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.

S&P Implies Hospital Pensions Are Not a Problem -- I'll Be the Judge

I read two excellent articles on the same topic recently. Both Rebecca Moore for Plan Sponsor and Jack O'Brien for Health Leaders Media wrote about an S&P study that implied that pensions are not a problem for not-for-profit hospitals in the US. I found the different perspectives interesting as Rebecca is a retirement plan journalist who was covering a hospital retirement issue while Jack is a hospital journalist who was covering a retirement issue with regard to hospitals.

In summary, here is what I learned:

• The U.S. not-for-profit health care sector has benefited from an increase in the median funded status of its pension plans in fiscal 2018—increasing from 80.6% to 85%, according to S&P Global Ratings;
• S&P measures the underlying pension liabilities using a "conservative municipal bond rate;"
• S&P applauded that many hospitals have focused on de-risking liabilities;
• S&P views the following as positive with respect to hospital pensions:
• Full funded status;
• Any sort of de-risking; and 
• No pension plan at all.

I'm not going to spend a lot of time dissecting what S&P thinks is good. As a firm, they employ many excellent economists while my formal economic training is quite sparse. But, I'd be remiss if I did not comment on the use of municipal bond rates. While they are not far from the measures typically used for corporate pension plans, I'm not sure how movement in yields on municipal bonds should affect the measurement of obligations in hospital pensions.

Let's return to the initial premise that being that hospital pensions are well-managed (I said not a problem in my title, but the words that were actually used were well-managed). Are they? Is 85% a good funded status? Are the hospitals managing frictional overhead costs? Is de-risking the right approach for a plan that is 85% funded? If so, which type(s) of de-risking should they be using?

While it's not the case for all of them, the majority of hospital pension plans are either [hard] frozen or they are soft frozen (no new entrants). This implies that the goal is to eventually terminate those plans. A plan that is 85% funded cannot be terminated. In fact, generally speaking, a plan that is 100% funded on the basis that S&P uses cannot be terminated (annuities have some level of built-in costs as compared to a traditional actuarial measurement of pension obligations). 

Getting from 85% funded to just a bit more than 100% funded is a tall task. There are a number of ways to make progress on this, some passive and some active. They include watching discount rates increase, investing more aggressively (and hoping that produces better returns), contributing more money to the plan, and cutting the overhead costs of the plan.

Let's attack those in order.

Unless a hospital has more control over the economy than I think it does, it cannot affect the yields on municipal bonds.

Investing more aggressively works well when it works well meaning that if you can beat your bogie, you improve your funded status and get closer to being able to terminate the plan.

Contributing more money to a plan is an easy concept. All it requires is having money to contribute. In 2019, hospitals, generally speaking, don't seem to have that kind of money laying around. On the other hand, hospitals do have lots of assets many of them not pulling as much weight as they might were they re-deployed into the hospital pension plan. I have some ideas in this vein, and would be happy to tell you about them.

Finally, for the last three years, October Three has published a report on PBGC premiums. The report has found that hospitals, compared to any other industry, are consistently paying more in needless PBGC premiums than any other industry. In other words, there are techniques available to them to lower those premiums that as a group, they are not using.

So, with all due respect to S&P, the judge has ruled. Hospital pension are a problem and generally speaking, hospitals are not managing those pensions well. The judge thinks those hospitals should contact him.

Do We Have A Retirement Crisis? Of Course We Do.

Do we have retirement crisis in the US? Showing my age and with apologies to Messrs. Rowan and Martin, you bet your sweet bippy we do. Despite all the pundits citing data and telling us that we don't have that problem, I'm telling you we do.

I was inspired to write this by an excellent piece that I read in Investment News this morning. The theme was that Vanguard's data shows that the average combined savings rate (employee plus employer) has increased since 2004 from 10.4% of pay to 10.6% of pay. To understand this better, let's look at what else has happened during this period.

The Pension Protection Act (PPA) of 2006 became law. Many defined benefit (DB) pension plans were frozen and or terminated. The new in vogue terms in the 401(k) world all suddenly started with auto: auto-enrollment, auto-escalation, auto-pilot. At the same time, the new fear became that of outliving your savings.

That's right, people are living longer. People know that people are living longer. This frightens many. From a retirement perspective, they don't know how to deal with this. So, the old normal (2019) cannot continue to be the new normal (beyond 2019).

Why do I say that? What's wrong with the analysis from pundits?

Suppose I told you that 55% of Americans are "on track to retire," whatever that means (every recordkeeping firm who puts out data like that has their own basis for what that does mean). Is that good news or bad news? Most who think that the 401(k)-only system is as close to nirvana as one can get would tell you it's great news. They say so on social media. They go out of their way to bash those who disagree.

Well, I disagree and here is why. I'm going to reword what they are saying taking what they say as factual. Suppose I told you that 45% of Americans are not on track to retire. How would you react to that? My intuition says that you would think that is a horrible thing. Yet, it is exactly the same thing as 55% of Americans being on track to retire.

Further, the data being used often assumes that Americans will take their 401(k) balances and draw them down ratably and prudently. Which Americans are those? They're not the Americans of 2019. They're not the ones who want the latest gadget. They're not the ones that love their Amazon Prime accounts. They're not the ones from the instant gratification world of today.

For most Americans, being able to guarantee a level of lifetime income protection is of nearly paramount importance. It's not easy in a 401(k) world. In-plan annuity options are rare and expensive. Taking a distribution to buy an annuity is even more expensive and requires an education in an industry that few Americans have access to.

Look at the generation that retired over the 25 years or so from roughly 1980 to 2005. They often have lifetime income. They may also have account-based savings. They, because they did not live in a 401(k)-only world, were able to get it right.

DB plans of the past had problems. Smart people designed better solutions, but the really [not so] smart people conspired to make us think that 401(k) only is the best solution.

It's time to visit those better solutions.

• Cost stability and predictable cost for plan sponsors.
• Lifetime income availability at actuarially fair prices for participants.
• Account growth through professionally managed assets, but with a guaranteed return of principal.
• The ability to take your account with you.

And, you can still have your 401(k) on the side to supplement it.

Doesn't this feel closer to nirvana. Isn't this a way to truly move the needle and get us out of the retirement crisis?

Surprise -- Employees Want Pensions

I read an article yesterday highlighting, as the author pointed out, that employees value benefits more than a raise. Some of the findings were predictable -- the two most important were health insurance and a 401(k) match and they were followed by paid time off. But, just barely trailing those were pension benefits with flexible work hours and the ability to work remotely far behind.

Let's put some numbers behind the ordering:

• Health insurance -- 56%
• 401(k) match -- 56%
• Paid time off -- 33%
• Pension -- 31%
• Flexible work hours -- 21%
• Working remotely -- 15%

What I found remarkable about this is that five of those six get constant attention. In today's workplace, however, as compared to one generation ago, pensions get little, if any, attention yet nearly one-third of workers would rather have pensions than a raise.

Why is this the case? Neither the survey nor the article got into any analysis as to the reasons, so I get to way in here entirely unencumbered by nasty things like facts. I get to express my opinions.

Ask a worker what they fear. I think they will tell you that two of their biggest fears are losing their health and outliving their savings. The second, of course, can be mitigated by guaranteed lifetime income.

Workers are beginning to realize that 401(k) plans are exactly what Congress intended them to be -- supplemental tax-favored savings plans. In fact, generating lifetime income from those 401(k)s is beyond what a typical worker is able to do. Their options for doing so, generally speaking, are to self-annuitize (when you run out of money, however, the guarantee goes away) or to purchase an annuity in the free market. 

That, too, comes with a problem. While that purchase is easy to do and does come with a lifetime income guarantee, it also comes with overhead costs (insurance company risk mitigation and profits plus the earnings of a broker). Roughly speaking, a retiree may be paying 20% of their savings to others in order to annuitize. That's a high price. Is it worth it? Is that why workers want pensions despite often not really knowing what they are?

Pensions are not for everybody; they're also not for every company. But, this survey strongly suggests that companies that provide pensions may become employers of choice. In the battle for talent, that's really important.

Many companies exited the pension world because the rules made those pensions too cumbersome. But, the rules have gotten better. They've put in writing the legality of plans that many employers wanted to adopt 15 to 20 years ago, but feared doing something largely untried. And, there is bipartisan language floating around in Congress that would make such plans more accessible for more employers.

Designed properly, those plans will check all the boxes for both the employer and the employees. It seems time to take another look.

Fitting a Square Retirement Peg Into a Round Hole

I just don't get it. We knew what they were and honestly, they may have been well defined before then, but in 1974, Congress saw fit to codify defined benefit plans (DB) and defined contribution plans (DC) in ERISA. At the time, there was no Section 401(k) in the Internal Revenue Code.

It was also pretty clear back then. Pension plans were required to offer annuity options. Plans that were not pension plans (mostly profit sharing plans) were not required to offer annuity options. And ERISA said it was good.

In a profit sharing plan, a participant's accrued benefit was his or her account balance, generally. In a pension plan, generally, a participant's accrued benefit was the amount of his or her annuity. And ERISA said it was good.

But, time went by and despite ERISA saying things were good, Congress decided to tinker. And, as a group, Congress has few tools in its bag of tricks that exceed its ability to tinker. It usually works like this. Representative A introduces a bill and she has just enough votes locked up that she can almost get it through the House. And, Representative B comes to her with an idea and says that if you'll just add this one [stupid] provision, I'll vote with you and I can drag C, D, E, F, G, and H along.

That's how the sausage is made in the tinkering factory.

So, once upon a time, we had this round retirement hole (the structure that ERISA gave us) and it was good. It worked pretty well. The evidence of that is that people who spent a good part of their careers under the structure developed in ERISA have generally retired and if they planned at all well, their retirements are not at all bad compared to their working lifetimes.

But, as Congress saw fit to tinker with the rules, it found ways, among others, through bills known as Pension Protection Act[s] to convince employers to get rid of pensions. That's right, Pension Protection Acts killed pensions.

Irony.

So, through Pension Protection Acts, workers were suddenly left with nothing but account balances and through improved awareness of health risks and better medical care, they were also left with longer life spans. Those account balances that were perfectly sufficient to get them to the age 75 or so that was their life expectancy at birth had no chance of getting them to their new life expectancy that was closer to 85.

Now what?

The hue and cry was for annuities. And, thus Congress began to tinker again. How could they possibly fit this square account balance peg into the round annuity hole. So, Congress explored ideas for annuities in DC plans.

But, you see that if you offer actuarially equivalent annuities from a DC plan, then you have gains and losses and that would essentially be a DB plan. If you offer insurance company provided annuities (and recall that insurance companies are in business to make money), then you have too small of an annuity.

Oh the ignominy of the square peg.

We had a perfectly good system. It came with perfectly good benefits and for most plans, perfectly good actuarial assumptions and methods.

And Congress broke it. And after all these years, despite taking file and rasp and hammer to the square peg, the round hole remains empty.

Congress, there are smart people who do not sit in your chambers. Give us your objectives and let us find you a solution. We'll make that peg round and Americans will be able to look forward to their golden years again.

ERISA will once again say it is good.

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.

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.

Convinced this is worth looking into?

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.

Wake Up and See the Light, Congress!

Congress has a once-in-a-generation opportunity. Since its first major overhaul in 1922, Congress has seen fir to make earth-shaking changes to the Internal Revenue Code (Code) once every 32 years. 1922. 1954. 1986. And, while it seems that they may be one year early this time, they are pitching tax reform once again.

The concept of qualified retirement plans as we know them today comes from the Employee Retirement Income Security Act of 1974 (ERISA) signed into law that Labor Day in 1974. Since that time, there have been relatively few changes to the Code affecting retirement plan design. And, frankly, most of them have come on the 401(k) side. In fact, Section 401(k) was added to the Code after ERISA and since then, we have been blessed with safe harbor plans, auto-enrollment, auto-escalation,Roth, and qualified default investment alternatives (QDIAs). Over the same period, little has been codified or regulated to help in propagating the defined benefit plan -- you know, that plan design that has helped many born in the 40s and early 50s to retire comfortably.

Isn't this the time? Surely, it can be done with little, if any, effective revenue effects.

Since ERISA, there have been really significant changes in defined benefit (DB) plan design including the now popular traditional cash balance plan, the even better market return cash balance plan, pension equity plan, and less used other hybrid plans. And, DB plans have lots of features that should make them more popular than DC plans, especially 401(k) plans.

• Participants can get annuity payouts directly from the plan, thereby paying wholesale rather than the retail prices they would pay from insurers for a DC account balance.
• Participants who prefer a lump sum can take one and if they choose, roll that amount over to an IRA.
• Assets are professionally invested and since employers have more leverage than do individuals, the invested management fees are better negotiated.
• In the event of corporate insolvency, the benefits are secure up to limits.
• Plan assets are invested by the plan sponsor so that participants don't have to focus on investment decisions for which they are woefully under-prepared.
• Participants don't have to contribute in order to benefit.

But, they could be better. Isn't it time that we allowed benefits to be taken in a mixed format, e.g., 50% lump sum, 25% immediate annuity, 25% annuity deferred to age 85? Isn't it time that these benefits should be as portable as participants might like? Isn't it time to get rid of some of the absolutely foolish administrative burdens put on plan sponsors by Congress -- those burdens that Congress thought would make DB plans more understandable, but actually just create more paperwork, more plan freezes, and more plan terminations?

Thus far, however, Congress seems to be missing this golden opportunity. And, in doing so, Congress cites the praise of the 401(k) system by people whose modeling never considers that many who are eligible for 401(k) plans just don't have the means to defer enough to make those models relevant to their situations.

Sadly, Congress prefers to keep its collective blinders on rather than waking up and seeing the light. Shame on them ...

Focusing on the Pension Part of the Deal

Let's suppose you're on the finance side of a business. That business is buying a company and you learn that the company that you are acquiring has one or more defined benefit (including cash balance) pension plans. What do you do now?

Pension plans and the finances associated with them are among the most confusing and misunderstood elements of a deal like this.The rules are unnecessarily complex and are often misunderstood even by people that you might be inclined to engage as experts. Cash flow requirements do not align well with financial accounting charges and not knowing the right questions to ask could seriously impede your ability to get the answers that you need.

So, how can I help?

Among the really nice things about pension plans is the amount of information that is publicly available on each of them. You see, in its infinite wisdom, Congress and the agencies that Congress has entrusted to regulate pensions have deemed that a myriad of such information has to be disclosed every year for each plan. In unknowing hands, that information is just that -- information. In the right hands, however, it's a veritable goldmine.

As a senior finance person, what do you need to do?

1. Identify all of the plans that you might be (will be) acquiring.
2. Identify what measures are important to you (e.g., cash flow, financial accounting expense, government disclosures, volatility, loan covenants).
3. Identify your constraints (e.g., available cash to use for pensions, funded status triggers to loan covenants).
4. Identify your goals with regard to the plans.

Notice that I didn't mention plan documents, participant census data, plan asset statements, or anything else that you thought you needed to provide. This is where that goldmine comes in.

I call your attention to a recent situation where we had just the information in 1. through 4. above. The goals were fairly simple and included roughly these:

• Help us to understand the amount of cash necessary to pay for the plan(s),
• Tell us what is not being done optimally, and 
• Help us to find ways to optimize these plans on a path to termination.

Our client now has a 10-year forecast of cash flow requirements under multiple scenarios. They understand what has not been done optimally over the last 10 years or so. And, they now have a strategy all set to go so that when they do pull the trigger and finish their deal, they'll be putting their pension dollars to optimal use.

This is a place where off-the-shelf, cookie-cutter solutions don't work. Every plan is different. Every plan has different thresholds. Every company is different. Every company has different resources.

But what makes every company the same is that every company needs a solution that is customized to their situation.

When Pensions Met Vintage TV

Many of my readers are pretty familiar with pension plans. Those of you who have been around for a while may remember a time on the TV show 60 Minutes before the closing segment was occupied by Andy Rooney. Back in the late 70s, it was Shana Alexander on the left versus James J. Kilpatrick on the right on the Point-Counterpoint segment. In the early days of Saturday Night Live, this also led to the Jane Curtin-Dan Aykroyd segments famous among other things for their tag lines, "Jane, you ignorant slut," and "Dan, you pompous ass."

What does all this have to do with pensions? Not a thing, but today I'm going to tie them together anyway.

In any event, late last week, I read an article highlighting a Prudential study on the uptick in pension risk transfer (PRT). I thought that bringing back Shana and Jim (or Jane and Dan if you prefer) might be a good way to discuss it.

Point: 31% of respondents to the survey said that desire to reduce their pension plan's asset volatility was a key reason to engage in PRT.

Counterpoint: Jane, you ignorant slut, that means that 69% of plan sponsors didn't think that reducing asset volatility was a big deal. And, as I'll explain to you later, asset volatility can be dealt with.

Point: Dan, you pompous ass, another 25% said they wanted to focus on their core business rather than deal with a pension plan.

Counterpoint: But, Jane, you ignorant slut, a pension plan is part of their core business and 25% isn't very many anyway.

Point: Dan, you pompous ass, 25% said that they were tired of having to deal with small benefit amounts.

Counterpoint: Jane, you ignorant slut, if they didn't freeze their pensions, those companies wouldn't have to deal with small benefit amounts. Everyone would have wonderful pensions benefits.

We'll return to Point-Counterpoint after a short commercial break, but while that's airing, let's consider what each of our erudite commentators is pointing toward. Shana/Jane (actually likely taking the more conservative Jim/Dan role) are taking the position that managing pensions has just gotten out of hand in the US. With rising PBGC premiums and wild asset fluctuations, they want out of the pension business, at least to the extent possible.

At the same time, the other side is espousing that pensions can help with workforce engagement and management and that asset fluctuations need not cause angst for plan sponsors.

After hearing "Plop plop, fizz fizz, oh what a relief it is" and "Mr. Whipple, please don't squeeze the Charmin," we return to our regular programming.

Switching to our more traditional commentators ...

Point: Jim, so you are trying to tell me that companies should still maintain these blasted pensions and that the problems that a group of CFOs are worried about just don't matter?

Counterpoint: No, Shana, they matter. But, they are solvable. You've never had a creative mind, Shana.

Point: Jim, you're getting curmudgeony now. If you don't watch it, they'll replace you with that Rooney guy with the bushy eyebrows.

Counterpoint: Shana, I've heard you talk about LDI (liability driven investments), but how come you never talk about IDL.

Point: Jim, now you've lost it. Are you telling me that Interactive Data Language should be part of a pension discussion. Or, are you telling me that I should die laughing at your ignorance of real financial issues.

Counterpoint: Shana, IDL is investment driven liabilities. Since you clearly know nothing about this concept, you could choose to learn. Perhaps it doesn't resonate with you that if liabilities track to assets in a defined benefit plan, then all of these CFO issues would go away and companies would be able to keep their workers while keeping costs stable.

And, returning to our other cast of characters ...

Point: Dan, you pompous ass, that makes no sense at all. Everyone knows that assets don't drive liabilities.

Counterpoint: Jane, you ignorant slut, suppose they did.

HR Practices and Their Funding Similar Within Industries

This shouldn't come as a revelation, but HR practices, particularly benefits and compensation tend to be similar within industries. It makes sense. They tend to be competing for the same talent and, therefore, they benchmark against each other.

What may be a little bit less obvious is that allocations of capital to benefits and compensation also tend to follow patterns within industries. Reasons for this may not be quire as clear, but in a lot of cases, if what you are providing is the same, the way you pay for it and the amount that you pay for it may also be pretty similar.

Again, it makes sense. If Company A pays me $50,000 per year or Company B pays me $50,000 per year, the cost of my cash compensation during that year will be $50,000 (ignoring taxes). If each company further offers me a 401(k) plan that matches 50 cents on the dollar up to 6% of pay and very similar health plans, their costs for the year for me remain pretty similar. There aren't a whole lot of choices there.

So, now you may be asking why I am writing this. I haven't told you anything useful yet and you may be thinking I won't. But, wait, there's more!

Certain rewards elements can be paid for differently. Primarily, those are incentive compensation (can be paid relatively immediately or deferred) and defined benefit (including cash balance) pension plans. There you as an employer have options.

Let's consider briefly some of what those might be. You can fund the minimum required contribution (MRC) exactly on the statutory schedule. It's easy. You follow the rules. You do no more and you do no less. You can fund to the greater of the MRC or to 80% on whatever is the current funding basis. You can fund to the greater of the MRC or to 90% on that same current funding basis. Or 100%. Or, you can fund to the point at which you eliminate PBGC variable rate premiums.

Sure, there are other levels to which you can fund, but that's enough to illustrate. The point here is that behaviors within industries tend to be pretty similar.

Why does that matter?

Let's consider the health care industry. Not insurers, but hospitals, clinics, and other similar organizations. Lots of them have pension plans of one flavor or another (many are frozen cash balance plans) and most of them fund those at the minimum on the statutory schedule. That is following the law, so from a compliance standpoint, it's fine.

Where it's not as fine is from a financial sense standpoint.

Suppose you looked at all of the companies that sponsor defined benefit plans and then among that group, you considered only those who are paying more in PBGC variable rate premiums than they need to (this is important because for a typical company like this, those variable rate premiums may represent a 1% or more "drag" on plan assets).

What industry would predominate in that group?

You guessed it -- health care.

If you've made it this far and you are in the health care industry and you still have a pension plan, you probably want to see if you are facing that drag on assets. You probably are.

I would encourage you to check and when you find out that you are experiencing that drag, there are strategies that can be employed that will save you on that drag without depleting valuable cash from other needs.

Instead of Making Defined Contribution Look More Like Defined Benefit, ...

I don't think I've ever ended the title of a blog post with an ellipsis before. But, surely, there's a first time for everything.

Lately, the benefits press has written an awful lot about what must be the latest trend in employer-provided retirement benefits -- making the defined contribution (DC) plan look more like the defined benefit (DB) plan. Perhaps I am missing something, but it appears that this "major" initiative has two components to it (that's right, just two):

• Communication of an estimate of the amount of annuity a participant's account balance can buy
• The option to take a distribution from the plan as either a series of installments or as an annuity

Let's consider what's going on here.

Annuity Estimate

Yes, there is a huge push from the government and from some employers to communicate the annual benefit that can be "bought" with the participant's account balance. Most commonly, this is framed as a single life annuity beginning at age 65 using a dreamworld set of actuarial assumptions. For example, it might assume a discount rate in the range of 5 to 7 percent because that's the rate of return that the recordkeeper or other decision maker thinks or wants the participant to think the participant can get.

I have a challenge for those people. Go to the open annuity market. Find me some annuities from safe providers that have an underlying discount rate of 5 to 7 percent. You did say that you wanted a challenge, didn't you?

I'm taking a wild (perhaps not so wild) guess that in late 2016, you couldn't find those annuities. In fact, an insurer in business to make money (that is why they're in business, isn't it) would be crazy today to offer annuities with an implicit discount rate in that range.

But, annuity estimates often continue to use discount rates like that.

Distribution Options

Many DC plans offer distribution in a series of installments. Participants rarely take them, however, For most participants, the default behaviors are either 1) taking a lump sum distribution and rolling it over, or 2) taking a lump sum distribution and buying a proverbial (or not so proverbial) bass boat.

Why is this? I think it's a behavioral question. But, when retiring participants look at the amount that they can draw down from their account balances, it's just not as much as they had hoped. In fact, there is a tendency to suddenly wonder how they can possibly live on such a small amount. So, they might take a lump sum and spend it as needed and then hope something good will happen eventually.

Similarly, if they have the option of getting an annuity from the plan, they are typically amazed at how small that annuity payout is. And, even with the uptick in the number of DC plans offering annuity options, the take rate remains inconsequentially small.

A Better Way?

Isn't there a better way? 

Part of the switch from DB plans to DC plans was predicated on the concept of employees get it. They understand an account balance, but they can't get their arms around a deferred annuity. So, let's give them an account balance.

Part of the switch from DB to DC plans was to be able to capture the potential investment returns. Of course, with that upside potential comes downside risk. Let's give them most of that upside potential and let's take away the worst of that downside risk. That sounds great, doesn't it.

Once these participants got into their DC plans, they wanted investment options. I recall back in the late 80s and early 90s that a plan with as many as 8 investment options was viewed as having too many. Now, many plans have 25 or more such options. For what? The average participant isn't a knowledgeable investor. And, even the miraculous invention commonly known as robo-advice isn't going to make them one. Suppose we give them that upside potential with professionally managed assets that they don't have to choose.

Oh, that's available in many DC plans. They call them managed accounts. According to a Forbes article, management fees of 15 to 70 basis points on top of the fund fees are common. That can be a lot of expense. Suppose your account was part of a managed account with hundreds of millions or billions of dollars in it, therefore making it eligible for deeply discounted pricing.

There is a Better Way

You can give your participants all of this. It seems hard to believe, but it's been a little more than 10 years since Congress passed and President George W Bush signed the Pension Protection Act (PPA) of 2006. PPA was lauded for various changes made to 401(k) structures. These changes were going to make retirement plans great again. But, for most, they didn't.

Also buried in that bill was a not new, but previously legally uncertain concept now known as a market-return cash balance plan (MRCB). 

Remember all those concepts that I asked for in the last section, the MRCB has them all. Remember the annuity option that participants wanted, but didn't like because insurance company profits made the benefits too low. Well, the MRCB doesn't need to turn a profit. And, for the participants who prefer a lump sum, it would be an exceptionally rare (I am not aware of any) MRCB that doesn't have a lump sum option.

Plan Sponsor Financial Implications

Plan sponsors wanted out of the DB business largely because their costs were unpredictable. But, in an MRCB, properly designed, costs should be easy to budget for and within very tight margins. In fact, I might expect an MRCB to stay closer to budget than a 401(k) with a match (remember that the amount of the match is dependent upon participant behavior). And, in a DB world, if a company happens to be cash rich and in need of a tax deduction, there will almost always be the opportunity to advance fund, thereby accelerating those deductions.

Win-Win

It is a win-win. Why make your DC plan look like a DB when there is already a plan that gives you the best of both worlds.

More on the Public Pension Controversy

The media has fallen in love with the ongoing controversy over public pensions. In the last few weeks, article after article has appeared in major print and electronic media mostly discussing how poorly funded the majority of public pension funds are and placing blame everywhere they can. This is not to say that there are not problems and it's also not to say that there's not plenty of blame to go around, but as in most any controversy, there's more than one side to this issue.

Before delving into it, let me provide some background for those who may not be particularly familiar with public pensions.

Virtually all public pension plans are traditional defined benefit (DB) pension plans in which most, if not all, of the benefit is provided through contributions from the sponsoring governmental entity (some do require significant participant contributions in order to get that benefit). The benefit is typically related to final year's (or the average of the last three or five years) compensation. As a result, spikes in compensation in the final year or years of a career produce much larger pensions. And, when overtime pay is included in those amounts, workers are smart enough to know that their pensions can easily be boosted by getting as much overtime as possible.

As I said, most of these pensions are funded largely through contributions from the governmental entities. Where do those contributions come from? Well, for most of those entities, the very large majority of their budgets come from tax dollars. So, if the recommended, or even legally mandated contributions get too large, there are only two choices -- ignore those requirements or raise taxes (of course in most jurisdictions, future benefits can be reduced prospectively, but that's a different story for a different day).

The current debate centers on public plans in California. What we have recently learned is that the California Public Employers Retirement System (CalPers) values pension liabilities in two ways -- one using what the New York Times referred to as the actuarial value and another referring to it as a market value.

The next two paragraphs briefly discuss a rationale for each basis. For the sake of both simplicity and brevity, both are oversimplified and should not be taken as a precise rationale for either.

The actuarial value discounts obligations using a discount rate at the expected long-term rate of return on plan assets. Proponents argue that this is correct because plans are expected to have a degree of permanence and as assets are invested for the long haul, the obligations that they support should be discounted on that same basis.

Market value discounts obligations using a current settlement rate; roughly speaking, that is the rate at which you could go out to the insurance market to settle those obligations. Proponents argue that in an efficient market, there is no risk premium in investments and therefore, this is the only appropriate basis on which to discount.

What we have read about in the news is that governments that thought that the plans that they sponsor were well funded and that wanted to pull out of the system are learning that to do so will cost them money that they will likely never have.

So, which method is correct? I suppose I could argue that it depends upon which media piece you read. You see, what is happening is that most of the articles have interviewed experts (or self-proclaimed experts) on only one side of the debate. So, they present that side.

The reality is that neither side is correct. It's not as simple a question as the strong proponents on either side would have you believe.

So, here's my take (you knew I would get to it eventually).

Public plan trustees need to understand the true costs of the plans they sponsor. On average, when an employee retires, their pension should be fully funded. This is often not happening. In years when investment returns are good, they use them to reduce contribution requirements. In years when investment returns are poor, they say they can't afford to make the appropriate contributions. It doesn't take an experienced actuary to tell you this is a problem.

I would urge that governments embark on prudent funding policies that build up surpluses in strong years in order to pay for shortfalls in lean years. Doing so will have only minimal effect on the tax base. Studies to understand these issues should be par for the course.

I also urge the popular media to realize that this is not a one-sided issue. While it may make for a great read to tell of the sad tale of a small Citrus District pension plan that is woefully underfunded, it's a small part of the story.

Within the Conference of Consulting Actuaries (yes, I am biased, I serve on the Board of Directors), there is a Public Plans Community that regularly discusses issues such as this. For those who are interested in a view of the problem from people who understand the issues, it's an excellent read.

Lessons From California Public Pensions

Over the last few days, the print media (at least we used to call it print media) has hit hard on public pensions in the State of California. The New York Times hit hard on the differences between the "actuarial approach" and the "market approach." The Los Angeles Times took on a pension deal from the late 90s. Both of these are symptomatic of the issues that all of taxpayers, legislators, workers, and actuaries face in the public pension world.

Let's take a step back. Some of the most generous of all public pensions are those available to public safety officers primarily police and fire. I could give you lots of reasons why this approach is correct and why it's not. You might disagree with my analysis on all of them, but that's not what's important here.

Historically, people who have chosen careers in police and fire have thought of their careers differently than people in most other professions. Those careers are very risky and they are physically demanding. Many in those professions would tell you and me that lasting more than 30 years or so is just not practical. And, if we take that as a correct statement (I do), then it is reasonable that such public safety officers be eligible to retire from that career earlier than we would expect in most other careers. After all, if you were trapped in a burning building, would you be happy if the people trying to save you were just trying to hang on until normal retirement age at 65, but weren't really physically capable of handling such a demanding task?

Over time, states, cities, towns, and other governmental organizations found the answer. Provide those public safety officers with a significant incentive to retire early (compared to other careers) and if you do that, you don't have to pay them all that much. So, what that has historically achieved is that costs for current public safety employees have been relatively lower and costs have been deferred into their retirements.

That's a problem. It doesn't need to occur. The correct answer for a governmental employer, or other employer, is to realize that deferred compensation (that's what a pension is) is earned during a employee's working lifetime. Therefore, it should be paid for during that working lifetime. After all, once an individual in any profession retires, they no longer provide a benefit to the organization that they previously worked for. Further, the burden to pay for those pensions should not be passed on to future generations of taxpayers.

In the past, I have commented about various actuarial cost methods. An actuarial cost method is a technique for allocating costs to the past, the present, and the future. Looking at things as any of a taxpayer, legislator, employer, or employee (I happen to not be all of those, but even so, I can put myself in the shoes of those that I am not), the correct answer has the following characteristics:

• An employee's pension is paid for (funded) over their working lifetime. Once they retire, the cost of providing their benefit is over. (Understand that actuarial gains and losses make this an inexact science, but we should be close.)
• The cost of providing that employee's pension should be level. That is, it should either be a constant percentage of their pay or a constant dollar amount. As an employer, I can budget for that. 

Let's consider an example of that second bullet. Suppose I pay a public safety officer $60,000 per year (I know -- in some jurisdictions that seems high and in others it seems low) in salary. Further suppose that their deferred compensation costs me 10% of pay annually. Then when I am budgeting for that person, I know how to budget every year. If their pay goes up by 5%, so does the cost of their pension, roughly. This year, I budget $66,000 for current plus deferred compensation. Next year, with that 5% budgeted increase, I budget $69,300 for current plus deferred compensation.

There is an actuarial cost method that does exactly this. It's called Entry Age Normal (EAN). When I entered the actuarial profession back during the days when we used green accounting paper rather than spreadsheets, in my experience, EAN was the actuarial cost method of choice. But, it had its downsides. 

• Neither the accounting profession nor the federal legislators accepted it as the method of choice.
• Employers were advised that their current cash cost would be lower using a different actuarial cost method. It's easy to say you will fix that problem later on.
• Observers understand a method where you pay for benefits as they accrue, but nor one in which you pay for benefits as they are allocated by actuaries.

So, now we have come to a crossroads. Many of the largest public pension plans are horribly underfunded regardless of how you determine funding levels (some have been funded responsibly; others have not). Getting them well funded requires cash which can only come from increasing taxes or from taking money from elsewhere in the budget (dream on). Legislators want to get re-elected which means you don't raise taxes. 

Hmm, I see a problem here.

The problem extends to private pensions as well, but there are  good solutions there. Since EAN is not available as an actuarial cost method anymore (we could choose to have our valuation done using the legally prescribed Unit Credit actuarial cost method, but fund not less than the EAN cost although that is very rarely done), we need to look in other places. 

Plan design is an excellent lever in this regard. Suppose we had a plan design  that even under a Unit Credit cost method allowed us to achieve exactly what we are talking about here. And, suppose that design allowed for all the benefits of defined benefit plans (DB) including market-priced with no built-in profits annuity options, professional investing, no leakage, portability, and virtually no cost volatility. Wouldn't that be an ideal world?

That design exists. And, you can have it now.

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.

Opinion: American Workers Need Pensions and They Should Look Like This

Since I last blogged, I've seen a lot of survey data. Among the very compelling themes has been that Americans are afraid that they will not have enough money with which to retire. Those fears are well founded for many.

As I've written here many times, the 401(k) plan was never intended to be the primary retirement source of retirement income for American workers. Neither was Social Security. Rather, Social Security was intended to be a supplement to bridge people for what was usually just a few years of retirement before death. Section 401(k) was a throw-in in a late 70s tax law that was suddenly discovered. It was intended to give companies a way to help their employees to save more tax effectively. And, remember, in the late 70s, the norm was that whatever company employed you at age 35 was likely to be your last full-time employer. ERISA had recently become law and most American workers had defined benefit pensions. These plans were designed to assist employers in recruiting and retaining employees.

Then, again, as I've written many times, along came change through the government and through quasi-governmental organizations. Employers didn't like the mismatch between cash flow requirements and financial accounting charges. New pension funding laws, beginning in 1987, were designed not to ensure responsible funding of pension plans, but to provide an offset to tax expenditures (a fancy name for tax breaks and government overspending). Looking at it from the standpoint of someone in Congress trying to decrease tax expenditures, if you can decrease required company contributions, you decrease their tax deductions, and thus cut those evil tax expenditures.

Nearly 30 years later, pensions have tried hard to go the way of the dinosaur. The fact is, however, that there are still lots of defined benefit pension plans out there. But, they don't look the same as they did 30 years ago. The laws have changed, creative minds have been at work, and new and better designs have emerged.

American workers generally should have employer-provided defined benefit pension plans. But, since these creative minds have been at work, what exactly should these new plans look like?

• While they offer a sense of stability in retirement, annuity payments do not appeal to many Americans and they do not necessarily understand them. So, while all defined benefit plans must have annuity options, they should also have lump sum options.
• The plans should not be "back-loaded" (a term that means that most of your accruals and therefore cost to your employer emerges late in your career). The typical final average pay plan of yesteryear was designed so that most of your accruals occurred close to or after you were eligible to retire. This made some sense when you spent your whole career with one employer. But, in 2016, that very rarely happens. So, plans should accrue benefits fairly ratably.
• Benefits should be portable. That is, you should be able to take them with you either to an IRA or to another employer. This works best if there is a lump sum option through which you can take a direct rollover and maintain the tax-deferred status.
• Employer costs should be predictable and stable. This can be achieved when there is no longer a mismatch between assets and liabilities in a plan.
• Employers should see that plan assets are professionally managed, but fluctuations in asset returns from those that are expected can be borne by plan participants.

This sounds like pension nirvana, doesn't it? Such plans and designs can't possibly exist.

Well, they do. 

The plan design that accomplishes this is often known as a Market Return Cash Balance Plan (MRCB).

While an MRCB carries with it all of the required characteristics of defined benefit plan and it looks a lot like a 401(k) or other defined contribution plan, it brings with it additional benefits. It satisfies all of the bullets I've outlined above. Budgeting gets easy and predictable. There is no "leakage" due to sudden expenses when a participant's car decides to break down or an unexpected flood ravages their house.

An MRCB is very suitable to be a primary retirement plan. You want to save a bit extra? That's what your 401(k) plan is for. 

If you are an employer and you're reading this, you really need to know more, don't you?

The Truth About Actuarial Valuations of Pension Plans

I've heard the same comments for years. I've heard that a company loves its actuary, but they can't give you one reason why. I've heard that actuarial work is a commodity and that everyone produces the same numbers, so you might as well go with the lowest bidder. There's more; there's lots more.

I'm here to tell you that it's all wrong and it's wrong now more than ever.

Let's revisit history a little bit. In the beginning (well, not quite the beginning), there was ERISA. And, Congress saw that it was good ... for a while.

ERISA brought us rules and choices. The rules said that plan sponsors had to fund the sum of the annual cost of benefits that were accruing (normal cost) plus a portion of the amount by which the plan was underfunded using some fairly complex formulas. But, those calculations were pretty malleable. In fact, there were many methods by which to calculate those numbers and if you couldn't find the methods to get you the answers you wanted, you could likely talk your actuary into selecting assumptions to get you to those numbers. That's the way the game was played from the mid-70s through the mid-80s.

Then, the rules began to change. Congress saw that corporate tax deductions for funding pensions were a significant drag on the federal budget. So, Congress sought to limit those deductions by bringing in multiple funding regimes. So, was passed the Pension Protection Act of 1987 as part of the Omnibus Budget Reconciliation Act of 1987. And, Congress saw that is was good ... for a while.

Multiple funding regimes theoretically brought multiple choices, but with the 90s came the era of full funding. With the use of high discount rates tied to assumed rates of returns on plan assets, those assets exceeded the calculated liabilities of the plan. More plans than not had no required contributions. Pensions were cheap.

And, then came the perfect storm. Interest rates fell, asset values fell, and Congress had to do something. In 2006, Congress passed another Pension Protection Act (PPA). And, Congress saw that it was good.

But, there was something different about PPA. It severely limited flexibility in calculating the actuarial liabilities of a pension plan. In fact, with very limited exceptions, without any knowledge of the actuarial assumptions being selected, another actuary could fairly well reproduce that calculation of actuarial liabilities (at least within in a few percent).

But, what we have now is a tangled web. There are so many liabilities and percentages. Every single one of them affects the cost of your plan. There is the funding target, the plan termination liability, the liability for purposes of calculating PBGC premiums. There's the FTAP, the AFTAP, and various other funding percentages.

While each individual calculation is simple, getting to the correct answer is not.

And, that's why your choice of actuary for your plan is actually far more important today than it used to be.

Suppose I told you that your actuary's lack of attention to your plan as compared to the rules was costing you more money annually than you pay in actuarial fees.

Suppose I told you that your actuary's not focusing on your business's cash flow needs was forcing you to borrow unnecessarily.

Suppose I told you that that renegotiation of a loan covenant that you just went through because your pension plan had too low a funded percentage could have been avoided.

The scary thing is that I have told companies all of those things. We're in an era now where calculation is easy, but strategy is difficult. In fact, more plans than not are using a suboptimal strategy. Don't you need to know if you are spending more money than you need to or if you are spending it inefficiently?

The Pension Tale of the Cash and the Calendar

Once upon a time, there was a defined benefit (DB) pension plan. And, the plan was fully funded. And, that was good.

Well, at least, the plan's actuary told the plan sponsor that the plan was fully funded. And, then he said something else after that -- something about a HATFA basis. Oh, but it couldn't matter. That was clearly some foreign word. After all, the sponsor knew that the actuary was a really smart and he probably lapsed into foreign tongues once in a while. All that actuarial gibberish is pretty much a foreign language, anyway.

So, the plan sponsor, in this case represented by the Benefits Manager (Bob) and the Controller (Cliff), armed with the knowledge that its frozen plan was fully funded gleefully went off to see the CFO (Charlotte). It was time to tell her that the plan was fully funded and that the plan could be terminated.

Those of who work in the pension world know that this little story didn't end well. For those who don't work in that world, let's just say that being fully funded at the beginning of 2016 on a HATFA basis may mean that on a plan termination basis, assets may only be very roughly 2/3 of liabilities.

Our story goes on.

After understanding that they couldn't terminate the plan, the sponsor Craters R Yours (CRY), the world's largest manufacturer of inflatable moonwalks set about to continue managing their frozen DB plan. CRY had initially assumed that freezing the plan was an end to its pension worries, but it soon learned that was not the case.

They learned that frozen plan management can be a tale of volatility caused by cliffs and calendars. In year 1, we get funding relief. In year 2, it's gone and we revert to the old rules. We're 80.01% funded; all is well. We're 79.99% funded; life gets really tough. We make a contribution on March 31; a ratio gets better. We make it on April 2; there are things we have to tell the government.

Bob and Cliff learned that their jobs had become really difficult. Charlotte had roundly praised them when they found a new and inexpensive actuary, Numbers For Cheap. And, NFC always provided legally correct numbers. But, there was no strategy. NFC didn't tell Bob and Cliff that contributing $1,000,001 on March 31 was going to be much more valuable in the long run than contributing $999,999 on April 2. Because NFC really had no clue, CRY would up doing a lot of crying.

Bob and Cliff, and Charlotte, for that matter had been sure that when they froze CRY's pension plan that the actuarial work was a pure commodity. All the strategy was done. All that was left was to hire the cheapest actuary and get the plan terminated.

The moral of the story, of course, is that pension funding strategy doesn't end until the plan is gone. Until then, there is a difference, and you, as a plan sponsor need someone who can help you to find that optimal strategy. Let us help.

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?