Using Cash Balance to Improve Outcomes for Sponsors and Participants

In a recent Cash Balance survey from October Three, the focus to a large extent was on interest crediting rates used by plan sponsors in corporate cash balance plans. In large part, the study shows that those methods are mostly unchanged over the past 20 years or so, this, despite the passage of the Pension Protection Act of 2006 (PPA) that gave statutory blessing to a new and more innovative design. I look briefly at what that design is and why it is preferable for plan sponsors.

Prior to the passage of PPA, some practitioners and plan sponsors had looked at the idea of using market-based interest crediting rates to cash balance plans. But, while it seemed legal, most shied away, one would think, due to both statutory and regulatory uncertainty as to whether such designs could be used in qualified plans.

With the passage of PPA, however, we now know that such designs, within fairly broad limits, are, in fact allowed by both statute and regulation. That said, very few corporate plan sponsors have adopted them despite extremely compelling arguments as to why they should be preferable.

Why are they preferable?

For roughly 20 years, the holy grail for defined benefit plan, including cash balance plan, sponsors has been reducing volatility and therefore risk. As a result, many have adopted what are known as liability driven investment (LDI) strategies. In a nutshell, as many readers will know, these strategies seek to match the duration of the investment portfolio to the duration of the underlying assets. Frankly, this is a tail wagging the dog type strategy. It forces the plan sponsor into conservative investments to match those liabilities.

Better is the strategy where liabilities match assets. We sometimes refer to that as investment driven liabilities (IDL). In such a strategy, if assets are invested aggressively, liabilities will track those aggressive investments. It’s derisking while availing the plan of opportunities for excellent investment returns.

How exactly does this work?

I alluded to the new design that was blessed by PPA. It is usually referred to as market-return cash balance (MRCB). In an MRCB design, with only minor adjustments necessitated by the law, the interest crediting rates are equal to the returns on plan assets (or the returns with a minor downward tweak). That means that liabilities track assets. However the assets move, the liabilities move with them meaning that volatility is negligible, and, in turn, risk to the plan sponsor is negligible. Yet, because this is a defined benefit plan, participants retain the option for lifetime income that so many complain is not there in today’s ubiquitous defined contribution world. (We realize that some DC plans do offer lifetime income options, but only after paying profits and administrative expenses to insurers (a retail solution) as compared to a wholesale solution in DB plans.)

When asked, many CFOs will tell you that their companies exited the defined benefit market because of the inherent volatility of the plans. While they loved them in the early 90s when required contributions were mostly zero, falling interest rates and several very significant bear markets led to those same sponsors having to make contributions they had not budgeted for. The obvious response was to freeze those plans and to terminate them if they could although more than not remain frozen, but not yet terminated.

Would those sponsors consider reopening them if the volatility were gone? What would be all of the boxes that would need to be checked before they would do so?

Plan sponsors and, because of the IDL strategies, participants now can get the benefits of professionally and potentially aggressively invested asset portfolios. So, what we have is a win-win scenario: very limited volatility for sponsors with participants having upside return potential, portability, and wholesale priced lifetime income options.

The survey, as well as others that I have seen that focus on participant outcomes and desires, tells us that this strategy checks all the boxes. Now is the time to learn how 2018’s designs are winnersfor plans sponsors and participants alike.

Everybody Must Get Sued

I logged into my social media this morning and I noticed a pervasive theme. LinkedIn, Facebook, Twitter -- the trend in their highlights or whatever the particular site is calling that section is that somebody is getting sued. In fact, looking at my top highlights on each of those sites, more than 50% of those highlights is that somebody is suing somebody else. That's a frightening sign of the times.

Suppose instead of those sites, there was a site called BenefitsGram or SnapCompensation, what would they look like? Well, there are sites that are a little bit like that -- there's Plan Sponsor's News Dash and Benefits Link's Benefits Buzz, a pair of news consolidator sites. And, when I look at what's trending there, it's the same -- everybody must get sued.

So, why am I writing about this here?

In these days where many of the pundits talk about risk management and de-risking, is there a bigger risk than getting sued? For many companies, there may not be. A big enough lawsuit can put one of them out of business. I could certainly name some where that has happened (I'll skip that part though as I'm sure you have access to Google search as well).

In my world, it's happening around benefits and compensation programs on a more than daily basis. Somebody is getting sued. And, yes, I will agree, many of those lawsuits are frivolous. And, even among the ones that have some substance to them, an awful lot of those should fail on the merits.

The sad part, though, is that among those that should fail on the merits and even those that should succeed, almost all of them could have been avoided.

Defending a lawsuit is expensive. Even if you win, you probably paid an attorney a lot of money to defend you. And, that attorney likely convinced you (rightfully so in most cases) that you needed an expert witness or two or three on your side and you paid them a lot of money as well. So, even if you won, you lost.

What does real winning look like? It looks like not getting sued in the first place. On the contracts side, the key seems to be to write 100 page license agreements (or similar documents) that you know your customers won't read before they sign off on something that is so one-sided that they have no rights at all. On the benefits and compensation side, it's not so simple. Usually, you have to have things like plan documents and those documents have lots of legal requirements to comply with all the laws that Congress touts, but that are festered with so much junk that makes for great PR, but no sense at all.

So, you write those documents or get counsel to do that for you (probably a better idea). And, back in Section 14.23 of one of the documents, somebody wrote a really long and confusing paragraph. and, they left off an s at the end of a word that would have changed a singular to a plural. Voila! Somebody finds that the s is missing and decides that was always intended and not having that s will entitle an entire class of potential plaintiffs to double their benefits or more.

Will they find a court that will allow them to strike the first blow? Do they win at the District Court level? If they do, you have already spent a lot of money and if you want to appeal, you'll have to spend  a lot more.

So, what's the message here? Do everything you can to make sure that your intent of each of your plans is clear. Explain with examples. While I don't often praise IRS and Treasury for their mastery of the English language, they are well known for using words such as "the provisions of this paragraph (b) can be illustrated by the following examples" and then they give maybe five examples to make crystal clear what they intended.

You can too.

And you should.

But you probably haven't.

And neither have your counterparts at thousands of other companies.

So, here's your checklist:

1. Address the litigation risks in your plans.
2. Take steps to fix and problems that you have uncovered.
3. If you do get sued, make sure your counsel finds great expert witnesses for you.

Otherwise, everybody must get sued ... with apologies to Bob Dylan and Rainy Day Women #12 and 35.

Compensation Risk Assessments -- What is Compensation Risk?

Prior to Dodd-Frank, the SEC published a final rule on Compensation Risk Assessments. Among other things, this rule requires that registrants make new or revised disclosures (in their proxies) about compensation policies and practices that present material risks to the company. To date, most companies have either ignored this requirement or given it short shrift. Perhaps that is a natural response to neither internal nor external compensation practitioners customarily dealing with risk and risk assessments.

Unlike many other proxy requirement related to compensation, this one in Item 402(s) is not restricted to executive compensation. Rule 402(s) asks companies to look at all of their compensation practices to determine what material risks are presented to the company. As a shareholder, I have yet to see a proxy that complies with the spirit of the rule.

What is compensation risk? Sadly, nobody seems to know. But, since I am writing here, I will take my shot at it. A compensation risk exists when a company's programs and policies are such that compensation could call fall significantly out of line with the company's earnings or with the company's ability to pay compensation as suggested by those policies and programs. This could occur when incentive payouts are keyed to too many subjective or non-financial measures. This could occur when a company has results that are particularly volatile year after year and as a result, long-term incentive payouts are more reflective of past years' performance than that in the most recent year.

Unfortunately, that seems to happen fairly frequently. And, as a result, I think that companies should take this compensation risk assessment more seriously. A benefit of doing so would be that their compensation programs would be less likely to present material risks.

You knew this would be the case, but I have some thoughts on the matter. If implemented, my thoughts might help companies to decrease these risks. They're not perfect -- nothing is -- but, here are a few.

Weight/Age the Years in Long-Term Incentive Plans

In a typical long-term incentive plan, an executive is rewarded for performance over an extended period of time (three years is not atypical). So, to use Total Shareholder Return (TSR) as an example, an executive would be rewarded at (or close to) the end of 2015 for his or her company's TSR over the period from the beginning of 2013 to the end of 2015. That's fine, but frankly, by the end of 2015, who cares all that much about 2013 TSR? Many shareholders will not have been shareholders in 2013.

Suppose instead, 2013 TSR was given a weighting of 0.5, 2014 TSR was given a weighting of 1.0, and 2015 TSR was given a weighting of 1.5. Rather than taking an arithmetical (or geometric) average, we would use a weighted (for aging) average.

It makes a lot of sense, doesn't it? It rewards long-term performance and it should, but it puts a bit more weight on what you've done for me lately. And, the great part about it is that each year over the 3-year period gets the same total weighting that it does right now, but it stops the executive team from resting on its laurels from a great 2013.

Discretionary Profit-Sharing Tied to Corporate Performance has Merit

Way back when, profit sharing plans were tied to profits. Gee, that sounds revolutionary doesn't it? If the company made a lot of money, it distributed more of it through its profit sharing plan. If it made less, it distributed less, and if there were no profits, it distributed none at all. Then, the good folks in the Treasury Department informed us that you don't need to have profits in order to share profits.

Say what?

Perhaps I am missing something here, but it makes sense to tie some elements of compensation, even at the lower-paid levels of the company, to corporate performance. It gives everyone a stake in how the company is doing. It's similar in the way that it motivates employees to an ESOP and according to the Employee Ownership Foundation, an ESOP advocacy group, companies that have ESOPs perform better. But, profit-sharing plans are, from my viewpoint, more compliance friendly and flexible than ESOPs.

Extend it to Unions

Labor unions will tell you that unionized companies perform better than those with non-union companies. They will also tell you that those with mandatory (for specific job categories) union membership perform better than those where it is optional or right to work.

Make the unions make the company perform better. Let the unions share in the success of the company, or the lack of success if that's the case. In other words, tie the rewards of the union and its members to the corporate performance. If the company does well, presumably the union had something to do with it. If the company does poorly, it's tough for the union to sit in the corner and say that the poor performance occurred despite the exemplary work of union employees.

Frankly, if the union says this is not the case, then all of its other words are just rhetoric. You're not a contributor to results in only the good years; you influence them in the bad years as well.

Measure the Risk

Companies and their shareholders really should understand their compensation risks. This may sound strange to some, but if the team currently considering these risks is not trained and educated in risk assessment, then find someone who is.

I'm biased in this regard, but since actuaries are trained in risk assessment and risk management and understand compensation and benefit programs, nobody may be better positioned to assist you with this. Ask an actuary.

Another Argument for Defined Benefit

I know, defined benefit (DB) plans are dead. Actually, while there aren't as many as there used to be, I'm going to give you one more argument why they make more sense as a retirement vehicle.

Yesterday, I wrote about managing the risk in active pension liabilities. Way back in 2010, I wrote about generally managing risks and noted that plan sponsors tend not to manage defined contribution plan risks. Most of those risks that I have considered have been financial risk. Today, I am going to focus on the intersection of financial risk and compliance risk and make a case to have a DB plan as your primary retirement vehicle rather than a 401(k) plan.

In the world of 2015, we see consolidation in many industries. We also see companies, often private, being gobbled up by private equity firms. Either of these actions will usually create a larger controlled group. And, people who focus on retirement plan compliance know that most retirement plan compliance testing must be done on a controlled group basis.

Before working to point out a solution, let me give you an example to help focus on the problem.

BPE is a big private equity firm. Their general approach to retirement plans (and other benefits) has been to ignore them and let each company do what it wants. But, as BPE get bigger, its controlled group gets more complex. Having multiple industries represented in its portfolio, BPE is ultimately the sponsor of all kinds of 401(k) plans. Their engineering company (EC) has an extremely generous 401(k) plan that matches 150% on the first 8% of pay that an employee defers. Their pork rinds company (PRC) has a 401(k) plan that matches 10 cents on the dollar on the first 2% of pay that an employee defers.

BPE never saw this as a problem. But, then one day, an inquisitive Principal (IP) at BPE was reading my blog (of all things) and came across this. He saw that BPE might have a compliance problem in its controlled group because of the disparate nature of its 401(k) plans.

Ring ring ring -- that's my phone as IP calls me. He wants to know how to fix the problem. He says that surely this problem can't be real. After an hour on the phone, we have inventoried all the plans at BPE and found that they have failed to satisfy various compliance tests (coverage under Code Section 410(b), for example) for several years.

IP has a solution though. He tells me that BPE will force some of its companies to retroactively cut the employer match in some of these more generous plans.

Bzzz!

You can't do that. In fact, if BPE were to choose to fall on its sword and approach the IRS for a negotiated retroactive solution, we would suspect that the IRS would only be receptive to increasing benefits for nonhighly compensated employees (NHCEs) in the less generous plans.

IP is not happy about this. PRC runs on very low margins, but because they make more pork rinds than any company in the world, they do throw off a lot of cash. However, increasing benefits would eliminate most of that free cash that is being generated. There is stunned silence on the other end of my phone.

While the story is fictitious, the gist of the scenario is not. I've seen this happen. By being a serial acquirer, companies run into compliance problems and with 401(k) plans not being the easiest to prove nondiscriminatory, either costs escalate or they get cut at the portfolio companies that tend to employ more higher paid individuals.

What sort of plan tests better? A few weeks ago, I wrote about some. Suppose BPE had a defined contribution looking cash balance plan. One of the nice things about these plans is that they test well. Designed properly, and proper design truly is a key, financial risk is manageable. And, with that as their primary plan, the secondary 401(k)s can be managed so that compliance there will no longer be an issue.

Unfortunately, the benefits world has been resistant to this whole concept. But, you have an open mind, don't you?

We need to talk.

Derisking Your Defined Benefit Plan or Not

Every couple of years, there is a new trend in the remaining corporate defined benefit plans. Lately, it has been derisking in one sense or another. In fact, the Mercer/CFO Research 2015 Pension Risk Survey says that plan sponsors have been spurred by a perfect storm of events.

I'm not going to argue with there having been a perfect storm of events, but I think that everyone else's idea of what constituted the perfect storm is a bit specific and technical. They focus on falling interest rates, a volatile equity market, and a newly (last year) released mortality table. Instead, I would tend to focus on constantly changing pension rules both in the law and in financial accounting requirements that give plan sponsors a constantly moving target.

But, all that said, the study tells us that 80%-90% of plan sponsors are pleased with the risk management actions they have taken to date. What makes them pleased? Is it that they have cleaned up their balance sheets? Is it that their funding requirements have decreased? Has the derisking decision helped them to better focus on or run their businesses?

Isn't that last one what should be at the crux of the matter? The fact is that 2014 was not a good year to offer lump sum payments to individuals with vested benefits if what you were looking to do was to pay out those lump sums when the amounts would be low. Underlying discount rates were very low meaning that lump sums would be larger. Similarly, the cost of annuities was high, but many chose to purchase annuities for substantial parts of their terminated and retired participants.

What all of these plan sponsors did was to decrease future volatility in pension costs (however they choose to think of cost). For many, that truly was a good thing. But, at what cost?

For some, that cost was significant. For others, it was not.

Defined benefit pension plans used to be viewed as having a degree of permanence. That is, when funding them, calculations assumed that the plan would go on forever. While we know that forever is a very long time, we also know that plans with benefits that are based on participants' pay in the last years of their careers are wise to consider the amounts that they are likely to have to pay out in the future as compared to the amounts that would be paid out if everybody quit today. That is not reality. There used to be what are known as actuarial cost methods that allowed sponsors to do that and frankly, they resulted in larger current required contributions. But, those larger current contributions tended to be very steady as a percentage of payroll and that was something that CFOs were comfortable with.

But, the wise minds in Congress with the advice of some key government workers determined that this was not the right way to fund pension plans. Actually, their real reasons for doing so were to reduce tax deductions for pension plan funding thereby helping to balance the budget.

Sounds stupid, doesn't it? It is stupid if what you are doing is making sponsorship of a pension plan untenable for most corporations.

Risk truly became a 4-letter word for pension plan sponsors. As time went by, it became important for sponsors to find new ways to mitigate that risk.

Unfortunately, many of them have been so eager to do that over the last few years that they likely overspent in their derisking efforts. For others, it was clearly the prudent thing to do.

My advice is this if you are considering your first or some further tranche of derisking. Consider the costs. Consider how much risk you mitigate. Make the prudent business decision. What would your shareholders want you to do?

Then decide whether you should derisk.

Employer Retirement Plan Priorities -- Cut Risks and Costs Says Survey

This morning, I opened up my daily NewsDash email from Plan Sponsor and found an article telling me that employers that sponsor retirement plans (almost all employers of more than a few people do) are looking to curb risks and cut costs. While it's nice to know that a survey confirms prevailing opinion, this is not exactly a revelation.

As disclosures have become more comprehensive, two elements of retirement plans that have gotten particular scrutiny from outside observers are unnecessary risks and unnecessary costs. Interestingly, if a company chooses to make a generous retirement program part of its overall broad-based rewards program, outside observers generally have no problem with this.

Risk in this case is usually measured in terms of volatility. However, just plain old volatility should not be a concern. What should be a concern is volatility in plan costs as it relates to some useful metric or metrics.

Consider a hypothetical company (HC) with free cash flow of $100 million. Suppose the volatility that they are looking at is in pension contributions and that HC is expecting (baseline deterministic scenario) to have to make a contribution in 2015 of $500,000. In looking at forecasts provided by its actuary, HC notices that the 95th percentile of required pension contributions is $2 million. While that is a big increase in relative terms, it may not be enough to have any meaningful effects on the way HC runs its business (it may, depending on circumstances, but in this hypothetical situation, it does not). Depending upon HC's tolerance for risk, this may be a situation where no action needs to be taken.

On the other hand, Failing Business (FB) has a legacy frozen pension plan with expected 2016 required pension contributions of $50 million. FB has significant debt and if it contributes the full $50 million, it will just barely be able to run its operations and service its debt. If that number hits $52 million, FB will default on its largest loan.

What should FB do?

There are several schools of thought here. One is to mitigate pension contribution risk to the extent possible thereby ensuring that the ominous $52 million pension contribution number will not be reached. But, is that really a good strategy? Or is it just part of a spiral to a lingering death? The other school of thought says that FB is an ideal candidate to take on risk for potential reward. If the risk turns out to produce bad results, FB may go out of business, but it looks like whether that happens or not is only a matter of time. On the other hand, if taking the risk generates a big upside, FB will be in a much better position to revive its business.

FB is purely hypothetical and we don't know all the facts here. But, my point is that just because the trend says to do something doesn't mean its right for your company.

On the defined contribution (DC) side, the analysis is a bit different. Today, most companies (I don't have a percentage for you) offer 401(k) plans with some level of employer matching contributions. In this scenario, many companies have thought about the costs, but few have thought about the financial risks.

What are the costs that companies are thinking about? Here are a few:

• The cost of plan administration (recordkeeper, custodial, legal, accounting)
• The fund management fees
• Institutional class versus retail class
• Passive versus active management
• Open architecture versus proprietary

Generally, these are costs that a plan sponsor can control by careful selection of vendors and evaluation of options. Take a look. It may be that your current providers have let their fees to you creep up while their service to you has gone down.

Then, there's the risk. 

One of the other concerns in the DC industry is that employees are not saving enough money. So, many employers are taking steps to encourage their employees to defer more. However, if they defer more, the cost of matching contributions will increase. In my experience, almost no companies actually consider this risk, but I have seen a few CFOs who have been really upset when those matching contributions got big enough that they affected the company's financials.

There are plan designs that can help to control this. Perhaps you should consider one.

Click this link if you want to ask me how.

If We Only Knew What 401(k) Participants Really Want

I read an article this morning called "What Participants Really Want From Their Bond Fund." It was written by a gentleman named Chip Castille. Mr. Castille is the head of the BlackRock US Retirement Group. As such, Mr. Castille is likely a participant in a 401(k) plan, although to be truthful, I don't even know if BlackRock offers a 401(k) plan to its employees.

More to the point, the article tells us what participants really want in a 401(k) plan and specifically in a bond fund in such a plan. While I could not find where the author cited any survey data, either he has some on which he is basing his conclusions or he is divining the answers because he seems to really know better from my read of the article (more on that later).

The author implies that participants are looking for safety, return or retirement income. That is a pretty broad spectrum. But, he doesn't dig into it enough for us to know how a plan sponsor or an investment professional would decide. What he does do is point out that an investment manager in a bond fund looks at how closely his fund is tracking a benchmark while participants look at whether the fund has gained or lost money or it will produce sufficient income.

I don't mean to demean what any professional says. But, here I beg to differ with the author. Participants get a lot of junk in the mail these days (not that these days are really any different from any other days in that regard). If the participants to whom he is referring are anything like the ones that I know, they don't look at individual fund performance very often. In fact, in the case of most that I know, "not very often" is spelled N-E-V-E-R. That's right; they don't look at individual fund performance. They look to see how their total account is doing. They judge (that's spelled G-U-E-S-S) whether it's a good day to be in equities or a good day to be in fixed income and periodically move their money around because they think they know.

Typically, participants don't like losses in their accounts. In fact, I would say that if you were to rank account balance events in order of importance, my guess would be that far more participants would say that they would like to avoid meaningful losses perhaps at the expense of a few big gains than the number who would say they would like to go for big gains at the potential expense of taking some very large losses.

But, I'm just guessing. I don't really know. And, frankly, the author of the article doesn't know any of this either. Face it, he hangs around with investment professionals. Investment professionals are not representative of your average garden variety 401(k) participants.

I happen to be an equal opportunity dumper, however. While I cannot find data that the author is using to draw his conclusions from, I will also take this opportunity to dump on many authors who do use data, usually from surveys.

Let me show you why with an example. Suppose a survey question is worded like this:

What do you want from your 401(k) bond fund?

1. Safety
2. Return
3. Retirement income
4. Guacamole
5. Health care

I've never posed this question this way, so I get to guess at hypothetical results. Some number of people will answer with 4 or 5. Among those who don't, that is, they answer with 1, 2, or 3, or they just skip the question entirely, do they know what I mean by each of 1, 2, and 3? My guess is that they don't. Safety has lots of meanings in life. To an investment professional, it means one thing. To a plan participant, it might mean NEVER losing money. You and I know that is essentially impossible in a bond fund, but the average participant may not.

Some firm out there that wants to prove their own point will have a survey question like this one. They will ask about 1,000 random selected people to answer the questions and some smart people in the proverbial back room will analyze the answers so that the author of the next great white paper will have the definitive solution. 

Suppose the potential answers were flip-flopped (that is, health care was at the top followed by guacamole with safety last), would that change the results? What does a participant do if they wanted to answer none of the above? Or, suppose they don't understand one of the answers. Or, perhaps, in their mind, it's a tie between two answers. Or, maybe last week they would have answered return, but after they got their most recent statement and saw a 10% decline in their account balance, they suddenly place significant value on safety.

Let's face it, none of us know what the average participant wants in a 401(k) bond fund. We don't even know what an average participant is. 

Remember the two words that I capitalized -- NEVER and GUESS. That should tell you something.

There's More to Risk than Just Risk

Risk is a four-letter word. There is even a book with that title (I've never read it and I'm neither recommending it nor panning it). Every CFO will tell you that they hate risk. Most large companies in today's world have large departments whose sole function is to deal with risk. They are tasked with identifying risk, measuring risk, and mitigating risk.

So, John, you're telling me there is more?

I'm afraid there is. When you have fairly constant risk, you can develop a plan to measure it and often to control it. On the other hand, when your risk is volatile, that feels worse.

Consider a hypothetical element of risk related to some sort of performance. Let's say that the mean performance is denoted by 0 and that good performance is denoted by a positive number and poor performance is denoted by a negative number.

Which series of outcomes would you rather have?

• 1, -1, 1, -1, 1, -1, 1, -1, 1, -1
• 0, 7, -4, -8, 6, -3, -11, 5, 8, 0

I suspect that 100% of my readers like the first scenario better. Why? Each has mean and thus expected cumulative outcome 0. But, in the first scenario, the expected downside is (negative) 0.5. In the second scenario, it's (negative) 6.5. 

I developed those results by determining the probability (based on each data set separately) of achieving a sub-par performance and multiplying that by the average negative score in all years in which the score was negative. 

Suppose I want to insure or hedge against this risk. In the first case, it seems like I would be safe insuring against a risk of 1. Suppose I can afford to actually lose (and cover out of assets) 0.5, then I need to purchase insurance or a hedge to cover the other 0.5 each year. 

In the second case, however, it's not so easy. If I know that my loss could be 11, does that mean that I need to insure or hedge 10.5? At the very least, I need to be able to cover my expected downside (for years in which I have sub-par performance. So, in no event can I consider hedging or insuring less than 6.0. 

While the relationship may not be linear, it is probably not a bad approximation. So, in this case, depending upon my view of the situation, I need to insure or hedge somewhere between 13 (this possibly is a linear model and is 6.5/0.5) times as much and 21 (costs less than 21 times as much and developed as 10.5/0.5) times as much. 

That additional cost and it is likely very significant in this case is the cost of volatility. And, that's just the financial cost. There is also the headache cost, the reputational cost, and lots of other associated costs. 

So, when somebody tells you that some riskier strategy is better because it has more upside potential, look at it the other way. Nobody ever lost sleep over an upside. 

Think about it a different way. Consider yourself a golfer. On the 18th green, you have a 5 foot putt that affects a bet you have made. If you are a millionaire and the bet is for $1, you probably don't care all that much (other than for ego and pride) whether you make it or not. You can afford to lose or not win $1. On the other hand, suppose you have $50 to your name and the putt is for $5,000. If you're like most people I know, you will be petrified. You can't stand that kind of risk.

Business works the same way.

Think about it.

Managing HR Risk: Micro Versus Macro

It's an interesting question, at least I think it is; when looking at risks inherent in benefits and compensation programs, should a company look at them on a macro basis or a micro basis? Or said differently, do lots of small unattended risks add up to a large risk that if it were in a single program would be viewed as untenable?

One could probably look at some of the variety of public entities which either are seeking or have sought protection under Chapter 9 of the United States Bankruptcy Code. Additionally, we could examine those that are probably considering such action whether or not deliberations have been in the public eye. What makes them especially relevant to this question is that in so many cases, the costs that are causing these cities and counties to go bankrupt are related to benefits and compensation. They are, after all, the largest budget items for many of these entities.

How did they get to this point? We could get into a political debate here, but that is not my objective. I know that some of my readers lean left while others lean right. We could get into a debate about public unions, but again that's political and one sentence later, it remains not my objective.

Many cities, counties and other government entities provide generous benefits. The often include defined benefit pension plans that would be unheard of in the private sector, health care benefits that would be considered "Cadillac Plans" under the Affordable Care Act (ObamaCare), large amounts of bankable paid time off sometimes as a single quantity and sometimes as vacation time and sick time separately.

The accounting profession through GASB standards has brought attention to the liabilities associated with these costs. Funding of these obligations, however, is usually subject to municipal or state law and there have been some notable cases where local government may have played fast and loose with those laws.

Why do I raise these issues? Benefits were not always as generous as they are today. But, they creep up. In good times, they are enhanced. Look, we have a surplus this year, we can afford to enhance this benefit. Each time this is done, there is a new, albeit small, risk added to the total risk pie.

Suppose a public entity has a $1 billion annual budget and this new enhancement only increases annual costs by $1 million. That's only 0.10% of the annual budget. Surely, it must be affordable. And, frankly, if you thought about it on a personal level, you would probably agree. If you have an annual income of $100,000, a $100 annual increase in costs would not change your life. It's only about $8.33 per month. It's less than 3 cents per day. But, you all know what happens, you don't just take on a single $100 increase, you take on a bunch of them and all of a sudden, you have a meaningful increase in costs and with it, a meaningful increase in risk. So go the public entities as well.

This sometimes happens in the private company world as well. Because of things like ERISA and the Internal Revenue Code, there are more funding rules and they cannot be ignored. But there are lots of benefits and compensation programs that need not be funded. You know what, they add up. Have too many of them and it starts to affect the bottom line. But when companies look at this on a micro basis, there doesn't appear to be a problem. You might hear a conversation that goes something like this:

"We have annual revenues of $1 billion, so where is the problem?" "I don't know, we haven't changed anything with meaningful cost." "Maybe our consultants messed up. When I look at our changes over the last few years, they didn't price any of them out to cost more than $500,000 per year [they forget to mention that there have been 25 such changes over the last 10 years each with estimated cost projections, but that all of those estimates come with inherent volatility and therefore risk], so maybe we should look to see where they messed up."

Suppose the company had looked at all 25 changes together. And, further, suppose they had looked at them stochastically and considered the dreaded left tail -- the worst 5% of all plausible occurrences. Wow, this entails some real risk!

So, while it's okay to consider changes that have costs and to be a bit more cavalier about ones that have small costs, companies should always consider them in a more macro context. What other changes have been made recently or are they considering? What is the interplay between the costs and attendant risks? How do they correlate? Will the costs escalate at the same time as business has a tendency to go bad?

Food for thought? What do you think?

Does Your Plan Have Undue Risk?

An actuary friend of mine was complaining about upcoming end-of-year DB disclosures and the fact that his clients had funding calculations coming up that were going to be based on low interest rates and equity markets that have plummeted since the election. I further heard that the underfunded plans that he works with were overfunded as recently as September 1.

I asked him about de-risking, liability matching and things like that. He said that his clients give up too much upside return by doing that. I guess they would rather have underfunded plans.

In about 2002, I gave a speech to a bunch of pension investment professionals. In it, I espoused long duration fixed income investments in DB plans despite that everyone knew that interest rates couldn't go any lower. Of course, they also knew that this would take interest rate risk out of the equation, but people treated me as if I had some sort of strange disease.

I know of a few plan sponsors who did what I said. They are the ones with well-funded plans now. I don't know about you, but I'm not smart enough to know where interest rates are headed on any particular day. Frankly, I have expected them to be headed upward for that entire 10-year period, but that's not the point. The point is that there are a number of risks inherent in DB plans in the US. Some are outside of the sponsor's control, but others fall within it.

Shouldn't a sponsor consider controlling the ones that they can.

Building a 401(k) Plan that Prepares Employees for Retirement

It's one of the biggest concerns that I hear from people in 2012: "How will I ever be able to retire?" They tell me that their dad had a pension plan and Social Security, but they don't have a pension plan and they may not have Social Security. Whether these people will have Social Security benefits or not I can't tell you, but for most, their only employer-sponsored retirement plan will be a 401(k).

What does an employee whose only sources of retirement funds will be their 401(k) and Social Security need to do in order to ensure that he or she will someday have enough to retire? It's not rocket science, but it may not be easy either. Try this list on for size:

• Start saving early in your career. Money that is saved at age 25, compounded at just 5% annually will have more than double by age 40. But, at age 25, most people have other things in mind for their paycheck than their 401(k).
• Save continuously. Treat your 401(k) deferrals as if they will never be part of your paycheck. They are just money that is not there. In today's economy, that's not easy. When your expenses exceed your income, one way to cover that gap is to cut back on your 401(k). And, in these economy, more people than not seem to have an employment discontinuity. Just as employees don't have the loyalty to their employers that was once the norm, neither is the reverse true. Layoffs come frequently and re-employment is difficult.
• Invest prudently. Especially with the communications that plan participants receive, most of them have no idea what it means to invest prudently. They receive more advice than they know what to do with while their personal filters are not good enough to know which advice they should follow. One rule of thumb that I see frequently is that the percentage of your account balance that should be in equities is 100 minus your age. But, equities are volatile, and that has an effect -- a dramatic effect.
• Reduce volatility. Gee, John, didn't you just tell me to invest heavily in equities when I'm young, but that those investments are volatile? Actually, I didn't; I simply pointed out a common theme among the advice that plan participants receive. Consider this. Suppose I told you that in Investment A, the $1,000 that you deferred at age 25 would get an annual return of 5.00% every year until age 65, but in Investment B, your returns would alternate so that in the first year, you would get a return of -9.00%, in the second year, 20.00%, and that this would repeat itself until age 65. Simple math tells us that your average annual return would be 5.50%. So, which investment would you rather have (remember, these returns are guaranteed)? The answer is not even a close call. Despite the average return of 5.5% in Investment B, $1000 in Investment A after 40 years will accumulate to roughly $7,040 while $1000 in Investment B will accumulate to just $5,814. In fact, it would require the 20.00% return in the up years to increase to nearly 21.00% to make B as good an investment as A. Volatility is a killer.

So, the messages to the employees need to include 1) save early, 2) save continuously, 3) invest prudently, 4) reduce volatility. I would suggest that the first two items can be achieved for many people through auto-enrollment. But, most 401(k) plans that auto-enroll use a 3% deferral rate. 3% of pay is not enough. You'll never get there. Plans need to auto-enroll at rates closer to 10% of pay to ensure that employees will have enough to retire on. 10% is a lot. Many employees will opt out. It's going to be difficult.

The last two items relate to investments. The Pension Protection Act of 2006 (PPA) introduced a new concept to 401(k) plans, the Qualified Default Investment Alternative (QDIA). For employees who do not make an affirmative election otherwise, their investments are defaulted into the QDIA. Generally, QDIAs must be balanced funds or risk-based funds. Many plan sponsors use target date funds (TDFs) to satisfy the QDIA requirement. I went out to Morningstar's website to look at the performance of TDFs since the passage of PPA. All of them have had significant volatility. This is not surprising, of course, since equity markets have been extremely volatile over that period. But, we saw just a few lines up what volatility can do to you. Perhaps employees should be opting out, but into what? It's going to be difficult.

So, what are the characteristics of a 401(k) plan that guarantees employee preparedness for retirement? Many would argue that this 401(k) plan may not be a 401(k) plan at all. Perhaps what employees need is a plan that has some of the characteristics of a 401(k), but not all of them. Employees need to be able to save. Employees need portability as they move from one job to another. And, then, employees need protection against volatility and protection against outliving their wealth (longevity insurance). 

Consider that last term -- longevity insurance. The second word is insurance. Insurance generally is attained by a counterparty pooling risks. An individual cannot pool risks. An employer with enough employees can. An insurance company can.

Perhaps the law doesn't facilitate it yet, but a system in which employees can defer their own money to get a guaranteed rate of return (tied to low-risk or risk-free investments) and then have the amounts annuitized at retirement is the answer. Perhaps the law needs to facilitate it.

Asymmetric Risk Situations

These days, a good bit of my consulting practice is dedicated to defined benefit pensions and executive benefits and compensation. Over the last several days, in reading the news, it occurred to me the significant asymmetries in the two practice areas.

For those who have been living under a rock, certainly, at least in my opinion, the biggest business news has been the trading debacle at JPMorgan. Ina Drew, a long-time employee of JPMorgan who oversaw the trading unit is being held responsible. According to JPMorgan's proxy issued this spring, Ms. Drew earned approximately $14 million last year (frequent readers may know that the total annual compensation disclosed in a proxy may not be an excellent representation of the actual amount earned) making her, according to the proxy, the 4th highest compensated employee of the bank.

By all publicly available information that I could find, Ms. Drew has a reputation as being one of the best at her field. This from a Reuters article, "Until the loss was disclosed on Thursday, Drew was considered by some market participants as one of the best managers of balance sheet risks."

For full disclosure, I was once an employee of JPMorgan. I became one when my employer at the time was acquired by a JPMorgan unit. My employment there ended when the division of which I was a part was sold by the company. As a result of JPMorgan's incentive compensation plan which requires certain employees to defer parts of their incentive compensation ( the plan has previously been disclosed publicly), I have control of a relatively small number of shares of JPMorgan stock. This post is neither intended as approval nor condemnation of the company or its employees. JPMorgan happens to be in the news, currently, but on a different date, I could have chosen a different company.

So, where am I headed with this? Pension plans and individual (executive or commissioned) compensation represent entirely different risks. Each is asymmetric, but in opposite directions. So, this post is about behavioral risk management. It could easily be extended elsewhere, but I have no expertise in social psychology, for example (you may argue that I have none in the fields that I am writing about either, but I am going to defend that I have some, at the least).

Under current US pension law (see for example, Internal Revenue Code Sections 430 and 436), if we leave out transition rules and there are many, non-governmental qualified defined benefit plans typically get treated differently at funding levels of 60%, 80%, and 100%. Speaking in significant generalities, if your plan is less than 60% funded, there is not much that you can do with it. Participants generally cannot accrue new benefits, the plan sponsor can't improve the plan; essentially, all you can do is fund it, and the funding rules for plans less than 60% funded are pretty onerous (not judging the appropriateness of this part of the law here). Once a plan gets over 60% funded, but less than 80%, things get somewhat better. Restrictions are less. Between 80% and 100%, things are generally pretty uniform and a plan sponsor can operate on a normal ongoing basis, so to speak (this is not intended to be a course in pension funding law; it's illustrative). If your plan is better than 100% funded, it may be unusual these days, but funding gets easy. Note that there is no nice threshold in excess of 100%.

What does this tell us? If your plan is less than 60% funded, there are no more downside thresholds. The sponsor, oversimplifying significantly, has little downside risk. Between 60% and 100%, there is both upside reward and downside risk, and while they are not identical, there is certainly a degree of symmetry. Once your plan is better than 100% funded, there is almost no upside reward, but there is downside risk.

These risks and rewards should inform the asset allocation decisions. They should inform the fiduciary decisions and, in my experience, they often do.

Let's turn our discussion to compensation, specifically that of two types of individuals: 1) top executives whose incentive reward potential often dwarfs their base pay, and 2) commissioned salespeople whose commissions have the potential to exceed their base pay or are their entire compensation.

Here are some facts about the compensation of many of the people in both of those groups:

• There is little, if anything, that applies in practice that limits the upside of their incentive compensation. Even to the extent that it is limited, those limits are very rarely reached. (Some plans are not designed this way, but many are.)
• Unless a plan has clawbacks (a means for recovery of compensation for various reasons, often related to fraud or other criminal activity), employees don't receive a negative bonus. At least, I have never seen it.

In the context that we used for pensions, there is plenty of upside reward potential, but there is little downside risk. Suppose I am a commissioned salesman. Further suppose that my compensation is entirely based on a percentage, 3% for example, of my sales. The smallest that my compensation can be is $0. I cannot sell less than nothing. The most that my compensation can be is 3% of infinity. That's a big number. I have an incentive to take risks. 

In their best-selling book, Freakonomics, authors Levitt and Dubner discuss this in the context of real estate agents (excerpts can be found here). Oversimplifying, a real estate agent can sell two types of homes: someone else's or their own. When selling someone their own home, an agent has an incentive to sell for the highest price. For each additional dollar of sales price, the agent receives nearly 100 cents (their broker and the agent on the other side each receive something). When selling a client's home, out of every additional dollar of sales price, the agent gets about 3 cents. According to Levitt and Dubner (and I agree), the agent selling your home has an incentive to get sell your home quickly. If they can get an additional $300 for getting you an extra $10,000 in sales price, the system motivates them not to do it because $300 doesn't mean anywhere near as much to them as $10,000 does to you. Speed is more important. But, if they are selling their own home, that $10,000 represents more than $300,000 in sales of other people's homes. If they can afford to, that system motivates them to hold out for more.

Executive compensation is not quite the same. But, often, it's closer to the real estate agent model. Incentive payouts for many CEOs and their direct reports is discretionary. It may have theoretical limits, but according to dozens of proxies that I have examined (you can get proxies at the SEC website),an executive who has a fantastic year may have their compensation exceed even the upper limits specified in a plan. Upper limits are often more than twice a target. The incentive is there to take risk. 

Why do people play the lottery? It's a losing proposition ... for all except the winners. The upside is huge, however. But, it's a game of chance. You know that going in. And, if you play, you are willing to risk some amount for a huge potential upside. 

Should you treat your pension plan as a game of chance? I don't think so. The system has been set up against it. The system has rules and those rules should, in my opinion, inform your behavior. Whether the current system is the correct one is irrelevant. It is the current system.

Should your executive compensation program be a game of chance? Should it contain asymmetric incentives? When I am a shareholder with an opportunity to vote my shares, my bias is against it. I prefer the companies of which I am an owner to not take inappropriate risks. It's human nature. Even for an incredibly ethical person, incentives matter. If you give me an asymmetric bet, and that bet is in my favor, if I use the logical part of my brain only, I should take it. We would like executives to use logic.

When we give them an asymmetric risk opportunity, are we not asking them to take perhaps inappropriate risks? Are they risks that you wouldn't take in your pension plan?

How About Paying With Debt?

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

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

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

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

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

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

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

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

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

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

To LDI or not to LDI

I saw an interesting article today. It said that 63% of pension execs (whatever execs represents in this case) are now using an LDI approach for pension funding. I saw an article on the same site that asked the question, "If LDI is so great, how come more funds aren't doing it?"

"I see", said the blind man who knows that LDI stands for Liability Driven Investing. In a nutshell, pension funds that employ this technique seek to mitigate funded status volatility by having a portfolio of assets that varies with moving interest rates in essentially the same way as the plan obligations move.

I first discussed LDI with a client in (I think this is the correct year) 1998. At the time, this company's US pension funds had an overall funded status well in excess of 125% on any measure. The technique that I discussed with them didn't have such a catchy name though. I think we called it duration modeling (doesn't sound too catchy, does it). The good news -- that company adopted what came to be known as an LDI strategy and never fell into the morass of underfunding suffered my most US pension plans. The bad news (for participants anyway) -- the company eventually froze their plans to save money.

Back in the very late 90s and early 2000s, I gave some speeches on the topic. I always heard the same response from the naysayers -- roughly, do you mean to tell me that you think interest rates are going to go down? These naysayers were generally the absolute return people. Despite all the logic, they didn't seem to understand that even if you thought that interest rates would go up (they didn't over the next 10 years or so), probabilistic or stochastic analysis showed that for most plans, you would be doing a far better job of risk management by matching assets with liabilities.

Let's consider. Suppose that in 75% of all cases, you thought interest rates would go up and in 25%, they would go down (let's assume that in very few would they stay the same and we will just split them evenly between the two groups). Unfortunately, especially under the new PPA funding regimes, the worst possible scenarios for plan sponsors -- the ones that might put them out of business -- all occurred where interest rates fell and the plan sponsor chose to not match assets to liabilities. In the more positive (return) cases, the group that matched didn't do as well as the group that bet that interest rates would go up, but even so, they should have been able to sleep better.

You see, the matching, or immunizing, group, was coming close to ensuring that their required contributions would not be enough to cause corporate financial ruin. Yes, they were taking away some of their upside potential, but isn't that what risk management and insurance are all about? When you insure your home, for example, you know that you probably won't have a large claim. So, you are spending money on insurance that you probably won't recover (essentially decreasing your upside potential). On the other hand, if you do have that large claim, you'll be glad that you had that insurance, and that's what LDI is all about.

Sadly, so many companies that knew this was the correct approach for them resisted and many of them either had to reduce benefits, or in some particularly severe cases, were essentially put out of business by their pension plans.

It's not worth all that. If you still have a US defined benefit plan, at least consider your risks and see what you might do to mitigate them.

Are You Sleeping? Who is Managing the Compensation Risk?

Risk management used to be viewed with a somewhat jaundiced eye. It was something that the geeks did. I know, at your company, you just didn't need it because you understood your business better than some guy with a fancy degree, a pocket protector, and an HP-12C.

While companies had full-time risk managers and even risk management departments before then, this mad science really came to the forefront in the early 2000s. Suddenly, companies were seeing that risks that they had taken, especially in the area of leveraging themselves perhaps a bit too much, were starting to bite them in their proverbial hind quarters.

With that, the CRO or Chief Risk Officer, became the new sought after geek. Here was a person with specialized training who could look after the store, so to speak. If the CRO approved, then the CEO and CFO had a special comfort that all would be well.

Yes, CROs, as a group, do have specialized training. They tend to be smart people who can model the risks of a veritable cornucopia of corporate transactions. But, even the smartest person doesn't have the capacity to consider every possible risk. Sometimes, they are just not aware of certain risks. Sometimes, the other departments take actions without consulting the CRO and his staff because they just don't think the particular decisions has a risk potential that hits that threshold.

Perhaps that department was Human Resources. I know, you think I am wrong; by the early 2000s, the Risk Management Department was heavily involved in working with pension plans. Well, I am focused on a different part of Human Resources here, the part that develops compensation programs.

Way back when, you know, about 25 years ago, a typical bonus program worked something like this. Everyone in the program had a target bonus -- some percentage of their base pay. To go with that target bonus, you had a set of goals. They were, in theory, set up so that you had a roughly equal chance of exceeding your goals or of falling short. And, your bonus was typically capped, on the upside at twice your target and on the downside at zero.

Ah, theory, what a wonderful concept.

Picture yourself as a manager. You have three employees to review for their performance in 2011. Let's call them Larry, Moe, and Curly. Larry has always been a star performer. Each year, he has exceeded expectations. But, in 2011, Larry did not have a good year. He fell short of every goal. But, somewhere in your mind, although you can't quite put your finger on the exact cause, you think there must have been extenuating circumstances. You are sure that Larry will have a good year in 2012, and what's more, you don't want to lose him to a competitor. So, on your 1 to 5 scale with 5 being the best, you grade Larry as a 3.5. You tell him that he is being rewarded for a prolonged period of high performance, but that he needs to step it up in 2012.

Moe has always been your man in the middle. He's been a consistent performer, always meeting goals, but rarely exceeding them. But, Moe has those intangibles. They are not in his goals, but you just have to reward him because he makes everyone around him better. In 2011, Moe exactly met his goals, but because of that special something, you gave him a rating of 3.5.

Curly has been your problem child. Each year, he has been the laggard of the three, but you have kept him around both because the team has been meeting its goals (due mostly to Larry) and because of his wonderful sense of humor. Curly keeps you laughing and he is just so likable. Finally, for the first time, in 2011, Curly beat his goals. You gave him a rating of 3.5

Let's look at what happened. Your team exactly met its goals. Yet, you awarded each team member with a rating that gets them a bonus of 125% of target. Hmm?

And, then in another year, business was really good. You find out that the bonus pool is going to be really big. Curly had another very good year. You give him a rating of 4.5. Moe had a better year than Curly, and you know that somehow, Moe also contributed to Larry's success this year, so you give him a 4.9. But, Larry, oh Larry, had the year of a lifetime. If Moe got a 4.9, there is no rating that does Larry's year justice, so you take it up the line to get Larry a bonus of 3 times target. And, because business was so good, it gets approved.

But, the next year, the economy goes into the tank. Nobody meets their goals, and in fact, the company lost money. It would like to have a negative bonus pool, but that can't happen. And, all of your employees tried really hard, so you want to give them something. You beg to your superiors just as every manager is doing, but where will the money come from?

As time went by, companies survived this strange concept where everyone got a bigger bonus than they really deserved. So, it became accepted that there was really no upside limit to bonuses, at least not for the top producers.

But, I digress for a brief commercial. If you haven't read Michael Lewis's book, The Big Short, then you should. To a large extent, it shows how having no upside limits to incentive payouts encourages absolutely ridiculous risk-taking. Without giving away the whole book, people were making and taking 12-figure risks on bets that they didn't understand. Hmm?

And, they were being rewarded for it. People who had budgeted incentive payouts in the range of several hundred thousand dollars were suddenly getting 8-figure payouts. They were betting on these wonderful instruments known as credit default swaps, and most of them were taking what turned out to be the wrong side of the bet. But, the risk management people didn't understand them either. In fact, very few people did.

So, now we are really in 2011, very close to the end of it, in fact. Managers with explicit incentive compensation plans will be facing the same issues all over again. Far more visibly, Compensation Committees will be facing the same issues all over again.

Let's peek in at a deliberation as the Compensation Committee decides how much of an incentive payout to give to CEO Lou Abbott and CFO Bud Costello. The company didn't have a great year, but neither did any of their competitors. And, Abbott and Costello, everyone knows, are legends in the industry. We really can't afford to lose either one of them. Last year wasn't too good either. We really can't risk losing them over a bad incentive payout. Let's give them something extra this year and we'll go harsher on them the next time their scheduled payout would be huge. [Hopefully, this behavior isn't occurring in any real Compensation Committees, but you never know.]

Do you think the Compensation Committee will remember?

So, here's the deal. In a bad year, bonuses in total may be more than the company can afford because they can't afford to pay out that little and risk losing people over it. In a mediocre year, bonuses in total may be more than the company can afford because everybody had something positive about their year. And, in a great year, the risk-takers won and they will get bonuses so big that the company will pay out more than it can afford.

And where is the Risk Management Department to ask who is managing the compensation risk?

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?

Funded Status of Corporate Pensions Improves Due to Increased Funding

Each month, Mercer does an analysis of the funded status of pension plans sponsored by S&P 1500 companies. Based on the Mercer study, the aggregate funding deficit as of March 31, 2011 was about $213 billion, down from $256 billion a month earlier. Mercer said that one of the primary reasons for this smaller deficit is that pension plan sponsors continue to make significant contributions to the plans. This is especially true for corporations with high quality debt where the current extremely low cost of borrowing for these companies has caused many to choose to borrow to fund up those plans. Also notable in the Mercer study is that the aggregate funded status for the same plans increased from 81% to 87% during the 3-month period ended March 31, 2011.

What's going on here? While I haven't had the opportunity to discuss this issue with all of the finance heads, many of whom are presumably the ones who are making this decision, let's consider a very plausible rationale. Suppose you sponsor a pension plan that is underfunded by $100 million. In simple terms, this leaves you with a $100 million liability on the balance sheet. Now, if you turn around and borrow that same $100 million (or some piece of it) at today's very low rates, you 'move' the liability on the balance sheet from the pension plan to more standard corporate debt, and you do it a low rate.

Why might this be good? In and of itself, it might not be, but suppose you use that new level of funding to help de-risk the pension plan. You are now taking what many consider to be a risky, highly volatile (this has been addressed over and over again here and in many other places) liability and replacing it with a stable, less risky liability. In today's world, where risk is bad and risk management is king, this is highly desirable. My employer has been at the forefront of such risk management efforts in pension plans since our inception.

Frankly, it's not just funding that has decreased deficits and increased funded statuses. Equity investments have generally performed well year-to-date and underlying discount rates have remained relatively stable.

I haven't seen the gory details of the Mercer study, but I must wonder to what extent the Pension Protection Act (PPA) funding rules have been behind these contributions as well. With plans being as poorly funded as they have been recently, and CFOs having the knowledge that PPA does require particularly rapid (7-year) funding of the underfunded, might they not be simply opting to throw cash at the plans when the cost of cash is low? Better, perhaps to do it this way, than to fund only when it is required when their borrowing costs may be higher.

So, the large corporate world seems to be getting this under control. If only sponsors of public pension plans could fix their underfunding as easily.

Do Target Date Funds Have it Bass Ackwards?

Target date funds or TDFs as they are sometimes known are all the rage in defined contribution (DC) plans. Perhaps, you have your money invested in one. Before I try to confront conventional wisdom, let me explain how they typically work.

Your plan account is set up on what is known as a glide path. What this means, oversimplified somewhat, is that your funds are invested in a diversified portfolio which is fairly aggressive at younger ages, and gets more conservative as it moves along the glide path toward older ages.

I'm not saying that this is wrong, but I'm going to challenge conventional thinking. I did a really simple simulation for 25 years. I assumed that a person started with annual compensation of $50,000, got annual pay increases of 4% per year, deferred 6% of pay into his 401(k) plan each year and got various rates of return on his money for each year. In the case where our hero earned a 10% rate of return in year 1 and 0% in year 25 with intermediate years sloping down smoothly, his account balance at retirement (end of Year 25) was about $182,500. When I assumed an annual rate of return of 5% (never varying), his account balance at retirement was nearly $223,500, and when I reversed the first scenario by grading upward from 0% to 10%, his account balance at retirement was just shy of $272,000.

But, the whole philosophy behind TDFs is to sacrifice potential reward for decreased risk as a participant approaches retirement. These illustrations imply that this is all wrong. Why? Well, the close that you get to retirement, the more money you have in your account. So, in Year 1, it probably doesn't make much difference what your rate of return is as there is a limit on what can happen to $3,000 deferral. But as deferrals and earnings add up, the annual rate of return becomes much more important.

This is too simplified for you, isn't it? Well, I made it more complicated. I developed multiple scenarios using a random number generator where the rates of return in Years 1 through 5 averaged 6%, in Years 6 through 10, they averaged 5.5%, in Years 11 through 15, they averaged 5.0%, in Years 16 through 20, they averaged 4.5%, and in Years 21 through 25, the average return was 4.0%. The mean ending account balance of all the simulations was about $192,000. Then, I reversed the process so that 5-year time-weighted returns averaged 4% in the first 5 years up to 6% in the last 5 years. Now, the simulated mean ending account balance was about $225,000.

Come on now. Don't do this to us. Don't mess with conventional wisdom. It hurts the brain on a Friday. What is going on here?

Let's step back and think about the underlying TDF premise. I'm going to point out a huge flaw in that premise (I'd love to be besieged with comments telling me why I am wrong). TDFs are designed so that the participant takes more risk and presumably gets more reward early in his career, and that is gradually reversed to the point where the participant takes less risk and gets less reward later in his career. This makes a big assumption which is usually false.

Read on, MacDuff!

The assumption made in TDF design is that a participant nearing retirement actually has enough money in his account that he no longer needs the upside potential that he needed when he was younger. In other words, it presumes that our participant has nearly enough money in his account to retire on as he nears retirement age, and that only some significant downtrends could disturb that.

We've all seen the data. It's just not so. Our participants rarely have enough in their accounts these days to retire on and they don't understand that. So, this de-risking strategy, while it doesn't make our participants significantly less able to retire when they plan to, also doesn't make them able to retire.

What is the answer? If I could snap my fingers and tell you, I wouldn't need to be sitting here blogging. I'd be out in northern California in my rocking chair looking out the window at my vineyard being tended to by others. But, I'd like to posit that DC plans need to learn something from defined benefit (DB) plan funding methods. I'm not talking about the current farce where all plans with pay-related benefits are forced to use a non-pay related cost method to determine contribution requirements. I'm talking about an old friend, Individual Aggregate.

If I've lost you now, I'm going to bring you back to the story. A long time ago in a faraway land (shortly after the passage of ERISA in the ivory towers of the Treasury Department), the IRS and Treasury were good enough to tell us in regulations and other guidance what constituted a "reasonable actuarial cost method." Individual aggregate was a favorite for funding one-person plans. It was constructed to produce a cost of a level percentage of pay throughout a participant's career so that a participant's retirement benefit would be fully funded at retirement, and the cost of deviations from assumptions were spread over the participant's remaining future working lifetime, so that the benefit would be fully funded at retirement. That's a really neat concept, isn't it?

What does it have to do with DC plans? Well, part of funding a DB plan is (or at least used to be before Congress starting meddling with funding rules) that the actuary makes a bunch of actuarial assumptions related to compensation, retirement date, mortality patterns (life expectancy), rates of return, and other related factors. Couldn't a participant in a DC plan do that?

So, a participant makes assumptions. He decides what percentage of pay he can defer to his plan, and through this fancy concept known as individual aggregate, he gets a necessary rate of return. Necessary rate of return is too high, he better defer more, or retire later. In any event, this would amount to sound planning.

Yes, for those who start early, defer a lot, and get a nice inheritance, TDFs will work well. Those participants will be prepared for pre-retirement in their pre-retirement years, and for them, downside risk avoidance will be paramount. But data shows that most participants are not in that situation. For them, I think we need to re-think TDFs.

Tell me why I am wrong. Tell me why I am right. Tell me something.

Top Concerns for Pension Plan Sponsors

An SEI 'Quick Poll' found that controlling funding status volatility is the number one priority for defined benefit plan sponsors. When I look at the Top 10, however, a common theme emerges: Managing Risk.

Here are the Top 10 (in traditional as compared to Letterman order):

1. Controlling funded status volatility
2. Providing senior management with long-term pension strategies
3. Improving plan's funded status
4. Conducting an asset-liability study
5. Effectively managing duration moving forward
6. Implementing a liability-driven investment (LDI) strategy using long bonds
7. Defining fiduciary responsibilities for trustees and investment consultants
8. Changing funding policies and timelines
9. Stress-testing the portfolio to gauge its ability to withstand extreme macroeconomic environments
10. Implementing a plan design change such as closing the plan to new entrants or freezing accruals in already closed plans

It's time to make a few comments on this list. First, who comes up with these choices? #9 was clearly the brainchild of someone with too much time on their hands trying to sound smart. Isn't that what you do as part of #4? Second, all ten of them address some element of risk management. Third, of the companies that chose #8, I wonder for how many of them, changing funding policies is the same thing as actually having a funding policy.

On The Dynamics of Investment Committee Decisions

In a September 2010 survey conducted by Vanguard, more than 80% of investment committee members surveyed said that the knowledge level of their committee was above average and more than 60% said their committee seldom makes a mistake.

Wow!

I could spend hours now harping on the US educational system as the reason for this (grade inflation where a 'C' meaning average is only given to the worst performing students, but that's for another day and another blog). This is amazing, though ... or is it?

Let's consider why, and then we'll look at a potential solution. Who chooses committee members? The CFO? The Treasurer? Someone similarly situated? The Committee Chair? No matter which one of those it is, it's probably one of them. Who do they choose for the committee? In most cases, they probably choose people that they view as being a lot like them -- their proteges, for example. If that's the case, then a lot of the people on the committee will have gotten a lot of their knowledge from the same place.

Hmm! That's not good. That means that they may have similar biases. They may be serving on this committee chaired by their boss.

Hmm! That's not good. Through peer pressure, group dynamics, inertia, and many other dynamics, people tend to think that their group's ideas are the best, especially if their group builds consensus. Building consensus  generally is good, but what happens if the consensus is wrong? What happens if the consensus is under-(or un)-informed? What happens if the Committee Chair steers the committee toward his or her bias?

I know. This never happens on your committee, but you do know that it happens on most other committees. In fact, I've attended committee meetings where this happens. Sometimes, it produces good results, but all too frequently, it produces bad results based on what the committee thinks were outstanding decisions.

Let's put this in a defined benefit plan context. In order to properly invest defined benefit assets, the committee needs to understand both the assets and the liabilities. (Not doing so increases risk for the enterprise.) Yet, in my experience, very few committee members understand both sides of the equation (plan assets and plan liabilities). These people have other jobs. This is not their area of expertise. That being said, there are plenty of committees and committee members out there who just don't care. They have their committee comprised of some of the smartest people they know (including them, of course). Because they are smart, they will make the right decisions.

Consider an analogue. Suppose WeFlyHigh Airlines was considering which type of airplane to buy to add to their fleet. Should they buy the newest Boeing jumbo jet or the competing Airbus. Do you think they would have the Investment Committee members making that decision? Why not? They are smart people. Surely, they would make the right decision, wouldn't they? No, those decisions are usually made, or at least informed, by true experts. Shouldn't these committees also be informed by experts?

I promised you a solution, didn't I? And perhaps I've already shown my cards.

Hire an expert. Don't bring them on full time. But, this is why consultants exist, isn't it?

How should you choose your consultant? Look for these criteria:

• As part of their engagement, the consultant will educate the committee.
• The consultant understands the asset side and the liability side.
• As part of the liability side, the consultant understands the subtle changes to the liability profile that plan design changes and employee population shifts can cause.
• The consultant has a track record of making changes to the thinking of the committee.
• The consultant will challenge the decisions of the committee.
• The consultant can demonstrate a track record of giving different advice for different plans because those plans had different characteristics and were sponsored by different companies with different goals.
• The consultant freely admits that they are serving in the role of fiduciary.

I expect I'll write more on this topic. In the meantime, I'd love your comments.