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.

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.

Is Your Executive Plan Top-Hat?

Most larger companies and some smaller ones provide many of their higher paid employees the opportunity to participate in a nonqualified retirement plan often referred to as a Supplemental Executive Retirement Plan or SERP. The rationale for having such a plan is spelled out in ERISA. The regulations specifically grants "top-hat" status to plans that are limited to a select group of management or highly compensated employees. The plan must also be unfunded (and for those people who say that lots of top-hat plans have assets set aside, that is informal funding in a rabbi trust or through insurance products or some other means).

Before going further, I'd be remiss if I did not mention that my motivation for posting this is a recent series on top-hat plan litigation in Mike Melbinger's blog.

So why should an employer or employee care if their plan is a top-hat plan or not? According to regulations under ERISA Section 104, top-hat plans are exempt from the participation, funding, vesting, and fiduciary rules under ERISA. As we shall see, this can be critically important, especially in the current statutory environment.

Backpedaling just a bit because this will help the less knowledgeable reader to understand why top-hat plans exist, let's consider what it could mean to be in a top-hat group. ERISA was enacted in 1974 to provide certain protections for employees in retirement and certain welfare benefit plans. When a plan is exempt from some of the key provisions of ERISA, it fails to provide those protections. So, being in a top-hat plan could alert a participant that he or she might not need those protections.

As some authors, mostly attorneys, have pointed out, the last year or two has seen more than the usual amount of litigation related to top-hat plans. In the typical situation, either an individual thinks that they were improperly excluded from a top-hat plan (in my completely non-legal view, this would be a tough claim to make) or because they were in a plan that was treated by their employer as being a top-hat plan, but they thought that it did not satisfy the criteria for being top-hat.

Depending on your viewpoint, the latter is either an easy claim or a difficult claim to make. Why is that? It's been more than 40 years since the passage of ERISA and we still don't have formal DOL guidance telling us what a top-hat group is. Some have argued that an individual may properly be in a top-hat group by being either management or highly compensated or both. Despite the current definition of highly compensated (Internal Revenue Code Section 414(q)) not existing until late 1986, some have argued that satisfying that criterion is sufficient. Many years ago, the DOL floated a concept that a person should be eligible for a top-hat group that a person would be eligible if their compensation was at least two times (three times in a separate informally floated concept) the Social Security Wage Base. And, finally, there is the concept that a person may rightfully be in a top-hat group if by the nature of their position, they have the ability to influence the design and amount of their compensation and benefits package.

So, knowing that we currently don't know what a top-hat group actually is, why do we care?

Suppose your company sponsors what it believes to be a top-hat plan and it turns out that it's not top-hat. Then, it's going to be subject to some fairly onerous provisions that could create massive current costs in some cases and unsolvable compliance issues in others.

Consider the following scenario.

Suppose you have a DB SERP with 20 participants. Further suppose that for whatever reason, this plan is found to not be a top-hat plan. Assuming that the company is large enough, then the plan will fail the minimum participation rules and it will necessarily (unless the company has only highly compensated employees) fail the minimum coverage tests. Full vesting must occur generally within 5 years of entry and that entry must occur not later than age 21 with 1 year of service. The plan must be funded according to ERISA's minimum funding rules. And, those plan assets must be invested according to ERISA's fiduciary standards. But, the plan will still not be a qualified plan as it doesn't meet all of the Internal Revenue Code's standards under Section 401(a).

If the plan is not qualified, it must be a nonqualified plan of deferred compensation. That makes the plan subject to Code Section 409A. So, let's throw in one more wrinkle. Let's suppose the company also sponsors a qualified DB plan and let's suppose that the qualified plan is less than 80% funded. Now, you are between a rock and a hard place. Setting aside assets (funding) for the nonqualified plan will violate Code Section 409A which will subject participants to a very large unplanned additional tax liability. (By the way, those participant will likely have to find a way to pay those taxes perhaps without having access to the deferred compensation assets in order to pay them.) Not funding the SERP will cause the plan to fail to meet minimum funding standards which will result in excise taxes under IRC 4971.

Ouch!

What should an employer do?

I've been told by more than one attorney that it is unlikely that you can get a formal legal opinion that your top-hat group is, in fact, a bona fide top hat group.

If you can't get a formal legal opinion, perhaps the best way to get comfort is to get an outsider with expertise in this area to assist with an independent analysis.

Looking at a history of case law and DOL opinion on the topic, one might consider these elements:

• The percentage of the workforce in the top-hat group
• The relative pay of the top-hat group as compared to the pay of those people not in the top-hat group
• Whether the top-hat group was selected by the Board as compared to being, for example, any employee with the title Vice President or higher
• Whether individuals in the top-hat group, especially those among the lower-paid in the group, have significant management responsibilities
• Whether individuals in the group need the protection of ERISA

Nobody really knows. But, having an independent analysis might show that an employer is acting in good faith in determining the group. Given the downside of getting it wrong, it may just be worth it to find out.

Finally, I want to reiterate that I am not an attorney and I have no qualifications to provide legal advice. As such, nothing in this post or anything else that I write should be construed as legal advice or as the practice of law.

The Recommended Pension Contribution

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

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

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

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

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

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

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

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

Multiemployer Pension Plan Crisis ... Or Not

Late last week, the New York Times published an article by Floyd Norris, its chief financial correspondent and an economist, on the crisis in multiemployer pension plans. I decided to write about it for a few reasons: 1) it's an interesting topic to me, 2) my strong impression is that the crisis is is not quite as the picture painted in the article, and 3) to go with the article, I think it's important to give some background and education.

I preface by saying that I do not generally work in the area of multiemployer plans, but then neither does Mr. Norris nor most of the people cited in his article.

Multiemployer (ME) pension plans are defined benefit (DB) plans. They meet the general tenet of DB plans in that they promise a benefit to plan participants at retirement rather than simply a pool of money segregated for that participant. But, there are lots of differences between ME plans and what most of us would think of as traditional (single employer) DB plans. Here are some of them.

• ME plans are collectively bargained.
• As the name suggests, these plans are generally maintained by more than one employer, usually in the same or related industries. The rationale is that a worker can be used by multiple businesses while all the time accruing a single pension.
• What is negotiated at the most basic level is the level of contributions that each employer will make. For example, a negotiated contribution might be 20 cents per hour worked or 25 cents per 1,000 miles driven.
• ME plans are managed, so to speak, by their trustees, joint committees having equal representation from labor unions and from management.

The article notes that the Pension Benefit Guaranty Corporation (PBGC), the governmental agency that insures pension benefits, believes that it will run out of money in its ME fund in the very foreseeable future. This could be the case (I have no reason to doubt the PBGC's forecasts) as two of the largest plans (those of the United Mine Workers and Central States Teamsters) are nearing the point where they will have insufficient assets to pay benefits to retirees.

What the article does not point out, however, is that the large majority of ME plans are really pretty well funded. Generally, ME plans have been managed responsibly and as a result, most of those plans do not face similar dangers.

When the Employee Retirement Income Security Act (ERISA) was signed into law in 1974, ME plans were not even covered by the PBGC. It wasn't until 1980 when the Multiemployer Pension Plan Amendments Act (MEPPAA) became law that such a fund was established for ME plans. And, even then, it was thought (I don't know any of the logic which may have been very good at the time for these thoughts) that the likelihood of ME plans needing PBGC coverage was small. So, as PBGC premiums for single-employer plans continued to increase, premiums for ME plans stayed low.

From my viewpoint, the reason for this might have been that it is up to the plan trustees to assure that the level of benefits provided to ME plan participants not be such that plan assets would be insufficient to pay such benefits. However, I have heard it said by people working in the ME arena, that in some of the larger, less funded plans that the strategy used amounted to a death spiral which is now approaching that death.

What happened?

As we know, plan assets have some years where their underlying investments perform well and some where they don't. So, when assets did perform well, and this is oversimplified a bit, the plans appeared to be better funded than they had been and therefore able to support higher levels of benefits for plan participants. In some plans, the trustees granted such increases. But, we all know that not all years provide excellent investment returns. When the plans were suddenly less well funded, benefit levels did not decrease. Further, and the United Mine Workers represent a good case study for this, when the ratio of active workers to retired participants decreases (similar to the US Social Security system), sources of assets may no longer be sufficient to support benefits. [This is a great reason to fully fund benefits for an individual participant on a reasonable actuarial basis by the time that participant leaves employment, but that's for another rant.]

What Mr. Norris does not point out in his article is that most ME plans are not in danger of needing PBGC protection. And, for the two plans in question, one might posit that they dug their own graves, so to speak. That is, they offered levels of benefits that the plans were not able to sustain over the long haul. Some ME actuaries have told me that the trustees who engage them for valuation services and for consulting advice have not necessarily followed that advice. 

The losers in this story are likely the people who have done nothing wrong. Plan participants, as a group, tend to do their jobs and assume that that their pensions will be paid. It is not the fault of a coal miner in the UMW plan that the industry fell on hard times. And, that long haul trucker in the Central States plan probably has no idea how his pension plan works, but he does expect that when he retires that he will get the benefits that he has been guaranteed. 

A joint business and labor group developed a plan designed to rescue the ME system without bailouts and without saving the PBGC. It was controversial in that it violated one of the most sacred tenets of ERISA -- thou shalt not reduce benefits that have already been earned. However, for any plans that go under, benefits in excess of the PBGC maximum guaranteed benefit may be reduced. And, if the PBGC runs out of money, even benefits less than that limit will likely be reduced. 

The situation is more complex than I describe. ME rules are quite complicated. But, I reiterate that the crisis appears to be limited to a relatively small percentage of plans, and according to the joint business and labor group could be solved by reducing benefits only in those plans that promised benefits that it could never have expected to support for the long term. Anything like that, however, would require Congress to pass a bill and the President to sign it.

Oh well ...

Pensions: Are They Just a Toy For Congress to Play With?

In 1963, Studebaker, once a large and proud American auto maker closed its doors in the US for the last time. With that door closing, as legend has it, New York Senator Jacob Javitz had the idea that the retirement income promised to employees needed more security. So was born in his mind the law that in 1974 became the Employee Retirement Income Security Act (ERISA). While it did far more than take steps to make pensions more secure, that was purportedly its primary purpose.

ERISA provided a framework for corporate retirement plans. And, in 1974, before paragraph (k) had been added to Section 401 of the Internal Revenue Code, the predominant employer-provided retirement income came from defined benefit (DB) plans. Unions bargained for them, and what the unions got, management wanted. Also, back in 1974, it was not unusual that if there was a company that an employee worked for in their mid-to-late 20s that that employee would eventually retire from that company. If you, as an employer, promised that employee a pension, you could expect 30 or more years of loyalty from that employee.

So, ERISA set up a minimum funding regime regime for DB plans. If you were using what is known as an immediate gain (or loss) actuarial cost method (if you know what that means, you don't need an explanation and if you don't know what it means, you don't want an explanation), then your minimum funding requirement for the year was the sum of these elements:

• The normal cost or the actuarial present value of benefits accruing during the year
• Amortization over 30 (or 40) years of the unfunded liability remaining from inception of the plan or transition to ERISA
• Amortization over 30 years of the actuarial liability emerging due to changes in plan provisions, the thought likely being that you got 30 years of value from the amendment
• Amortization over 30 years of the actuarial liability emerging due to changes in actuarial assumptions
• Amortization over 15 years of the actuarial liability emerging due to actuarial gains and losses (deviations from the expected)
• A few other elements that rarely came up

By the mid-1980s, DB plans were generally pretty well funded, and most of those that were not yet fully funded were getting much closer than they had been. The exceptions, for the most part, were plans sponsored by companies in dire financial straits that often convinced their actuaries to use fairly aggressive actuarial assumptions, or companies that frequently provided large benefit increases that had not yet been funded.

In 1986, we were graced with the Tax Reform Act (TRA86), a massive and sweeping change to the entire Internal Revenue Code -- so massive, in fact, that the Code was renamed from the Internal Revenue Code of 1954 to the Internal Revenue Code of 1986, a moniker it keeps to this day. A not insignificant portion of TRA86 included changes to pension funding rules. Amortization periods were shortened. For the most part, this increased required contributions for underfunded plans, which in turn increased corporate tax deductions.

Those new rules were revamped quickly. Just a year later, embedded in the Omnibus Budget Reconciliation Act of 1987 (OBRA87) was the Pension Protection Act of 1987. OBRA87 was the annual budget bill. And, has become the trend, each powerful legislator had his own pet spending project. To pay for all that pork, either a revenue generator or a decrease in tax expenditures (a fancy name for deductions) was needed. OBRA87 found a useful tool in DB pension plans. How is that? Just change the funding rules to decrease required contributions and tax deductions will go down which in a backhanded sort of way increases revenue for the government. of course, this was thinly veiled in a complex set of new requirements that applied only to underfunded plans.

A star was born!

Congress needs a revenue raiser? Change the funding rules. Cut the maximum benefit limitations. Change required interest rates. 

With this new toy, Congress looked at changes in pension rules at least every other year. It created uncertainty for employers. Yes, they could plan and budget based on current rules, but they lived in fear that the rules would change. That's a tough way to run a business. Many of those plan sponsors froze their pension plans. Many of them wanted to terminate their plans, but interest rates were so low that the cost of terminating those plans was too high. 

Fast forward to 2006. Coming out of the economic malaise and stock market tumble at the beginning of the decade, many plans were underfunded on an accrued benefit basis using market-based discount rates. It was time to protect pensions yet again. Thus was born the Pension Protection Act of 2006 (PPA), the most sweeping change to corporate pensions since ERISA. It provided a regime that essentially ensured that underfunded plans would be fully funded within 7 years. Employees would get their pensions. 

But, those extra contributions from employers are tax deductible. That's an extra burden on the government. And, it was just one year later (falling from its October 11, 2007 peak) that the markets crashed yet again. Employers couldn't afford these new levels of required contributions. But. Congress had an agenda to help those employers and help themselves. 

Welcome pension smoothing in the form of several laws since then. PPA brought us 7-year funding based on "fair market" conditions and assumptions. Pension smoothing undid that and then undid it again and undid it again as Congress invoked its favorite toy at least 3 times in the period following the signing of PPA. Employers had funding relief. Congress had its decrease in tax expenditures. Employees in pension plans had less funded benefits and the rules got so complex that almost nobody wanted to sponsor a pension plan anymore.

And, the places that pension funding relief gets buried are just amusing. I think the 2014 relief is my favorite -- the Highway and Transportation Funding Act of 2014 (HATFA). That's right. Congress decided it was time to improve our roadway system, but new roads don't come for free. So, to help pay for this, Congress invoked its favorite tax toy, pension funding relief.

Shame on them!

Pension Miseducation

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

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

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

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

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

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

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

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

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

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

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

Federal Court On the Money in Pension Case

I am stunned. Defined benefit pension plans and their funding measures and funding rules are a very complicated topic. In fact, federal judges (for private plans, they must be federal as ERISA preempts state law) often struggle to understand the intricacies of defined benefit plans.

I can't blame them. Congress has written statute that is so twisted as to make it extremely difficult for experts at the IRS to provide regulations and for trained actuaries to them implement. These are people who spend much of their working lives worrying about the rules underlying pension plans. For a judge with little or no formal pension training to see through the fog is a really nice change.

So, what's it all about, [Alfie]?

In Palmason v Weyerhauser, as I understand it, plaintiffs brought suit because Weyerhauser invested too large a portion of its qualified pension assets in risky asset classes, primarily alternatives (while the opinion doesn't specify, generally pension assets are considered invested in alternative assets when those assets are classified as none of cash, fixed income, or equity, e.g., real estate or infrastructure). At some point, the plan became underfunded.

It's time for an explanation. And, the Court got this one right. Measures of the funded status of a pension plan can be on many different bases. For accounting purposes, we have two different measures of the obligations (often referred to as plan liabilities) of a plan each based on a discount rate which is determined based on yields of fixed income instruments on the last day of the fiscal year. The Pension Benefit Guaranty Corporation (PBGC) looks at the plan's liabilities based on the rates at which PBGC thinks those obligations could be settled in the event of plan termination (this tends to produce a particularly high liability). IRS (and ERISA) funding rules are theoretically similar to accounting rules, but due to smoothing techniques and a constant stream of funding relief rules, a plan's funding liability (sometimes referred to As AFTAP) may be far less than these other liabilities.

In the Court's opinion, it points out that plaintiff must have standing to sue when the claim is filed. Attorneys could give you chapter and verse as to why this is the case and what generates standing, but I'll keep it simple. Under ERISA, generally, to sue for monetary damages, one must be able to show monetary harm.

In a US qualified defined benefit pension plan, a participant (except in the case of certain plan terminations) is entitled to a payment from a pool of assets. Those assets are used to pay the benefits of all plan participants. So, unlike a defined contribution plan, a diminution in plan assets may not affect the ability of the plan to pay benefits to a particular participant.

In any event, plaintiff's expert pointed out that the plan was funded 76% or 85.5% at the time the suit was filed. These were apparently accounting and PBGC measures, but not funding measures.

How can a participant be harmed by the funding level in a defined benefit plan if the plan is not being terminated? Essentially, there are two ways:

• If a plan's AFTAP is less than 80%, a participant's ability to receive a lump sum payment may be eliminated in part or in full.
• If a plan's AFTAP is less than 60%, a participant's future accruals will cease [perhaps temporarily].

The plan was not close to either of these conditions. Near the date that the suit was filed, the AFTAP was likely in the vicinity of 100% or more.

While I do not have access to the report or testimony of plaintiff's expert, it would appear that he focused on the measures that he did because they helped his client's case. Perhaps he did this because he realized that participant had no case otherwise. 

Would you as an expert take a case where the only testimony that you could provide would be that which only purpose would be to obfuscate the real point?

Judge Lasnik was not pleased. Rarely, if ever, have I seen a pension case where the judge calls out an expert by name and essentially criticizes his testimony for ignoring the real facts of the case. I hate to criticize my actuarial brethren as oftentimes, judges have not understood really relevant testimony from actuaries and made, shall we say, interesting rulings, but in this case, the judge saw the smoke and mirrors and appropriately, in my opinion, shot down the expert. 

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.

A New Look at an Old Friend

About 10 years ago, they were all the rage for companies that had defined benefit (DB) plans. Lots of DB plans were still in surplus, or at least thought they were, and lots of companies still had ongoing DB plans. Something happened in the interim (OK, a few somethings happened), but that's not the point here. Roughly 10 years ago, lots of companies were looking for an ideal way to fund their DB Supplemental Executive Retirement Plans (SERPs), In my opinion, the most effective way to fund these nonqualified (NQ) benefits was through a qualified plan (QP). This strategy has gone by many names, but the most prevalent in the industry has been the QSERP.

On the surface, the QSERP is simple. An executive has a NQ accrued benefit which is usually composed of a gross benefit offset by a QP accrued benefit. The resultant net benefit is what the executive would get from the SERP. In a QSERP, the QP is amended to increase the QP benefit to include some or all of the SERP benefit, thus (because of the offset feature) decreasing the net SERP benefit by an equal amount.

What does this do for the executive? Here are some of the benefits.

• It generally secures the benefit. Of course, if the plan sponsor goes bankrupt, such security is subject to PBGC limits on guaranteeable benefits.
• It takes the benefit out from under the purview of Code Section 409A.
• While the benefit is still in the plan, it does not fall prey to the doctrine of constructive receipt under Code Section 83.
• If the benefit is payable in a lump sum, it can be rolled over into an IRA further deferring taxation.
• The executive can wait until just before his benefit commencement date to make an election as to the timing and form of benefit distribution.
• The benefit is exempt from FICA taxes.
• The benefit is protected in the event of a change-in-control.

And, for the plan sponsor, here are some of the benefits.

• To the extent that the benefit is funded immediately, the sponsor gets an immediate tax deduction.
• Since the plan is qualified under Code Section 401(a), the trust will be exempt from taxes under Code Section 501(a), meaning that the plan assets grow tax-free.
• Payment of the benefit comes from a trust that holds all of the plan assets, not from the corporate coffers, or a far smaller rabbi trust.
• Qualified plans have better optics than do SERPs.

How about for the shareholder? How does a QSERP affect them?

• In every case that I can think of, implementation of a QSERP has been either income-neutral or income-positive.
• The company is less likely to have sudden cash flow requirements.
• From a risk standpoint, it is far easier to use risk management techniques in a qualified plan than in a SERP.

So, why can companies put in these QSERPs? Generally, from a technical standpoint, it goes to two things in the Internal Revenue Code: 1) the nondiscrimination rules of Code Section 401(a)(4) are highly objective; and 2) the combined limits under Code Section 415(e) were repealed.

Yes, that's highly technical stuff. But, suffice to say that it works. For years, I had the extreme pleasure <cough, cough> of teaching nondiscrimination testing to generally younger and aspiring actuaries. One of the things about the testing that I drilled into their heads was this: if you don't pass, you're not trying hard enough. 

Sometimes benefits actually are discriminatory, and there is nothing that any of us can do to change that. But, I have seen some benefit formulas over time that are extremely discriminatory to the naked eye. So, what do we do? We take the employee data and put it in a big pot. We add in the benefit provisions. We stir a bit with the nondiscrimination rules (remember, they are objective; either you pass or you fail.) and out comes a nondiscriminatory plan.

We're late in 2011 now. The funding rules have changed. There are fewer large defined benefit plans, and of those that remain, many are in one state of freeze or another. 10 years ago, there was no 409A. There was no Dodd-Frank, 

There is still lots of merit to this approach. Consider it. Talk to us.

The Values of Shortfall and Surplus

You can look at it in lots of different contexts -- gambling, savings, personal finance, defined benefit plans. Which is bigger, the negative value of a 10% shortfall or the positive value of a 10% surplus? Of course, they are the same, 10% of something, but are they really?

From a personal finance standpoint, if you have a 10% surplus -- that is, 10% more money socked away than you need to meet your current obligations -- that is nice. But, if you have a 10% shortfall, that is really painful. The surplus gets you some comfort or some discretionary spending. The shortfall, on the other hand, increases your cost of money.

In defined benefit plans, it may be worse. And, the value of increasing surplus gets smaller and smaller (somewhat simplistically) as the surplus grows, but not so with the negative value of shortfall. Let's consider a fairly simple example. I'm going to assume that your defined benefit plan has a funding target of $100 million and assets of one of $80, 90, 100, 110, or 120 million. In other words, you have a Funding Target Attainment Percentage (funded status or FTAP) of one of 80%, 90%, 100%, 110%, or 120%. Let's ignore the Target Normal Cost and determine the one-year cost of paying down that unfunded liability (assume an effective interest rate of 5.00%).

At 80%, it's about $3.45 million. At 90%, it's about $1.73 million. At 100%, 110%, or 120%, it's $0. From a one-year funding standpoint, the negative value of shortfall is meaningful, but the positive value of surplus is not.

Suppose you are planning to terminate your plan. Absent the additional cost of annuities (insurance companies need to build in margin to manage their risks and to turn a profit), the surplus is generally worth about 15 cents on the dollar (less if you use it for a replacement plan), but the shortfall has a negative value of $1 on the dollar, unless you are going to get the PBGC to take over your plan.

Why do we care about all this? Until your plan gets into a restricted status (<80% funded) or an at-risk status (<60% funded), all oversimplified, each dollar of underfunding has the same negative value. But, overfunding has less positive value. So, when you are looking at your investment policy for your plan, when it is already fully funded, you should simply be looking to develop a strategy to keep the surplus there, but taking risks to grow the surplus is probably not prudent. It is only when a plan is underfunded that risk-taking may make sense. Again, absent the negatives that fall to a plan once it crosses below that 60% or 80% threshold, every dollar upside has the same value as every dollar downside. So, where a sponsor of an overfunded plan should be risk averse, the sponsor of an underfunded plan should be largely risk neutral. Frankly, the only scenario in which a sponsor should have a preference for risk is one where they are so poorly funded and the company's finances are so bad that they are making a bet with two possible outcomes: 1) the risk pays off and as a result the company is able to stay in business, or 2) the risk goes bad, and the PBGC takes over the plan.

Think about it. Then, think about your plan's investment policy. Does it make sense? Do you need help?

Risk Management Isn't Just for Qualified Retirement Plans

Do you work for a company that has an active risk management policy? Do you consult with companies that manage risks or should? Are you in a benefit plan that may or may not manage risks? Then, perhaps this is for you.

Much has been made of risk management in recent years. During the economic downturn that started sometime during Bush (43)'s second term (I'm not going to argue about specifically when it started) and that is still continuing (or is not depending on which "expert" you believe), every company that I am aware of talked about risk management in earnest. Some actively did something about, some just talked about it, but it became a buzzword (I'm sorry, but a buzzword can be more than one word in my blog).

Let's focus on employee benefit programs, both broad-based and executive. Most everyone out there does some sort of risk management in most of their welfare benefit plans. Their health care plans are often fully insured, or if not, they at least have some sort of stop-loss insurance in place. And, they know that they can increase the employee portion of cost-sharing next year. With regard to other welfare benefits, LTD plans are often fully insured, life insurance plans as well. Think about them, in virtually all of these plans, employers are pooling their risks.

Suppose we turn to retirement plans. I am going to look at them in four baskets:

• qualified defined benefit
• qualified defined contribution
• nonqualified defined contribution
• nonqualified defined benefit

Qualified DB

What a trendy topic to write about: risk. The word has been out for nearly 25 years now. Get out of defined benefit plans. Diligent readers (I'm sure I have at least one) will recall that I wrote several weeks back that certain DB plans (specifically cash balance) managed appropriately are less risky than 401(k) plans from the plan sponsor standpoint. Since nobody commented on this, can I presume that everyone who read it agreed with me? I;m not that foolish, but ...

In any event, anyone who deals with qualified plans has heard about risk management, LDI, and lots of other trendy terms. When I got into this business, more large companies than not sponsored DB plans, and extremely few did anything to manage their inherent risks. Now, only those who think that they are omniscient with regard to both interest rate movement and equity and fixed income prices do nothing.

Qualified DC

In my experience, very few companies even evaluate their risks here, but most companies have them. Consider these:

• Suppose an employer provides a matching contribution in their 401(k) plan and all of their communications to employees are successful. Then, employees will contribute more and employers will be on the hook for more matching contributions. Isn't this a risk? I think it is. How many companies forecast this under any, let alone many scenarios? Shouldn't they?
• Many private or closely held companies sponsor ESOPs. When a private company sponsors an ESOP, isn't there really only one way to pay out plan participants when they terminate with a vested benefit? And, isn't that to repurchase the shares? I know that there are some companies out there that perform (or have done for them) an assessment of their repurchase liability. For the ones, who don't, in my opinion, they are just rolling the dice.
• I've seen a lot of companies scrap their defined benefit plans in favor of a profit sharing plan. In doing so, they make an implicit promise to their employees (not all companies do this, but there are enough that do), that they will contribute at least some minimum percentage of pay to the plan on behalf of each employee. Suppose business is bad. Suppose there are no profits to support these profit sharing contributions. That's pretty risky. The old way of sponsoring a profit sharing plan, basing contributions on and sharing profits, is probably more prudent. 

Nonqualified plans

Why don't employers (as a group) manage their risks in these plans? Are the obligations too small to worry about? Is it because they are just executive plans and since they may not get ERISA protection, they are not worthy of risk management? Is it because they don't know how? Is it because they have never thought about it?

Let's go back a few years, say to some point before 1986 (there were sweeping changes to tax laws including the treatment of certain life insurance products). Nonqualified plans were much smaller than they are now. But the promises made in many of them were just plain silly. 

I'm aware of one former Fortune 100 company (the company no longer exists due to acquisitions, but its particular identity is irrelevant) that promised a return in excess of 20% annually in its NQDC plan. They funded the plan using COLI, and they could point to broker illustrations that showed that all was taken care of. [pause for me to laugh out loud] I'm sure that there were other companies out there that did similar things. Remember that whoever it was that designed the plan (internally) was going to benefit from that large rate of return. If they were at the level that they were involved in the design, they were probably at least 40 years old at the time and they were smart enough to know that it doesn't take too many years at a guaranteed 20+% rate of return to build up a pretty good nest egg. And, they also knew if they thought about it that the risks that they created for the company wouldn't become really apparent until after they had become a wealthy retiree.

Why didn't this company manage this risk better? They were using the same mentality that many others have used in a retirement plan investment context -- that of total return. And, their assumptions were overly optimistic.

I'm going to make a bold statement (it's not really so bold, but teeing it up this way gets your attention better). Whether it be on a micro basis (at the plan level) or on a macro basis (at the enterprise level), it is critical that companies manage their nonqualified risks. This means that it is incumbent upon them to set aside assets to appropriately manage those risks (whatever that means to the particular company). While it may seem prudent to make the play that, on average, minimizes financial accounting costs, this is often wrong. While it may seem prudent to take the position that managing cash flow, in a way that on average, minimizes that cash flow, this is often wrong.

I'm going to attempt something drastic here. I'm going to try to insert a graphic in this blog (people over the age of 50 should generally not resort to such technological indulgences).

Tell me, in this matrix, which risk do you really want to take additional steps to actively manage? If I ask people (limited to ones that I consider to pretty intelligent), they assume that this is a trick question. Of course, they want to focus on the northeast corner -- the one with high risk and high likelihood. Think about it. Aren't these the risks that they are already very actively managing? With regard to these risks, companies tend to be fully insured, fully hedged, or at least fully something. They don't let these risks go unwatched. They know that they could bring down the company.

Does anyone remember what happened to BP in the Gulf of Mexico a few months ago? The likelihood of that event was small, but the downside risk was immense. Similarly, does anyone remember the performance of assets and liabilities together during the 10-year period that just recently ended? We had about 4 years of "left  tail events during that 10 year period (the left tail in a normal distribution is where you usually find the low probability, but very poor outcome events). In other words, 40% of the time, we had an outcome that models said would occur less than 5% of the time. What went wrong?

I could go on and on about what went wrong in terms of bad models, bad laws, bad accounting rules and the like, but that's not the point. The point is that not enough companies prepared for this low-probability event. Now, risk management in pension plans is all the rage (at least for companies that still sponsor pension plans). As time goes by and the rich get richer (they do, don't they?) nonqualified liabilities grow rapidly. And, as those liabilities grow, companies are actively managing the risks attendant to those plans, right?

WRONG!

Some have looked at this carefully, but you can probably count that list of some pretty darn quickly. Am I suggesting that companies formally fund their nonqualified obligations in a secular trust? Probably not, the tax rules usually don't work. Am I suggesting that they fund in a rabbi trust? Maybe, perhaps more than maybe. Am I suggesting that they somehow evaluate their low probability, high magnitude risks in their nonqualified plans and then quickly take reasonable steps to ensure that those risks will not get in the way of the successful operation of their company?

With due credit to Rowan and Martin's Laugh-In, you bet your bippy I am.

Do it now, and do it right, and if you're not sure how, let me help you do it.