When Your Deal Involves a Pension

Corporate deals abound perhaps like never before. Mergers, acquisitions, consolidations -- call them what you will. They're still deals and they involve pensions, sometimes frozen, more often than you think. If you are the acquirer in any of these transactions, it would not be at all surprising to find that your team is giving these pensions were getting shorter shrift than they deserve.

Why?

More than most other elements of a corporate transaction, the costs of sponsoring a pension plan (single-employer) or being a participating employer in one (multiemployer) are both volatile and perhaps a bit out of your control. On the surface, that's bad. And, a significant problem is that traditional due diligence does not address this.

What do I mean by that? There are plenty of firms out there that perform due diligence in deals. On the financial side of this, the work is typically done by large accounting firms and their consulting arms or by the larger, traditional, multi-service consulting firms. What I have seen, and I have by no means seen everything, tends to be a fairly standard report with numbers filled in. It often relies a lot on the past and tends to assume that the past will be reflective of the future. For many of those future costs, that's probably not a horrible assumption. For pensions, unfortunately, it often is.

You see, whether you are focused on cash or on financial accounting, the amount of your future costs is dependent on rules. The rules are complex and they do not lend themselves to cost stability. Today, estimating what those costs will be is not easy. Doing so under a variety of economic scenarios is more complex and likely more expensive. Developing strategies to control those future costs adds even more difficulty and even more cost. It also takes a long time. And, of course, you are never able to work with current or perfect data. In the future, it will be much simpler. At least that sounds nice, but our predictions about the future are often wrong.

The future is here. It's here today.

Everything I said above that was difficult and expensive and more difficult and more expensive and takes a long time -- it doesn't have to.

We don't need great data. We don't need to bother your staff. We can move at the speed of deals. And it won't break the bank.

That future you were hoping for -- it's here now.

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.

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.

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.

Winning the Race to Retirement

You can see it on TV all the time. This investment management firm or that one will help you to get to a prosperous retirement. There is nothing wrong with that. In a 401(k)-only world, you may need all the help you can get. So, with regard to those firms, while I am not Mark Antony and they are not Caesar -- friends, readers and others, I come to praise those firms, not to bury them.

Suppose you are a participant in a 401(k) plan. You probably are if you are reading this. Then, it wouldn't be surprising if your plan's recordkeeper (by the way, they may also hold the majority of the funds in the plan) gives you online access to some sort of retirement modeling tool. This is a good thing.

OK, so why is this idiot blogger wasting your time? There is a little problem here. On any of these sites, either the site makes assumptions for you, or, sometimes within a set of constraints, you get to choose assumptions for yourself. This can be dangerous.

Why?

Consider your best friend. Is he or she a smart person, financially savvy? Let's assume the answer is yes. And, you, of course, are financially savvy? Would you trust that best friend of yours to be able to pick your annual return on your 401(k) balance? Would your best friend trust you with guessing a return on their balance. Probably, the answer is no, so why would you think you can guess your own rate of return. And, even if you can, is that an average return, or a constant return. And, if it's an average return, what does that mean?

Oh, come on, idiot blogger, everyone knows what an average is.

Not so fast, there may be more than meets the eye.

I'm going to consider four scenarios as follows:

• In the first, I am going to assume to assume that you have 10 years to save, that you are currently earning $50,000 per year, that 5% of that will go into a defined contribution (DC) plan every year (on the first day of the year), that you will get a 3% pay raise every year, and that those funds will earn a constant 5% rate of return.
• In the second, you still have 10 years to save and you are still currently earning $50,000 per year. You are still going to get a 3% pay raise every year and you are still going to put 5% of your pay into your DC plan. And, on average (arithmetic mean), you are still going to get a 5.5% annual rate of return on your money, but I am going to throw some volatility into the mix. I am going to give your annual investment return a normally distributed standard deviation of 11%. In simple terms, this means that about 69% of the time, your actual annual return will be between -5.5% and 16.5%. Further, about 95% of the time, your actual annual returns will be between -16.5% and 27.5%.
• In the third, I will keep all of these assumptions the same, except that your average annual return will be 6% and your standard deviation will be 18%.
• Finally, in the fourth scenario, your average annual return will be 6.5% and your standard deviation will be 26%, with all other assumptions kept the same.

Before I give you the results of this analysis, I need to explain a few more of the details here. In scenario 1, since there is no variability, I need not perform more than one simulation. In the other scenarios, however, I have normalized the annual returns so that the arithmetic mean return over the 10-year period is, in fact, the intended arithmetic mean. Additionally, I have done this simulation 10 times each and then taken the average (arithmetic mean) of the 10 account balances after 10 years.

What do you expect the relationship between the four ending account balances to be? What do you expect will be the range of results in each scenario after 10 years? 

Scenario 1:

      Average account balance after 10 years:  37,403

      Highest account balance after 10 years:   37,403

      Lowest account balance after 10 years:   36,403

Scenario 2:

      Average account balance after 10 years:  36,387

      Highest account balance after 10 years:   42,024

      Lowest account balance after 10 years:   29,106

Scenario 3:

      Average account balance after 10 years:  38,641

      Highest account balance after 10 years:   48,640

      Lowest account balance after 10 years:   28,022

Scenario 4:

      Average account balance after 10 years:  38,662

      Highest account balance after 10 years:   57,439

      Lowest account balance after 10 years:   26,411

Interesting?

The volatility is essentially offsetting the improved investment returns. So, when you go to your recordkeeper's website and use their modeling tool, what rate of return are you going to assume? Do they give you a place to input assumed volatility? I'll bet they don't.

I'm sure your recordkeeper means well. They don't want to confuse you. But, are they really helping you to win the race to retirement? Or, does slow and steady win the race?

It's your retirement. You make the call.