Pension Funding Relief On the Way?

While the Supreme Court was front and center making the big news of the day and the House of Representatives was busy finding Attorney General Eric Holder in contempt, the US Senate appears to have come to an agreement on a bill that would provide for more highway funding and for a better deal for students and prior students on student loans.

I know, what does this have to do with pension funding. Well, leave it to your Congress, because when they do stuff like this, I deny any linkage to them. Buried not so deep in this bill is so-called pension funding stabilization. You remember the pension reform law to end all pension reforms, the disastrous Pension Protection Act of 2006 (PPA), don't you? Well, it hasn't ended pension funding reforms yet and it doesn't look like it's close to doing so.

So, what is pension funding stabilization? Well, in a nutshell, PPA was supposed to do all of these things:

• Force companies to use current (or almost current) discount rates to value their liabilities
• Provide incentives for companies to get their plans better funded
• Get all plans essentially fully funded on a mark-to-market basis within 7 years

That was 2006. Things were rosy. The economy was booming. Interest rates were very low, but surely they were going to get at least a little bit higher.

Find the flux capacitor, Doc Brown. Where's the DeLorean? Let's go back to the future.

A few things have happened since 2006, including various types of pension funding reform. But, they haven't been enough. And, now, Congress in its infinite wisdom is working on legislation that, in my humble opinion, is very wrong.

Before I explain why it's wrong, let's look at the key provision of pension funding stabilization. Currently, companies (and their actuaries) in performing their pension funding calculations get to use an average of rates over the last 24 months. While this isn't quite a spot rate, rates have been in the same general range over the last 24 months, so it's far from abhorrent. And, putting in market-based funding was a cornerstone of PPA. 

Nearly six years after PPA's passage, however, we are in for a change. Should the bill become law, companies will get to average their rates over 25 years. That's a lot of years. 25 years ago was 1987. Rates on 30-year Treasuries, were, if memory serves me (because I am writing this remotely and am not in a position to look it up), in excess of 9% (for at least part of the year). What does 9% have to do with prevailing interest rates today? In fact, even if you believe that pension liabilities should be discounted at an expected long-term rate of return on plan assets, where can you get a consistent return of 9% these days?

If Congress wants to give pension funding relief, the way to do it is to still make companies pay for the cost of current year accruals, but let them pay off their unfunded liabilities on a basis slower than seven years. Instead, they are going to get to full funding on a basis that makes no sense.

Why is Congress doing this? Funding highway improvements and student loan writeoffs takes money. Pension contributions generally result in corporate tax deductions. So, the pension funding stabilization gets scored as a revenue raiser because the asinine rules of Congress look at only 10 years. As you and I know, the cost of a pension is the cost of a pension and no silly rules can change that. This means that those tax deductions are merely deferred. So, in reality, the government is once again spending money on stuff it has no way to pay for. 

Stupid bill!

Yes, stupid bill.

How About Paying With Debt?

If you follow proxy statements or outrageous headlines, you'll know that Timothy Cook, CEO of Apple got nearly $400 million in compensation last year (I use the word got because he didn't actually receive that much, but he did receive equity compensation with a calculated value nearly that number). The headlines have made it even worse. With the run-up in Apple stock, that $400 million in equity is now worth more than $600 million.

Is Mr. Cook worth that much to Apple and its shareholders. I doubt it. But, how does one calculate how much Mr. Cook is worth to shareholders. Is it based on the shareholder value that he adds? That would be nice, but how do you calculate that? Stern Stewart used to (maybe they still do) like the idea of compensating executives based on Economic Value Added (EVA). EVA, in my opinion, was very precise, but not very exact.

At the end of the day, we don't know the exactly right way to compensate a chief executive. It's not an exact science. Here is what we do know. Institutional Shareholder Services (ISS) and other similar proxy evaluation firms would like for executives to be paid not above the median for their peer group. They would like for an executive's incentive payouts to be tied to performance and linked to shareholder return. They would like for no component to be excessive.

That's all nice. But, here are a few facts ... got that, these are FACTS!

• Unless all peer groups are homogeneous and all CEOs within a peer group are paid at the median, some CEOs will be paid above the median of their peer group. The mathematical proof is simple, but will be left to the reader as my old math texts used to say.
• Some CEOs are better than others.
• Within a peer group, different CEOs have and should have different sets of goals.
• Some companies within a peer group will be more mature than others in their life cycle.
• No two companies within a peer group are exactly the same.

That's all nice, but where am I going with this?

Between outcries from advocacy groups, law changes pushed through Congress, and general screams from all who seem to care, executive compensation, especially for chief executives, has become very largely equity-based. That way, their compensation is tied to the returns of the owners of the company. In the case of Apple, maybe this is appropriate (maybe tends to imply maybe not as well). If you look at Apple's balance sheet, you are blown away by assets, including cash, but you don't see a company mired in debt.

That may not be representative of corporate America though. Suppose we look at a company that like many others today is mired in debt. I'm not going to pick one in particular, but if you've read this far, then I feel confident that you could. What happens if we paid the chief executive of the company partially in debt? What would this do?

When a company carries too much debt, it's credit rating tends to go down which makes the value of its debt go down. Doesn't this imply that a heavily debt-laden company should not take undue risk? (Yes, I understand that for a heavily-depressed company, the only option for survival may be to take seemingly undue risk, but that's not the point here.) Well, if the chief executive's compensation falls when he or she subjects the company to undue risk, perhaps that will be a warning to lay off the heavily leveraged bets. Under a structure like that, I can think of lots of chief executives who failed the company (and shareholders and debtholders), but ran off to retirement heaven as extraordinarily wealthy men, who wouldn't have fared so well. Perhaps their shareholders and debtholders would have done better if those chief executives had taken less risk.

I'm not saying that this is THE right way, or even part of the right way for every company, but think about it. Suppose the CEOs of all the failed banks had been paid with debt ... just suppose.

IMHO: Why Congress is the Wrong Body to Fix The Financial Crisis

Congress will never fix the financial crisis. At least, this Congress with their current rules will never fix the financial crisis. My profession could do better ... much better.

Let's consider the incredibly stupid negotiated settlement of one week ago. It raised the debt limit and allowed us to continue to prosper. Bullfeathers!

Moody's and Fitch affirmed their AAA credit ratings for the US although both (to my memory) have given us negative future outlooks. Then, Standard & Poor's came through and downgraded the US credit rating to AA+. And the President squawked. And the Republicans squawked and the Democrats squawked. Sure, S&P has a fairly recent history of mis-rating companies and various financial instruments. But, look at those mis-ratings. For the most part, they rated debt too optimistically. That is, they gave AAA ratings when B- might have been more appropriate. You can't find as many situations where they gave a B-, but AAA was justified.

What does this all have to do with actuaries, my profession? I'm getting there, hold on just a minute.

So, we had this great debt deal. It is to cut something like $2.5 trillion from the baseline budget over the next 10 years. Here is the problem. Roughly $1 trillion of that is specified and that amount is largely backloaded (meaning the cuts come toward the end of the 10-year period as compared to the beginning). The other $1.5 trillion will come from the Super-Congress, 12 hand-picked Congresspeople (Senator Reid (D-NV) picks 3, Senator McConnell (R-KY) picks 3, Rep Boehner (R-OH) picks 3, and Rep Pelosi (D-CA) picks 3) will need to get together and find the other $1.5 trillion. That is, when they get back from their vacations, they will start work on this. And, if they don't find that trillion and a half, then some pre-determined cuts (not particularly specific) will kick in.

Can you imagine running a business that way? Can you imagine running your household that way?

There is this apparently nerdy little group called the Congressional Budget Office (CBO). Each time that Congress is going to vote on a bill with financial implications, the CBO gets to score it. And, by rule, the CBO scores it over 10 years with static assumptions, compared to a baseline, and with no discounting for the time value of money.

Where are the actuaries when we need them?

Do you know how stupid the results that such a process produces can be? Consider health care reform (PPACA, if you prefer) for a moment. According to CBO estimates, it is supposed to save money. Bullfeathers! The system can be manipulated. When you start the revenue raisers in Year 1 and start the expenditures in Year 4, is the annual expenditures do not exceed roughly 1.4 times the annual savings (once the expenditures start), then the law saves money. How does that work? 10*1=10. 7*1.4=9.8. Voila, savings! Of course, Years 11 through 20 (by the same math) have expenditures of 14 and savings of 10 producing a large cost, but that's not part of the CBO forecast.

Where are the actuaries when we need them?

Suppose we gave this problem to actuaries. What would they do differently?

• They would make assumptions about things like inflation, growth in the economy, growth in savings and expenditures, discount rates.
• They would do more than a 10-year forecast (actuaries do forecasts all the time called actuarial valuations that tend to forecast costs more than 75 years into the future).
• They would use Actuarial Standards of Practice.
• Where the assumptions that were used were not those of the actuaries, but were chosen by someone else (Congress), the actuaries would disclose that fact, and would either concur with the assumptions or say which ones they did not concur with.
• To the extent that they found the assumptions chosen by Congress to be unreasonable, the actuaries would estimate the answers based on reasonable assumptions as well.
• All of these calculations would be disclosed.

Where are the actuaries when we need them?

When individuals aspire to become actuaries, they take a series of examinations. These exams are not easy. The competition is tough, and while I'm not sure what percentage of candidates passes each exam these days, 25 years ago, a number of the exams had fewer than 40% of candidates pass. That is 40% of a group that is generally considered pretty smart. And, that is on just one exam in order to get to the next one which may also pass fewer than 40% of candidates.

How about Congress? How much training does a typical Congressperson have in financial matter? Does the number ZERO come to mind? It does for me. Yet, they are the ones who are going to fix our problems, albeit using flawed methods. Bullfeathers!

Where are the actuaries when we need them?

What is the Risk-Free Rate?

For years, when looking at an expected rate of return on a pension trust, I have been asked to look at things like real rates of return, risk premiums, and the "risk-free rate." The risk-free rate has always been defined as the yield on US Treasury debt instruments, the safest investment in the world. Yesterday, the fine folks at Standard & Poor's gave a negative outlook on the US. They said that this means that there is at least a 1 in 3 chance that the United States' AAA credit rating will be downgraded within the next two years. S&P gave as its reason the potential inability of the government to get together and find a way to control the spiraling federal debt.

There remain a number of debt instruments, according to S&P, with a solid AAA rating. Interestingly, they all seem to yield more than US Treasuries. Should they become the risk-free rate? What is going on here? What is the risk-free rate?

I spoke with a few friends and acquaintances with more economic training than I. The consensus was that this was simply S&P's way of lighting a fire under Congress' and the President's collective posteriors. Surely, no US-based company can be more credit-worthy than the country in which it is domiciled. If the US economy is that weak, then how can individual companies be that strong?

As I meander back to my more customary topics, I look at the implications for pension plans. Surely, this action by S&P will cause the US borrowing rates to increase. This, in turn, would suggest that the yield on high-quality fixed income investments will increase. But, this will cause discount rates on public and corporate pension plan liabilities to increase which will decrease those liabilities and give the plans that support those liabilities better funded statuses.

What? Does that mean that this is a good thing? Are the collective state and local and pension plans really far less than $3 trillion underfunded?

It seems that this is a quandary worthy of the legendary Scotsman immortalized by the Bard of Avon: "Fair is foul, foul is fair."

In any event, this tells me that its time for the United States to employ some of the strategies that many have been preaching about at corporate levels for the last two decades. Our country is a large enterprise. Is it time for us to practice some sort of enterprise risk management? Should the Department of Homeland Security report up to the Secretary of Risk? Or is the Secretary of Risk just another name for the President?

I don't know, but perhaps it is useful food for thought.

Getting Ready for the Budget Debate

I can see it coming now. Its magnitude and its long-term effects could dwarf them all -- Lincoln-Douglas, Kennedy-Nixon, Reagan-Mondale, Bentsen-Quayle, Burr-Hamilton (well, that one was really more of a duel). I'm talking about the budget debate of 2011.

The war has started. I'm not sure just what the first shot was. Was it the failure of the 111th Congress to send a budget to the President? Was it the Tea Party forcing the more traditional Republicans to insist on cuts for the remainder of fiscal 2011? Was it Paul Ryan's (R-WI) proposal to cut roughly $6 trillion from the budget over 10 years, not leaving untouched the sacred cows known as Social Security and Medicare? Was it President Obama's proposal to similarly make some significant budget (and tax) changes, perhaps in response to the Ryan proposal?

For purposes of this post, I'm going to focus a bit on the Ryan proposal. As I read it, his proposed budget would make fairly sweeping changes to both Social Security and Medicare. With regard to Social Security, I think I'm safe. That "Fund", and I use the term loosely as it operates as nothing more than a bookkeeping entry is not in as bad shape as its younger sister, so the biggest changes appear to be set up to come in 25 year chunks. As I will be eligible for my unreduced Social Security benefit before 2025, I only need to worry about the program's ability to pay. But, for me, this will almost be found money, as I have assumed for years that I would never see a dime from Social Security (and I still may not, but that is for another day).

Medicare, on the other hand, that "Fund" is about as bankrupt as bankrupt can be. When President (Lyndon, not Andrew) Johnson signed it into law, nobody with a voice that could be heard figured that we would have the changes in health care that have occurred. Double-digit health care inflation wasn't even a nightmare, it just wasn't a possibility. Longevity improvement just wasn't a consideration. And, now look what's happened.

All of those employer-provided retiree medical plans - companies had to start accruing costs for them, and they all but disappeared. It's ok, Medicare is there. Well, for those of us not yet age 55, as I understand the Ryan budget proposal, Medicare may not be there, at least not in its current form. Yes, it needs changes, but like the rest of the people in my age cohort, I've paid a lot of money into that system, and I actually have expected, probably naively, that it would take care of a pretty good portion of my health care costs when I make it to age 65. I am beginning to feel betrayed.

It's not just me, though. For as long as I have been in this business, employer-sponsored retirement programs (including health care) have been designed with the presumption that both Social Security and Medicare will remain largely as they are. In these times of a down economy (yes, on the record, I think the economy is still down), global competition, and mark-to-market accounting fanaticism, companies are not feeling the need to provide better and more costly (to employers) health care benefits.

I'm a fan of what Congressman Ryan is trying to do. He is trying to cut runaway spending. I think it's common sense that if your goesoutas (expenditures) exceed your comeintas (revenues, generally from taxes) that you have to either cut your goesoutas or increase your comeintas or both.

Well, in round figures, the federal debt is about $14 trillion and the GDP is about $15 trillion. My very rough analysis of some graphs that I found online say that the economy is healthiest when debt as a percentage of GDP is in the range of 40% to 55%. Let's take a number in the middle, say 50%, because that makes my math easier. That would imply that we need to cut the debt by $6.5 trillion if the GDP doesn't grow. Frankly, growing at about 3% per year, it's change is not that significant to the equation.

So, let's do some math. The population of the United States is about 310 million. Cutting $6.5 trillion from the debt could be accomplished immediately if each American would be kind enough to contribute about $20,000 to Uncle Sam.

Ain't happening.

Among the people who want tax cuts, they surely don't want to see an increase. And among those who are calling for tax increases, very few are saying that those increases should start with their wallets.

So, Social Security and Medicare may truly need some huge changes. And, these changes will have a significant impact (for all the real grammarians and wordsmiths out there, I know that impact implies a physical collision, and because of that, I rarely use the word impact where affect or effect will suffice, but I feel a physical collision here) on benefit plan design and retirement income planning. And, after all, those are among the topics of this blog.

So, we'll try to keep you updated here, and occasionally attempt to both humor and educate the readership with some analysis, but in the meantime, to paraphrase President Reagan, I'm not sure that I am happy that Congressman Ryan wants to make my youth an issue in his campaign.