If CFOs Are Worried About Benefit Costs, Why Are They Leaving Avoidable Pension Costs on the Table?

This morning's lead article in the Wall Street Journal's CFO Journal says that CFOs are concerned about benefit costs. This was not at all surprising to me. What is surprising though is how much they are leaving on the table relative to defined benefit pension plans, often frozen legacy plans.

Let's start out with some background. 40 years ago, most large companies in the US provided defined benefit (DB) pensions for large parts of their workforce. This was, of course, before the 401(k) gave us the perhaps misguided self-sufficiency explosion. Over time, many of those employers froze those DB plans (meaning no new participants and those in the plan get no further accruals) and some terminated them. But, there remain a lot of frozen DB plans that remain in what some call hibernation. I call it lingering death.

That lingering death seems to go on interminably. And, there are reasons that happens. Freeze the plan and it becomes out of sight, out of mind. Not to overdo the cliches, but they go into a set it and forget it mode.

But, set it and forget it with a legacy pension may not work so well. Research by October Three has shown that many of these plans have what might be termed overhead or frictional costs exceeding 1% of plan assets. That means that for a not atypical frozen plan that the long-term cost of that plan -- unless the sponsor is willing to fund it sufficiently to terminate it may be 10-15% higher than if those frictional costs were entirely eliminated. (Understand that it is impossible to eliminate all of those frictional costs, but most can often be eliminated.)

How does this happen? Nobody is paying attention. There's nobody on staff focused on efficiency in that frozen plan. The last person doing that went away a few months after the plan was frozen. So, now, a typical company with a, for example, $50 million frozen plan may be spending more than half a million dollars per year on that plan unnecessarily. 

Suppose the company assigned one professional to that plan. Suppose they made that plan half of that person's responsibility, at least until the plan is terminated. And, suppose they pay that person $200,000 per year. Let's add in another 25% for additional employment costs and we're up to $250,000. Then, this company is eliminating more costs than it is incurring and in doing so, they are getting rid of perhaps an unnecessary headache.

The last obstacle is figuring out what this person should focus on. And, since they probably have not been focused on pensions, they may not know. However, there is a good chance that they are paying a lot of money for consulting that is not focused on their needs. Or, the consulting might be excellent, but the company's lack of focus causes them to ignore it.

Either way, this is something to consider and if they're not sure, I know someone who can guide them down the right path.

Cookie Cutter Doesn't Cut It

I was on the phone with a sophisticated client a few days ago. She remarked that the solution she was looking at was just pulled off the shelf and could equally apply to any [company]. She said that was bad consulting. I have to agree. Thankfully, that consulting was not ours.

When I started in the business, back in prehistoric times, the modus operandi that many of us were introduced to included answer the phone, do the work, record your time, and someone will bill the client for it. Complaints appeared to be limited.

Things got more complex. The booming economy in our business created by the Reagan-era bull markets and the Tax Reform Act of 1986 was a veritable full employment act for consulting actuaries. Employers of those actuaries needed all the quality staff they could find and clients needed all the support they could get.

Things changed. As processes got automated and later, as companies began to exit the business of sponsoring pension plans, this once highly valued actuarial service became more of a commodity. Whether it was true or not, consulting actuaries who could deliver actuarial valuations were viewed as being a dime a dozen.

How did the best differentiate themselves? They began to provide more and more customized solutions. They began to understand the client's business needs. There was a sudden shift in the order of necessary skills. The key ability of being able to do things was replaced in the pecking order by the ability to listen and then to thoughtfully react.

Somewhere around the same time, our society seemed to become far more litigious. The answer to many problems became finding some other party who could be found to be at fault and exacting a price from that party. Some made the observation that in response to this, there were a number of consulting firms that developed solutions that everyone should bring to each of their clients. In fact, I can recall professional friends of mine complaining that they needed to be able to "check the box' for each of their clients even if they felt as if that meant they were providing less than the optimal answer. In other words, they were being encouraged, or even required to pull the answer off the shelf or some might say, to deliver a cookie cutter solution.

Put yourself in the corporate shoes. Your adviser that you have worked with for years brings you a solution that they label best-in-class. A few days later, you find yourself at a gathering with your peers from other local companies. Alas, they have all been brought the same solution.

How is that possible? The companies aren't the same. Their plans aren't the same.

It's then that you remember that you had agreed, based on a referral, to a meeting the next day with some consultant you had never heard of. You wondered if she would try to sell you on the same best-in-class solution.

She didn't. After the initial niceties, she asked you a bunch of questions. And after each question, she listened to your answer and reacted accordingly by asking a follow-up, more probing question. She remarked that she was surprised that you weren't pursuing [pick your favorite strategy to fill in the blank] instead of the not best-in-class one that your longtime adviser had brought you.

You wanted to to business with her, didn't you?

It's Your Plan's Money They are Wasting

You're a defined benefit plan sponsor. That means that you have to hire an Enrolled Actuary (EA). No, you don't have to have one on staff, but you must have an Enrolled Actuary provide an annual actuarial valuation for the plan.

You know that your EA is providing great service and making smart decisions on your behalf, don't you?

If you are a prudent sponsor, you will periodically bid that work. In other words, you will put out a request for proposal to ensure that your current EA and his or her firm are providing you with excellent service at a fair price.

Fair is in the eye of the beholder. If what you are looking for is a cheaper price, you can almost always find one. There's usually someone out there who will do the work for less money. That doesn't necessarily mean that engaging them will be a good decision.

Suppose I pointed out to you, however, that your plan's EA was making bad decisions on your behalf. Perhaps those decisions are costing your plan more money than you are spending on the services for that EA. You probably think that can't be your plan. But, it could be.

Suppose I told you that I could educate you as to those decisions for your plan. I know, you don't have the time to give me all the information that I'll need. Well, suppose I told you that I don't need your time for that. I just want to be able show you what I've learned.

Would you be interested then?

Send me a note or call me at 770-235-8566. You'll never know unless you do.

Doing Your Due Diligence on Advisers and Actuaries

I read an interesting article this morning. In it, I read about a company that had used the same retirement plan adviser for quite a long time and developed a good relationship with them. After 13 years of this adviser assisting them with investment monitory, a fiduciary policy, and an investment policy, as well as manager searches, the company in question decided that just as part of due diligence, even though they figured there would only be about a 10% of chance of changing advisers to go through that due diligence process and bid those services out as well.

What the company, Dot Foods, found was that it was being charged perhaps more than a market competitive price and getting less than market competitive level of service. It was time for a change.

We could draw an analogy to lots of different kinds of services, but as consultants like to say, I'm going to drill down a little bit (I can't believe I used that term as hearing it always makes me hear a dentist's drill).

Let's put this in the context of a decent-sized, but not enormous defined benefit pension plan. To give some context, let's say that the plan has between $50 million and $1 billion in plan assets and let's assume that the plan is frozen (this is not an uncommon situation).

Now consider your plan advisers, particularly your actuary. Ask yourself these questions:

• How long have you been working with your current actuarial firm?
• Over that time, how many fresh ideas or analyses have they brought you with respect to your plan? When was the last time they brought you one that they didn't charge you for?
• Reflecting the fact that your plan was frozen and that some of the work behind the actuarial valuation would be much simpler, did they voluntarily reduce your actuarial fees the year after you froze your plan?
• Do you get as much attention from them as you did before your plan was frozen?
• Have they given you a strategic plan to get to termination of your plan? Or, have they just told you that interest rates are too low now and you'll have to wait it out?
• If they have given you a plan, was it provided in the context of your business or was it just their standard template?

You can pretty easily tell what the so-called best practice answers to all of these questions are. And, for your sake, I hope that after reflecting on your answers that you are able to tell yourself and your colleagues that most or all of those answers are what you would like them to be.

Suppose they're not. 

I know. You have a frozen plan and you think you are in set it and forget it mode. You don't really want to spend time both in the due diligence or RFP process to do this check and you certainly don't want to invest the time and effort that you think will be necessary during transition. 

Consider this scenario. You are able through that process to identify enough hard savings and soft savings that hiring a contractor or temporary employee to help with the transition would be a drop in the bucket in terms of cost compared to what you will be saving. During the RFP process, you get a freebie of some ideas that will help you to meet your strategic objectives with a promise of more to come. You learn that your actuary had gotten lazy and was delivering sub-optimal consulting.

Hmm ... there's an interesting term. What in the world is sub-optimal consulting? 

Sub-optimal consulting is a fancy way of saying that your actuary is just going through the motions. Everything they are providing you is correct, but none of it is the best correct answer.

I'm not implying here that your actuary should be doing anything underhanded or unethical. Quite to the contrary, your actuary should be following the law and Actuarial Standards of Practice to a tee. Oftentimes, however, within those constraints, there are a range of potential answers. Some are far more conducive to your business than others.

Consider this recent real example. A company, now a client, didn't like the news it was consistently getting from its actuary. That company didn't know if that news was the only way or if there was a better way. So, they asked. 

What they learned was that if their actuary did take the time to understand the interrelationship between their plan and their business that there was better news that they could be getting. The company came back to us and asked, "Can you save us money?" The answer was that there were hard dollar savings (fees) that would be small and other savings that would be significant. 

Perhaps you are the company that is getting great service and perhaps you maintain the plan for which everything is being done properly.

Perhaps you're not.

Suppose You Didn't Have to Ask All the Right Pension Questions

Think about it. Oftentimes, your consulting services are only as good as the questions you knew to ask. Suppose you didn't have to ask them.

I think back to some of my earlier days as a consultant. Leaving a meeting, one of my mentors said to me that I had answered all of the client's questions that they needed to have answered, but didn't know it. In other words, I delivered optimal consulting to my client.

In the actuarial consulting world, what plan sponsors are frequently encountering is something short of optimal consulting. We can refer to it as suboptimal consulting.

I'm not going to give away exactly what goes into suboptimal consulting. What I will do though is to tell you a little bit about it, how damaging it might be to not avoid it, that it can be identified, and what a better solution looks like.

To paraphrase the old TV show "Dragnet" -- the tales of suboptimal consulting you are about to encounter are true; the names have been changed to protect the innocent. And, by the way, the innocent are the clients. They have businesses to run. With the exception of those big enough to have full-time, in-house pension consultants, they can't be expected to know all this stuff on their own.

Surprisingly enough, National Widget Company (NWC) is in the business of manufacturing and distributing widgets. NWC currently sponsors two frozen pension plans. Their actuarial firm, Too Big For the Mid-Market (TBFM) has assigned a litany of what it views internally as mediocre consultants to NWC for the last 15 years or so. Here is some of what we know about this relationship.

• There have actually been six separate Enrolled Actuaries from TBFM assigned to NWC over the last 15 years. Only one of the six has ever met NWC management. None has worried about learning NWC's corporate goals, needs, or points of pain. All simply assumed that NWC was pretty much the same as the rest of TBFM's clients.
• The two NWC pension plans, in total, have about $100 million in plan assets.
• NWC pays TBFM about $250 thousand per year in actuarial fees.
• NWC has been laying out an average of slightly more than $100 thousand in cash every year (either to the plan or on behalf of the plan) that it didn't need to and for which there is no real benefit to the company or to plan participants. This is wasted money that could have been saved.

How do I know all of this? Suboptimal actuarial consulting can be identified. Deficiencies can be pointed out. Solutions can be found going forward. No, we can't turn back time, but we could ensure that NWC doesn't make the same mistakes over and over again. 

That NWC sponsors two frozen pension plans implies to me that they would like to terminate them. In other words, they'd like to get out of the pension business. Currently, however, there is no path to those plan terminations. They live in a world of hope and despair. That is, their strategy is that they hope that everything will go right and that these pension plans go away yet they are faced with the despair of knowing that this is not very likely to happen. 

Suppose NWC had a real strategy. Suppose that strategy included solutions with more upside potential and with less downside risk. Suppose every dollar that NWC spent on the plan was optimal. Suppose someone answered NWC's questions that their lack of pension expertise made them unequipped to ask. 

Are you responsible for a pension plan? Do you know if you are getting optimal actuarial consulting? Wouldn't you like to know? Wouldn't you like to get that optimal consulting?

What You Might Find in the Actuary's Bag of Tricks

As actuaries, we work a lot with attorneys. In fact, for the most part, those attorneys are what as known as ERISA attorneys, employee benefits attorneys, executive compensation attorneys, and tax attorneys. Save perhaps intellectual property attorneys/patent attorneys, the ones that we work with would be considered the geekiest by their peers. Some have quite a bit of quantitative ability. Some have actuarial training. A few are credentialed actuaries. For the most part, however, even actuaries who happen to be practicing law don't think the same way that experienced, practicing actuaries do. For their clients, that's probably a good thing as they are engaged to think as lawyers. Similarly, those practicing actuaries who happen to be attorneys as well tend to think as actuaries. And, since that is why they are engaged by their clients, that's probably a good thing as well.

Okay, John, you've written a paragraph saying that actuaries and attorneys are different people. We all know that. Who cares?

Let me illustrate with a case study where the names and numbers have been changed to protect the innocent. And, while those elements are changed, this really happened.

Two similar Fortune 1000 companies were getting ready to merge. Technically, company Y was buying Company Z (they were keeping Z's name, but keeping Y's management team, Z's shareholders would receive stock in Y, and Z's executive team would generally be the beneficiaries of golden parachutes).

The deal was to close on a Friday morning. One of my colleagues was spearheading the benefits and compensation side of due diligence. He was very good at his job, but he was not an actuary. We'll call him Eddie just so that he can have a name.

Late that Wednesday afternoon, I was contacted by Eddie. He told me about the deal he was working with and that he had run into a strange looking SERP. I'll spare you the details, but when he described it to me, it was like none I had ever encountered. He asked if I had some time to look at it which I did.

What had happened was that the old CEO of Z had had a custom-designed SERP and employment agreement and then he went and upset the apple cart -- he died completely unexpectedly. The Board knew who had been intended as the CEO's heir apparent although that was not supposed to happen for a little more than five years. With nowhere else to turn, YRS (young rising star) became the CEO. Frankly, YRS was probably a pretty good choice, but when things are done in a hurry, things can go wrong.

The SERP and employment agreement that the old CEO had had been written by counsel. Counsel said that an actuary had valued the SERP and that the company was comfortable with the costs. So, right along with the rest of the employment agreement, the YRS, the new CEO, got the same package.

The SERP itself wasn't too unusual as it turned out. But, when you integrated the SERP with the employment agreement which was necessary in the event of a change in control, the numbers just exploded.

After determining that the golden parachute payout of the SERP alone was to exceed the entire balance sheet of the merged company (that part is true without specifying numbers), talking to the Chairman of the Board of Y, and working on negotiations with YRS, I did spend some time with Y's management and counsel. I asked them as nicely as I could how they could have given YRS this package without really understanding it. I was informed that an actuary had carefully analyzed the SERP when it was written for the old CEO and he had said there was nothing wrong with it. Therefore, there should not have been a problem giving the same SERP to YRS.

But, the actuary had never seen the employment agreement. And, he had never done his analysis in the context of the employment agreement, a young CEO, and a change in control.

The attorneys in this particular case were good at their jobs. I've worked with them since and seen that. In fact, they are fairly facile quantitatively. But, they think as attorneys (as they should). They don't think as actuaries. And, that was the problem.

So, when you run into a complex quantitative situation where there might be some contingencies involved, save yourself some significant risk and find an actuary who can help.

Are You Missing Out Because Your Company Uses an actuary not an ACTUARY?

Okay, your company sponsors a defined benefit (DB) plan and you have an actuary and of course, your actuary is the best. Having been in this profession for 30 years, I've learned that most companies and their actuaries develop a mutual trust.

The reason is not as obvious as you think. How do I know that? It's because I have seen it in action. You see, actuaries produce numbers and results that most people don't understand. It seems magical. And because those numbers and results are often important to plan sponsors and the people who work for them, they develop a trust for the people who bring them those numbers.

Are those numbers correct? Almost always, they are.

So, tell us, John, what's your point? We should trust those actuaries, right?

In short, you should trust the numbers that they produce. Today, with sophisticated actuarial valuation software that is relatively uniform in the industry, most actuaries produce about the same bottom line numbers in an actuarial valuation.

So, what's the problem? It's just a commodity, isn't it?

Frankly, the problem may be in what your actuary doesn't tell you that an ACTUARY would. What I'm not being specific about here are things that would take up far too much space for this blog. But, how well do you understand the true financial effects of your plan? Are there opportunities that you are missing out on because your actuary hasn't told you? Is the problem that your actuary just hasn't thought about these things?

Honestly, it doesn't matter why you're not getting that kind of information, but just that you're not getting it.

An ACTUARY could show you what you're missing out on.

Contact me here or after January 1, contact me here.

It couldn't hurt, not even a little bit.

The Recommended Pension Contribution

For years, I have seen in many pension plan actuarial reports a line item that the actuary or the actuary's firm refers to as the "recommended contribution." When reviewing these reports, that item has always been an anomaly to me.

Sometimes, what it represents is spelled out in the report; sometimes, it's not. But, when it is seemingly well-defined, where does it come from? Many times, it is equally to the minimum required contribution under ERISA. Other times, it looks like the actuary through a dart at a sequence of numbers between that minimum required amount and the maximum amount that the plan sponsor can deduct on its corporate tax return.

I'm not saying that an actuary should not recommend a particular level of contributions. But, what I am saying is that it's not so simple. It's certainly not based on the same formula for every plan. In fact, there are lots of elements that should go into that recommendation.

This is where we might see a difference between an Enrolled Actuary who happens to label himself or herself as a consultant and an excellent consultant who is also an excellent actuary. The consultant will focus on the client's business needs in working with the client to develop a recommendation. Some very key questions to which the consultant needs to understand the answers might include these:

• Where will the money come from to make any contributions? Will they come out of free cash flow? Will the sponsor need to borrow. If so, at what rate? Will that borrowing cut into the company's borrowing limits to the point that it may encumber their ability to run their business?
• Do the potential tax deductions with respect to these contributions have value to the company? Is the company paying income taxes currently? There are a variety of reasons that it may not be. The company may not currently have positive net income. It may already have sufficient deductions to offset all of its income. Does the company have what are often referred to as NOLs or Net Operating Loss carryforwards?
• Will the company be better positioned to make contributions in excess of the minimum required amount in some future year than it is this year? Perhaps this year, the cash would be better used elsewhere, but the company's forecasts indicate that it will have free cash flow to make up its funding deficit in 2016. 
• How will any of this affect the company's risk management strategy? What sorts of risks are in that strategy?
• How will various stakeholders react to a large, but not legally required contribution?
• Will the effects on financial accounting expense (ASC 715 for those who care) matter? Sometimes, the decrease or increase in pension expense attributable to making or not making additional pension contributions (actually the return on those assets) looks like a big number. However, when we look at that change divided by the number of shares of company stock outstanding, the effect does not move the needle enough to change the company's reported earnings by share by even a penny. In other words, it goes away in the rounding.
• How about loan covenants? Oh, Ms. or Mr. Actuary, do you know about those? Does the company have any? (I'm pretty sure they do.) Do any of them relate to the pension plan? Maybe they do; maybe they don't. 

And, finally, the plan sponsor needs to act in the best interests of plan participants. While it doesn't seem likely that making any contribution to the plan at least equal to the ERISA minimum required amount would fail to meet that requirement, those interests need always be top of mind for the individual or committee making such decisions.

This is by no means an exhaustive list of the issues that the plan's actuary should consider, but it's a start. When your actuary "recommends" a contribution amount, have they made sure that they understand the answers to questions like this?

If not, perhaps we need to talk. If not me, then contact one of my colleagues.