Pension Miseducation

Like many benefits and compensation professionals, I receive daily my fair share of e-mail blasts from consolidators -- those services that scour the web for tidbits to provide to their readers. Because they have tens of thousands of free subscribers, they are able to sell advertising. That's their business model, as I understand it.

This morning, I opened one of those e-mails and found this article that looked like it was worth a read. In fact, there was some interesting material in there. And then there was this:

That aphorism also suits one frustration of today's pension plan sponsors. Somehow, they have to attain lofty actuarial return goals of 7% to 8%, but the expected returns they have to draw from, for both equities and fixed income, are stuck at ground level.

Hold on a second. Lofty actuarial return goals, you say? This implies somehow that the actuaries set the target and that based on that, plan sponsors and their associated investment committees then struggle to meet that target.

This is backwards. The selection of actuarial assumptions is different for accounting and for funding. In either case, however, the actuary does not just willy-nilly pick a target return on assets assumption. For ERISA funding purposes, the law mandates the selection. For FASB (ASC) purposes, the plan sponsor selects the return on assets assumption with the advice of experts including the actuary and investment adviser for approval by auditors. To the extent that the actuary finds the assumption to fail to meet Actuarial Standards of Practice (ASOPs), the actuary is to disclose such and to provide calculations representing what the amounts would have been had the assumption met the ASOPs.

Those who do not seem to understand this take a different position. The typical process for those sponsors looks like this:

• Look at the expected return on assets assumption.
• Go to the investment adviser and tell them that they need an investment portfolio that will meet or exceed that expected return on assets assumption.

But, the sponsor owns that assumption (if it is for accounting purposes). If it's for government plan funding, usually (state and local laws differ) the sponsoring government has input into the assumption. 

If an actuary has some (or all) purview over the return on assets assumption and (s)he is doing his or her job properly, the actuary will look at the investment lineup together with a capital market model and develop a return on assets assumption commensurate with that lineup. It is not the other way around. If plan sponsors do not think that their investment lineup can return 7% to 8%, then they should lower their assumption for expected return on plan assets. Yes, this will increase their financial accounting costs (and their funding costs for governmental plans). Ultimately, the cost of a plan is what it is. The cost of paying $1 per month for the rest of an individual's life is the same, no matter the actuary.

In my personal experience, for years, many plan sponsors pressured their actuaries to use more aggressive actuarial assumptions in an effort to influence P&L and, back in the days when it mattered for funding costs, to keep required contributions down. Some actuaries agreed to do that, some did not. 

But, when a plan sponsor, including a state or local government, chooses a high expected return on assets assumption, usually to manage short-term costs, that they are unable to find a suite of investments to generate that expected return is not the actuary's fault. Place blame where it belongs.

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.

Be Careful With COLI

Most of you are familiar with it. If you've ever been in corporate HR or Finance, someone has undoubtedly tried to sell it to you. It can look like the greatest thing since sliced bread, and frankly, before 1986, it probably was, but corporate-owned life insurance, commonly referred to as COLI, is not the be all and end all.

It has its uses. I have recommended in favor of it and I have recommended against it. But, understand that I have never sold it. I am not licensed to sell insurance products. I never have been. That makes me relatively agnostic to COLI. I don't make money from its sale. The work that I have done and do with respect to COLI is either analysis of its merits or performance, or helping a client unwind it if they decide they don't like it.

So, why am I writing this? While I have no insurance credentials, I do have a bunch of actuarial credentials. As such, I am held to a whole set of professional standards. They start with the Code of Conduct and include adherence to a set of Actuarial Standards of Practice (ASOPs). While adherence to all of this can feel annoying at times, I fully support that my profession has adopted this framework. If only all of the other professions that we deal with had as stringent a framework, in my opinion, the benefits world would be a more honest and straightforward place.

Let's go back to COLI. I looked at a COLI illustration this morning. It was based on a Variable Universal Life (VUL) product. Note the variable part. That means that the product invests typically in a mixture of equity and fixed income instruments, usually chosen (all or in part) by the policyholder. So, like a defined benefit trust or defined contribution account, it has a return of return that is closely linked to the rates of return on those instruments (there are often charges and or loads).

What was alarming? The cash value seemed to be building up really quickly. I did some analysis. The agent who produced those illustrations chose to assume a 10% rate of return inside the policy. I checked. That is legal in his state. It is in many states. But, as an actuary who has to make similar assumptions for defined benefit trusts, I would tell you that it's not reasonable. In fact, if I put in writing today in a Statement of Actuarial Opinion that a 10% rate were reasonable, I would expect to be reported to my profession's disciplinary body.

You know what, if you can get tax-favored asset build-up that has a geometric mean 10% long-term rate of return guaranteed, you should put all the money that you can afford to into the underlying instrument. And, you had better tell me about it so that I can invest in it as well. It's just not feasible, it's not reality, but it was in an illustration presented by an agent to a prospect.

So, the message is this. COLI has its uses. It has its purposes. But, the guy who has the goal of selling you COLI is not going to be unbiased, no matter how hard he tries to convince you. If you can do the analysis yourself, do it. Find out if the COLI product is, in fact, good for your company. If you can't, then find an unbiased third party to do it. And, if either you or a third party find that the illustrator thinks he can get you a 10% annual rate of return, run away from it as fast as you can.