How The SEC Got DB Plans All Wrong

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

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

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

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

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

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

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

• Total pension accrued benefit as of 12/31/2014: $1,000,000
• Total pension accrued benefit as of 12/31/2015: $1,100,000
• Actuarial present value "factor" as of 12/31/2014 using 2014 discount rates and 2014 mortality table: 11.00
• Actuarial present value "factor" as of 12/31/2015 using 2014 discount rates and 2014 mortality table: 11.50
• Actuarial present value "factor" as of 12/31/2015 using 2015 discount rates and 2015 mortality table: 12.50

So, the actuarial present value of WPE's defined benefit as of 12/31/2014 was 11*1,000,000 or $11,000,000. 

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

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

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

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

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

Who Put the Dagger in the Heart of Defined Benefit

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

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

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

Congress

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

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

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

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

PBGC

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

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

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

What happened?

The PBGC tried to commit suicide.

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

Various Economies

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

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

FASB

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

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

SEC

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

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

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

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

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

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

Identifying the Wrong Vendor

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

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

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

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

• Staffing
• Qualifications
• Experience
• Timing
• Fees
• Project methodology

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

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

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

As I see it, there were a few red flags here:

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

Now let's consider the WCDA proposal. 

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

Note the red flags:

• Most of what was in the WCDA proposal was unrelated to this assignment.
• WCDA highlighted credentials and qualifications that were irrelevant to development of an employment agreement.
• WCDA led with a reminder that it had helped to save NW money in an unrelated area.

The bad news was that NW hired WCDA. What I didn't tell you was that the closing sentence of WCDA's proposal was, " For NW, We Can Do Anything."

Well, WCDA may think they can do anything, but the fact is that they didn't understand this assignment. In the recommendations that they delivered, WCDA spent a full page explaining that they are 

• Registered Investment Advisors
• Chartered Arbitrators
• Fellows of the World Coffee Drinkers Association (there actually is a World Coffee Drinkers Association, but I chose it for the WCDA acronym)

WCDA's recommendation report was long. It needed to be to justify the level of fees. It contained lots of filler, or fluff, if you prefer. What is was short on was substance. That shouldn't come as a surprise, though, because WCDA's proposal was also short on substance.

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

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

CFO Priorities and Benefits and Compensation

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

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

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

• Precision and efficiency in cash forecasting
• Budgeting
• Balanced scorecards
• Margins
• Risk management
• Performance management

Additionally, and in many cases perhaps more important, but less relevant for this blog is cybersecurity.

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

• Health and wellness benefits
• Retirement benefits
• Other traditional welfare benefits
• Feelgood benefits
• Base pay
• Short-term incentives (bonus)
• Long-term incentives (often equity)

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

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

So, what is better?

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

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

How about compensation? 

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

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

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

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