Month: December 2015

Corporate Tax Evasion or Avoidance?

On December 16th, CFA Society Chicago hosted a timely panel discussion focused on US corporate tax policy and how it compared to the tax policies of other nations.  The current policy motivates US companies to move profits to overseas subsidiaries where corporate taxes are much lower.  Corporate tax inversions may become more common; these will become an important political issue as the election year unfolds.

Mr. Graziano began the event with a presentation entitled “Corporate Tax Risk, The Thin Gray Line”.  He makes the case that US Corporate Tax Policy is not competitive on a global basis.  The US has not cut its corporate tax rate in over 25 years and has the highest tax rate (35%) of any developed country. This antiquated tax policy has motivated US corporations to take action to avoid paying tax in their home country.

The method whereby US companies are able to enjoy the lower tax rates of foreign countries has led to the storing of corporate cash in the country where the lower tax is paid.  Many multi-national US companies now have large cash holdings in countries other than the United States.  The ramifications of these large cash holdings being held abroad by US corporations was discussed at length in the presentation and during the panel discussion.  To repatriate the cash, US corporations would have to pay the 35% federal tax along with any state tax.

Panel Discussion:

Mr. Graziano began the panel discussion by asking if it thinks that US corporations have an economic (or moral) obligation to pay a repatriation tax.  The panelists were unanimous in their opinion that there is not an obligation.  The US has created its own problem in this regard due to its inability to reform these policies.

There was a brief discussion as to how a US value added tax (VAT) might help to replace lost tax revenue if the corporate tax rate was lowered.  The possibility of repeating another “one-time” tax repatriation holiday as was done in 2004 was also discussed.  The panelists were convinced that another “one-time” tax holiday would not solve the problem.  There was very little evidence that the US economy benefitted from the 2004 tax holiday.

Panelists were unanimous in their belief that the antiquated US corporate tax rate puts US corporations in a difficult predicament. Under the current laws, corporations are incented to move cash and business overseas to the detriment of the US economy.  In this environment, tax inversion transactions that make American companies subsidiaries of a parent company in another country can be expected to increase.

Unfortunately, there is no easy solution without bipartisan support for reform.

Ron GrazianoModerator: Ron Graziano, CPA

Mr. Graziano is a Director at Credit Suisse and serves as the Global Accounting & Tax Strategist with the HOLT advisory service of Credit Suisse.


Barry Jay EpsteinPanelist: Barry Jay Epstein, Ph.D., CPA, CFF
Dr. Epstein is a Chicago based financial reporting expert, author, and litigation consultant. In his work with Epstein & Nach LLC, he has consulted and/or testified in over 120 cases.


Anna GreenPanelist: Anna Green, CPA
Ms. Green is a Tax Partner with PwC Chicago’s Industry Tax Practice. She is responsible for managing a team of professionals providing tax accounting advice to large corporate clients.


Robert M. WilsonPanelist: Robert M. Wilson
Mr. Wilson is an investment officer and research analyst at MFS Investment Management. He is responsible for working with portfolio managers to integrate ESG (environmental, social and governance issues) into the investment decision making process

Pension Finance: Putting the Risks and Costs of Defined Benefit Plans Back under Your Control

Pension Finance: Putting the Risks and Costs of Defined Benefit Plans Back under Your Control

Book Recommendation: Waring, M. Barton. Pension Finance – Putting the Risks and Costs of Defined Benefit Plans Back under Your ControlNew Jersey: John Wiley & Sons, Inc., 2012. Print.

This article provides a detailed, technical overview of one of my favorite books on how to effectively manage defined benefit pension plans. M. Barton Waring does an amazing job of simplifying this highly complex topic while providing incredible insights—that every investor should understand—on risk and return. By the way, if you’re looking for information on how an individual can effectively plan and save for retirement (using 5th grade math), then I’d suggest you click here to readThe Retirement Lifeguard. 

About the Author

M. Barton Waring is a financial economist and lawyer, and an active researcher in pension finance and investing. He retired in 2009 from his role as Chief Investment Officer for investment strategy and policy, emeritus, at Barclays Global Investors. Mr. Waring is well known in the pension industry for his many thoughtful and often prizewinning articles. He serves on the editorial board of theFinancial Analysts Journal and as an Associate Editor of the Journal of Portfolio Management” (cover).


I highly recommend Pension Finance to you with its very timely guidance on the management of defined-benefit pension plans. Mr. Waring presents a complete treatment of the overall pension accounting system on a market-value basis for the purposes of improving plan management. Even if not adopted for financial reporting purposes, implementation of a mark-to-market based pension accounting system with a surplus optimization investment strategy could provide significant benefits to both labor and management. Waring also presents a thorough discussion of risk management and investment strategy. In short, with better economic information and more informed risk management strategies, better pension plan management decisions can be made and defined-benefit plans can be well funded and managed with lower risk.

The Need for Economic Pension Accounting Information

The following quotation aptly describes Waring’s view of the need for economic pension accounting information:

“While it may appear that going to market value accounting causes new problems for the plans, the fact is that it doesn’t – the plan’s status is what it is, regardless of the accounting. But economic accounting brings a benefit, a clear-eyed view of what is really going on in the plan, a means of understanding the plan’s true financial condition, a means of understanding the true cost of benefit changes, and a means of understanding the true level of contributions needed to support the benefit promises. It even provides a path to investment strategies that reduce risk to the deficit and to contributions. So while there may be short-term pain, the path to longevity for pension plans must include economic accounting and actuarial approaches. Traditional accounting and actuarial work held sway as plan solvency declined; the path back is to use better tools (225).”

The total unfunded pension plan debt for all plans (public and private) in the United States is estimated to be at least $4 trillion dollars (2). The size and complexity of this crisis as revealed through current actuarial and accounting methodologies have provided misleading information to both plan sponsors and participants. The fact that the pension funding crisis is as bad as it is should tell us that the current approach is not working. This is big money and it’s intended to be available to solve the most difficult financial problem that most people face during their lives: safely accumulating the means to retire comfortably after their working years are over (4). Clearly, these are significant issues for employers and employees alike and Waring provides an objective analysis that can assist in both labor negotiations (such as recognizing the Full Economic Liability which includes both off-book and on-book liabilities) and pension plan management. In addition, Waring outlines 22 Propositions which are important pension finance principles that may come as a surprise to many.

Weaknesses of Traditional Actuarial Asset/Liability Studies

Several of the traditional pension management tools have simply not delivered the desired results. Actuarial asset/liability studies have led to recommended portfolios of 80% equities and 20% bonds or 60% equities and 40% bonds (187). Yet, the portfolios do not hold enough long bond durations to hedge the liability which means that in declining interest rate environments the liability goes up dramatically while the value of the fixed income assets barley follow (188). On the equity side, these high allocations could increase your deficit by 10% of assets every time the market falls by 10% which adds significant volatility (146). The studies often over-complicate the analysis with Monte Carlo simulations which are misused as an “actuary in a box” (185). Waring explains that asset/liability studies are not needed as “surplus optimization” handles the investment strategy problem perfectly .

The Surplus Optimization Solution = LMAP + RAP

Surplus optimization controls the economic “surplus” (or deficit) of the plan. First, the interest rate and inflation risks of the liability stream (future benefit payments) are hedged through a Liability-Matching Asset Portfolio (LMAP). This is the single biggest risk management decision of the plan and hedging the economic liability can reduce over half of the variance of the plan (179). The accounting always follows the economics, if not sooner than later, and this approach will then significantly reduce the volatility in pension expense and contributions (20). Second, a Risky Asset Portfolio (RAP) can be added in a risk-controlled manner, if desired, but this is completely optional. One approach for the RAP would be to put in place an improved Dutch system: If the sponsor wants to invest in risky assets over and above an LMAP hedging portfolio, it must be fully funded – and then some. This policy can be improved by quantifying it: The cushion should be established relative to the surplus risk generated by holding the RAP in such a way as to manage the probability of becoming underfunded (261).

In developing the LMAP, you match the accrued liability’s total return sensitivity by matching (1) the dollar real interest rate duration and (2) the dollar inflation duration (147). This effectively provides immunity of the surplus or deficit of the plan to market risk and thus protects the funding level. In addition, it addresses a key goal of pension managers which is to stabilize the economic normal cost which is the expense accrued to the sponsor in this period for benefits that will be owed to employees at their future time of retirement and stabilizes future contributions.

Benefit Policy Drives Costs and Contributions (not discount rates)

The actuarial funding method concept is another relic of the past that should be eliminated. This approach assumed that future benefits would be paid out of contributions plus earnings on the investment. In reality, the funding method was a “balancing act” in which contribution levels were experimentally adjusted up or down while the “expected” rate of return assumption was adjusted up and down as well. The temptation was to select higher “expected” rates of return to reduce contributions as well as reduce the “valuation” of the liability (196). In short, the required rate of return should not be used for the management of the pension plan. When holding a LMAP, contributions are really just a function of the benefit policy plus or minus some minor gains or losses from the RAP (if held).

Adding Exotic Assets is Not the Answer

Waring makes a huge point of the fact that plan sponsors and strategists agonize over which new asset classes to add to their portfolios (e.g. hedge funds, venture capital, exotic beta classes, etc.). Yet there is no “magic” asset class that always goes up and that you are able to accurately choose in advance. He reminds us that finance theory is quite clear on this matter and that the Risky Asset Portfolio (RAP) should be a market-capitalization weighted portfolio of all risky assets. Otherwise, we are assuming that our asset manager has some specific, unique market knowledge that suggests he can outperform the market over a finite period of time on a risk-adjusted basis. In reality, the results will be a random outcome and not a good strategic decision (145).

Taking More Risk is Not the Answer

Some sponsors may attempt to “pay for the plan” by adding even more risky assets to the portfolio (146). However, the point cannot be under emphasized that sponsors will not “get” the “required” or “expected” rate of return on their investments over time. In fact, a realized (actual) return is drawn from a wide distribution of returns if you’re investing in risky securities (213). Market returns can be quite volatile and long periods of bad luck (realized returns less than expected returns) are just as likely as long periods of good luck (1980s-1990s) (40). The market declines of 1998, 2002 and 2008-2010 damaged the asset side of most plans as well as significantly increased deficits. This type of volatility typically adds to the deficits because sponsors typically don’t want to make up the loss with contributions. In the end, the deficits are left in place hoping that they will go away in the future. They could potentially or they could also get worse, much worse.

Hoping Time Reduces Risk is Not the Answer

Another common misconception is that risk goes away over the long term but in fact it accumulates with time. The standard deviation of returns increases by the square root of the number of years. For example, if the time horizon is 25 years then the standard deviation of returns (risk) over the period is five times wider (√25 years = 5)  than the one-year standard deviation of returns. The risks to wealth accumulate with time and we must remember that markets will fail to meet the expected return assumption (39).

First Hedge the Liability – It’s the Single Biggest Risk

The key conclusion is that the biggest single risk to hedge in a pension plan is the liability. Sponsors spend a lot of time focused on asset allocation decisions which can only marginally help the plan while ignoring the decision to hedge the liability. In short, sponsors should do three things in this regard (1) hedge the interest rate risk of the liability (2) revisit the risk tolerance decision, it is a real investment decision (3) be very careful about any active or tactical decisions that require special skills in order to yield success (146).

Measure the Big Picture: The Full Economic Liability

The process really begins with gaining a full understanding of the economic cost of the plan. The “Full Economic Liability” FEL is the proper starting point for a plan sponsor to gain a complete picture of the on-book and off-book economic liability (63). The off-book liability will inexorably make its way on book eventually. Waring points out that an economically determined accrued liability and its associated normal cost method will accrue portions of the full economic liability related to current employees onto the books over time. On some agreed basis, which will generate the economic accrued liability whose form can be chosen and interpreted as an acceptable funding target for benefit security purposes.

Since the ABO (Accumulated Benefit Obligation) and PBO (Projected Benefit Obligation) are accrued “subsidiary” measures of the liability by definition they leave something off the table. That something is the portion which is still unaccrued for both current and future employees. Waring suggests that wise management teams do consider the off-book (non-legal) obligation and they consider its value when talking to labor during negotiations.

Discount the Liability at Real Risk-free Interest Rates

In order to determine the proper economic value of the liability in today’s dollars one must use market-based discount rates. Some people continue to believe that the expected rate of return on the asset portfolio is the appropriate economic discount rate to use when valuing the liability (future benefit payments). This is still used quite frequently for state pension plans. Yet, the only rates of return we have the power to “require” are the rates on the risk free spot rate curve for a particular time horizon. And the correct rate to use is the spot rate curve for inflation protected government securities (real risk-free interest rates) which is hedgeable. Therefore, you can finance these benefits with little risk to the plan sponsor. Although the accounting liability increases with a lower discount rate the actual economics of the plan (actual cash flows for the benefit payments) are not changed and also cannot be magically reduced if someone elects to use a higher discount rate. In fact, a higher discount rate establishes the rate you must earn on funds borrowed from employees to pay future benefits. From this perspective, if sponsors guarantee higher returns on risky assets which are not realized then they are eventually faced with the realization that the liability was higher than they originally thought and that planned contributions were too low – a “double whammy” (200).

Select a Normal Cost Method that Improves Benefit Security 

A key component of pension expense is normal cost. Waring uses the term “Full Economic Normal Cost” which represents the expense accrued in this period for benefits owed to employees at their retirement (also called service cost) however, it does not contain the panoply of other items such as investment returns, financing costs, etc. which are in service cost. There are many different normal cost methods: ABO – accumulated benefit obligation, PBO – projected benefit obligation, present value benefits or “initial funding method”, the “cost prorate constant dollar method” or Entry Age Normal (EAN) cost methods which is a level payment approach. Ironically “normal cost” does not affect or control costs over the long term. Rather, costs are a function of the benefit promise.

Although all of the normal cost methods must terminate at the full funding requirement, the speed or pace of the accumulation of the accrued liability must be observed carefully. Therefore, it has an important impact on benefit security. Waring prefers the economic version of the EAN method because it makes sense to those who think of a pension as a constant proportion of the overall pay package which is then useful in both budgeting and benefit negotiations and seems to be the right compromise between labor and management (98).

The practical point is that if the “notional normal cost” entries were in fact real monetary contributions which were calculated similar to a payment amortizing a debt (253) and placed into a liability-matching asset portfolio then the possibility of becoming underfunded through investment results will be substantially eliminated. In this case, the pension assets would grow following the same line as the on-book accrued liability. The funds would ultimately be there to pay the liabilities when they come due.

Utilize Mark-to-Market Management Accounting Information

Waring recommends the use of this economic mark-to-market “management accounting” picture because today’s smoothing and amortization of pension accounting data is not a hedge and does not provide risk control. There are no “smoothed” assets to purchase to hedge against a smoothed liability (248). An economic hedge on the surplus/deficit will naturally smooth out pension expense and contributions and is a superior approach. The fact is that conventional amortization and smoothing of data actually add risk rather than reduce it.

Importantly, even if the formal accounting continues to be done on a conventional basis (until political and regulatory changes are made IASB, FASB, GASB) moving to an economic accounting view for management of the plan is highly recommended. In addition, once the underlying economic risks of the plan are properly measured, the conventional accounting risk measures will also be under control. In short, it provides guidance to discover what’s really going on “under the hood” of the plan.

Be Good Stewards: Act on Behalf of the Beneficiaries 

Plan sponsors must be good stewards of the plan assets that are required to provide for employees in their old age. Across the industry, confusion and fear has led many plan sponsors to switch to defined contribution (DC) plans because they provided more clarity of both cost and accounting for such plans. However, Mr. Waring contends that the best defined-contribution (DC) plan is still not as good as the worst defined-benefit plan. Why? Because, defined contribution plans have not been shown to accumulate the level of resources an employee needs to adequately be prepared for retirement. For example, one detailed study showed the average account value for employees over the age of 60, that has been in a DC plan longer than 30 years, was only about $180,000 which is too low to provide for retirement (224). Waring points out that DC plans don’t seem to be the answer but that DB plans can be saved if one first recognizes the need to measure them on an economic basis and then optimize the surplus of the plan.

Face the Problem Head On

Mr. Waring believes the best way to address the problem is to face it head on. The advantages will be to establish more certain costs now and minimize the probability of further negative surprises later. Managing the accounting is not the route to controlling pension-funding risk or cost. Rather, only good benefit policies and some lucky investment returns will help. And good policies can only come from meaningful economic information.

Pension Finance is an excellent read for anyone in the defined-benefit pension plan administration or management roles. I completely enjoyed Pension Financeand applaud Mr. Waring for his forthright analysis of the subject.

Distinguished Speakers Series: Dan Fuss, CFA

Blog_FussDan Fuss, CFA and former member of the CFA Society Chicago, spoke to a packed house at the University Club of Chicago on December 3. Fuss has over five decades of investment experience and joined Loomis, Sayles & Company in 1976. He’s Vice Chairman of the firm’s Board of Directors and manages the firm’s flagship Loomis Sayles Bond Fund, as well as a number of other fixed income offerings. Fuss has earned numerous accolades over the years including Morningstar’s Fixed Income Fund Manager of the Year, the Institutional Investor Money Management Lifetime Achievement Award, the Lipper Excellence in Investing Award, the CFA Society Milwaukee Lifetime Achievement Award, and was named to the Fixed Income Analysts Society’s Hall of Fame.

During his talk, Fuss focused on what he calls the Four Ps: Peace, Prosperity, People, and Politics. Starting with peace, he discussed the growing conflicts in the Middle East, Eastern Europe, and South China Seas. While he brought up the Cold War and the challenges faced by governments and leaders then, he remains optimistic about the issues facing the world today. Fuss believes that world leaders can work together to solve these problems.

Fuss also believes that in the United States, despite a gridlocked Congress with little appetite for increased spending, the nation’s share of military spending is likely to rise, especially given the geopolitical climate. That’s “prosperity,” or lack thereof. With rising military spending, the government will need more revenues and those revenues can come from two sources: debt and taxes. Higher taxes, he says, will push more investors to favor tax-exempt muni bonds and which will have implications for the taxable bond market.

Fuss’ “people” is focused on changing demographics, which is not just a challenge faced by the United States.  All developed countries are aging and those aging populations require more resources, especially healthcare, which is another reason he expects taxes to increase. Fuss also believes that this demographic shift will increase the demand for bonds because private and public sector defined benefit plans will need to rely more heavily on bonds, rather than stocks, for liability matching.

As for politics, Fuss was not optimistic. He believes the Senate and the “ruckus” House will continue to be unable to deal with serious issues facing the country. This means the United States may be a ways from solving some of the issues facing it today, including the demographic shift and the resulting impact on government revenues.

Though not an official “P,” Fuss also talked briefly about the Federal Reserve. He noted that, despite the Fed’s domestic mandate, it has been more transparent about its consideration of global issues in determining the timing and magnitude of increasing interest rates. While many believe that if the Fed doesn’t raise rates this December it won’t move in 2016 because it’s an election year, Fuss disagrees. That said, he believes the chance of a rate hike in December remains 50/50, despite the recently positive statements by Chairwoman Janet Yellen. In all, Fuss anticipates a slight upward pressure on interest rates and a slight downward pressure on P/E ratios because of these aforementioned “Ps” and is positioning his portfolios cautiously.