Professional Standards

I haven't had a good rant for a while, but I think it's time. I am an actuary. For a number of reasons, including the standards of conduct to which we hold the members of our profession, I am proud to be an actuary.

We have a fairly rigorous Code of Professional Conduct. Trust me, this Code is well enforced. The Code tells us that we must adhere to a set of Actuarial Standards of Practice (ASOPs). Those of you who are reading this who are not actuaries would be amazed at the level of compliance with the ASOPs by actuaries. It is extremely high. We take our professional responsibility seriously.

Many actuaries are consultants. When we are viewed as consultants, we are often compared to strategy consultants, IT consultants, human resources consultants who are not actuaries and others with whom we may compete for business from time to time.

It gets frustrating sometimes. I have experienced more situations in my career where consultants who are not actuaries do things that would violate our Code of Conduct, but because of it, they have been viewed favorably. I am not suggesting that actuaries should have a more lax Code of Conduct or that we should not follow it, but I am suggesting that some of the other professions should be viewed less favorably.

Consider a particular large, well-known consulting firm whose name would probably be second nature to most of you. I have worked side-by-side with them on several assignments. On two of those assignments, they actually signed off on their own actuarial assumptions. They have neither the training nor the expertise to do so, but they do not belong to a professional organization or even a profession that seems to hold them to any level of standard. Clients believe them because of who they are. In my first-hand experience with them, they have gotten things wrong ... very wrong.

OK, I'm done with my rant. If you deal with actuaries, hopefully you have had positive experiences regarding professionalism. Check out our Code of Conduct. See if it gives you a new-found respect for the profession.

Beware the Compensation Audit

OK, HR people, if your company got audited, how would it do? I'm not talking about the audits of broad-based employee benefit plans that the IRS and DOL have been conducting for years. I've heard attorneys give advice with regard to those benefit plans that they may not be compliant, but you'll never get caught on audit. I'm talking about compensation audits, targeting primarily executives. I'm talking about 409A and 162(m) audits. Would you feel confident if you got that dreaded letter than an auditor would be arriving soon? Many companies have felt confident. Many of them have not been so happy when the auditor left.

Before discussing those audits and what you might do to prepare (long before you get that audit notice), I digress. What is your role in the company? Do you have a boss? Murphy's Law says that the first person in the company with a 409A problem will be either your boss or your boss's boss. In my experience, the 409A version of Murphy's Law strikes far more often than logic or probability dictate that it should. And, if it does, you are going to get blamed ... and that's not good.

Let's suppose you do get a request for information from the IRS for a 409A audit. They give such requests a nice name. They call them Information Document Requests. I have one sitting in front of me. Thankfully, from my standpoint, it was provided to me by a company that I did not assist with their 409A compliance process. I say thankfully because at the end of their audit, they were not happy with what the IRS found. In any event, here is what the IRS requested (paraphrasing somewhat to take out IRS-speak where possible) from them:

• Every plan and arrangement providing for a legally binding right to compensation in one year, but payment in some future year that is not subject to 409A. The company is then asked to explain why it is not subject to 409A. If the answer that they will give is the exclusion for short-term deferrals, then the company is to provide the relevant terms of that plan and and relevant terms for substantial risk of forfeiture.
• Terms and conditions, including deadlines for initial deferral elections.
• Terms and conditions for any subsequent deferral elections, including documentation of the initial deferral election, documentation to show that the subsequent election was made at least 12 months before the initial payment date and documentation to show that the subsequent election reflects at least a five-year pushback. 
• Detail related to any accelerations in payment that have been made.
• A list of specified employees and the times at which such employees have been specified employees.
• Payments made to specified employees and documentation demonstrating compliance with the six-month delay rule.
• Any funding of deferred compensation as a result of an event relating to a decline in the company's finances.
• Violations of 409A and whether they were fixed in one of the IRS 409A corrections programs.

For some companies, that's a lot of stuff (that's a technical term for saying that it may take you a long time to comply with the Information Document Request). But, that's only the first part of the misery. Let's look at where the IRS has been generating revenue (that is also a technical term, this time for finding compliance errors).

• Time and form of payments
• Short-term deferral rule
• Identifying specified employees

With regard to time and form of payments, the biggest culprit has probably been in severance plans. Recall that broad-based severance plans may be exempt from 409A, but to the extent that the payment is more than two times the pay cap under Code Section 401(a)(17), they are not. So, we are talking about executive severance payments here and there have been a lot of them the last few years. 

How have companies gone wrong? Many executives have had employment agreements that provide for significant severance payments in the event of termination without cause. And, in a lot of those cases, they allowed the executive freedom to take that payout in a lump sum or installments as he saw fit. 

Oops! That's a 409A violation. And, if he was a specified employee and he took the payment within 6 months of separation from service, Oops again.

Companies (and their advisers) have taken significant advantage of the short-term deferral rule. Oversimplifying somewhat, here's how it works. Suppose compensation is earned in one year (and vests in that year) and is paid out (without employee choice) by March 15 of the following year, then it usually qualifies as a short-term deferral. Think of a typical annual bonus plan.

Now, let's change the situation. An employee earns compensation (and it vests) in one year. He separates from service the next year before March 15 and the amount gets paid out (because of the separation from service). It is NOT a short-term deferral because the payment could have been after March 15 if the separation from service had occurred later. Essentially, you can't dodge the short-term deferral rule in this fashion.

Identification of specified employees is not easy for large companies. At a minimum, they are the key employee group as determined under Code Section 416(i). Here is the problem. During the year, you may not know who those 50 highest-paid officers are for a year. This is why the 409A regulations defined specified employees as compared to just key employees. Specified employees can be a group of up to 200 that includes the key employees, but may also include certain other employees. It's that group that must not be paid out within 6 months of separation from service. And, all 409A plans and arrangements of an employer must use the same definition of specified employees.

Many companies have applied the 6 month delay rule to all 409A plans of the company for all employees. In that case, it doesn't matter who the specified employees are. Other companies have chosen not to do this. Therefore, they need to know who their specified employees are. IRS experience says that many companies don't know who their specified employees are. This is another good revenue source for them.

So, how should companies prepare for the possibility that they may get audited? Have an independent third party review. Don't have it done by the people who did your initial compliance work. They'll never think they made any mistakes. If the initial work was done by an attorney, consider having the third party review done by a consultant. You'll get a different and hopefully useful perspective. If the initial work was done by a consultant, consider an attorney to do the third party review.

Or, in either case, if I didn't do the initial compliance work, I'll give you a different perspective than the person who did it originally.

Could CEOs of White Collar Companies Learn Something?

Through the wonders of modern technology, I can watch pretty much any TV show any time that I want to if I am at home or in front of a computer. I spend enough time on my computer, though, so I'd rather watch on the not so small anymore screen.

Why should you care about this? Well, there's this CBS show called "Undercover Boss". It's a little bit corny and sappy, but there is a learning experience there as well.

Here's how the show works. A corporate executive, usually the CEO, goes undercover and does jobs alongside some of the company's workers. Usually, the CEO learns a few things such as:

• Those jobs that are the meat and potatoes of the company may not be so easy
• Sums of money that are pocket change to the CEO are meaningful to the company's workers
• People that the CEO doesn't talk with every day have good ideas

And, for the sappy side of the viewer, most of the workers who are shown on TV have some back story such as a child with a disability or they work for a charity on weekends. At the end of the show, the CEO usually gives them some amount of money and other goodies. On the most recent episode, we saw the CEO if Oriental Trading Company give 'awards' of perhaps $125,000 and authorize expenditures of probably another $500,000 per year. We saw the CEO's house. It wouldn't surprise if, in a good year, he gets a bonus of more than $500,000 per year (by the way, he may deserve it, I'm not opining on that, but simply making a point).

I've worked for a few large firms in my life. [I've learned that smaller firms run differently. The CEO's can actually talk to their employees.] When I worked for Exxon way back when, I was a young blue-collar worker and frankly, I was pretty clueless about what was going on there. Since 1985, I've been in the consulting business. Mostly, I've worked for large firms (you can look them up if you like as I have not hidden my profile online). 

Let's consider one of those large firms (if you try to work out which one this is, that's at your peril and for your enjoyment). The CEO there has had earnings according to public disclosures in the broad range of roughly $3 million to roughly $20 million per year according to public disclosures. [Every company that I have worked for since 1985 has a make CEO, so using the masculine here is factual.]

I compared the progression of that CEO's pay to shareholder return. Guess which was bigger. It's not shareholder return. On the other hand, over that same period of time, anecdotal data (talking to co-workers) suggests that many of them, even high performers, had no increases in compensation. Certainly those increases were not as high as those experienced by the CEO. 

Let's dig deeper. The CEO was lauded by the Compensation Committee for cutting costs. He slowed down increases in compensation costs. He cut benefits. He cut the little things at work.

From an employee's standpoint, what did that get him? It made him unpopular. It got him high turnover. Turnover costs money. In the consulting business, turnover costs clients. In fact, in any customer service business, unhappy employees and high turnover cost clients. But that blame can be pushed elsewhere.

I dare one of these CEOs. Contact CBS. Go on Undercover Boss. See what your employees think. Maybe they have good ideas. Maybe you'll find out why so many of them leave. Maybe you'll find out why you are losing clients. Maybe then you'll earn your compensation.

Defined Benefit Supply and Demand

This should be good. This fool is writing about supply of DB plans and demand for DB plans? No, not really. But, we are going to look at a really simple way that supply and demand affect DB plans.

There are lots of DB plans out there that are frozen, be it soft or hard. Presumably, very few of them will ever be unfrozen. More likely is that plan sponsors are seeking to terminate those plans that are frozen. And, since the process for doing other than a standard termination often requires a plan sponsor to go into bankruptcy (yes, there are other ways, but that is beyond the scope of this article).

Let's look at the standard termination process in the simplest of terms. A plan has to be fully funded (including employer commitments) for the purchase of annuities, sufficient to provide all the benefits accrued and vested in the plan. Determining the level of assets to do that should be fairly simple, right?

Of course, it's simple. Presumably, you know what your funded status is on a PPA basis and you just pick up the phone and call your actuary. Actuaries have good rules of thumb for estimating everything, so your actuary will just give you a loading factor and you'll know where you stand, right?

Not so fast. Life insurance companies that are in the annuity business presumably want plan termination business. It's where they can get a large volume of business quickly. Let's consider a couple of scenarios.

Plan investments perform well, interest rates stay stable. If this is the case, then funded statuses will improve. A reasonable number of plans will be able to terminate. Insurance companies will presumably hit their goals for annuity volume.

Plan investments perform well, interest rates go up. Now, virtually everyone will think they can terminate their plans. The market will be flooded with demand for annuities. Insurers either will not be able to accommodate that much volume or will be able to create that impression.

In the second case, there is more demand, but no change in supply. I learned about this in Economics 101 (actually, it was called 14.001, and if you understand that, you'll know where I took it). Prices go up. So, your actuary's rule of thumb is going to be off by a bit ... and in the wrong direction.

We could create lots more scenarios to look at supply and demand, but this is pretty basic stuff. It's intuitive.

If you have a frozen plan and you're looking to terminate it, wouldn't you like to be able to track this loading factor or ratio of plan termination liability to PPA liability? Now you can. Contact us. Contact me.

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.

Good News -- IRS Floods Us With Guidance on Lifetime Income Options

When it rains, it pours. And, unlike in days of future past (for you, Moody Blues fans, with a slight spelling change), when the IRS decides to provide guidance on a topic, we get a package. In this case, the package is related to distribution options, primarily from qualified defined contribution (DC) plans, but also with implications for defined benefit (DB) plans and individual retirement accounts (IRAs).

So, here's what we got:

• Proposed regulations essentially on partial annuity distributions from DB plans
• Proposed regulations on longevity annuity contracts
• Revenue Ruling 2012-3 on survivor annuity requirements for deferred annuity contracts in DC plans and IRAs
• Revenue Ruling 2012-4 on treatment of rollovers from qualified DC to qualified DB plans in order to receive an additional annuity

So, what's in them? Since it's American Idol season, dim the lights, here we go. 

Partial Annuity Options

For participants, this is good news. For plan sponsors and especially for plan administrators, this could be a nightmare, because participants may actually elect split options. Under these regulations, participants could take a split distribution option from a defined benefit plan. For example, a participant could elect a partial lump sum and a partial annuity. 

The proposed regulations specify that [Code Section] 417(e)(3) assumptions would be used to calculate the lump sum amount, but that plan assumptions (plan's definition of actuarial equivalence) would be used to calculate the amount of the annuity. This makes things way simpler than the existing rules which would require use of 417(e)(3) assumptions for the entire calculation.

Let's consider an example. Suppose a participant was entitled to an immediate single life annuity of $1000 per month or a lump sum of $140,000, among other options. Further, suppose that the plan conversion factor for this participant and this participant's spouse for a 50% Joint and Survivor Annuity payable immediately is 0.95 (if you don't like my factors, you may write your own blog, but they seemed simple and convenient for my purposes). Now, suppose that the participant elects a split option: 60% as a lump sum and 40% as a 50% Joint and Survivor. The math gets simple. The lump sum would be 0.60*140,000 = $84,000. The monthly annuity would be 0.40*0.95*1000 = $380 per month.

Hmm, maybe this is more of a pleasant daydream than it is a nightmare for plan administrators, but computer-based administration will require a lot of re-programming.

Longevity Annuities

This is great news for plan participants. I repeat, this is great news for plan participants. When a participant uses their DC or IRA account to purchase a longevity annuity (sometimes referred to as longevity insurance), the longevity annuity piece will be disregarded for purposes of the minimum distribution rules under Code Section 401(a)(9).

Here is how it works. Sometime before a participant turns 70, he elects to allocate some portion of his account to a Qualified Longevity Annuity Contract (QLAC). In order to be a QLAC, the single premium for the annuity must not exceed the smaller of 25% of the account balance or $100,000 (indexed for inflation). A participant may make multiple QLAC allocations, but in that case, the total QLAC premium is similarly limited. The QLAC must specify the deferral date for the deferred annuity and that date cannot be later than age 85. 

In the event that participant makes such an allocation, the QLAC allocation will not be subject to the required minimum distribution rules. 

And, in a piece of bad news, money in a Roth account will not be considered a QLAC.

DC Spousal Consent Rules

This one is very simple. It clarifies that when a participant invests part of his DC account balance in a deferred annuity, that part of the account is not subject to the Qualified Preretirement Survivor Annnuity (QPSA) requirement until the participant makes an affirmative election to begin annuity distribution immediately.

DC --> DB Rollovers

This is another piece of good news. Suppose you are a participant in both a DC plan and a DB plan. Revenue Ruling 2012-4 allows a DB plan to be amended to accept rollovers from a DB plan. And, when you do so in order to get an  annuity, you get the DB plan's definition of actuarial equivalence rather than having to subsidize the profits of an insurance company.

DOL Finalizes Fee Disclosure Regulations.

It's been nearly two weeks since the Department of Labor (DOL) finalized its regulations under
Section 408(b)(2) of ERISA. For those of you who are more words people than numbers people, those are the fee disclosure regulations that require service providers (vendors) to inform plan fiduciaries just how and how much those vendors are getting paid for their services.

It's been interesting hearing some of the observations to the finalizing of this regulation. One experienced retirement practitioner noted to me that this regulation was the result of a recent law change. Hmm, ERISA, recent, Gerald Ford signed it into law and he died in 2006. He last signed a piece of federal legislation in 1977, not exactly recent in the benefits industry. Another experienced benefits practitioner remarked that these regulations were the result of a new government agency established under the Obama Administration. Well, for those of you who are not fans of our current president, there are many things that you could probably choose to blame him for, but I can assure you that President Obama did not create the Department of Labor.

On to the actual guidance ... I'm going to assume that if you are reading this that you have at least some knowledge of the history of this regulation. If not, you can certainly look in this blog under the label "Fees" or in thousands of other places on the internet. Or, you can read my take here or here.

Effective Date


The effective date is now July 1, 2012, postponed from April 1, 2012. Since an earlier DOL pronouncement synced the timing of the effective date of this regulation with the participant-level disclosures under ERISA Section 404(a)(5), the initial disclosures for calendar-year plans under those regulations will be due on or before August 30, 2012.

Electronic Delivery


The body of the regulation is silent. However, nerdy people like me who read a lot of regulations from the DOL and IRS know that in recent years, the preamble to regulations is often (read that as almost always) far more useful and informative than the regulation itself. The preamble, in this case, tells us that there is nothing in the regulation that would limit the ability of service providers to furnish fee disclosures electronically including making that information available on a website so long as participants are notified how they may access those disclosures. [Tell me, why doesn't the government do what a normal person would do and specify in the regulation what vendors can do to fulfill their requirements?] In any event, the regulation indicates the DOL's expectation that 50% of disclosures will be provided electronically. I expect that the DOL's margin of error in making that statement is not more than 50%.

The Disclosure Goesintas


For the uninformed, goesintas is an old term (I think it comes from 298th century BCE (we used to call that BC) Aramaic) for what goes in to something. The analogue for the really curious is the comesoutas. For the most part, this has not changed from earlier proposals. However, at some point in the future, the DOL may require service providers to give fiduciaries a guide to understanding the disclosures. For the time being, there is a sample guide in an appendix to the regulation. And, there is a placeholder in the regulations for such a guide.

For the curious, the sample has two columns. The first column lists services [to be] provided. The second column shows where in the service agreement (if you don't have a service agreement, you can't use this) that service can be found or where information related to investment fees and expenses can be found online.

Enhancing the Technical Details


Service providers will be required to provide to plan fiduciaries sufficient information to assess the reasonableness of both direct and indirect compensation. While the interim regulation required the service provider to at least estimate the amount of indirect compensation it expects to receive, the services for which that compensation is to be received, and from whom that compensation is to be received, the final regulations require that the relationship between the service provider and the payer be disclosed. So, for example, under the final regulations, the service provider might identify a payer as a subcontractor, an affiliate, or a subsidiary.

Certain investment products are often referred to as look through investments. In 401(k) plans, for example, perhaps the most common of these are collective investment trusts (CITs). Under the interim rule, the disclosures were required to contain:

1. compensation charged directly for acquisitions, sales, transfers, or withdrawals
2. annual operating expenses or expense ratio unless the product's return is fixed
3. ongoing expenses

Under the final regulations, a designated investment product (DIA) need not disclose numbers 2 and 3. Instead, it must disclose total annual operating expenses which in turn must be disclosed to participants under the disclosure regulations that apply to them.

What Brokers and Recordkeepers Have to Tell Fiduciaries

The change from the interim rules appears to be fairly subtle in this regard. For most organizations, I think it will be. Under the interim rules, recordkeepers with DIAs on their platforms were required to provide certain DIA information on their platforms. They could satisfy that requirement by passing through information from the issuer, typically a prospectus, but the materials had to be regulated by a governmental agency. The new rules change the government oversight. No longer do the materials need to be regulated, but instead, the issuer of the pass-through materials needs to be regulated. Further, the issuer may not be affiliated with the recordkeeper in order to use the pass-through rule, but the regulations indicate that the requirement can be met by replicating materials.

... time out for a rant ... what is the significance of copying and pasting as compared to just passing through? I don't think I am overly stupid, but this seems like burden for the sake of burden.

... now we return to our regularly scheduled programming ...

Information Requests

The interim rules required service providers to respond to requests (for Form 5500, for example) for additional information from fiduciaries within 30 days. The final regulation changes that to "reasonably in advance" of the governmental filing deadline.

Corrections

In keeping with the interim rule, the final rule says that corrections to disclosures must be provided within 30 days. The final rule, however, adds that such corrections must include errors and omissions, not just corrections.

Cost

Where there is an explicit fee agreement (e.g., contract) in place, this information must be disclosed. Where there is not, the final regulation specifies that reasonable estimates must be made and that any assumptions used to make those assumptions must be disclosed. Further, the final rule indicates that ranges may be used as a reasonable method of disclosure of compensation. However, the final rule states that where more precise information is available, it is to be disclosed.

So, that's about it. The remainder is generally unchanged. Since this is a final rule, and we haven't heard people screaming yet, it looks like disclosures will begin being provided by mid-year. That's not bad. ERISA was signed into law on September 2, 1974 (Labor Day). We get required disclosures in less than 38 years.