Today’s guest is Dave Paauwe. He’s the president, an enrolled actuary, of a company called Watkins Ross out of Grand Rapids, Michigan. David is an enrolled actuary. David, what’s an enrolled actuary?
Welcome to our listener-supported podcast, Money Talk, uncompromised absolute financial truths behind financial perceptions with host, Ed Sutkowski and Chuck LeFebvre. Let’s listen in.
Chuck LeFebvre: Welcome to My Piggie Bank. This is Chuck.
Ed Sutkowski: Here’s Ed.
Chuck: We have a guest.
Ed: Today’s guest is Dave Paauwe. He’s the president, an enrolled actuary, of a company called Watkins Ross out of Grand Rapids, Michigan. David is an enrolled actuary. David, what’s an enrolled actuary?
David Paauwe: An enrolled actuary is someone who has passed a number of actuarial exams and is allowed to practice actuarial work before the joint board for the enrollment of actuaries. Probably about 25 years ago, I took a number of actuarial exams administered through the joint board. Upon successful completion of those, will be able to practice as an enrolled actuary at Watkins Ross.
Ed: Now you major in math as an undergrad, is that it? You’re a mathematician bottom line, is that fair?
David: Yes, I went to the University of Michigan, and I got my actuarial mathematics degree, undergrad, from there.
Ed: Well, it sounds to me like you and Chuck, Chuck you’re the math major, weren’t you? [laughs]
Chuck: Yes, but not actuarial math, so a little bit different. I know it all seems the same from the outside.
Ed: You guys are birds of a feather? [laughs]
Chuck: Birds of a feather, yes.
David: Who knew?
Chuck: We can probably appreciate each other.
Ed: Well, having said that, first, you have an ESOP company, that is your company is owned by its employees. Is that about right, David?
David: That’s right, yes. We became an ESOP almost 30 years ago, and we are now 100% employee-owned for probably the last 10 years or so.
Ed: Now, I want to make sure that everyone understands, an ESOP is like a profit-sharing plan only and that’s primarily in employer securities and it is what’s called a defined contribution plan, that is an individual account plan where everyone has an account reflecting the value of the assets allocated in trust for that account. Is that right?
David: That’s right, and we have an outside firm come in and assign a market value to our share price each year for purposes of valuation of the ESOP. We’re at 331 fiscal year-end. We just had our due diligence call with our ESOP valuation provider, and we look forward to what they have to say in terms of our share price here in the next few weeks.
Ed: For example, if instead of shares of the company, you had shares of Caterpillar, you wouldn’t have to bring an independent, a third-party in because the value would be market value of the stock that’s really traded, but these shares of Watkins Ross are not traded, it’s simply owned by the ESOP trust. That’s where I’m getting is?
David: Correct, yes.
Ed: Now, let draw the distinction between this individual account plan and a defined benefit plan, more specifically a pension plan. I think of a pension plan like social security, in other words, designed to come up with a dollar amount per year based upon several factors. Could you expand on that?
David: We have really two kinds of defined benefit plans here that we administer at Watkins Ross. We like to refer to the first is called a traditional defined benefit plan where the plan itself has a legal plan document that states the benefits that will be provided to each participant based on the formula that’s in that plan documents. Say, when you retire, you get a monthly benefit equal to 50% of your last five years of earnings before you are retired, and that’s converted to a monthly annuity, and that monthly annuity can be paid over the life of the participant, the joint lives of the participant, and the participant’s spouse is a actuarial reduction for that form of benefit versus the life only, those benefits will probably last longer than a life-only form of payment. That’s a lot of the traditional plans that we administer here in-house. The expectation is you work for 20, 30, 40 years at a company, and in return, when you retire, the company will provide you with a monthly annuity form of payment. The other type that we have, and it’s been extremely popular, and that we’ve worked with you on probably for 20 years now, that is the cash balance type of benefit. That type of plan looks and feels more like a profit-sharing plan in that a participant’s benefit is– there’s an account balance, like a profit-sharing or 401(k) plan, except your account balance in a cash balance plan grows at a set rate of interest regardless of how the performance of the plan assets are within the trust, a participant’s account balance will grow at, say, 3%, 4% or 5%, whatever is defined in the plan document in terms of growth. From an investment risk standpoint, the employer is taking on the investment risk because the asset portfolio could have a rate of return that’s greater than the interest that’s being credited to the participant’s account. We’ve had a lot of success with the cash balance plan. The idea of an individual account balance resonates a lot more than the idea of receiving a deferred annuity at a future point in time.
Ed: Well, Chuck, we talked about this. Why would an organization have a cash balance versus a traditional pension plan or, for that matter, an ESOP or profit-sharing plan or other types of arrangements? Why?
Chuck: Are you asking me or are you asking Dave?
Ed: Oh, no, both of you guys, both you guys. What’s ever first. Chuck, you’ve had one and, Dave, we’ve worked with you on more than one or two. Why do this? It’s a lot of money, isn’t it? You’re not free? The lawyers charge nothing on these things.
Chuck: Well, I know from my perspective, it seems like the main motivation behind the cash balance pension plan is the ability for people to defer– or it’s not really a defer, but the ability to make contributions to the plan that are substantially higher than what they can make in a regular pension plan or a 401(k) type plan. These contributions really are only available in a plan that is structured or regulated as if it’s a pension type plan, which is the magic of these cash balance plans is that the money going in is treated as if it were a pension plan rather than a true pension type plan in terms of the dollar limits as opposed to a contribution type plan. Is that a fair way of putting it, Dave? You probably have a better way of putting it than what I said.
David: Yes, a lot of the reasons that our clients put in a cash balance plan is they have an existing profit-sharing plan. For a group of physicians that are making, say, $500,000 a year, well, in a profit-sharing plan, they are statutorily limited as to how much they can contribute to profit-sharing 401(k) plans each year. For 2021, that statutory limit was $58,000, and if you’re over age 50, you can do an extra $6,500 in 401(k) deferrals for a total of $64,500. When we come in with a cash balance plan, we have the opportunity to take that $64,500 to maybe a total of $164,500 between a 401(k) profit-sharing plan and a new cash balance plan. If a lot of the principals are in their mid-50s to early 60s, that $64,500 could become something like $264,500. The big caveat there is those plans are subject to what we refer to as non-discrimination testing. You cannot discriminate significantly in favor of what the IRS defines as highly compensated employees. There is necessary testing that has to go on. It’s certainly a demographic-sensitive thing. If you have younger participants leave, that testing could be much harder to do. If the group is big enough and the demographics are good, it allows those principals to significantly increase the amount that they can save each year for retirement.
Ed: Wait a minute, I have a theoretical question here. Let’s assume there are three employees, one age 30, one age 40, one age 50, and the promised benefit at the normal retirement age, let’s assume it’s 62, is $100,000 a year for life. If we’re funding for someone who’s age 50, that means it’s only 12 years to fund for that full amount versus someone at 30, that person’s got far more years to fund for this benefit. Is that how this skewing, I’ll call it, in favor of the older folks occurs, David?
David: That’s absolutely right. If you’re funding for the same level of benefit at say age 65, the less years you have till normal retirement age, the more you can contribute each year. The IRS limits the amount that you can take out of a cash balance plan, and on a lump sum basis right now at age 62, that’s about $3 million.
Ed: Whoa, wait a minute. Are you telling me that an individual with a requisite number of years of service and compensation can have $3 million in this cash balance pension plan at age 62 assuming a rate of return expressed in the instrument at 4%? Is that what’s going on here? Am I hearing that correctly?
David: That’s right. There’s caveats in that you have to, again, pass non-discrimination testing on an annual basis between the two plans with demographics that you’d have and the IRS has a 10-year phase-in on that limit. You would have to have a plan in place for at least 10 years to get that lump sum at age 62 of $3 million.
Ed: Okay. Let’s assume, Chuck, you’re a client and you make all this money and you’re 52 now. Chuck has gobs of money, he has more money than he has hair. [laughs]
Chuck: Well, this sounds so much like me, yes.
Ed: That’s right. I’d give anything to have a head of hair. No, I wouldn’t. Let’s assume we have Chuck at age 52 making all kinds of money and with a retirement age of 62. How much could Chuck–? You’re telling me then at his age 62, he can have 3 million bananas in that cash balance pension trust. Is that right, David?
David: That’s right, yes. For someone who’s age 52, the maximum contribution that you can make is about $176,000. That scales up each year from 52 to 62 so that the accumulated value over those 10 years again gets up to that $3 million statutory limits of the IRS.
Ed: Well, wait a minute now. What happens if the fund doesn’t earn this 4% or it earns 14%?
David: The big problem is if the fund earns 14%, and that’s something that as an actuary, we need to monitor each year especially for our clients that are trying to fund towards that maximum benefit, we want to know that that asset portfolio is trying to move as close as possible in lockstep with the interest crediting rate in the plan. Cash balance plans in general, we’re not looking to to seek out extremely high returns, we’re looking to mirror the interest crediting rate so we don’t have a situation where we get to the end of the plan and say there’s $4 million plan, but per IRS rules, you can only take out $3 million. Again, that’s something we provide our input for each year when we do the actual report to give the client an update on where they stand in terms of their maximum benefit limitation and how much room they still have before they hit normal retirement age and how much funding can go in in future years.
Chuck: The reason you have this target interest rate, if I understand what you’re saying, is because that’s what allows you, the actuary, to be able to predict, 10 years prior to retirement, how much can safely go into that plan for each participant because you can just take that interest rate and just do the calculation of, “Well, here’s how much this will earn at such and such interest rate over that period of time.” Is that why I’m understanding you correctly as the reason why you have that?
David: Yes. Again, even though it’s a cash balance plan, it’s considered a form of a defined benefit plan, so that interest crediting rate is specified in the plan. We utilize that each year. There’s no discretion each year to say, “Well, this participant’s account is going to go up by 8% because the assets did really well this year.” That is in the plan document along with what the annual allocation will be for each participant.
Ed: Well, wait a minute, I draft this document and I select that rate of 4%, 5%, 6%, 10%? Sounds like the draft person is dictating the rate which, in turn, dictates the level of contributions, is that–?
David: Yes, it is drafted into the document and there are minimums and maximums per IRS regulations what those rates can be. Right now, the highest set rate you can have is 6%.
Chuck: Really the higher the rate– it’s counterintuitive, I guess, because if I’m understanding you correctly, the higher the rate you select, that means you can only make lower contributions to the plan. Is that right?
David: That’s right. You actually get penalized for high-investment returns in your portfolio because you’re going to get to your $3 million either by contributions and investment earnings. The more investment earnings you get, the less contributions you can make to get to that $3 million.
Ed: Well, let’s certainly set it at 3% for Chuck, guy’s making gobs of money. What don’t I use 3%, I’m the draftsperson?
Chuck: Why not 0%? Maximize the deferral.
David: You could do that. Absolutely, you could.
Ed: Well then, there would be too much money in the plan too early though. Wouldn’t there be? If I invest in commodities, did a great job, I made 12% in year one, maybe I lost 30% in year two. All of a sudden they got an assumptions very low, I could be fully funded.
David: Right, yes. The reason why we use a rate like for 3% to 4% is primarily for non-discrimination testing. If we have a physician group with staff nurses, nurse practitioners, whatever, the benefit they’re being provided, we have to make sure the IRS considers that a “meaningful benefit”. The higher that interest rate is, the lower the allocation has to be. I don’t want to get too technical here.
Ed: I don’t get this discrimination business, that’s the human cry of this decade. What are we talking about discrimination? Is that taken to account? What do you mean by discrimination?
David: Well, we have to test the benefits that are given to each participant each year on a benefits basis. What we have to do is we have to convert a participant’s profit-sharing allocation to a monthly benefit at normal retirement, we have to take a participant’s cash balance allocation and convert that to an equivalent monthly benefit at normal retirement divide that by their compensation and come up with an aggregated accrual rate between those two plans. We have to do that for each participant. I don’t want to get too specific, but we have to have a sufficient number of non-highly compensated employees receiving accrual rates that are greater than the highly compensated employees.
Chuck: What I’m guessing here is that it’s easier to make this work if the non-highly compensated people are also younger than the highly compensated people?
David: Correct, yes. When we accumulate participants’ profit-sharing contributions, we can do that per the IRS regulation at a rate as high as 8.5% for purposes of calculating those accrual rates. When you have participants that are in their mid-20s and some 40 years from the plan’s normal retirement age, even a modest profit-sharing contribution can generate a substantial accrual rate for testing purposes.
Ed: Well, wait a minute, I hear profit sharing, I thought we’re talking about cash balance pension plan. You’re dropping on the cash balance in another plan? Is that possible?
David: Well, we’re talking about the profit-sharing piece of the aggregated testing. I should’ve said, we have to do the same thing for the cash balance allocation. We have to convert it to a monthly benefit, but we have to use a specified interest crediting rate in the plan to accumulate that allocation to the plan’s normal retirement age for purposes of calculating the cash balance accrual rate. We add that to the profit sharing.
Ed: David, I get that. What I’m saying, I’m greedy. That’s the definition of a lawyer, right? I’m greedy. The idea is I’ve got a cash balance pension plan, I’m telling this to Chuck, and he’s still got some money left over. Can I drop on top of that a 401(k) plan? Where there’s a defined contribution plan where there’s no limits on how much can be in the plan with the cash balance plan where there is limits as how much can be– A mere $3 million, have $25 million in the profit-sharing plan, the 401(k) plan. Is that right?
David: That’s right, assuming you don’t have the combined deduction limit issues between the two plans. The IRS limits the amount you can deduct between having a cash balance and a profit-sharing plan at the same time if you are not subject to coverage by the pension benefit guarantee corporation.
Ed: What’s that percentage, David? What can we put into this 401(k) profit-sharing without getting any limits?
David: If the limits apply, when you have a small professional service group, the aggregate contributions that can be made between the two plans is 31% of compensation. For purposes of compensation, you have to limit each participant’s comp to the statutory limit of $290,000 for 2021.
Ed: This sounds like a little loop of interesting statistical and mathematical analyses, but the bottom line here is that in a cash balance pension plan, at age 62, Chuck can have $3 million in the plan, assuming he’s got the compensation. Let’s assume he’s an artist. I’ll assume he’s a lawyer and makes gazillions of dollars doing nothing, right? Lawyers get this, but I’m doing nothing, you’ve accumulated this money. You’ve got $3 million in the plan at age 62. Can he transfer that to an IRA? What can he do with it?
David: Yes, you can continue to defer taxation on that in the event the plan was terminated at, let’s say, age 62, that money can be rolled over to an IRA and can continue to defer taxation until your first required minimum distribution which is now at age 72. With pending potential legislation, we’re hearing that that could be scaled up to age 75.
Ed: Chuck, we talked about this topic just a little bit about the funded status of these public pension plans. David, what’s going on there with these interest assumptions, these 3%, 4%, 5%, 6%? Why do we have these issues in typically the public sector pension?
David: Boy, that may be outside of my scope here, but I can talk about that there’s an interest rate set by the actuary and whoever is doing that work, for example, the state of Illinois. They have all these people that are– They’re active employees, they’re working for the state, and they’re continuing to accrue benefit, and they’re going to be entitled to an annuity form of payment at whatever the retirement age is at the state of Illinois pension system. There are those who are already receiving monthly benefits. They’ve retired and they are receiving, say, $2,000 a month. There could very well be a COLA adjustment, I’m pretty sure there is, on those retiree payments. Those monthly payments get adjusted upward due to cost of living adjustments each year. Those benefits have to get valued in terms of a single sum liability for disclosure purposes. It’s going to make a huge difference on what interest rate is used to value those stream of payments. The higher the interest rate used to value those payments, the lower the liability will be. There’s an incentive to use a higher rate to make the plan look less unfunded.
Chuck: [laughs] It seems like where you really end up in trouble then is if you essentially assumed an interest rate that’s higher than the actual performance of the investments, right? If you assume an interest rate of 12% but the earnings are 15%, there’s really no penalty for making a high assumption, right?
Ed: You assumed 6% and it makes 0%, so what happens then?
David: Right. Yes, the interest rate used for valuing the liabilities is independent of what you expect the asset’s return on a future basis. For example, we have a lot of– This is a much smaller sample, but when we do an accounting disclosure for our clients, in this current interest environment, they may use a 3%, 3.5% interest rate for valuing those liabilities in the plan. They may say, “For purposes of asset growth, assumed interest rate of return on the asset, we’re going to use 7%, 7.5%. We’re in like a 60, 40 blend between equities and bonds. We’ve had a strong track record over the last 10 years. 7% interest rate for purposes of projecting the assets is reasonable. For purposes of valuing the liabilities, given our low-interest-rate environment, a lot of our clients are using right now a discount rate of around 3% to 3.5% for purpose of valuing”
Ed: David, I’m sensing this is a bit of a political football. In other words, in Chuck’s situation, let’s assume we have a group of licensed professionals. They’re going to be very careful knowing that if there’s a shortfall in investment performance, a company’s got to make it up. Now, in the case of the government plan, who cares, it’s the taxpayer’s money, if there’s a shortfall in the plan. These folks have no skin in the game, or am I missing something?
David: You’re right. Who pays for it, right? The taxpayers. That could be recouped in terms of increased taxes. I read about the state of Illinois and their tax liabilities and the number of people that are leaving the state because of things like that. There’s not a lot of accountability, it ultimately comes back to the taxpayers in recouping that revenue.
Ed: Who’s the gatekeeper, Chuck?
Chuck: Well, it seems to me like you end up with the– isn’t this the same issue that you have with these union-sponsored plans too? They have tremendous underfunding in some of those plans as well. It seems like probably the same kind of mechanism is at play, or is that a completely different issue?
Ed: Well, the employers got some to say so, but this can be a part of the bargaining process. Maybe the employer has very little leverage.
Chuck: Well, my impression is the employer has very little control over how that fund is handled too, right?
Ed: That’s true, both the employer– Anyway, yes, we’re getting into some technical issues there.
Chuck: Anyway, have you ever had the opportunity to study those and what’s going on there, Dave?
David: Not a whole lot. I see articles in The Wall Street Journal about the state of Illinois. I think a few years ago, they tried to take some of the COLA adjustments out of the state of Illinois pension plan, but apparently, those were enshrined in the Illinois Constitution and the Supreme Court in Illinois ruled that those cannot be taken out.
Ed: Where’s the state of Illinois as a state in insolvency? I think New Jersey’s worst, is it? The worst of the–
Ed: The issue is who has the skin in the game? If the taxpayers, they have nothing to say. They’ve elected X, Y, and Z to handle it, and X, Y & Z wants to get re-elected– Don’t get me started on that. Anyway, the bottom line is the cash balance pension plan is a unique vehicle that would fit certain circumstances but not all circumstances. As contrasted with the traditional defined benefit plan, at least you can assess the liability on an annual basis. Is that what’s going on here? Why would we do this other than to set aside more money and to make sure I know what’s going on?
David: Right, yes. With most of our clients, we do an annual actuarial report and say three, four years into the plan, the accumulated value of participants’ benefits, the sum of everybody’s account balance in the cash balance plan may be a million dollars, and at the end of the year, the value of the assets is $900,000. From a funding perspective and making sure that you’re not carrying this large unfunded liability, we would say you should probably put another $100,000 in that so that with that receivable, as of 12/31 of say, 2020, assets and liabilities are equal and we just repeat the process year after year. Then it’s up to the plan sponsor if they want to fund an amount sufficient to fully fund the plan. If they want to overfund the plan and provide a little funding cushion for future years. If they’re having a cash crunch this year and they want to make less than the amount to fully fund the plan, we can carry for that unfunded liability and potentially spread that over X number of years or recoup it in a future year where they’ve had a lot better investments.
Chuck: I think I finally understand what happened with the state of Illinois. Sounds like you just described it.
Ed: It sounds like the individual account plan, like the 401(k)plan where you can measure your performance based upon the investment return that you may select versus the defined benefit plan should be the way these public employee arrangements should be funded. All should have a 401(k) plan and there’s then no unfunded liability on the heads of the taxpayers.
Chuck: Right, there’s no liability at all, it’s just the balance. These pension plans, whether it’s a cash balance plan or a traditional type of pension plan like the state retirement plans typically have and then the union contracts typically have, those are plans that are built around a future liability. Then you’re engaged in all these gamesmanship about how to put money into the plan in anticipation of that future liability versus what most people experience, the 401(k) or the regular profit-sharing plan where there’s just a balance in the plan and that’s your benefit. Your benefit is the balance in that plan, it’s very simple. Where you have simplicity, you have some certainty. Where you have complexity, like in the case of these pension plans, two things happen. First of all, there’s an opportunity for things to go wrong. Second, and that’s where our conversation started today, there’s an opportunity for people to engineer around that in order to achieve great savings if they’re careful.
Ed: I get to the basics, the skin in the game. If the taxpayers are the ones that are suffering, I can assure you who’s handling on behalf of the taxpayer versus the private sector, that’s not going to happen. The bottom line is I’ll say that the public pension plans, at least in Illinois here, are nothing more, nothing less than a great deal of a scam, end of story.
Chuck: Ed, you just keep making friends. Every time we have a podcast, we get more fan mail.
Ed: It’s fair, grade the government in revenge, that’s what we do every day. After a while, you realize that grading the government are twins. Don’t get me wrong, I think it’s a great opportunity for everyone that’s on the pension plan dole. The point is the grandchildren and the great-grandchildren are other ones that are paying for these omissions at this point. I tend to view the descendants having a little greater stake in this than the current retirees. That’s a perspective, and just make sure you don’t know my home address.
Chuck: I think a lot of those descendants agree with you, Ed.
Ed: They don’t know the social security benefits, the defined benefit pension plan benefits are on the shoulders of people that perhaps aren’t even born. That’s okay, because– go ahead, David.
David: The views of Mr. Sutkowski do not necessarily reflect the whole panel here.
Chuck: That was wonderfully put.
David: Someone had to throw that disclaimer in there.
Ed: I agree. Mine is just a function of X number of decades of doing this. Greed does wonder, so we go from there. David, this has been a– Chuck, any parting observations?
Chuck: None whatsoever.
Ed: Again, no address. I don’t want any letters in the house. That’s okay. Truth is a defense by the way.
Chuck: There you go.
Ed: Okay. Have a good one, David,
David: Thank you for the opportunity.
Chuck: Thank you, David.
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