Wake Up and See the Light, Congress!

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

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

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

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

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

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

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

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

Proposed Tax Bill Would Change the Face of Executive Compensation

Yesterday, Representative Kevin Brady (R-TX), Chair of the powerful House Ways and Means Committee, rolled out the Republican tax reform proposal. And, while no tax bill in my lifetime or likely anyone else's lifetime has made it through the legislative process unscathed, the draft bill fashioned as HR 1 certainly provides an indicator of where we may be headed.

Much seems completely as expected. We knew about the slimming to four tax brackets. We knew about the narrowing of deductions. We knew that some of the more heavily-taxed states would feel the pain of restructuring. What we didn't know and what frankly came as a surprise to me and to others that I know would completely change the face of executive compensation in the US. Honestly, on its surface, these proposed changes look to me as if they they had been constructed by Democrats. It wouldn't surprise me if these changes had been pre-negotiated, but that's entirely speculation on my part.

So, what's the big deal?

There are two extremely significant proposed changes according to my initial reading.

1. The draft would amend Code Section 162(m) (the $1 million pay cap) to eliminate the exemption for performance-based compensation. In addition, that section would be amended to cover the Chief Financial Officer in addition to the Chief Executive Officer. 
2. Code Section 409A would be repealed (you thought that was good news, didn't you?) and replaced with a new Code Section 409B. Essentially, 409B as drafted would apply the much more stringent taxation upon vesting rules that have previously applied generally only to 457(f) plans. 

162(m) Changes

Section 162(m) was added to the Internal Revenue Code by the 1993 tax bill. Widely praised at the time as a way to limit executive compensation, the exemption for performance-based compensation turned out to be a far bigger loophole than had been imagined. Many companies saw this as a license to offer base pay of $1 million to their CEO while offering incentive pay (some only very loosely incentive based) without limits while taking current deductions.

That would change. 

My suspicion is that companies would return to paying their top executives as they and their Boards see fit, but with the knowledge that particularly high compensation whether performance based or not would not be deductible. Additionally, so called mega-grants and mega-awards would likely become much rarer as the cost of providing them would no longer be offset by tax savings.

409B

The ability to defer compensation has long been a favorite of high earners. The requirement to defer compensation has also been considered a good governance technique by many large employers (for example, a number of large financial services institutions require that percentages of incentive compensation be paid in company stock and that receipt must be deferred),

Much of this would go away as very few people have the ability or desire to pay taxes on large sums of money before they actually receive that money.

What Might Happen If the Bill Passes

Nobody really knows what might happen. But since this is my blog, I get to guess. Here, readers need to understand that there is no hard evidence that what I say in this section will happen, but it seems as if it could.

The draft of HR 1 appears to keep tax-favored status for qualified retirement plans. That's important because qualified retirement plans are a form of deferred compensation with some special rules and requirements attached. What this means is that to the extent that an individual would like to defer compensation on a tax-favored basis, he would need to do it through a qualified plan.

However, qualified plans need to be nondiscriminatory; that is, they must (not an exhaustive list):

• Provide benefits that are nondiscriminatory (in favor of highly compensated employees)
• Provide other plan elements sometimes known as benefits, rights, and features that are nondiscriminatory
• Cover a group of employees that is nondiscriminatory

There are techniques by which this can be accomplished in a currently legal manner, but they are not simple. It would not surprise me to see more interest in these techniques.

As I said at the beginning, I don't expect this bill to pass as is. But, these particular provisions written by Republicans should not draw ire from Democrats. We'll see where it goes.

Tax Reform on the Horizon ? Probably Not

Representative Dave Camp (R-MI) has just introduced into the House Ways and Means Committee which he happens to chair the Tax Reform Act of 2014. You can read it here. Given that the Republicans only control one house of Congress and do not control the White House, the bill has little likelihood of passing. However, it gives notice as to where the party leadership may want to take tax policy.

After I've done my skim-through of the roughly 1000 pages, I'll try to comment here if it's worthy of any such comment.

SAFE Retirement Plan -- A Paper from the Center for American Progress

The Center for American Progress (CAP) released a paper entitled American Retirement Savings Could be Much Better. For readers interested in the topic of retirement savings, I would highly recommend a read or at least a perusal of the paper. The authors are Rowland Davis, a well-known actuary who very clearly does have the training and experience necessary to undertake such a study and David Madland, a commentator on the economy, unions, retirement policy and public opinion. Not having the same background as Dr. Madland, I am not in a position to judge his background and experience, but as the paper is well-founded, I will presume that he too is highly qualified to opine on this topic.

Essentially, the authors propose what is often referred to as a collective savings or collective defined contribution plan. Under such a plan, in a nutshell, a worker would enroll in a SAFE (secure, accessible, flexible, and efficient) retirement plan. This plan would have all of these characteristics (not an exhaustive list):

• Workers would opt into a SAFE Plan of their choosing
• Employers could choose to contribute or not
• Plan assets would be professionally invested at what would currently be considered very low levels of fees
• Workers' accounts would get the returns on the professionally managed pools of assets subject to a floor and a ceiling (in combination, referred to as a collar)
• At retirement, the account balance would be converted to an inflation-adjusted annuity

Let's consider what the authors have created here. Essentially, it's a contributory multiemployer cash balance pension plan with a set of features not currently permitted under the Internal Revenue Code for qualified plans. 

What a novel concept! The authors have chosen to separate retirement policy from tax policy. For this, they are to be applauded. Combined with the access that CAP has to legislators, this has far more value than when your poor little blogger (me) spews forth similar ideas ("public policy" ramblings in this blog). 

Frankly, this is a pretty cool idea. It has these attributes that are very positive:

• The plan is portable
• It provides for retirement income
• It reduces "leakage" (the authors would have us believe, according to my reading, that it eliminates leakage and this might be the case if workers never experienced bouts of unemployment, but alas, they do)
• The retirement income is somewhat protected against inflation
• Employers can be employers of choice by contributing to their workers' SAFE Plans

What I like best about the proposed design, however, is that it violates the current Internal Revenue Code in oh so many ways. The retirement plan design is founded on retirement policy. Note the symmetry!

I would be remiss if I did not point out some of the issues that I take with the authors' work. In their paper, in at least one of their models, they appear to assume historical equity and fixed income returns going forward, but 2% inflation. In my opinion, this set of assumptions is not internally consistent. In my lifetime (it started in late 1957), there have been only 12 years out of the 55 from 1958 through 2012 in which inflation was less than 2% while in the other 43, the rate of inflation exceeded 2% annually (you can see the data here). 

Assuming that workers' salary deferrals to a SAFE Plan would be continuous from entry until retirement at age 67 is unrealistic (rates of unemployment are high). However, regardless of the assumption, SAFE Plans would be safer for workers (by a lot) than the current mostly 401(k) system that we have. Again, that is the point that the authors seek to make and they make it well.

Finally, in giving workers the option to reduce the automatic contribution to SAFE Plans, the authors tempt reality. To think that the typical worker will have the discipline to continue contributing at the appropriate level in times of hardship, need, or even desire to spend, is not, in my opinion, realistic. Once again, however, the results inherent in SAFE Plans far outpace those in the current retirement system.

The financial economists in the actuarial profession will scoff at the assumed equity risk premium. This is a debate on which both sides are fervent and will likely never agree. Regardless of who turns out to be correct, however, SAFE Plans will outperform any other equal cost plan currently permitted under the Internal Revenue Code.

Unlike most (in my experience) papers on retirement policy published by think tanks, CAP has engaged a highly qualified and experienced retirement actuary. Mr. Davis has made a set of actuarial assumptions and has disclosed the key assumptions. The paper has been reviewed by a group of individuals, two of whom are credentialed actuaries. I rue that several other of the reviewers are life-long Congressional staffers and or think tank workers, but I did not fund the work, so I have no say.

Ardent Republicans in my readership will have the inclination to look for flaws in the paper. Fervent Democrats will likely be in awe of the wondrous solution. I choose to read it with both a jaundiced eye and an open mind. It's a significant step in the right direction.

Senate Finance Committee Mulls Executive Compensation Changes

In late May, the Senate Finance Committee released its seventh paper in a series discussing ways on which it might consider reforming the existing Tax Code. Earlier this week, I discussed some of the possibilities in the retirement arena; today, I explore executive compensation.

For years, the intermingling of executive compensation and the Tax Code was a pretty simple consideration. Companies paid their executives a lot of money (but nowhere near as much as they do today). Essentially, executives paid taxes on compensation when it was constructively received and companies got deductions at the same time.

Each time that there was an abuse or perceived abuse, Congress saw fit to fix it through changes to the Internal Revenue Code. Rather than solving a problem, they often created a newer and bigger one. Congress sought to control the amounts that executives are paid by creating the $1 million pay cap under Code Section 162(m). I wrote about this problem back in 2011. Then, there were the Enron and Worldcom debacles and Congress presented us with Code Section 409A as part of a jobs bill of all things.

In any event, here are the proposals that the Finance Committee "may wish to consider" as it moves forward with all deliberate speed.

1. Revise the limits on the deductibility of executive compensation.
1. Repeal 162(m). In my opinion, repealing the limit would allow companies to pay executives more directly and would probably meaningfully decrease executive compensation.
2. Expand the 162(m) group. This, again in my opinion, would serve to increase the number of people for whom large companies would try to get overly creative and overpay their top employees, especially on the sales side.
3. Apply 162(m) to all equity compensation as well. 
4. Change the 162(m) limit to 25 times the compensation of the lowest-paid employee in the company. This would cause companies to eliminate lower-paying jobs. I see no benefit to this proposal.
2. Revise the rules related to nonqualified deferred compensation (NQDC). 
1. Modify or repeal Code Section 409A.
1. Repeal 409A and replace it with Treasury authority to promulgate rules that tax NQDC when it is constructively received. Didn't we used to have these rules?
2. Repeal 409A for private companies. 409A was put in to stop a run on the bank like the one that occurred in the Enron debacle. Private companies truly are a different situation.
3. Repeal the 20% penalty tax under 409A. Hmm! If you take the penalty out of a tax penalty, then you lose its teeth. Either repeal the section or keep it, but don't have it there with no teeth.
2. Repeal NQDC. That is, tax service providers on compensation in the year that it is earned rather than allowing deferral.
1. As an alternative, tax the employer currently on the buildup in deferred compensation.
2. Allow either the company or the executive to pay that tax in the item immediately above.
3. Revise the rules related to equity compensation.
1. Repeal incentive (at the money) stock options. Since ISOs get special tax treatment, repealing them would remove the incentive for grantees of such options to hold the shares once they exercise their options.
2. Modify deductibility of stock options.
1. Limit the deduction to the amount recorded on the company's books when the options are granted.
2. Deduct the stock option cost in the year that it is expenses.
4. Revise golden parachute rules.
1. Essentially repeal the excise taxes and the limitation on employer's deductions. This sounds like the pre-1984 rules.

This is certainly an interesting combination of proposals. I feel sure that even the least observant among my readers can work out which proposal came from Democrats and which from Republicans. Note that not a single one of the proposals talks about repealing Title IX of Dodd-Frank. Alas.

Tax Reform on the Horizon

The Washington Post reported yesterday that Congress has begun meetings on Tax Reform. And, for the grammarians who are reading this, I capitalized tax reform for emphasis, not because we have anything formal yet.

Could we have tax reform? And, if we do, what might it do to the world of benefits and compensation?

Let's focus on my first question first. Could we have tax reform? Of course we could. The better question is will we? I think it is as likely as not. Although some measures say that it has picked up, the economy, in the opinion of your humble (well, I try to be humble most of the time) correspondent, it is still abysmal. Republicans in Congress want to balance the budget, but without raising tax rates. Democrats in Congress and the White House generally want to get the budget closer to being balanced, but would like to do it without cutting back social programs which would require more revenue. More revenue comes from three places:

• Growing the tax base (the two parties do not agree on how to do this)
• Raising tax rates (Republicans say this will not raise revenue and will filibuster such a bill in the Senate and vote it down in the House)
• Decreasing tax expenditures (regular people refer to this as closing loopholes and cutting back on deductions)

The third one seems to be the way to go. I head similar sentiments way back at the beginning of 1985. And, guess what, that was the first year of a President's second term. He was a President who inherited a terrible economy. And, before the mid-term elections, we had the Tax Reform Act of 1986. What did it do, generally? It decreased marginal tax rates, cut the number of marginal rates from a lot (I don't recall how many) to two and eliminated a tremendous number of deductions.

Hmm?

In fact, suppose we look at the first half of the last few two-term President's second terms (I am going to count Nixon as two-term since he was elected a second time).

• Nixon -- ERISA was passed and signed into law shortly before the mid-term election of his second term (actually Ford was President by then and if you don't know why, then either you are very young or have been living under a rock).
• Reagan -- In the first two years of his second term, we got COBRA as well as TRA86, and a plethora of smaller bills. TRA86 as I noted above was signed into law shortly before the mid-term elections.
• Clinton -- This is the apparent anomaly and perhaps we should note that he is a Democrat who was working with a Republican-controlled Congress. We got some smaller bills, but nothing of the magnitude of TRA86 or ERISA. But, even in what was then a booming economy, the first half of Clinton's second term brought us the Taxpayer Relief Act, the Balanced Budget Act, and the ever-memorable Child Support Performance and Incentive Act.
• Bush (43) -- Nearly halfway through his second term, we were greeted with the landmark Pension Protection Act of 2006, shortly before Congress recessed to campaign for the mid-term elections.

Do you detect a pattern here? I know that my readers are very observant, so as they say in the math textbooks, the observation of the pattern is left to the reader.

It could happen. And, if it does, what can I tell you about what it will look like?

• It will be thick. Major legislation that has come out of the Obama White House has been fairly universally thick. Consider that both PPACA and Dodd-Frank weighed in in exess of four full reams of paper apiece. Should we truly get a comprehensive tax reform bill (perhaps it would be called the Comprehensive Reform And Policy ACT ... if you can't work that out, go back to the beginning), I would take the over if five full reams were the betting threshold.
• It will focus on what the media will call loopholes. This is one thing that the two parties can agree on is that there are too many loopholes in the current Internal Revenue Code. It will attempt to simplify, but once it goes to a Conference Committee and each member appeases his or her favorite special interest, simplicity is not going to happen.

When you hear about loopholes in the media, they tend to focus on two things: deductions for corporations that allow what we know to be highly profitable ones to pay no federal income taxes; and deductions for very high earners that are just not available to the rest of us.  Bearing those two things in mind, consider these potential changes:

• Reduction in corporate tax deductions for employer-provided health benefits either by simply limiting the deduction, disallowing the deduction for a far tighter definition of discriminatory plans, or not allowing a deduction with respect to all but preventive health benefits for highly compensated employees. This would be somewhat analogous to the limits that were placed on long-term disability benefits about 25 years ago.
• Reductions in the pay cap and 415 limits (maximum benefits and contributions limits) for qualified retirement plans. Additionally, we could see a reduction in the 402(g) limit, the annual limit on elective deferrals to a 401(k) plan.
• A tighter definition of what constitutes a nondiscriminatory retirement plan thereby reducing the level of deductions attributable to highly compensated employees.
• A reduction in the compensation threshold under Code Section 162(m). This would be a significant appeasement to the major labor unions.
• Tying deductions for executive compensation to the Dodd-Frank Say-on-Pay votes. I went out on a limb on this one, but voting for this would not cost any elected official many votes.

So, that's what I see the style of such a bill to be. Even at Congress's worst, though, that would only fill up 100-200 pages. They would still need almost five reams more for me to be on the winning side of the over-under bet. What's your opinion? If you have one, and I know you do, please comment, be it here, on Twitter, on LinkedIn, or on Facebook. Or, if you don't want to go public, send me an e-mail.

Tax Reform -- Will We Get it? What Will it Look Like?

Oops, you read the title of this and you thought you were going to get answers from me? Readers certainly know that I am neither insightful enough to know nor bold enough to even make a prediction. But, both parties say that we need tax reform.

So, it should be easy, right? 51 Republicans have signed on to the Fair Tax. In the 2008 election, however, some Republican candidates who support the Fair Tax were pounded in commercials saying that they were proposing adding a 23% national sales tax. That was correct, to a point, but the same commercials didn't note that the same people were proposing an elimination of income taxes, FICA taxes, and other taxes under the Internal Revenue Code.

Republicans as a group favor the lowering of income taxes. Democrats as a group favor simplification of the Code and elimination of deductions frequently taken by high earners, but not available generally to lower earners. At the end of the day, methinks that each is simply staking out the position that will get them the most votes.

In 1986, the protagonists were these: President Ronald Reagan, Speaker of the House Tip O'Neill, House Ways and Means Chair Dan Rostenkowski, and Senate Finance Chair Bob Dole. It took them 3 or 4 years from when they started (memory tells me that the first proposal put forth that eventually morphed into TRA 86 was in late 1983 or early 1984), but they got something significant done.

People who have read about it may remember that we changed from a myriad of marginal tax rates to just two -- 15% and 28%. I think that lasted for a year.

In any event, the voters are calling for tax reform. Plenty of polls say so. And, if you want the down and dirty from the hill, check this out: http://blogs.ajc.com/jamie-dupree-washington-insider/2011/01/20/whither-tax-reform/

While you're at it, see if you can figure out where Jamie Dupree's biases are. I'll bet you can't. He is, in my estimation, the only unbiased political reporter in the United States. That's a mean feat.