Proxy Hysteria Coming For Companies With DB Plans

You read it here first. During the upcoming proxy season, there is going to be hysteria over the executive compensation disclosures in proxies for companies with defined benefit (DB) plans, especially those with nonqualified plans for their named executive officers (NEOs).

What's going on? As part of an NEO's compensation, filers are required to include the increase in the actuarial present value of DB plans. The actuarial present value is a discounted value of the anticipated payment stream just as it was a year earlier. While there are many assumptions that actuaries select in determining an actuarial liability, two, in particular, have changed for many companies from 12/31/2013 to 12/31/2014. One is the discount rate which will have decreased by somewhere in the neighborhood of 100 basis points and the other is the mortality assumption. Late last year, the Society of Actuaries (SOA) released its newest mortality study and many companies elected to adopt the new tables.

The effect of the change in discount rate will vary, largely on the age of the NEO in question, but it's not unreasonable to think that for most NEOs that just that discount rate change will have increased the actuarial liability attributed to them by 8%-12%. Yes, Americans are living longer. Mortality assumptions should be updated from time to time. But, for proxy purposes, the year of the update causes an additional spike in the liability attributed to the individual NEO, perhaps an additional 5% depending upon age and gender.

So consider an NEO whose 2013 compensation included $1,000,000 due to the increase in the actuarial present value of accrued pension benefits. If that person is still an NEO at the end of 2014, he or she will have had an increase in liability due to surviving one more year (interest and mortality totaling perhaps 6%), an increase due to increases in included compensation (a large bonus could have increased even 3-to-5 year average compensation by 25% (recall that in the case of a 5-year average that 2014 which was a good year for many businesses replaces 2009 which was a dismal year for many businesses)), and increases due to changes in discount rates and mortality assumptions.

So, with no changes in compensation practices, our NEO who had $1,000,000 of compensation attributable to him or her in 2013 might see that turned into an increase of $1,500,000 in 2014.

There will be outrage. Proponents of the pay ratio rule of Dodd-Frank Section 953(b) will point to these increases and say that the rank-and-file got 2%-4% increases. The media will not understand what happened. Congress, and this might be the year that it matters as the new Republican control has suggested that it will try to repeal some parts of Dodd-Frank, will not understand.

But those people who chose to read my ramblings will get it. Companies that foresee the issue can address it. It can't be solved in its entirety, but it can be managed.

I know how.

Do you?

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.

DOL Suggests Rules on Lifetime Income Illustrations

Earlier this week, the Employee Benefit Security Administration (EBSA) of the Department of Labor (DOL) released three items related lifetime income illustrations for benefit statements for defined contribution plan participants. I know, that's a mouthful. Here's what we got from them:

• An advance notice of proposed rulemaking (ANPR) under Section 105 of ERISA that gives us an idea of what future regulations might look like and to seek comments
• A "fact sheet" discussing briefly what they have done
• A lifetime income calculator using the methodology expressed as a safe harbor in the notice

For background, the Pension Protection Act of 2006 (PPA) established a requirement for annual benefit statements from qualified retirement plans. All these years later, we don't know how to do the required lifetime income illustrations.

The ANPR tells us that any set up of assumptions that we use that employ generally accepted investment theory will probably be considered reasonable. EBSA also gave us safe harbor assumptions. When push comes to shove, we expect that most sponsors (or their vendors), once the regulations become effective, will opt for simplicity and use the DOL's safe harbor assumptions.

What are they, you ask?

• Contributions continue to normal retirement age at the current (dollar amount), increased by 3% per year
• Investments return 7% per year
• Discount rate of 3%
• To convert account balances to annuities, use the interest rate on Constant Maturity 10-year T-bills
• Use a 417(e)(3) mortality assumption (for those who don't keep their noses mired in the Internal Revenue Code, this means that the mortality assumption is to be the one currently used for most pension purposes under the law)
• If you're married, you and your spouse were born on the same day ... even if you weren't
• For purposes of converting the current account balance to a lifetime income stream, payments begin immediately and you are assumed to be your current age or normal retirement age, whichever is older

To me, some of these assumptions are not bad and some are ... well, they're not not bad. Let's start at the top. For people who stay in the workforce continuously until retirement, the 3% annual increase in contributions is probably as reasonable as anything else. But, very few people stay in the workforce continuously anymore. There are all of maternity leave, paternity leave, layoffs, reductions-in-force, and then there are the companies that freeze pay or cut benefits making the 3% annual increase assumption a bit lofty.

How about investment returns of 7% per year combined with a 3% discount rate? That's a 4% real rate of return, net of expenses. Did anyone watch the Frontline special on PBS telling you how your account balances are eroded by expenses? If you did, I bet you don't think a 4% real rate of return is reasonable.

What a participant is to receive in his or her statement are four numbers:

• Current account balance on the effective date of the statement
• Projected account balance on the later of the effective date of the statement or normal retirement date
• The amount of lifetime income that could be received on the current account balance over the lifetime of the participant or joint lifetime of the participant and spouse if married
• The amount of lifetime income that could be received on the projected account balance over the lifetime of the participant or joint lifetime of the participant and spouse if married

I see several outcomes from this exercise.

• Participants will have an overly rosy view of their defined contribution plans
• Despite that, they will suddenly think that their 401(k)-only retirement program isn't very good
• Most participants will not achieve the lifetime income projections that the illustrations suggest

So, what happens?

• Just as they do with Summary Annual Reports, participants find the nearest trash can or recycling bin and insert these statements, or
• Participants read the statements and ask their generally unknowledgeable friends what they mean
• Participants go to HR and ask HR what it means
• When participants start to understand, they learn that a 401(k)-only retirement program is generally not very lucrative unless they defer far more than they are currently which they probably don't they can afford

Some will complain. Some will jump ship.

What can an employer do? An employer can say that this result is fine and move on as if nothing happened. Or, an employer can decide paternalistically that it has some responsibility here and revisit retirement design. Perhaps the answer is that old dinosaur, defined benefit. Perhaps the answer is another old dinosaur, profit sharing. Either way, both have far more flexibility in design than do 401(k) plans.

The DOL needs intelligent comments on this one. I hope it gets them.

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.