Friday, February 23, 2018

Are You Better Off than You Were 20 Years Ago?

Nearly 40 years ago, Ronald Reagan asked voters if they were better off than they were four years earlier. And, that was the beginning of the end for Jimmy Carter's reelection hopes. So, without trying to end anything for you, I ask if you are better off from a retirement standpoint than you were 20 years ago.

For Americans as a group, I think the answer is a clear no. Our retirement system has been broken by the momentum that has gathered around the 401(k) plan. After all, when Section 401(k) was added to the Internal Revenue Code in the Revenue Act of 1978, it was never intended to be a primary retirement vehicle. In fact, it was a throw in that even among those who were there, there doesn't seem to be much agreement on why it was thrown into the Act.

When it was, however, defined benefit (DB) pension plans were in their heyday. People who were fortunate enough to be in those plans then are now retired and an awful lot of them are living very well in retirement. On the other hand, people who are now retiring having been in 401(k) plans only have their retirement fates scattered all over the place. Some are very well off, bit others are essentially living off of Social Security.

Let's consider where those people went wrong. For many, when they first had the opportunity to defer, they chose not to. They had bills to pay and they just couldn't make ends meet if they didn't take that current income. By the time they realized that they should have been saving all along, they couldn't catch up.

For others, they were doing well until they lost a job. Where could they get current income? They took a 401(k) distribution.

Yes, I am very well aware that the models show that people who are auto-enrolled and auto-escalated in a 401(k) plan with a safe harbor match will fare quite well. Those models all assume no disruptions and constant returns on account balances of usually around 7%.

Let's return to reality. The reality is that young workers are (likely because of all the campaigns telling them to do so) deferring liberally when they start in the workforce. The problem is, and I get this anecdotally from young workers, that more of them than not reach a point where they just can't defer at those levels any more. They get married, buy a house, and have kids, and the financial equation doesn't work. So, they cut back on deferrals. I know a number who have gutted one or more of their 401(k) plans in order to buy a house. The fact is that it's not easy to defer, for example, 10% of your pay into your 401(k), another 5% into your health savings account (HSA), and save money for a down payment on a house.

Where were we 20 years ago? For many Americans, they were about to be getting those notices that their DB plans were getting frozen. Congress killed those DB plans. The FASB killed those DB plans.

When I got into this business in 1985, most (not all) corporate pension plans were being funded responsibly. And, this status was helped, albeit for only a year or two by the Tax Reform Act of 1986 (shortening amortization periods). One of the big keys, and this will be understood largely by actuaries, is that we had choices of actuarial cost methods. My favorite then and it would be now as well for traditional DB plans is known as the entry age normal (EAN) method. The reason for this is that under EAN, the current (or normal) cost of a plan was either a level cost per participant (for non pay-related plans) or a level percentage of payroll for pay-related plans. Put yourself in the position of a CFO -- that makes it really easy to budget for.

But Congress and the FASB knew better. In the Pension Protection Act of 1987 (often referred to OBRA 87 because it was one title of the Omnibus Budget Reconciliation Act), we had it imposed on us that we must perform a Unit Credit (another actuarial cost method) valuation for all DB plans. And, in doing that Unit Credit (UC) valuation, we were given prescribed discount rates. At about the same time (most companies adopted what was then called FAS 87 and is now part of ASC 715), DB plan sponsors also had to start doing a separate accounting valuation using the Projected Unit Credit (PUC)  (Unit Credit for non-pay related plans) actuarial cost method. Most of those sponsors found that their fees would be less if they just used these various unit credit methods for their regular valuations as well and we were off and running ... in the wrong direction.

You see, PUC generally produced lower funding requirements than EAN and the arbitrary limits on funding put in place by that second funding regime known as current liability (the UC valuation) and most DB plans had what is known as a $0 full funding limit. In other words, they could not make deductible contributions to their DB plans during much of the 1990s. And, it stayed that way until prescribed discount rates plummeted and there were a few years of investment losses.

What happened then?

CFOs balked. They had gotten used to running these plans for free. Suddenly they had to contribute to them and because the funding rules were entirely broken, the amounts that they had to contribute were volatile and unpredictable. That's a bad combination.

So, one after another, sponsors began to freeze those DB plans. And, they did it at just the time that their workers could least afford it.

For all the data and models that tell us that it should be otherwise, more people than ever before are working into their 70s, generally, in my opinion, because they have to, not because they want to. As a population, we're not better off in this regard than we were 20 years ago In fact we are far worse off.

Even for those people who did accumulate large account balances, many of them don't know how to handle that money in retirement and they don't have longevity protection.

We need a fresh start. We need funding rules that makes sense and we need a plan of the future. It shouldn't be that difficult. I'd like to think that my actuarial brethren are smart people and that they can design that cadre of plans. They'll be understandable, they'll be portable as people change jobs, they'll have lump sum options and annuity options , and they'll even have longevity insurance. They'll allow participants the ability to combine all those in, for example, taking 30% of their benefit as a lump sum, using 55% for an annuity from the plan beginning at retirement, and 15% to "buy" cost-of-living protection from the plan.

That's great, isn't it? Even most of the 535 people in Congress would probably tell you that it is.

But those same 535 people don't really understand a lick about DB plans or generally about retirement plans (there are a few exceptions, but very few). In order to get that fresh start, we need laws that will allow those designs to work.

We surely don't have them now.

Over the years, Congress has punished the many plan sponsors because of a few bad actors. If 95% of DB plans were being funded responsibly, then Congress changed the funding rules for 100% of plans to be more punitive because of the other 5%.

Isn't it time to go back to the future to get this all fixed?

Let's kill the 401(k) as a primary retirement plan and develop the plan of the future. It could be here much sooner than you think.

Friday, February 2, 2018

How Big Does Your ROI Have to Be? You Can Get It Here

Let's make believe it's 2018. Let's further make believe that the Tax Cuts and Jobs Act (TCJA) or whatever it's long-winded name turned out to be was signed into law late last year. And, let's finally make believe that you hold a corporate position where you get to weigh in on corporate investments and deployment of capital.

Just how big of a return on investment do you need to be able to project in order to pull the trigger?

8%? 10%? 12%? 15%?

For most of you, I'm guessing that I've finally surpassed or at least hit your target. You'll definitely want to read on. For those that need a bigger number, give me a chance. But, I didn't want to scare away those people who think that really big numbers are only found in Fantasyland.

For those of you that really want to get into the technical details, I'm going to refer you to an excellent piece written by my Partner, Brian Donohue. Some of you may not want to get into that level of gory detail and you just want the big picture and a summary to convince you, you've come to the right place.

First off, you need to sponsor a defined benefit (DB) pension plan. It's fine if it's of the cash balance or some other hybrid variety. So, let's suppose that you do because if you don't and you have no plans to, unless you just really love my writing or just have a strange desire to find out what you are missing out on, you can probably stop reading now.

I don't want to put this in terms of dollars because if I talk about billions and you are a $100 million company, you may not think this is for you. And, conversely, if I talk about millions and you think millions go away in rounding, you won't think it's for you. So, let's talk about units.

Suppose your DB plan is fully funded on a Schedule SB basis. In other words, your funding target and your actuarial value of assets both equal 1000. Then your minimum required contribution, generally speaking, is equal to your target normal cost, probably not a big number compared to what we are talking about here.

Despite not having to, contribute 200 units. Go ahead. Do it. Trust me. I wouldn't sell you snake oil.

Here are your benefits from having done so before September 15, 2018 (assuming calendar year plan year and tax year):

  • The 200 units are tax-deductible under Code Section 404 for 2017 when your corporate marginal tax rate was likely 35% (yes, there are unusual circumstances where they may not be or where the deductions may not be of value to you, but for most sponsors, this is the case) as compared to 21% beginning in 2018. Savings of 14% of 200=28 units.
  • Your PBGC variable rate premiums may come down by as much as 8 units, But that could be as much as 8 units per year for multiple years (let's call it 5 years for sake of argument). Savings of 8 units times 5 years=40 units.
That's 68 units of savings on a 200 unit deployment of cash. That's 34%.

Now, I'm not going to claim that your ROI here is actually 34%. Yes, you will contribute these amounts more than likely in future years and when you do, you will take a tax deduction. But, you'll take it in the future (you remember time value of money) and you'll only get a 21% deduction when you do. And, yes, you may not get those full PBGC savings and some of them will be in the future, but your savings are likely to be significant.

And, then there is the other really key benefit -- your plan will now have a surplus on a funding basis meaning that you almost certainly don't have to contribute and deal with volatility of minimum required contributions in the near future.

I'd be doing you a disservice, of course, if I didn't give fair consideration to the downsides and perceived downsides of this strategy. So, I'm going to shoot straight with you.

Yes, you will have 200 units of cash tied up with no immediate means of accessing it. However, it's getting you a pretty good and rapid ROI, so in most cases, I think you'll get over that one.

Pension surplus is considered to be a bad thing. In fact, prevailing wisdom is that pension surplus is worth only pennies on the dollar. Well, sometimes prevailing wisdom shouldn't prevail.

If your DB plan is ongoing, this is just advance funding, plain and simple. It's money that you would have to contribute and the future when you could take your deductions at a 21% marginal tax rate.

If your DB plan is frozen, the argument is a little trickier. But, for most sponsors, if you do have a frozen plan, the cost to terminate is likely going to exceed your funding target. In fact, it's likely to exceed your funding target by a fair amount. So, those 200 units will be put to use.

But, let's take the extreme scenario where your investments do well, interest rates rise, and those 200 units really start to look like trapped surplus. 

Do you sponsor a defined contribution (DC) plan? It may not fit your current DC strategy, but generally speaking, your DB surplus upon termination can be used to fund a "qualified replacement plan" (think profit sharing or non-elective contributions) for up to seven years. So, in that case, you would be getting an advance deduction for future DC contributions.

Yes, I've simplified things and there are potential tax and legal issues here, so I leave you with this:

Nothing in here should be construed as tax or legal advice which can only be obtained from a qualified tax or legal professional. If you need tax or legal advice, you should consult such a professional. And as with any strategy of this sort, your mileage may vary.