More International Equity?

A question posed by fiduciary investors today is whether they should increase their allocation to International Equity. The answer depends on whether their intention is to chase international performance or to adjust their long term strategic exposure to international equity?

A neutral global market capitalization weighted investment benchmark would allocate about 50% of equity to international. Academic studies and industry practice suggest there is diminishing value from international allocations beyond 40% of equity. A 20% international allocation of total equity is often considered a minimum prudent allocation. Many plan fiduciaries discount back from a strategic 40% exposure for the following reasons:

1) global market return correlations have been going higher thereby reducing the diversifying value of int’l equity,
2) pension plan liabilities are often denominated in US $’s making foreign denominated assets more volatile relative to liabilities,
3) foreign investments costs more than domestic investments, and
4) comparability with similar pension plan allocations.

Many investors are tactically overweighting international equity due to the weakening dollar and perceived lower valuations. Long term institutional strategies presume currency effects tend to cancel out over time and that valuations tend to mean revert. Using currency or valuation to support changes in international equity is tactical and implies performance chasing rather than strategic alteration.

Senate Committee Review of Target Date Funds

The Senate Special Committee on Aging held another fact finding session on Target Retirement Funds (TRF), concerned by their lack of transparency, high fees and and potential conflicts of interest. Testimony (available via webcast) provided by a range of regulators and private fund providers was similar to what has been presented in the past.

The Q&A portion was of particular interest in that it addressed arguments on both sides of proprietery fund management and whether conflicts of interest inherent in proprietary target date funds, but not addressed by ERISA due to an exemption, are adequately covered by securities regulations as intended by Congress when drafting ERISA. Other points of interest raised during the prepared comments:

SEC will be focusing on the use of dates in fund names, whether TRF sales material requirements provide sufficient information and balance and investor education.

EBSA is looking at QDIA regs to see if more specific guidelines are necessary to help plan fiduciaries better understand, select and monitor TRF's. In the Q&A it sounded like DOL will give additional consideration to the use of more conservative funds as QDIA.

Morningstar was concerned about the range of fee, the issue of proprietery fund management which would not be considered institutional investing best practice, and the low level of conviction managers have in these funds as indicated by their very low personal investments in them. 57% of TRF managers have no investment in them.

Fidelity made some important and often overlooked points about the intrinsic value of these products for uninvolved investors. They also indicated support for a number of recommended communication initiatives. A later point about investors desires to have a company and brand they are comfortable with manage the totality of their investments was well made. Having a good product is only half the battle, getting plan particpants to select the product is just as important and brand plays a big role in that decision. Plan fiduciaries must also consider that aspect when selecting a TRF for their plan.

A private TRF provider pointed out the inconsistency of DOL's rethink of the investment advice rules because of conflicts of interest while allowing proprietary funds to be used within a TRF product because they are not considered plan assets under ERISA. A point made here was that requirements & remedies are available under securities laws to address these issues.

The Committee members seemed to appreciate the difficulty in trying to legislate investment results in this area.

Mutual Fund Incubation

Establishing a minimum required track record of at least 3 years along with setting a minimum asset requirement can help investment fiduciaries avoid the potentially misleading effects of mutual fund incubation.

Defined Benefit Plans - Modest Relief in 2009

Market turmoil over the last year has severely impacted DB plan funding levels and future funding obligations. While plan sponsors can t directly control interest rates or capital market performance, they can influence funding requirements via plan actuarial assumptions. Recent legislation and regulatory guidance provides additional flexibility in this area.

Liability Discount Rates: new IRS guidance allows plans to change their yield curve election in 2009 without IRS approval. Plan sponsors that choose to use the corporate bond yield curve in lieu of segment rates may use the same look-back period ( 4 months preceding January 2009 for a calendar year plan) that is allowed for plans selecting segment rates. This would allow plan sponsors to use discount rates that could be up to 1% higher than those allowed without the look back provision and in lieu of the segment rates. The IRS has not indicated whether another election will be allowed in 2010 so the use of a current yield method could introduce higher future volatility in plan funding requirements.

Asset Smoothing : the IRS provided additional guidance (Notice 2009-22)on how asset smoothing, allowed under the Worker, Retiree, and Employer Recovery Act of 2008, could be implemented. This guidance is particularly valuable given large recent asset losses. The notice provides automatic approval for a change in asset valuation methods for plan years beginning in 2009.

Adopting actuarial assumptions which reduce long term funding volatility while providing a beneficial current impact seem to be a win-win for plan sponsors. Adopting an asset smoothing methodology seems to be an easy decision while the benefits of adopting a corporate bond yield are not as straightforward. Each case should be determined in consultation with your plan actuary.

Fiduciary Liability Insurance

Given market conditions and investors need to make up for losses, plan fiduciaries should get to know the details of their fiduciary liability insurance. Steve Saxon provides guidance in his comments at Plansponsor.

Mutual Funds Fees are Too High

This study on mutual funds, Identification And Performance of Equity Mutual Funds with High Management Fees and Expense Ratios by Haslem, Baker and Smith, finds that economies of scale are not generally shared with fund holders because the market lacks the competitive pressures to drive fund expense downward. This is due to product a variety of product differentiation strategies that probably have little correlation to a funds future sucess.

Active vs Passive

Another perspective on the active vs passive debate. Typically, its a toss-up before fees and a loosers game after. Good managers do exist but they cant be uncovered simply by looking at past performance.

Active Manager Underperformance in 2008

If your actively managed investment funds underperformed dramatically and collectively in 2008, Wurts & Associates developed a presentation which describes what happened. Their points may be useful in putting 2008 benchmark relative results in context for your investment committee.

Target Date Retirement Funds - Best Practices

According to testimony before the Advisory Council on Employee Welfare and Pension Benefit Plans, evaluating Target Date Funds(TDF) is challenging, difficult, complex and one-size-does not fit -all. Best practices noted in the testimony

• the single most important decision is the design of the glide path of the TDF
• active/passive management, value customization and participant impacts are other important factors in considering the utility of TDFs
• TDF’s must be evaluated periodically (most often quarterly).
• fiduciaries should compare TDFs to their peers and relevant benchmarks,
• communications that effectively explain the TDF so participants clearly understand the underlying investments and how the glide path works is important also,
• a plan sponsor should consider what levels of defined benefit, Social Security benefit or other pension benefit that participants are likely to have,
• the design and structure should be compared to the plan’s unique demographics,
• consider individual participant risks - participants need to understand the limitations of these funds,
• customization will be big in the future,
• annuity type options or managed payout type funds are going to become more and more prevalent,
• benchmarking is a problem. Focus should be on trying to define a “process” for evaluating these things and not relying on one particular measure to monitor it,
• one firm’s TDFs would be appropriate if the plan sponsor is comfortable with the overall philosophy and that should not change based on the target date of the fund,
• looking at the underlying funds that may make a TDF could be illustrative since the underlying funds have likely been in existence long enough to build up a track record,
• liquidity of certain investments in a TDF may be a challenge,
• consider using different TDFs from different vendors,
• carefully evaluate costs,
• Plan sponsors should ask vendors for an investment policy statement,and
• sponsors should strive to maximize the number of participants who reach a minimum level of income replacement in retirement.

Mutual Fund Family Performance

Many publications provide periodic data or rankings on composite mutual fund family performance. A question arises as to whether investment fiduciaries should derive comfort or concern from these lists.

For instance, in a recent WSJ article, the performance of the 10 largest mutual fund families was profiled. The fund family rankings were based on asset weighted excess returns over their morningstar style box from the market peak in October 2007. The article acknowleges that "this overall scoring may have little correlation to your personal investment results" though they point out that "the results give some indication of how each complex has served its investors overall since the market peak".

The Street.com provides its own ranking of fund families based on its rating system which they indicate should "provide a solid framework for making informed, timely investment decisions".

There is often dissonance between lists. For instance, The Street's top performing fund family with more than 100 rated funds rates a 2.6 under the Morningstar ranking system where "the scores range from 1.0 to 5.0. A score below 2.5 is an indication that the firm has met with little success in that asset class. A score between 2.5 and 3.5 indicates the firm is about average".

All performance rankings have limitations, especially those based on short time periods. Family fund rankings have even less value since they dont reflect the characteristics of any specific investment strategy. They are simply an artifact of a set of asset class, investing process, research and outlook biases that may be correlated across funds in a family.

Investment fiduciaries whose investment programs, such as 401(k)'s, hold many investments from a single fund family may not be fully meeting their fiduciary responsibility to diversify plan assets. A study by Elton, Green and Gruber, "The Impact of Mutual Fund Family Membership on Investment Risk" finds:

"evidence that mutual fund returns are more closely correlated within than between fund families. As a result, restricting investment to one fund family leads to a greater total portfolio risk than diversifying across fund families. The increased correlation is due primarily to common stock holdings, but is also more generally related to families having similar exposures to economic sectors or industries. Fund families also show a propensity to focus on high risk or low risk strategies, which leads to a greater dispersion of risk across restricted investors. An investor considering adding an additional fund either inside or outside the family would need to believe the inside fund offered an additional 50 to 70 basis points in return to achieve the same Sharpe ratio."

Using fund family ranking information to assess the merits of an investment progam would be like selecting a job candidate by interviewing her family. Though some general traits may be "genetic", investment performance and therefore fiduciary attention should correlate to the unique characteristics of each investment fund.

401(k) Tweets

A new 401(k) program ranking tool, Brightscope, is now available on line. According to the firms press release;

"The new BrightScope Rating is a quantitative 401k plan rating developed by BrightScope, Inc. in partnership with some of the country's top independent fiduciaries, finance professors, and 401k experts. BrightScope Ratings take into account over 200 unique data inputs per plan and calculate a single numerical score to define 401k plan quality at the company level. The ratings algorithm runs thousands of simulations for each 401k plan in order to determine how quickly each plan will propel the average 401k participant to retirement. Using this rigorous approach, BrightScope ensures that every factor that affects retirement outcomes - such as company generosity, fees, investment menu quality, vesting schedules, and more - is accurately reflected in a company's rating. The site provides open access to 401k ratings, allowing anyone to compare any 401k plan with another."

Proclaiming the value of true transparency and disciplined benchmarking, the firm indicates that;

"Plan sponsors who use BrightScope can demonstrate to their employees, their board, their retirement committee, and to regulators that they are taking the necessary steps to improve the quality of their 401k plan."

Unfortunately, transparency isnt very transparent when a proprietery and presumably undisclosed process generates rank results. Fiduciaries would not be wise to rely on a quantitative "black box", especially one designed by industry experts....because we have seen where that will lead. The quality and timeliness of plan data inputs have been a persistent problem in past plan comparability efforts. A database that relies on voluntary data of unknow quality or stale but offical public domain data shouldn't necessarily be relied upon for fiduciary decision making either.

Perhaps, when a comprehensive suite of federally mandated investment and plan disclosures becomes available on a close-to-real-time basis and its ranking criteria and standards are revealed, a tool like this will have real value. Until then it will be an interesting curiosity.

While their intentions may be good and the output is interesting, Brightscope seems to sacrifice meaningful detailed information and a transparent ranking process for mindless usability. That may be a wise tradeoff to capture the eyeballs of the twitter generation but probably won't support its goal of being a fundamental fiduciary support tool that plan sponsors could really use.

FAS FSP 132R-1

Plan sponsors will be required to provide more transparency about the assets in their defined benefit pension plans based on FASB’s recently issued FSP FAS 132R-1, "Employers’ Disclosures about Postretirement Benefit Plan Assets."

This new disclosure guidance addresses perceived inadequacies about the types of assets and associated risks in retirement plans. Plan sponsors generally provide info on only four asset categories: equity, debt, real estate, and other investments. The growing popularity of alternative assets and their lack of homogeneity and unique risks make the "other investment" category particularly challenging for financial statement users to evaluate.

The new disclosures are designed to provide additional insight into:

• The major categories of plan assets
• The inputs and valuation techniques used to measure the fair value of plan assets
• The effect of fair value measurements using significant unobservable inputs (Level 3 measurements in FASB Statement 157, Fair Value Measurements) on changes in plan assets for the period
• Significant concentrations of risk within plan assets
• How investment decisions are made, including factors necessary to understanding investment policies and strategies

Required for financial statements with fiscal years ending after December 15, 2009.

Pension Expected Return Assumptions - Hitting Back

Current pension accounting allows pension plans to use an estimate of expected future returns instead of actual returns to compute periodic pension costs. The logic behind this accounting is that, in the long run, a combination of company resources and investment earnings must equal plan obligations. Pension plan liabilities are long lived and therefore some stable long run estimate of corresponding asset returns should be used to determine the periodic cost to the business of meeting plan obligations. Accounting further recognizes that annual differences between actual and expected returns are inevitable. These are accumulated and amortized into periodic cost over time.

There is a natural asymmetry to how this accounting regime is viewed depending on market performance. In bull markets, most seem satisfied in the conservatism reflected by periodic pension costs being higher than current earnings might suggest. Yet in bear markets, critics become vocal about the potential manipulation and overstatement of income as a result of using positive expected returns when market returns are negative. The wider the gap the more vocal the critics and the more concerned the actuaries and auditors who have a professional tendency towards asymmetrical conservatism. A recent article reflects this view.

“That 8 percent annual return on investment you and your pension fund manager were banking on is now looking almost as optimistic as Madoff’s magic 12 percent, as deleveraging and deflation bite. With extremely low or negative interest rates and everyone from consumers to banks trying to shed debt and assets at the same time, what seemed like reasonable projections for a mixed portfolio of stocks, bonds and other assets are now substantially too high.”

It is a well accepted fiduciary notion that short term investment results are very noisy and carry little useful information to guide long term investment strategies. Yet, after market drops like 2008, misguided critics insist that plan sponsors should be lowering their expected return assumptions to accommodate what ever change in strategic assumption they would argue has been revealed by the market drop. In this case, presumably, overleveraging was explicitly factored into past return forecasts rather than being a source of an unexpected positive variance from past forecasts.

In fact, long term expected return assumptions as defined by FASB, properly based on long horizon strategic factors, should not be subject to frequent marginal shifts given; the likely estimation error in any such forecast, the infrequency of major structural market changes and the provisions of accounting to amortize actual to forecast return differences overt time. Further, unless the market principle of mean reversion has been suspended, it is fallacious to assume that forward expected return forecasts should be lower after a market collapse. Historically, periods of heavy losses have been followed by periods with above average returns. Diamond Hill calculated that if the S&P 500 only returned to its April 2000 level in the year 2016, that appreciation, coupled with the dividend yield, would result in an annualized total return of over 12%.

While we are not expressing a view as to whether the average pension plan’s expected returns accurately reflect future returns, it is illogical to presume that the passage of the last year has provided plan sponsors with significant additional insight on strategic factors that were embedded in their long term forecast assumptions. Though it is understandable from a risk aversion perspective, it is also illogical that pension actuaries and auditors should bias plan sponsors to lower long term expected returns after the market has seen its worst decline in 50 years. Given their biases, pension plan fiduciaries should not unduly allow their advisors to tactically influence their strategic pension accounting assumptions.

The Perils of Cumulative Returns

In addition to having to confront miserable absolute returns in their investment programs, investment fiduciaries will have to contend with more than the usual number of relative performance issues where investment funds are not meeting their performance benchmarks. This is because of the higher than average fund performance dispersion in 2008 and the surprisingly significant impact that a single high deviation performance year can have on 3 and 5 year cumulative returns.

Short term investment performance is generally regarded as having a high noise to signal ratio. This means short term performance patterns usually do not persist into the future and therefore provides little useful information for investment decision making. Yet, 1 year performance variances, positive or negative, can substantially infect longer term 3 and 5 year cumulative performance measures, which are routinely used by investment fiduciaries in investment decision making. The larger a fund’s annual performance variance, the higher that years impact on 3 and 5 year cumulative performance. We have estimated that equity mutual fund performance return dispersion is 31% higher in 2008 than the average annual return dispersion since 2003. This suggests that the 3 & 5 year cumulative return rankings for investment funds will be subject to more fluctuation, influenced by a broader range of positive and negative 1year variances.

To counteract the effects of these short term performance biases, it is particularly important that investment fiduciaries look at a mosaic of other quantitative measures such as long term (5 +) and life of fund performance as well as rolling period data when evaluating fund returns. Fiduciaries might be considered imprudent not to consider other factors besides returns in their analysis. A number of risk measures are routinely used in conjunction with returns. Some studies, such as that by Martin Eling, Does the Measure Matter , point out that the Sharpe ratio is a reasonable and adequate measure to rank funds for additional due diligence work, though these measures are time period dependent as well.

In truth, even multiple statistical tools may not capture the critical attributes and dynamics of an investment fund. Subjective analysis and investment judgment will always be required to transform investment data into prudent investment decisions. Evaluating the fallout of 2008 will put a particular premium on those skills.

Investment Fiduciary Mulligan

Investors and investment fiduciaries may be wishing they could take a mulligan on their long term equity oriented investment strategies in the face of this decade’s second equity market implosion. Global equity (MSCI World) returns have been nil over the last decade ending November while global bond returns (MLGBM) were about 5.2% annualized.

Certainly, fiduciaries might surmise that, had they learned their lesson after the technology wreck in 2000, and either teed up a more conservative portfolio with less equity exposure or diversified their portfolios into alternative asset classes, they would be much better off today. Surprisingly this would not be the case. Since the market bottom in 2002 through November 2008, neither a more defensive asset allocation nor a more diversified allocation using alternative investments would have provided much relief.

Annualized returns for the period from the bear market bottom in October 2002 through November 2008 for various portfolios suggest that the positive equity returns enjoyed by investors over the intervening years was directly proportional to the losses they suffered in 2008. In other words, higher equity allocations lost a similar proportion of their past gains in 2008 as portfolios with lower equity allocations implying that the degree of equity allocation made only a modest difference in portfolio return over this period. The following benchmark portfolio returns illustrate this (Stocks=75% R3000, 25% MSCI EAFE, Bonds=Barclays US Aggr, rebalanced quarterly)

Portfolio 6Yr 1Mnth Return
Stock 80% Bonds 20%     4.16%
Stock 70% Bonds 30%     4.27%
Stock 60% Bonds 40%     4.36%
Stock 50% Bonds 50%     4.41%
Stock 40% Bonds 60%     4.43%
Stock 30% Bonds 70%     4.42%

Another investment strategy made popular by the large endowment funds was designed to diversify portfolios away from equity market risk. These strategies featured an asset allocation which included “alternative” investments. For all but the largest portfolios, this typically would have included allocations to real estate, commodities and hedge funds, through a fund of fund vehicle.

For comparison purposes we created a benchmark portfolio which included a 30% allocation to alternative assets (10% Wilshire global REITs, 10% HFRI Funds of Funds and 10% S&P GSCI) and an 80% allocation of remaining assets to stock and 20% to bonds. The 30% alternative portfolio returned 5.36% annualized for the 6 years through October 31, 2008 vs. 5.12% for the standard 80% stock 20% bond portfolio. The allocation to this set of alternative assets over this period added a modest .24% to portfolio returns (reduced porftolio volatility by a small amount) yet exposed investors to other non-statistical risk factors which are still playing out in the markets.

So, while all investors lost strokes over the last 6 years, mulligans were awarded for virtually every differential investment strategy. Investment fiduciaries have had the opportunity to learn a number of important lessons about the markets, about risk and about their own risk appetites and investment psychology. These should be carefully considered as part of their course management. Though no one knows what lies ahead in the markets, a big risk is that investment fiduciaries will rely too much on their “muscle memory” of 2008 in teeing up their investment strategies going forward.

401(K) Plan Cash Equivalent Options

As the credit crisis grinds on, issues in the money markets and Fed policy are forcing 401(k) Plan fiduciaries to consider their responsibilities to participants with regard to providing a safe, cash equivalent type of investment option.

To meet 404(c) requirements (as well as their basic fiduciary responsibility), Plans are required to provide a broad range of investment alternatives. The broad range requirement will be satisfied if “participants are afforded a reasonable opportunity to materially affect the potential risk and return on amounts in their accounts; choose from at least three diversified invest­ment categories; and diversify investments so as to minimize the risk of large losses”.

Further, “the three categories of investments in the aggregate (must) enable the participant, by choosing among them, to achieve a portfolio with aggregate risk and return characteristics at any point within the range normally appropriate for the participant”. Traditionally the three core investment categories have been considered to be stocks, bonds and “cash equivalents” (i.e. money markets or stable value funds).

From a modern portfolio theory perspective, cash equivalents anchor the efficient frontier and are necessary both as a standalone option or to modify the risk profile of a portfolio of either bonds or stocks, in order to meet the normal range requirement. Therefore, it is often interpreted to be a required core asset in a 401(k) plan.

404(c) further defines the required attributes of the core cash equivalent option. If any investment alternative permits changes more frequently than once every three months ( most do), at least one core investment must permit the same frequency of change, and the investment into which participants can transfer must be income producing, low risk, and liquid.

If the statutes require that a low risk, income producing and liquid cash equivalent account be available to participants to qualify for 404(c) protection, which alternatives satisfy these conditions?

Treasury Funds - After the Reserve Money market fund broke the buck on September 19, 2008, the US Treasury agreed to provide limited insurance for money market fund balances for participating money funds. Many money market fund vendors took the maximum time allowable to determine whether paying the trivial fee for the government protection was in their best interests. Meanwhile, a large proportion of their prime money market shareholders sought refuge in Treasuries and Treasury money market fund products, driving Treasury yields down further and likely costing these funds and their shareholders many multiples of the cost of the federal guarantee.

Now, as the FOMC recently set its target range for fed funds to 0% to 0.25%, Treasury fund yields are approaching zero, are closing to new money and are forcing Plan fiduciaries to consider whether negative yields are palatable to their participants or prudent from a fiduciary perspective. Plan fiduciaries should inquire how their Treasury fund managers are handling this issue and whether there are any disclosed yield floors in their funds. While US Treasury obligations are still considered low risk and liquid, their ability to satisfy the income requirement is limited, making then the functional equivalent of a "plush pillowtop".

Prime Funds- Meanwhile, those prime money funds which have the benefit of federal money market insurance, seem prudent and protected, at least for balances held as September 19, 2008. New money in these funds leave participants exposed to falling Treasury yields and the credit and liquidity issues associated with continued turmoil in the structured credit, commercial paper and repo markets. CD’s, another common investment in these funds, generally don’t carry full FDIC protection. Government “insured” prime money market funds seem to meet the 404(c) requirements, though fiduciaries should carefully evaluate a fund’s holdings to determine the potential risk and liquidity issues that face new uninsured allocations.

Stable Value Funds - Stable value funds offer a seemingly ideal combination of guaranteed principal and substantial yield in this environment. However, their risks are not well understood. Their risks are structural rather than statistical. Their book value security relies on low variance book/market value relationships, constrained cash-flows, careful contractual compliance and well capitalized wrap providers. A single headline event such as a stable value fund lockup could conceivably create a run on stable value funds regardless of competing funds provisions and employer put options. To protect existing fund-holders and wrap providers, product sponsors might be forced to suspend redemptions. The recent industry trend to provide additional “safe” alternatives and access to non competing fund alternatives may increase the risk of such a stable value fund event. The structural risks of stable value funds and their potential illiquidity should be of concern to plan sponsors. Additional fiduciary due diligence to monitor these risks is essential.

CD’s- Bank or brokerage certificates of deposit have not been traditional choices in 401(K) Plans. Yet they are often available through a brokerage window option. Current yields are respectable and within appropriate FDIC insurance limits could be considered risk free. Liquidity might be a consideration as most CD’s access a penalty for early withdrawal.

As a technical matter, plan fiduciaries must provide an income producing, low risk, liquid fund as a core fund option in their 401(k) plans in order to meet the requirements of Section 404(c). Current conditions in the money markets have altered the characteristics of many cash equivalent products. This requires that investment fiduciaries go through the exercise of re-evaluating the kind of cash equivalent alternatives they offer and performing additional due diligence on their composition and potential risks. In the context of today’s markets, a prudent investor should consider potential risks and illiquidity in much broader terms than might have been necessary 6 months ago.