized benefits programs (see, for example, ObamaCare). Look for his Administration to put forth a proposal for mandatory employer-provided retirement coverage with the option being contributing to a national retirement exchange. Retirement plans will look much more portable in this proposal. And, more coverage means more tax expenditures which must be paid for. Look for them to be paid for with tax savings generated from reductions in 415 limits and 402(g) limits. In other words, the highest earners will not be able to save as large a percentage of their incomes for retirement.

Historically, the Democrat Party has favored defined benefit (DB) plans more than the Republican Party. Republicans as a group have viewed that such plans are not representative of individuals taking responsibility for themselves. However, unless Congress really seeks the assistance of outside experts, do not look for any sort of resurgence in the DB world. Every effort from Washington to promote DB plans has been fraught with agency intrusion that moves employers away from DB.

At the same time, look for the President to leave Ben Bernanke in charge of the Federal Reserve and Tim Geithner in charge of Treasury. This will likely mean continuing low interest rates in an effort to spur the economy. The pension funding stabilization provisions of MAP-21 have, in the short run, allowed companies to not have exorbitant expenditures to fund their DB liabilities, but accounting disclosure often attached to loan covenants and credit-worthiness of companies that sponsor the plans will be unaffected by funding rules. In fact, companies that choose to make the MAP-21 minimum required contributions will have their accounting disclosures look worse.

President Obama has made it clear that he plans to raise taxes on high earners. We've previously written here about the FICA tax increases under ObamaCare as well as the 2013 combination of tax increases sometimes referred to as Taxmageddon. When marginal tax rates increase, deferred compensation becomes more valuable. Look for more companies to focus on nonqualified deferred compensation plans for their executives.

Similarly, the estate tax, or death tax, if you prefer, is due to return with a 55% top rate. Individuals who have accumulated significant wealth will be looking for ways to transfer that wealth to their heirs. Privately-owned companies will frequently look to ESOPs perhaps through so-called 1042 exchanges to plan for wealth succession.

Executive compensation is going to be a huge issue. As tax rates increase and the limitations in qualified plans likely decrease, deferred compensation will be become a bigger issue. With increases in deferred compensation come larger risks both for the executive and the employer. Funding such plans has become increasingly difficult while failure to fund them leaves unmitigated risk for both parties.

Dodd-Frank was one of the hallmark laws of the first Obama Administration. Seven key executive compensation provisions remain unregulated, but look for all of them to be regulated soon. Particularly critical among them are:

• Policy on erroneously awarded compensation
• Disclosure of pay versus performance
• Pay ratio disclosure

Look for the Administration to consider policies that would cut the million dollar pay limit under Code Section 162(m). While the original 162(m) codification probably backfired, most Americans would not consider it particularly controversial to limit the amount of compensation that is not performance-based that top executives receive.

Finally, in all areas, look for increases in required disclosures. Thus far, regulatory guidance in this arena has gone to levels under the Obama Administration not seen before. For employers, this means additional administrative burden. For employees, unless disclosures can be more useful, this will mean more stacks of paper for the trash bin.

And, look for gridlock once again as each side blames the other. Who will blink first? I'll report on the first blinkage here.

Suppose You Couldn't Have Your Annual Shareholder's Meeting

In 2010, Congress passed and President Obama signed the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank) into law. Billed as a reaction to the financial crisis and abuse by the financial services industry of the public trust, Dodd-Frank has been more ... much more. Whether that more and much more has been good for the public or for anyone else is a matter of opinion. My opinion, as it is with most laws is that there were good parts, and there were less good parts. But, as is often their wont, Congress attacked a problem with far too broad-reaching a weapon.

Many of the more controversial provisions of the nearly 3000 page law lie in Title IX dealing with executive compensation and paramount among those may be the Shareholder Say on Pay (SSOP). Under these provisions, shareholders have the opportunity to weigh in, albeit in a non-binding fashion, on executive compensation proposals.

As is often the case with such provisions, plaintiff's bar views provisions such as these as an opportunity to litigate the matters. In one case, in California, in order to get a temporary injunction lifted, a company was forced to delay the implementation of their executive compensation proposal, file a revised and more detailed definitive proxy (Form 14A) and pay plaintiff's attorneys more than half a million dollars.

Suppose they hadn't done this. Then a state judge in California was precluding the company from conducting its annual meeting.

And, this was not because the executive compensation package was viewed as being outlandish, but simply over a few provisions that MAY not have been worded perfectly.

On ISS and SERPs

We're getting close to proxy season for issuers of proxies under the purview of the Securities and Exchange Commission (SEC). And, especially since the passage of Dodd-Frank which gave us the new concept of the  (non-binding, but very important) Shareholder Say-On-Pay (SSOP), one of the most important names that we see is Institutional Shareholder Services (ISS).

In a nutshell, ISS provides a service to institutional shareholders of issuers. By performing their analysis of SSOP proposals, ISS gives its subscribers guidance related to how they should cast their SSOP votes. While I may not sound entirely favorable toward ISS and their opinions in this post, I do think this is a valuable service.

For those people who would like to understand ISS's standards and protocols, they have a fairly detailed website with new practices for 2013 as well as their comprehensive 2012 policies.

Now I quote directly from their comprehensive 2012 policies:

 Egregious pension/SERP (supplemental executive retirement plan) payouts:

§  Inclusion of additional years of service not worked that result in significant benefits provided in new arrangements

§  Inclusion of performance-based equity or other long-term awards in the pension calculation

I could be particularly troubled by what I see there, but it's not what gives me pause. Generally, granting of additional years of service for top executives is not a best practice. Similarly, inclusion of long-term awards in compensation for SERP purposes is not a best practice.

However, ISS appears (emphasis here on appears as compared to has) to have taken the position that having a SERP with a more generous formula than in a qualified plan also constitutes an egregious SERP. Often, they are correct. But, not always.

There is a reason, or at least there ought to be, that SERPs are designed as they are. Some companies, for example, tend to promote from within and their executives will likely be long-service employees who are motivated by retention devices rather than attraction devices. SERPs perform this function well. Freezing a SERP when the qualified defined benefit (DB) plan is frozen may be detrimental to shareholders as executives will no longer be bound by the retention device.

What should ISS do? While I have often said negative things about the Summary Compensation Table (SCT) in the proxy, perhaps the SEC had it somewhat correct when they designed it. While technical pension issues may make the pension data in the proxy less valuable than it otherwise might be, the pension accrual is part of annual compensation.

Now, suppose an executive receives lower direct cash compensation than his peer group (other companies), but receives more in deferred compensation through a SERP. Should this be problematic to shareholders? In my opinion, it should not be. In fact, since direct cash compensation is the proverbial bird in the hand while deferred compensation may not be paid if the company suffers particularly adverse business circumstances such as bankruptcy, the generous SERP in lieu of generous current cash may actually be more desirable. But, it's not viewed that way.

New methodologies allow reviewers of proxies to better make this analysis. I'm working on a paper that will explain this in more detail. Regular readers will see it here.

MAP-21 and SERP Funding, Now May be the Time

If you work with US defined benefit (DB) pensions and you haven't been living under a rock, then you are probably familiar with MAP-21, the law passed this summer whose more formal name is Moving Ahead for Progress in the 21st Century. It was positioned as a highway bill, but you are too smart for all that and know all about positioning. Where building highways costs money, lowering corporate deductions for pension plans raises money (or gets scored that way by the Congressional Budget Office). So, MAP-21 included pension funding relief.

In a nutshell, MAP-21 allows plan sponsors to use significantly above-market discount rates in the determination of funding requirements for their qualified pension plans. The trade-off comes in increases in PBGC premiums. But, while the first of these items is optional, the second is required.

So, where am I going with this? If you read the title of this post, you may be wondering.

Flashback to late 2004. Congress passed and a different president signed into law another act supposedly designed to create jobs. This one had a much more in-your-face title, the American Jobs Creation Act of 2004. With that innocuous name, however, came a new section of the Internal Revenue Code, Section 409A that among other things removed distribution and funding flexibility for DB SERPs. Since that time, many executives have wondered how to get their benefits, or at least portions of them, out from under the dark veil of 409A.

For some companies, MAP-21 may have provided an answer.

WARNING: before considering an option such as what I am about to describe, plan sponsors should very carefully consider the underlying risks.

The time may be right to consider a QSERP. Briefly, a QSERP is a means to transfer certain nonqualified benefits to a qualified plan. You can read about them in more detail here.

So, why might now be the right time. MAP-21 has given companies the ability to use higher discount rates in funding their pension plans. This means that any restrictions that might have arisen due to low funded statuses have likely disappeared. So, companies have the opportunity to fund this obligation in a qualified plan without having to fund it all at once.

Risk managers might tell you not to do this and there are good reasons. Paramount among them is that temporary use of above-market discount rates does not change the "true" funded status of a plan.

Other risk managers might tell you that you should do this and you should do it now. Why? Let's consider a simple example. Suppose you have agreed to pay your CEO an additional $100,000 per year (for life starting at age 65) from the SERP. This is over and above what he will get from the qualified DB plan. The present value of that obligation is the same whether that benefit is in the qualified plan or in the SERP. But, in the qualified plan, you get these advantages and many others:

• The benefit will not be subject to 409A
• You could efficiently fund the benefit immediately and generally get an immediate tax deduction for that funding
• That tax deduction may be taken at a higher corporate tax rate than it will be in the future
• When the CEO retires, his benefit can be paid out of a large pool of assets rather than creating a cash flow crunch

This is a complex process and there is much to consider. But, for the right company, now is the time. You'll only know if you are the right company after careful analysis. Ask an expert.

Inflation Finally Adjusts Pension Limits Again

I'll start out by apologizing for not posting for a while. I've been on the road in multiple time zones and sometimes (well, actually always), blogging isn't priority #1. But, it's time to get back to it.

As most readers will know many of the limitations that affect qualified retirement plans are subject to indexation and the timing of the announcements is mid-October. So, without further ado, here you go with the 2013 limits:

• The limit for deferrals to 401(k), 403(b), most 457 plans and (believe it or not), the Government Thrift Plan increases from $17,000 to $17,500
• The limit on catch-up contributions for people who turn age 50 (or older during the year) stays at $5,500
• The defined benefit 415 limit has increased from $200,000 (annual benefit as a single life annuity at age 65) to $205,000
• The 415 limit for defined contribution plans will be $51,000 up from $50,000
• The limit on compensation that may be considered under the plan increases from $250,000 to $255,000
• The threshold for determining Highly Compensated employees remains at $115,000
• The pay cap for governmental plans rises from $375,000 to $380,000

I'll be back to posting more regularly again. Thanks for being patient.

Compliance or Policy?

This is going to be a fairly short post, I think. I want to talk a bit about what should be the greater influence on benefit program design -- compliance or policy?

Right now, and especially as PPACA (health care reform or ObamaCare, if you prefer) is starting to exert its influence, it seems that most benefit program design is structured to facilitate compliance with the myriad of laws that Congress has passed since ERISA was signed 38 years ago. Just think, you provide a big health care benefit, you pay a Cadillac Tax. Your NHCEs can't afford to defer to your 401(k), your HCEs don't get to benefit. You would like to provide your employees with retirement income, but you cannot stand the volatility in corporate cash flow and P&L of a defined benefit plan.

Seems wrong, doesn't it?

So, even to the extent that you have a policy that is governed by things like true long-term cost and what is right for your employees and your business, you are unable to implement that policy while being in compliance.

Seems wrong, doesn't it?

Of course, it's wrong, but the people who make the laws don't seem to get it. They don't believe in benefits policy. They don't believe in retirement policy. They believe in tax policy and gerrymandering the tax code to make it work, often at the expense of corporations (large and small) and their employees.

Seems wrong, doesn't it?

Connecting Executive Rewards

After all these years, I find it amazing. Consideration of executive rewards is still split up into pieces. And, those pieces are handled by different internal functions and by different consulting constituencies.

In a fairly typical case, cash, long-term incentives and equity are handled by the executive compensation function and by the executive compensation consultants. Executive retirement programs are typically handled by the retirement function and by the retirement consultants (frequently actuaries).

This is not a problem. The problem lies in the fact that the left hand and the right hand don't communicate with each other. And, they don't have compatible methodologies.

Let's look at retirement first. Traditionally, executive retirement packages have been designed to replace some targeted percentage of the executive's base plus bonus in their last few years before retirement. That methodology is not wrong. In the typical executive retirement study, consultants are asked to benchmark the plan design. Does it align with current trends and practices?

Consider executive compensation. Here, consultants look at such this as total cash compensation and total direct compensation. They benchmark this against the organization's peer group regressing (adjusting) for differences in size (and sometimes complexity). They develop medians and percentiles. That methodology is not wrong.

Suppose a Board chooses to pay its CEO at the 60th percentile. Perhaps they feel that their is complexity to their organization that belies its size. Suppose they also have an executive retirement program that their consultants say is pretty mainstream. I am going to tell you that almost to a degree of certainty, the retirement consultants have not considered the level of the CEO's pay in determining that the retirement program is mainstream. Isn't deferred compensation a part of compensation?

What would happen if we used the same approach for retirement benefits as we do for other forms of executive compensation? Suppose we calculate an annual value for such benefits and add it to other forms of compensation before doing that regression. Something tells me that the results might be surprising. In some cases, it might justify that rich SERP for which the proxy analysts have such disdain. In other cases, we might find that the company is perhaps inappropriately inflating TOTAL compensation -- the sum of the value of the entire rewards package.

In order to make this work, the executive compensation people need to talk to the retirement people and conversely. They need to speak each other's languages. Today, there are many gaps. There just aren't enough of us who are bilingual in this regard.

Perhaps we need to be.

Why Companies Lose Their Best Young People

It's one of the biggest problems facing American companies these days -- the unwanted loss of lots of talented young workers. It's not exactly a new phenomenon, but it seems to be more rampant today. In my opinion, the reason often has to do with companies being penny wise and pound foolish, but I'll come back to that. In the meantime, I point you to an article that I found on LinkedIn.

If you choose to skip reading that article, I'll summarize the findings here. Talented young people leave because they are not learning. They're not learning the business they're in and they're not learning general business skills. Let's look at why this is happening.

I take you back to prehistoric times when I was a young up-and-comer in the consulting world. I had several means of learning:

• The people that I worked for mentored me and taught me. They explained what they were doing and why. They viewed my development as an important part of their job. My success would contribute to their success.
• I had the actuarial exam program. Yes, this still exists, but it has never and will never be the best learning opportunity for young actuarial wannabes. While it is improving, much of the examination process still appears to be about reading endless amounts of material to be able to regurgitate long lists of facts. This is not application, it's memorization.
• I read. I read a lot. I read books -- those things with covers and words printed on paper. I sometimes highlighted those books so that I could find things when I needed them in the future. And, every firm that I worked for distributed hard copies of research memos. 
• I was a participant in frequent training -- face-tot-face training -- where either an instructor from my office would address interested people from the office, or where designated people from many offices traveled to a centralized location for intensive multi-day training.

Much of this is gone in most companies. Supervisors (as a group) no longer spend much time teaching and mentoring those who support them. Why not? It's not in their goals. They don't get a tangible reward for developing staff. And, in fact, at most companies, if a star young person leaves and even attributes it to a lack of development, no senior person gets dinged for it. Since the senior people don't get money for it, they don't generally focus on developing others. Unwanted turnover costs. It's pound foolish.

Perhaps the exam program is better than it used to be. But, ask the students. For most, this is not the type of learning and development that they want.

Companies generally don't want to spend money on books anymore. Why? People can read snippets online. But, how do young people find the right materials to read online? For many of them, it's guesswork. They have no idea what to trust. They don't even know if what they are reading is factual. They don't develop and they leave. Penny wise and pound foolish.

Most training now is done via teleconference, webcast, or online. It's not as effective. People lose their focus. They don't pay attention. They don't learn and they leave. Penny wise and pound foolish.

Companies save money in terms of hard dollars, but they have lots of unwanted turnover and there they lose lots of soft dollars. In fact, my opinion is that the soft dollar cost of this exercise is far more than the hard dollar savings ... far more.

So, yes, I am suggesting that maybe a little bit less newfangled training and reading and a little bit more of the old-fashioned stuff might be an improvement. That means stop reading other people's blogs, but keep reading mine.

Building a 401(k) Plan that Prepares Employees for Retirement

It's one of the biggest concerns that I hear from people in 2012: "How will I ever be able to retire?" They tell me that their dad had a pension plan and Social Security, but they don't have a pension plan and they may not have Social Security. Whether these people will have Social Security benefits or not I can't tell you, but for most, their only employer-sponsored retirement plan will be a 401(k).

What does an employee whose only sources of retirement funds will be their 401(k) and Social Security need to do in order to ensure that he or she will someday have enough to retire? It's not rocket science, but it may not be easy either. Try this list on for size:

• Start saving early in your career. Money that is saved at age 25, compounded at just 5% annually will have more than double by age 40. But, at age 25, most people have other things in mind for their paycheck than their 401(k).
• Save continuously. Treat your 401(k) deferrals as if they will never be part of your paycheck. They are just money that is not there. In today's economy, that's not easy. When your expenses exceed your income, one way to cover that gap is to cut back on your 401(k). And, in these economy, more people than not seem to have an employment discontinuity. Just as employees don't have the loyalty to their employers that was once the norm, neither is the reverse true. Layoffs come frequently and re-employment is difficult.
• Invest prudently. Especially with the communications that plan participants receive, most of them have no idea what it means to invest prudently. They receive more advice than they know what to do with while their personal filters are not good enough to know which advice they should follow. One rule of thumb that I see frequently is that the percentage of your account balance that should be in equities is 100 minus your age. But, equities are volatile, and that has an effect -- a dramatic effect.
• Reduce volatility. Gee, John, didn't you just tell me to invest heavily in equities when I'm young, but that those investments are volatile? Actually, I didn't; I simply pointed out a common theme among the advice that plan participants receive. Consider this. Suppose I told you that in Investment A, the $1,000 that you deferred at age 25 would get an annual return of 5.00% every year until age 65, but in Investment B, your returns would alternate so that in the first year, you would get a return of -9.00%, in the second year, 20.00%, and that this would repeat itself until age 65. Simple math tells us that your average annual return would be 5.50%. So, which investment would you rather have (remember, these returns are guaranteed)? The answer is not even a close call. Despite the average return of 5.5% in Investment B, $1000 in Investment A after 40 years will accumulate to roughly $7,040 while $1000 in Investment B will accumulate to just $5,814. In fact, it would require the 20.00% return in the up years to increase to nearly 21.00% to make B as good an investment as A. Volatility is a killer.

So, the messages to the employees need to include 1) save early, 2) save continuously, 3) invest prudently, 4) reduce volatility. I would suggest that the first two items can be achieved for many people through auto-enrollment. But, most 401(k) plans that auto-enroll use a 3% deferral rate. 3% of pay is not enough. You'll never get there. Plans need to auto-enroll at rates closer to 10% of pay to ensure that employees will have enough to retire on. 10% is a lot. Many employees will opt out. It's going to be difficult.

The last two items relate to investments. The Pension Protection Act of 2006 (PPA) introduced a new concept to 401(k) plans, the Qualified Default Investment Alternative (QDIA). For employees who do not make an affirmative election otherwise, their investments are defaulted into the QDIA. Generally, QDIAs must be balanced funds or risk-based funds. Many plan sponsors use target date funds (TDFs) to satisfy the QDIA requirement. I went out to Morningstar's website to look at the performance of TDFs since the passage of PPA. All of them have had significant volatility. This is not surprising, of course, since equity markets have been extremely volatile over that period. But, we saw just a few lines up what volatility can do to you. Perhaps employees should be opting out, but into what? It's going to be difficult.

So, what are the characteristics of a 401(k) plan that guarantees employee preparedness for retirement? Many would argue that this 401(k) plan may not be a 401(k) plan at all. Perhaps what employees need is a plan that has some of the characteristics of a 401(k), but not all of them. Employees need to be able to save. Employees need portability as they move from one job to another. And, then, employees need protection against volatility and protection against outliving their wealth (longevity insurance). 

Consider that last term -- longevity insurance. The second word is insurance. Insurance generally is attained by a counterparty pooling risks. An individual cannot pool risks. An employer with enough employees can. An insurance company can.

Perhaps the law doesn't facilitate it yet, but a system in which employees can defer their own money to get a guaranteed rate of return (tied to low-risk or risk-free investments) and then have the amounts annuitized at retirement is the answer. Perhaps the law needs to facilitate it.

Higher FICA Taxes on the Horizon

Health care reform in the guise of the Patient Protection and Affordable Care Act (PPACA) came to us with many new benefits. In order to pay for those benefits, the government had two options -- cut costs or raise revenue (spelled T-A-X). Here we talk about one of those new taxes.

Beginning January 1, 2013, high earners will be required to pay additional HI (Medicare) taxes under the FICA program. The additional tax is 0.9% of compensation in excess of $200,000 for individual filers or $250,000 for couples filing jointly. The employer portion of FICA will not increase.

First, this is going to need to be administered differently from traditional FICA taxes which generally are paid through payroll deduction. Here, your employer has no obligation to know how you file (in fact, you don't need to decide until you actually file), and your employer has neither the obligation nor the right to know your spouse's income. So, presumably, higher earners will simply have an additional tax tacked on to their Form 1040.

Think about this. What are FICA wages. Generally, they are compensation first vested and reasonably ascertainable in a year. For most deferred compensation plans, the amount of compensation that has been deferred is reasonably ascertainable. However, for plans such as defined benefit SERPs or for certain stock plans, this may not be the case. Regulations under Code Section 3121(v) allow taxpayers to early include such deferred compensation. In the case of individuals with significant SERP benefits in particular, they may want to discuss the possibility of early inclusion with their employers. While the tax hit for 2012 could be meaningful, it may lessen the long-term blow.

On the other hand, we don't yet know the outcome of the 2012 presidential election. Mitt Romney has pledged to repeal PPACA if elected. Its repeal would eliminate this tax.

Planning isn't as easy as it used to be.

Keeping Up With Inflation Isn't Easy

OK, I admit it, I've had paid jobs for a pretty long time. I've been in this career for more than 27 years now. And, it's not the first career I ever had. But, I'm not writing this to brag about my grey hair. I'm not writing to show you how boring I am for having been in the same profession for this long. What I am doing is trying to show how hard it is for workers to keep up.

Back in days gone by, I heard talk all the time about how each generation left the country better off than they found it. I heard talk about how standards of living had gone up. And, in many ways, standards of living continue to go up. But, they are going up these days primarily because of technology, but not because people have more buying power.

I think back to a position that I held in the early 1980s. I didn't make much money. But, I had health care benefits. I had a traditional indemnity plan with a $200 deductible and a $500 maximum family out-of-pocket limit. And, I didn't pay a penny for it. It was employer-provided.

Things have changed. I'm not here to lament what my employers have done. Instead, I'm looking at the workplace in general. Pay raises except for those due to promotions tend to be barely enough to cover inflation. Pension plans have disappeared for many workers, often replaced by 401(k) plans that may provide for an adequate retirement, but only if the worker contributes perhaps 8% to 12% of his or her pay annually. Health care benefits continually get cut back (higher deductibles, higher co-pays) while the employee pays a larger percentage of the total cost. How about other perqs that workers used to get? Company cars? Largely gone. Lots of employee get-togethers? Largely gone.

The fact is that the deal has changed. For many, if not most, there appears no way to keep up with inflation. The 90s that had stock options that made many wealthy are gone. For those that didn't have that experience, maybe you won't have your parents' retirement.

All I can tell you is to save early and save often. Maybe you'll get to retire someday.

The RFP Process -- Full Disclosure or Not?

Some people send out lots of requests for proposals whether it's in their business life or in their personal life. Others respond to a lot of them. Recently, I was in that first category for a change, but far more often, I am one of the people responding to a request for proposal (RFP).

My most recent endeavor in requesting a proposal was in my personal life. My wife and I needed to engage a painting contractor for our home. We sought bids from several firms.

In each case, we told the salesperson or proprietor what type of paint we planned to use. In this case, it was a particularly high end paint that is designed to last, even in the hot and humid Atlanta weather where torrential summer thunderstorms are the norm. A keen observer should have learned something from that. We also told each potential bidder which contractors we were talking to. In my opinion, the smartest contractors took the opportunity to compare and contrast their own services with those of their competitors. Obviously, they slanted the analysis in their own favor, but we learned things about each potential vendor in the process that we would not have learned had we not been honest and open on our side.

I also get my fair share of RFPs that I have to respond to. Usually, I will ask for a lot of information. I want to know who I am bidding against.

Why?

Here are a few reasons:

• The group of potential consultants from whom the prospect has chosen to request a proposal tells me something about the company's mindset. It may even tell me that I don't want to bid because it's clear that I have no shot at winning, but have simply received the RFP as a courtesy.
• Ultimately, if I win the bid, I want my client to be happy with the services they receive. For this to happen, it's helpful if I can compare what I have to offer to what my competitors likely have to offer. Of course, I am going to try to use this to my advantage, but my competitors can and should as well. But, from the client's standpoint, this should help them to make a better and more informed choice of consultants.
• I may even make a statement to the prospect to the effect that if they are looking for what I am going to refer to here as style #1, they would be best off with Consultant X, but if style #2 is a better fit for them, then we would have a very good relationship with each other.

The client wins as well. The eventual successful bidder knows things about their client up front. They don't have to burn time and money on the learning process. Because of that and because consultants will be able to make more educated selling decisions, something else important happens that is of benefit to the client.

What's that?

If the consultants who are bidding think they understand the process and really go after the opportunities that they think are the right ones, they will price them more aggressively. That's right; consultants want the work where they know they are the right fit and they will bid more aggressively.

So, with full disclosure, the consultants (or other vendors) win and the clients win. Everybody wins. Isn't that the best result?

IRS Issues First MAP-21 Guidance

Kudos to the IRS. Yes, you heard it here first, kudos to the IRS. On July 6 of this year, President Obama signed into law the Moving Ahead for Progress in the 21st Century Act, hereinafter known as MAP-21. As anyone reading this blog will know, MAP-21 contained pension funding stabilization provisions, and interpretation of and guidance related to those provisions was of extreme importance.

Yesterday (that's a 41-day time span), the IRS issued Notice 2012-55 providing us with interest rate guidance for the preceding 12 months. For those of you who are pension actuaries or who are plan sponsors of defined benefit plans, this information is critical and the speed with which it got to us was essentially unprecedented.

For those who understand the terminology, First Segment Rates under MAP-21 are currently at 5.54%, Second Segment Rates at 6.85%, and Third Segment Rates are at 7.52%. These are increases of approximately 3.5%, 1.8%, and 1.3%, respectively from reality.

For those who are unfamiliar, these provisions of MAP-21 are allowing pension plan sponsors (and their actuaries) to use ridiculously smoothed interest rates to value their liabilities. It took only six years, but among the most key provisions of the Pension Protection Act has been gutted, all in the name of decreasing tax expenditures.

Most of the popular (and unpopular) media speaks about the IRS as the Evil Empire. They can be, at times, but in this case, don't blame it on them. They did their job, and they did it quickly. It's Congress and the President who passed and signed the law.

The Accidental Fiduciary

Lots of people in business aspire to be on a corporate board of directors. It's a position of power. It's a position of prestige. You get to rub elbows with movers and shakers. Depending upon whose board it is, you may get paid a lot of money. And, you may be an accidental fiduciary in a retirement plan.

What was that? What did you say, dear blogger author person? Did you just tell me that being on a corporate board could saddle me with fiduciary responsibilities in a corporate retirement plan? Doesn't that mean that I am mutually and severally responsible for ensuring that what goes on in the plan is done in the best interests of plan participants?

How in the world did this happen?

You may recall that earlier this month I posted about the dangers of boilerplate work. Back then, I did it in the context of providers bidding low amounts to provide services and then providing you with exactly the same work product they have given to everyone else. It's not just consultants, some attorneys do this as well.

Just last week, I was speaking with an attorney friend of mine (yes, even an actuary can have an attorney friend or two). He warned me that this was going on and while I was not surprised to hear it, I was a little surprised with regard to the specific context.

And, then I saw it. With my own two eyes, aided by some pretty spectacular reading glasses, I saw it.

The Plan Committee shall be responsible for the operation of the Plan. The Board of Directors, or if so specified by the Board of Directors the Compensation Committee of said Board, shall be responsible for the selection of said Committee.

Bam! That's how a Board member can become a plan fiduciary and be legally and financially responsible for the actions of that plan committee.

Maybe being a corporate board member has some downside, too.

Senator Harkin Proposes Changes to Retirement System

As Congress approached its August recess, Senator Tom Harkin (D-IA) released a position paper entitled “The Retirement Crisis and a Plan to Solve It.” The release of the paper is notable because as the Chairman of the Senate Health, Education, Labor & Pensions (HELP) Committee, Harkin is perhaps the most influential legislator in the entire Congress with respect to qualified retirement plans. Here, I will give you an overview of Senator Harkin’s paper with some commentary. Given his position, should the Democrats retain control of the Senate and the White House, this paper likely signals a directional shift for the retirement industry.

Senator Harkin proposes two very significant changes:

• Development of Universal, Secure, and Adaptable (USA) Retirement Funds 
• Changes to the Social Security structure designed to better finance the program while providing better benefits for the lowest earners and inflation protection better geared to inflation as it affects senior citizens

USA Retirement Funds

Senator Harkin is concerned that so many Americans have essentially no retirement savings including any employer-sponsored retirement plans. The solution, as he sees it, is to give employers a choice of sponsoring their own retirement plans or putting their employees into a USA plan. Plans that are entirely voluntary for employees (401(k) without auto-enrollment or without a sufficient employer match) would not suffice as employer-sponsored. To the extent that they were to go the route of the USA plan, here are the key features as I read Harkin’s paper:

• ·         Auto-enrollment through payroll deduction
• ·         USA Retirement Funds would be professionally managed
• ·         Regions, industries, or collective bargaining agreements might have default funds
• ·         Benefits would be 100% portable
• ·         Retirement benefits would be payable as annuity with survivorship rights for beneficiaries

Senator Harkin notes in his paper that USA Retirement Funds will compete with each other keeping costs low. They will be subject to significant disclosure requirements to ensure transparency.

Social Security Changes

As we all know, the Social Security system is projected to run into a shortfall situation at some point between 20 and 40 years out depending upon which forecast we look at. Senator Harkin’s proposal is designed to address this while improving benefits for certain retirees at the same time. Here are the three key points of his proposal with respect to Social Security:

• ·         Eliminate the Social Security Wage Base (currently $110,100) so that higher earners and their employers would no longer have the phase-out of OASDI taxes. Currently, employees and their employers pay 6.2% of pay up to the Wage Base into Social Security and 1.45% of all pay into the Medicare (HI) part of the system.
• ·         The existing methods for calculating Social Security benefits use a progressive three-tier approach. Currently, 90% of a person’s Average Indexed Monthly Earnings (essentially, their average inflation-adjusted compensation over their career) up to $767 is added to two other components in calculating the benefit. Under Senator Harkin’s plan, that 90% would phase up to 105% over a 10-year period. What this would mean is that low wage earners would receive a larger benefit from the Social Security in retirement than the pay they had been receiving from their employer.

·         Today, the annual inflationary adjustment for Social Security beneficiaries is based on the increase in the Consumer Price Index for all Urban Wage Earners (CPI-W). This index would be replaced by the CPI-E, the Consumer Price Index for the Elderly which places significant emphasis on the rising costs of health care.

Leakage -- The Scourge of the 401(k)

Leakage -- it is the scourge of the 401(k). What is it? Well, it's not a really well defined term. But, in a nutshell, it's what happens to a participant's account or accounts -- their total savings -- when they have a discontinuity.

Simplified, most people are doing well until they run into some sort of hardship. Then the problems start. If they have a hardship, but they are still employed, they are likely to continue deferring, but perhaps not to the same extent. However, the news gets worse for the unemployed and the underemployed.

The Investment Company Institute (ICI) published a survey recently. They found that 63% of the unemployed who had a 401(k) account with their last employer have taken a withdrawal and 34% of the underemployed (they don't defined underemployed that I saw) have done so.

You've seen those projections. If you get your first real job when you are, say, 25 years old, and you begin deferring and you keep it at it, you'll have a wonderful nest egg by the time you reach retirement age. That's when the angels are looking down on you. But the ICI survey says that with unemployment or underemployment comes the devil known as leakage. And, these days, there just aren't that many people who will never suffer from either or from some other short-term financial hardship. It's part of the way of an extended weak economy.

Suppose we took those rosy projections starting at age 25 and running to even age 70 and looked at them. What's a reasonable rate of investment return? Many of the projections say 8% per year compounded. That means a geometric 8% rate of return. I'll bet you that you can't get a geometric 8% rate of return. If you have  gotten that this century to date, you are probably in the 99th percentile of all investors.

How do you model leakage? Consider this. Little Miss Muffet was a star student at a top school. She graduated, then got her MBA and finally took a good job at a company with a good 401(k) plan at the age of 25. She had read all the articles and began to save in earnest in her 401(k) plan. Uh, oh, Little's employer ran into some business hardships. They had to do a layoff and Little's number came up. She had a house with a mortgage. She had a car payment, and even though she had put aside a bit of a nestegg, the job market was tough. Little Miss Muffet had no alternative but to withdraw her money from her 401(k) plan.

Leakage!

Muffet was now 30 years old. Finally, she got another job, but remember those projections where you start saving at age 25. She can't go back to 25. And, while she got another job, she was desperate and it's not as good a job as she had at age 25.

So, you tell me how Little Miss Muffet is going to overcome leakage to get to a good retirement. As I asked you yesterday, has the 401(k) system failed us? Methinks it has.

Another Viewpoint on Retirement -- Has the 401(k) System Failed?

Our Ridiculous Approach to Retirement - NYTimes.com

Last Sunday, Theresa Ghilarducci, a career retirement policy person and now Professor of Economics at the New School for Social Research wrote this interesting piece for the New York Times. In it, Ms. Ghilarducci's penultimate paragraph reads as follows:

It is now more than 30 years since the 401(k)/Individual Retirement Account model appeared on the scene. This do-it-yourself pension system has failed. It has failed because it expects individuals without expertise to reap the same results as professional investors and money managers. What results would you expect if you were to pull your own teeth or do your own electrical wiring?

In the article, she makes some very interesting points. Most people underestimate what they need to live well in retirement. One of her observations, however, is exceedingly important and rarely raised; that is, the probability that your last dollar will run out on the day you die is essentially zero, and if we take it to the moment you die, that probability, for the math geeks out there, is approximately epsilon (for you non-math geeks, that means it's not going to happen).

Put differently, this implies that you need to have more money in savings than you will need. But, all this is based on life expectancy. That's a median. Fully half the population will outlive that median. So, they need more. Do you know if you are part of that half? By how much will you outlive that life expectancy? Don't know that either, do you?

Clearly, the solution lies in lifetime income options, preferably with inflation protection. Where can you find that? It's tough. You can take your assets and find an annuity salesperson who will sell you such a product, although there aren't many such products around. And, given that there aren't many products, they are not priced fairly to the consumer. Then, there is the in-plan lifetime income option. But, I spoke to representative from a large 401(k) provider the other day who said that their research suggests that neither plan sponsors nor their employers currently want them.

So, how do you get lifetime income options? Defined benefit plans? You remember them, they used to be popular. Has anyone considered a low-risk (for the employer) defined benefit solution that might help to solve this problem? Sadly, the law has made this very difficult. But, consider this hypothetical design:

• Cash balance style
• There is a non-elective employer "pay credit" and a matching employer pay credit on employee contributions (this is not currently allowed)
• Inflation-protected annuities as a distribution option

What do you think? I'd love your comments, pro or con, serious or even with a little humor.

What Do You Think of Those Retirement Plan Fee Disclosures You've Received

Ah, ERISA 408(b)(2). Those horrible fee disclosures. If you're a plan sponsor, you've gotten a bunch by now. What are you doing with them?

If you're like a lot of other plan sponsors, you have newly found information. You have a better idea of how much you are really paying for various services. So will everyone else.

That means that you are in the beginning of a time where you can find out just how high or low those fees are. Are you paying a lot for a high-priced firm? Are you getting the level of service that justifies those high fees? If the answer is yes and you are happy with that equation, that's great.

Suppose the answer is no. Suppose you haven't changed firms despite mediocre service and now you find out that you are paying top dollar for that mediocre service. Perhaps you haven't changed providers for a while because it's just a hassle and a little bit of fee savings just wasn't worth it. Now you learn that there are a lot of savings to be had.

Consider why you are paying so much. Perhaps you've been with the same firm for years and years and they've just been raising your fees over time ... because they could. Perhaps you are with a firm that has a lot of overhead which helps their best people to provide better service, but you're not getting that level of excellence. It might be that you are not quite in their market sweet spot and while they tell you how much they value your business, they have assigned a 2nd or 3rd tier team. You're still paying for the best they have, but you're not getting the best they have.

Does any of this resonate with you? You're not sure? You can find out now. Or, to the extent that you don't have all the data you need, you can certainly find out soon. If when you do, you're not happy, rest assured that there are plenty of firms out there that would love to work with you and charge you a reasonable level of fees.

Think about it. You have a fiduciary responsibility under ERISA.

Boilerplate Burns -- Why The Low Bidder May Not be the Right One

How do you choose your consultants? Your attorneys? Your accountants? Your other advisers? Price matters, doesn't it? In fact, if you are in the public sector, price is likely the single most important component in your buying decision.

Now put yourself on the other side of the equation. Suppose you are the potential vendor, be it consultant, attorney, accountant, or other adviser. You understand the importance of price in your potential client's buying decision. Therefore, you strive to make one of the lowest bids. Now that you have made that low bid and gotten the work, how are you ever going to make money on the assignment?

Frequently, the answer lies in the dreaded boilerplate. If your prefer, pull something off the shelf. For those of you who abhor consultant-speak, what I'm saying is that the consultant will re-use a document that was already used for another client. Or, worse yet, that consultant will provide you with the same solution that they or a colleague used for another client.

Why would they do this? It saves money. Suppose you have two possible ways to produce a presentation. In the first method, you think long and hard about your client and about your assignment and develop a document that is customized to your client. In the second method, you use one that you used six months ago and change a bullet point here or there to justify your assignment. Which do you think costs more?

Which delivers a better value to your client?

In most cases, I think that the customized solution is the winner from a value standpoint. No two sets of circumstances are the same. And, it's rare that a well-done assignment has cost anywhere near the value of what the vendor is consulting on.

I remember a scandal at one of the large consulting firms back in about 1994 or 1995. It broke when someone internally notified the Wall Street Journal that its consultants in a particular practice were delivering the same work product (with just minor modifications) to every client. It made front page news. If you were on the client side and you hired that firm because the price was right, do you think it was a wise buying decision?

How about the law firm that gave you the lowest bid on drafting plan documents? Don't you think that they have a template that they start from? Suppose what you need is a creative solution and that solution doesn't fit the template? Will the attorney advise you to stick with a solution that fits the template? Or, will they work with you despite their low bid?

Finally, I consider M&A due diligence. That's the process during which a company uses many of its internal resources and engages many outsiders as well at significant expense to ensure that there are no gotchas (at least none for which they are not reasonably compensated) in the company they are buying. How would you choose someone to help you with that process?

To help answer, consider a home buying decision. In some regards, that is like a corporate acquisition. You are negotiating a deal and you are hoping nothing is wrong. To assist you in ensuring that nothing is wrong, you probably engage a home inspector. In the process of deciding which inspector to use, you have some key questions that you want to ask each prospective home inspector.

While not quite a question, here is one that I personally like: "Tell me about deals that you have killed in your home inspection career."

Killing deals takes guts. It doesn't necessarily make either party happy. But, that person is much more likely worth their fee, even if they are not the low bidder.

Distribution Dilemma in Times of Tax Uncertainty

Recently, I was speaking with a top executive at a decent-sized company. The discussion had much to do with his total compensation, but paramount in his mind was his distribution from his nonqualified defined benefit plan (SERP). You see, due to Code Section 409A and its ties that bind, executives with meaningful amounts of deferred compensation are stuck in a guessing game (more about that later).

409A was added to the Code by the American Jobs Creation Act of 2004 (a misnomer if there has ever been one). It came to be in the wake of the Enron and WorldCom scandals and was put in place to ensure that plans typically limited to management and executives would provide participants with treatment that was no better than that available to participants in qualified plans. For purposes of this discussion, paramount among the restrictions on nonqualified deferred compensation intended to achieve these goals were these (simplifying somewhat):

• Prior to the year in which compensation is deferred, participants must elect both the timing and form of their distribution.
• To the extent that participant wishes to changes his distribution option(s) with respect to money already deferred, he must make that change at least one year prior to the date that distribution would have occurred, AND postpone that distribution by at least 5 years.
• Failure to comply results in significant penalties.

Consider this scenario. You were fortunate enough to be a participant in a SERP. Then, 409A came along and you had to make your "initial deferral election" in that SERP. You didn't know what to do, but you sure liked the idea of the security and favorable conditions underlying a lump sum distribution. Your fellow executives did as well.

That was prior to late 2007. The economy was booming. Smart money was saying that Bush Era tax cuts (put in place by EGTRRA in 2001, but set to expire by the end of 2012) would certainly be extended.

Oops, wrong guess.

There's no way to be sure what's going to happen to the tax rates for the highest earners. But, there is certainly a good possibility that they are going to increase. And, there might be surtaxes for those with
ultra-high (undefined term, but you know what I am talking about) income in any given year. And, you as this executive expecting a lump sum distribution from your SERP would no doubt realize how hard you were going to get hit by this.

What's going through your mind if you remember having made your initial deferral election is that perhaps you should have made a different one. Who knew? Did you think about it that carefully?

I took a highly unscientific poll of people currently in plans subject to 409A. I asked them about their initial deferral elections. Had we been in person rather than over the phone, I expect that I would have gotten funny looks had I used that specific term. But, over the phone, I was able to explain and not see the looks in their eyes. In any event, here are the results of that poll:

• 11 of the 15 had no say in their initial deferral election; it was foist upon them by HR who said that they had made their decision for them based on legal and or accounting advice.
• 9 of the 15 didn't know what the rules were around changes.
• 13 of the 15 have a DB and or DC SERP in which they are scheduled to take a lump sum distribution.
• Given the current economic and tax climate, of those 13, 12 would like to take a different form of distribution.
• Of those 12, 11 said that back when they made their 409A initial deferral election, had they truly understood what they were doing, they would have made a different initial deferral election.

Choosing that distribution option well in advance sure does create a dilemma. There are certainly options, but more people than not don't seem to understand this.

Pension Funding Relief On the Way?

While the Supreme Court was front and center making the big news of the day and the House of Representatives was busy finding Attorney General Eric Holder in contempt, the US Senate appears to have come to an agreement on a bill that would provide for more highway funding and for a better deal for students and prior students on student loans.

I know, what does this have to do with pension funding. Well, leave it to your Congress, because when they do stuff like this, I deny any linkage to them. Buried not so deep in this bill is so-called pension funding stabilization. You remember the pension reform law to end all pension reforms, the disastrous Pension Protection Act of 2006 (PPA), don't you? Well, it hasn't ended pension funding reforms yet and it doesn't look like it's close to doing so.

So, what is pension funding stabilization? Well, in a nutshell, PPA was supposed to do all of these things:

• Force companies to use current (or almost current) discount rates to value their liabilities
• Provide incentives for companies to get their plans better funded
• Get all plans essentially fully funded on a mark-to-market basis within 7 years

That was 2006. Things were rosy. The economy was booming. Interest rates were very low, but surely they were going to get at least a little bit higher.

Find the flux capacitor, Doc Brown. Where's the DeLorean? Let's go back to the future.

A few things have happened since 2006, including various types of pension funding reform. But, they haven't been enough. And, now, Congress in its infinite wisdom is working on legislation that, in my humble opinion, is very wrong.

Before I explain why it's wrong, let's look at the key provision of pension funding stabilization. Currently, companies (and their actuaries) in performing their pension funding calculations get to use an average of rates over the last 24 months. While this isn't quite a spot rate, rates have been in the same general range over the last 24 months, so it's far from abhorrent. And, putting in market-based funding was a cornerstone of PPA. 

Nearly six years after PPA's passage, however, we are in for a change. Should the bill become law, companies will get to average their rates over 25 years. That's a lot of years. 25 years ago was 1987. Rates on 30-year Treasuries, were, if memory serves me (because I am writing this remotely and am not in a position to look it up), in excess of 9% (for at least part of the year). What does 9% have to do with prevailing interest rates today? In fact, even if you believe that pension liabilities should be discounted at an expected long-term rate of return on plan assets, where can you get a consistent return of 9% these days?

If Congress wants to give pension funding relief, the way to do it is to still make companies pay for the cost of current year accruals, but let them pay off their unfunded liabilities on a basis slower than seven years. Instead, they are going to get to full funding on a basis that makes no sense.

Why is Congress doing this? Funding highway improvements and student loan writeoffs takes money. Pension contributions generally result in corporate tax deductions. So, the pension funding stabilization gets scored as a revenue raiser because the asinine rules of Congress look at only 10 years. As you and I know, the cost of a pension is the cost of a pension and no silly rules can change that. This means that those tax deductions are merely deferred. So, in reality, the government is once again spending money on stuff it has no way to pay for. 

Stupid bill!

Yes, stupid bill.

Much Ado About a Tax

The arguments among the cognoscenti have been going on for months. Does the Patient Protection and Affordable Care Act (PPACA or ObamaCare) violate the United States Constitution?

The arguments that I heard most frequently centered around whether or not the Act violates the Commerce Clause or the Necessary and Proper Clause.

Attorneys, especially those who practice constitutional law are far more versed in these subjects than I, but they are also far more versed than most of my readers. So, when they refer to Ayotte v Planned Parenthood or to Hooper v California, many eyes will glaze over. This is intended for those glazing eyes.

For those lay people who want to know what happened, here you go. Note: I have no formal legal training and I do not practice law.

Article 1, Section 8 of the Constitution discusses the powers given to Congress. Among them are the right to regulate commerce among the several states. Many argued that this would be the point on which the constitutionality of PPACA would turn. And, most of the experts seemed to believe that forcing an individual to make a purchase was beyond the scope of the Commerce Clause. The Supreme Court agreed.

Article 1, Section 8 also contains the so-called Necessary and Proper Clause whereby Congress has the power to make all laws which shall be necessary and proper for carrying into execution the other powers granted by Article 1, Section 8. Since there was nothing in that section which needed to be executed, the Necessary and Proper Clause did not apply.

Some may recall that the Obama Administration had pledged that those families earning less than $250,000 per year would not see a tax increase. Therefore, the amount that individuals who choose to remain uninsured would pay was written as a penalty, not as a tax.

But, and now for the legalese. the Court through the decision handed down by Chief Justice Roberts, looked to Hooper v California, which says in pertinent part that "every reasonable construction must be resorted to in order to save a statute from unconstitutionality." In English, that means that if there is any way to find a law to be constitutional, then that way should be found.

So, the Supreme Court labeled the penalty to be a tax. And, the first clause of Article 1, Section 8 begins that '[T]he Congress shall have the power to lay and collect taxes ..." So, to the extent that the penalty is, in fact, a tax, Congress was within its constitutional powers to impose said tax.

Much of the law becomes effective in 2014. Of course, we have a major election coming in November and its anyone's guess as to what this will do to the inhabitants of the White House and the Capitol building. If there are big changes, we could see changes to the law. If not, then this law will stand at the very least through 2016.

Newspeople Can't Figure Out What The Supreme Court Said

More later, but CNN has reported that the individual mandate in PPACA has been struck down and that the entire law has been upheld.

Who knows?

More later.

GASB Improves Public Pension Plan Accounting and Disclosures

Yesterday, the Governmental Accounting Standards Board (GASB) approved  two new standards  related to accounting and disclosure for public retirement plans. GASB 67 will change the plan level reporting and disclosure while GASB 68 will change the employer level reporting. This comes after much debate and public controversy as the media has had many a field day trumpeting the cumulative underfunding of public pension plans.

Statement 67, according to the GASB press release, enhances note disclosures and required supplementary information for public defined benefit and defined contribution plans. Among the new requirements are annual money-weighted rates of return and 10-year supplemental information schedules.

Here I warn the reader, particularly the unknowing one, about the value of the new requirement as compared to the cost of providing it. Any of these 10-year projections will be supplied by actuaries. Actuaries, as a group, are smart people. I am proud to say that I am an actuary. So, to be sure, I am not denigrating my profession here.

However, when an actuary presents various measures of plan liabilities and forecasts of future costs to a plan sponsor, be it a public sponsor or a private one, one thing we are sure of is that the numbers are not perfect. What they are is a best estimate based upon a set of actuarial assumptions and methods. Based upon our experience and training, our estimates will likely be better than yours, but the likelihood that the plan liability that we calculate will be a precise measure of the present value of benefits accrued to date is essentially nil.

So, consider what happens when, even with our level of training and experience, instead of looking one year into the future, we look ten years into the future. I don't know anyone who knows what will happen to the economy over the next ten years. The last 10 years or so illustrate this well. Suppose I had asked you on June 26, 2002 whether interest rates would increase, decrease, or stay relatively steady over the next 10 years. What would you have said? Well, in July 2002, I did ask that question to a group of roughly 100 professional asset managers. As a group, these people were pretty savvy about the economy. About half a dozen of them thought that rates would stay relatively steady over the next ten years; the remainder thought they would increase and most thought they would increase significantly.

Statement 68 makes three significant changes to accounting for public pensions:

• Projections of benefit payments will now include assumed projections of pay increases, projection of service credits, projections of automatic cost-of-living adjustments (COLAs) and projections of ad hoc COLAs if those ad hoc COLAs are nearly automatic. Over time, a meaningful number of public employers have kept their reported liabilities down by providing annual ad hoc COLAs rather than automatic ones. While they were essentially the same, the reporting for them was very different, but no more.
• Perhaps the single most key actuarial assumption used in calculating a pension liability is the discount rate. Statement 68 will allow generally well-funded public pensions (there aren't too many of them right now, but they do exist) to use an expected long-term rate of return on assets to discount the liabilities so long as the assets are invested in such a way as to reasonably expect that rate of return to be achieved. Plans that do not meet the criteria to use a long-term rate of return must use what is essentially a risk-free rate for governmental entities -- a yield or index rate on 20-year AA or higher-rated municipal bonds.
• Finally, plans are to be valued using an entry age [normal] actuarial cost method. To the extent that a plan is pay-related, this method should produce roughly a level percentage of pay annual cost. If the plan is not pay-related, the method should produce roughly a level dollar amount annual cost. To my mind, this is a significant improvement and a step that other rule-setting bodies including the United States Congress should [have taken] take a lesson from.

What will this ultimately do for public pensions? I suspect that we will see a better picture of the levels of underfunding of public pension plans, but will not unfairly punish those that have been funded responsibly. The new standards are not perfect, but in my opinion, this is a step in the right direction.

Compensation Risk

I was reading Mike Melbinger's blog today about compensation risk assessments (if you want to read online legal analysis of compensation issues, I strongly recommend his blog) and I got to thinking that oftentimes, the people who may be assisting clients with this assessment may not know much about risk. You see, in evaluating compensation risk (and the SEC doesn't really tell us what that means), companies are to look at all elements of remuneration for both executives and for other employees. So, that includes things like deferred compensation which includes both qualified and nonqualified retirement plans.

I've written a lot about risk in retirement plans from the employer standpoint. How much cost variability is there? Does this benefit properly align with corporate goals? In an enterprise risk framework, where do these plans fit in? Is there compliance risk? Is there risk associated with having retirement benefits that are so large that you can't get employees to leave when you'd like them to? Is there risk associated with not having a defined benefit plan when some of your competitors for talent have them?

That last question is confusing, isn't it?. But, think about it. Defined benefit plans to favor older workers, not because they are discriminatory, but because of the shorter discount period until retirement date. So, if you sponsor a generous 401(k) plan and your top competitor sponsors a generous defined benefit plan, then a knowing employee might work for you until they get to be about 45 and then just when they really know the business, take off to your competitor who has a generous defined benefit program. It just makes sense.

So, compensation risk isn't only what you probably think it is. If you want to do a really thorough analysis and consider all of your rewards programs, consider people who have sufficient expertise to help you through the process. You might just learn something about your programs that you hadn't thought of before. And, it might be really useful.

Tunnel Vision Doesn't Always Work

I've been a consultant for a long time now. While I probably don't read as much of it as I once did, I still read a lot of IRS guidance (I know, that makes me a boring person, but somebody has to do it). In fact, in this business, a lot of us read a lot of IRS guidance, so I guess we are all boring people. But, the point of this post has nothing to do with being boring, it's about solving problems.

You see, lots of IRS guidance is extremely complex. So, there are two ways of reading that guidance -- you can either know the 20% that applies to 80% of the problems, or you can learn the other 80% as well that might apply to the other 20% of the problems.

We get accustomed to solving problems using that first 20% and that's what I am referring to as that tunnel vision. But, for those of us who have learned the rest of the guidance, sometimes we have to look outside that tunnel for a solution.

I've faced such a situation in the last day or two and for obvious reasons, I can't disclose the details. But, without going into any detail, I'll provide an overview.

Client X is reviewing certain of its benefits and compensation programs. They have a very specific problem and they have a pretty good idea what the optimal solution looks like. So, I went back to the law and thought about what its original purpose was. From there, I concluded that if the regulations matched at all with that original intent, then while we might not hit the optimal solution, there should be a big improvement.

Voila, there in the regulations, it looks like there was an answer. But, it wasn't in the 20% that lots of people know. It was in the other 80%. In fact, it was buried about as deeply in the other 80% as one could put it.

Not all of us take the time to read and understand the other 80%. But, if you do, you might as well take the opportunity to use that additional expertise. Perhaps we might say it's where we get by taking a different route -- outside of the tunnel.

401(k) 3.0?

Mark Iwry (pronounced eevry) gave a speech at the 2012 PLANSPONSOR National Conference in Chicago. I wasn't there, so I am taking PLANSPONSOR's reporting on it as the gospel. Mr. Iwry apparently spoke on the topic of version 3.0 of 401(k) plans.

Before discussing Mr. Iwry's recommendations, I think it's appropriate to provide a little of his impressive resume for those who don't know. Currently, he is senior adviser to the secretary and deputy assistant secretary (retirement and health policy), U.S. Department of Treasury. If you were unable to work it out from the title, that means he is a policy adviser for the federal government. Previous to that, he has been a Principal with the Retirement Security Project, a Senior Fellow with the Brookings Institution, and Counsel with the Department of Treasury. The two roles previous to his current one were related as the Retirement Security Project appears to be a part of the Brookings Institution.

This c.v. would seem to establish that Mr. Iwry is an intelligent man. He has spent a career working in positions in the government and in think tanks that require significant intellect. But, note something that is missing in Mr. Iwry's resume -- he appears to have never been employed by a traditional corporate entity. None of his employers have been focused on profits.

According to the PLANSPONSOR summary, Mr. Iwry laid out five ideas as part of 401(k) version 3.0:

1. Increase the use of automatic enrollment and do it at higher levels than 3% [presumably through automatic escalation]. Use automatic enrollment for existing employees as well as new ones.
2. Stretch the match by doing something like providing a 33 cents on the dollar match on the first 10% of pay deferred instead of a more traditional 50 cents on the first 6%.
3. Give lower-paid employees a higher rate of match.
4. Decrease the eligibility waiting period, or at least decrease it for employee deferrals.
5. Accept rollovers from other plans.

You see, there is a reason that I laid out Mr. Iwry's resume. While any of these ideas might improve the ability of our workforce, taken as a whole to retire, most have another side of the proverbial coin.

Automatic enrollment works really well in some cases. However, I have looked at a lot of 401(k) data. Two things have jumped out to my eyes with plans that use automatic enrollment:

• New employees tend to defer at the automatic rate.
• When automatic enrollment is forced on existing employees, a large number wind up decreasing their deferrals, because they simply do not read their communications from HR and they get-auto-enrolled at levels lower than those at which they were deferring.

Mr. Iwry's second idea may have a lot of merit. In fact, I blogged about it more than 18 months ago. In that post, I discussed a Principal survey based on their client base. It suggested that changing from a match of dollar for dollar on the first 2% deferred to a match of 25 cents on the dollar for the first 8% deferred tended to cost the employer less, but left employees better prepared for retirement. I would love to see similar data prepared by other 401(k) recordkeepers to see if it holds true across a broader universe. 

The third idea is nice. Theoretically, it's nice. Many companies would tell you, however, that it does not make business sense to do this. In fact, I called a corporate Vice President of Human Resources while I was working on this post. He told me, under promise of anonymity, that this is a nice idea, but makes no practical sense. He went on that that there are two ways to accomplish this -- either increase the match for lower-paid employees which cost more money, or cut the match for high-paid employees which hurts morale among the producers.

In my experience, many companies that have a waiting period for a particular benefit do it for one of three reasons:

• It's expensive to set up a record for someone who may not be around for long.
• It's a waste of money to provide a benefit to someone who may not be around for long (yes, I know that they can put a vesting schedule on a match).
• They have so many new employees who don't last long that the increased level of paperwork would overburden HR.

Accepting rollover contributions seems to be a no-brainer. For plans of any meaningful size, the only reason not to do it is the additional fees that a plan might be paying on the additional asset base. But, there is an answer to this. Negotiate up front that this won't cost extra money. If you can't negotiate it out, decide if you can live with the extra cost.

However, 401(k) 3.0? These are not a bunch of revolutionary ideas. There is nothing in here about investments. There is nothing in here about lifetime income options. It just doesn't seem that new.

Hard or Soft?

I'm going to make this a fairly short post. At least, I think I am.

Hard or soft? I can think of lots of connotations for those two, but I won't go into all of them. What I am really worried about here is the distinction between hard costs and soft costs.

What's that? Let's consider an example of where the soft costs may outweigh the hard costs. But, first, let's define hard costs to be ones that go directly to the financial statements and soft costs to be ones that may affect the financial statements, but are far more difficult to quantify.

Most calculations deal with hard costs. They can usually be quantified fairly easily. Soft costs can't be handled that easily.

Suppose XYZ Company pays Really Big Strategy Firm (RBSF) to do a strategy study for them. RBSF decides that among other things, XYZ needs to cut their workforce by 15%. In their analysis, RBSF quantifies lots of things:

• Payroll costs.
• Benefits costs.
• Real estate costs.
• Infrastructure costs.
• Overhead costs.
• Many more.

However, RBSF neglects all these:

• Damage in customer relationships.
• Morale.
• Continuity.
• Brand damage.
• Many more.

It's simple. The soft things matter. Don't forget them.

Margin of Error -- What Talking Heads Don't Know

This could apply in the benefits or compensation world. Why? Because we look at lots of data. And, when we look at data, we often do sampling, whether we realize it or not.

But, this is my turn to rant. Why? Because it's been a while since I last ranted.

It is mind-boggling to me that most of the talking heads (newscasters if you prefer) on TV have college degrees, or for that matter, high school diplomas. They don't understand basic math.

From one of them today: "Scott Walker is ahead in all the polls we are seeing, but they are all within the margin of error, so the race is too close to call."

Think about it. If you take one poll and the margin of error is, say, plus or minus 5% and Walker leads by 51.8 to 48.2, then that poll is within the margin of error.

Note that the margin of error is based on the sample size not the whim of the pollster. 

Now, suppose that you have 20 polls and Walker leads in each one and in each one, his lead is near the outer limits of the margin of error. What does that tell you?

Well, the sample size has grown. If the sample size in poll #1 is n1 and the sample size in poll 2 is n2, etc, then the total sample size assuming that no single person was surveyed twice among the twenty polls is n1 + n2 + n3 + ... + n20. Ostensibly the margin of error is inversely proportional to the square root of the sample size. Or, in lay terms, every time the sample size gets multiplied by 4, the margin of error gets cut in half.

So, for simplicity, if each of n1 through n20 is 192, then the margin of error is roughly 7%. But, if there are no duplicates in the 20 populations, then the total sample size of the 20 is 3840 leading to a margin of error in the vicinity of 1.5%. 

So, if Walker is ahead by 3% in each of the 20 small polls, then each poll shows that the race is within the margin of error. However, taken together, the race is well outside the margin of error and they are predicting that Walker will win.

Duh!

Multiple Employer Plans are for Related Multiple Employers

Last Friday, the Department of Labor (DOL) released Advisory Opinion 2012-04A. I found it interesting because it related to some conversations that I had several months ago. It seems that for the last number of months, one of the very hot topics among retirement plan advisers for smaller plans has been multiple employer plans.

Someone had found a gimmick. You see, a multiple employer retirement plan is a single plan for employees of multiple employers. As a single plan, it needs one Form 5500, one plan audit, one plan document, etc. Each of those elements costs money. Split among lots of employers, that's a lot of savings.

Several of those advisers asked me about this approach. I didn't have statute or regulations in front of me, but remarked that I didn't think it passed the smell test and that government agencies would find a way to kill this idea. The downside of being a part of it if it was found to be non-compliant far exceeded the upside of the cost savings.

Guess what? The DOL Advisory Opinion found more than just failure to pass the smell test. ERISA tells us that a plan must be maintained by an employer or employee organization or both. Employer further includes a group or association of employers acting for an employer.

To break this down into lay terms, organizations in one multiple employer plan need to bear some relation to each other. The DOL found that in the instant plan, many employers bore no relationship to each other.

Bottom line, while the Advisory Opinion only carries limited weight and does not specifically affect qualification under Sections 401 and 501 of the Internal Revenue Code, be assured that Labor and Treasury read each other's pronouncements related to retirement plans.

The downside may have exceeded the upside.

Dodd-Frank Section 953(b): A Legislated Disaster

I recently wrote this article for BNA.

It is © 2012 Bloomberg Finance, LP. Originally published by Bloomberg Finance LP.  Reprinted with Permission. The opinions expressed are those of the author.

You may view the article by clicking on the link below, but you are not authorized to edit, reproduce or distribute copies of the article without the express written consent of Bloomberg Finance LP and the author.

Here is an excerpt:


In my experience, what I would describe as reactionary laws are bad laws. In other words, when Congress
runs across a particularly unforeseen problem, it has a habit of over-legislating in an effort to solve that
problem. I’m not saying that every bill that is written this way is bad, or that even among the bad bills that
the entirety of every bill is bad, but reactionary bills tend to have some horrible provisions. Perhaps this is
why we are burdened with Section 953(b) of the Dodd-Frank Wall Street Reform and Consumer Protection
Act.

The requirements of this provision seem simple enough. Each issuer [of a proxy] is to provide three
items:


You can read the full article here.