Tag Archives: Michael Iacoboni

GASB 67/68: Substantively automatic plan provisions

This PERiScope article authored by Michael Iacoboni discusses “substantively automatic” plan provisions and their inclusion in the determination of a plan’s total pension liability (TPL). For many plans, the concept of “substantively automatic” is critical to the treatment of cost-of-living adjustments (COLAs), which are often granted on a discretionary or ad hoc basis. In Statements 67 and 68, the Governmental Accounting Standards Board (GASB) neither objectively nor specifically defines the term “substantively automatic” and it does not prescribe a one-size-fits-all formula for determining if a plan’s COLA policies fall into this category.

To read Milliman’s PERiScope series on technical and implementation issues surrounding GASB 67 and 68, click here.

GASB 67/68: Calculation specifics on individual entry age normal and recognition of deferred inflows/outflows

New accounting rules for public pension plans in the United States are set to take effect beginning in 2014. This PERiScope article in the Governmental Accounting Standards Board (GASB) Statements No. 67 and 68 miniseries discusses the individual entry age (IEA) actuarial cost method.

The IEA cost method is specifically identified in the new standards as the only appropriate method for determining a plan’s total pension liability (TPL), which is the portion of the present value of benefits attributable to past service. This article also discusses the calculation of the amortization period to be utilized in recognizing gains or losses that are due to demographic experience or actuarial assumption changes in the annual expense under GASB 68.

Flexible pensions: Giving control back to employers

Iacoboni-MichaelVolatility. Risk.

The word “pension” can mean so much more: recruitment, retention, reward, retirement.

In the “new” millennium this word has been rebranded, and has now become firmly linked to volatility and risk. Can pensions be duly unchained from this stigma?

What if year-to-year cash flows could be stabilized? What if the investment risk could be eased?

I know. I know. Hypotheticals are little more than devilishly idle hands. Corporations operate within practical realities.

But what if this was not hypothetical? Seriously: What if the volatility and risk could be significantly drawn down?

The challenge with a defined benefit (DB) plan is just that—the benefit is defined. The economy is fluid. Industries are dynamic. Yet “traditional” pension plans are intractable. Because the plan design does not respond well to an ever-changing business environment, a formidable challenge is left to the employer. Thus, corporations become exposed to volatility and risk.

One natural conclusion is that employers (and by extension, employees) need a pension plan in which the benefit is not so obstinately defined. In other words, the plan and the benefits it provides need to be flexible; they need to be able to adjust to the seemingly whimsical undulations of modern macroeconomics.

It turns out there are pension plan designs that do accommodate some flexibility, and some plan sponsors have started taking good, hard looks at these alternatives. There are a few variations on these new designs, which go by many names, including:

• Variable annuity pension plan
• Adjustable pension plan
• Variable benefit plan

Milliman’s work in this area includes the white paper “Variable annuities: A retirement plan design with less contribution volatility” and the blog article “Variable annuity plans may benefit employers and employees.”

Within a variable annuity pension structure, each participant’s total benefit annually rises or decreases based on the overall fund’s asset performance (this applies to both active and retired participants). This feature naturally results in a significant degree of pension responsiveness in adverse markets and imparts some inflation protection for retirees when returns are high.

Rather than varying the annual payment a retiree receives each year, a pension plan may change the amount that active participants accrue each year. Again, this adjustment in accrual rate would be based on asset performance in the prior year(s).

Under the variable accrual model, the plan document could even include a provision under which asset returns that are sufficiently poor (i.e., the portfolio return was negative for the prior year) would result in zero accruals that year. In this case, the plan would effectively be frozen during tough economic conditions. (This is similar to employers suspending 401[k] matches during the first years after the global financial crisis in 2008.)

With these alternative designs and the resulting responsiveness, a pension plan can keep up with the business needs of the employer and becomes much less volatile from a sponsor’s point of view.

Keep in mind that reduction of volatility is truly achieved on a plan-by-plan basis. The finer points of the plan design will vary depending on the needs and priorities of each plan sponsor. Details to consider include: investment allocation, size of the plan, maturity of the plan’s population, and specific plan sponsor concerns (i.e., financial reporting, contributions, Pension Benefit Guaranty Corporation [PBGC] premiums).

Whatever the particulars, a key takeaway is that within a defined benefit plan framework, risk can be shared between employer and employee. This seems a happy medium between the “all or nothing” risk distribution under traditional pensions and 401(k)-type defined contribution (DC) plans.

Over the last decade the question has been asked often and hotly debated: How can we get DC plans to “behave” more like DB plans? Usually this “behavior” refers to the lifetime income guarantee and retirement security that participants receive from a traditional pension.

To be fair, defined contribution plans have their own desirable qualities. Employer contributions to a 401(k) are typically a fixed percentage of salary each year, and with a 401(k) the employer is completely insulated from investment losses. Here we are back at volatility and risk.

Perhaps an equally poignant thought is: How can we get DB plans to behave more like DC plans? What would this entail? Answer: Give the plan sponsor more control over its cash flow responsibilities to the pension and lessen employer exposure to investment or interest rate risk. We can achieve both of these and also provide an adequate lifetime benefit by making pension benefits more flexible.

When external forces change, businesses adjust. So can pension plans. So should pension plans.

Dividends and the fiscal cliff: Look before you leap

The “fiscal cliff” yawns, seemingly bored with its own inevitability. Before we gape over the brink, many of us are pausing to consider: how might our collective heft be lightened that we land more gently? What steps are companies taking before submitting to freefall-induced torpor?

Varied and vast is the list, so let us focus on one item: dividends. If anyone tells you they know what will become of dividend tax rates, you should politely and quietly walk away (or ask them for next week’s lottery numbers and head to the convenience store).

With fiscal bedlam lurking in the shadows— if not in plain sight in the cubicle right next to you— many plan sponsors may be inclined to offer dividends by year-end. Shareholders will likely appreciate receiving the income at a (potentially) much lower tax rate than that to which future investment income may be subject. So if you or your client is considering such an offering, there are a few cautions that we’d like to share.

2010 relief
Let’s step back to the Pension Relief Act of 2010 (PRA). This legislation offered options for how sponsors amortized their unfunded pension liabilities. In lieu of the statutory seven-year amortization, sponsors could elect a nine-year plan (with the first two years interest-only) or a 15-year amortization period. For the plan years that this election was offered, 2010-2012, the law lowered a sponsor’s minimum required contribution (MRC).

The amortization options were allowed with some restrictions, one of which directly related to dividends. PRA requires that MRC reductions achieved by the relief must be offset by “excess shareholder payments.”

Excess shareholder payments
This three-word amalgamation is defined in IRC Section 430(c)(7)(E) as cash distributions made during a year that exceed the plan sponsor’s adjusted net income (ANI) for the prior year. Note: there is an alternative calculation available if the sponsor regularly issued dividends in the five preceding years. Adjusted net income can be determined from the income statement on the sponsor’s financial statements. If a plan filed a PBGC 4010 earlier in the year, these financials will have been attached.

The law prescribes the use of prior year ANI, so 2012 dividends are compared to 2011 income. Taxes, amortization, depreciation, and interest will likely be line itemed. All of these should be removed from the accounting calculation shown on the income statement. Gain or loss from sale of assets should also be taken out. Essentially, for purposes of funding relief, the ANI is operating revenues minus operating expenses.

An installment acceleration amount is created in the amount that the dividend exceeds adjusted net income. This increases MRC, which had been reduced by the funding relief election. The good news: this increase does not increase quarterlies, and it is capped. IRS Notice 2011-3 provides detailed guidance for determining the cap; essentially, plan sponsors cannot pay more under funding relief than they would have without the PRA election (cumulative from the year of the funding relief election).

Cartography and PFB
In 2012 the relief du jour was MAP-21, the timing of which left many plan sponsors finding that they contributed more in 2012 than was ultimately needed. The result? A prefunding balance that might be used to pay 2012 or 2013 quarterlies. Because installment acceleration amounts do not affect quarterlies, they will manifest in September 2013.

Take extra care if you have budgeted for 2013 thinking that a prefunding balance will allay your need to spend cash on the pension plan. If you plan to use a prefunding balance for 2013 quarterlies, make sure that the 2012 minimum has been completely covered. Keep in mind that any excess dividend in 2012 may have raised the minimum considerably higher than what MAP-21 promised you back in August.

Look before you leap
Ultimately, shareholders may appreciate 2012 dividend payouts, but plan sponsors need to carefully consider all that such distributions may involve (a reportable event under ERISA 4043 may also be triggered). Some companies may not be interested in undoing the savings they achieved under PRA 2010. If partisanship gridlocks Congress, we may have no choice about the leap, but let us not lose our final opportunity to take a real, hard look.