Saturday, February 26, 2005

Retirement Planning

Charles Kirk runs an interesting and broadly informative investment weblog (even for non-traders) called thekirkreport. He recently referenced ESPlanner. I first ran into the ESPlanner in Larry Kotilikoff’s book The Coming Generational Storm. Impressed with the book, I took a look at the ESPlanner website. They have posted numerous (though somewhat self-serving) research papers and articles on their “economic” approach to financial planning and the development of their financial planning software Economic Security Planner (ESP). The economic approach to financial planning seeks to define the highest affordable and sustainable living standard through time and in the event of an untimely death. The software uses savings rates and insurance decisions through-out lifecycles to optimize the living standard. Traditional planning approaches use targeted income or spending goals in retirement to set appropriate level savings rates to achieve those goals. The ESPlanner uses dynamic programming. This process deals with optimal solutions in multiple stage decision-making processes. I found the intuition behind this approach interesting. The academic and economic pedigrees as well as the quantitative process behind this alternative seemed attractive as well. So, like Charles, I invested my $200 to take if for a spin.

According to the research material the basic conceptual differences between this software and traditional planning software is a) how it determines expenditure targets, b) its treatment of demographics ( this program assumes some economies of scale for familial expenses and c) how it handles borrowing. Given the degree of uncertainty of planning items not accounted for in this model I felt that items b and c were somewhat trivial.

There are substantial forecast risks that are not well addressed by this or other financial planning products. Healthcare or long-term care costs and future employment risk are two examples. Other inputs and assumptions might also be more effectively managed stochastically, though complexity then becomes an issue. For instance, inflation and mortality risk are handled on a deterministic basis by ESP. These two elements can blow any plan into irrelevance in short order and a probablistic perspective on these elements might be useful. General investment risks/returns can be handled deterministically or stochastically via the monte-carlo enhancement available via the monte-carlo upgrade.

The model provided lots of flexibility in terms of defining future financial events and it was relatively user friendly from an input side. Descriptor screens were functional but not extremely explicit. After spending an afternoon inputting data and selecting assumptions, I was somewhat unfulfilled when I looked at the results. The ouputs of the program are chronological recommendations for spending, savings and insurance presented in excel using tables and graphs. As best I could interpret I should/could be spending more in some years. The variability in annual spending/borrowing didn’t make intuitive sense to me even though it makes economic sense. This product could be much enhanced with some additional guidance on how to interpret the output. Someone with a larger appetite for details and an undivided interest in a range of possible outcomes could certainly get their money’s worth from this application. For me though, the elegance of the concept worked better than its execution in reality.

I couldn’t shake the feeling that, despite what the forecast showed… I am not as well prepared for an uncertain future as I should be. Maybe this is because I know with certainty that I have mis-specified the future. The limitations and general ineffectiveness of any of these planning tools in the face of uncertainty allows us all to rationalize why our current habits are sustainable.

Thursday, February 24, 2005

Know your R2

Investment News reports that "at the end of 2004, 27.6% of all large cap funds had a 3 year R2 of .95 or higher relative to the Standard and Poors 500 fund..making them closet index funds". This statistic sounded a little high though the trend is not surprising so I decided to do a quick bit of research on this .

First of all R2 or"R squared" is a statistical measure of how closely correlated a fund's performance is with the performance of its benchmark. R2 values range from 0 to 1. 0 indicates no correlation while 1.0 indicates perfect correlation to the market. In CFA school we were taught to interpret R2 as follows: " The R2 indicates the % of a fund's performance that can be explained by the performance of the market". The collorary is that 1-R2 = the amount of performance that can be explained by active management. So you can see that an investor paying active management fees (averaging 1.47% according to the article) for a fund with an R2 of 95% should feel cheated when 95% of the fund performance can be explained by market performance available in index fund or ETF form for 1/10 the price.

I ran screen on all Large Cap Value funds using Morningstar data to look at the characteristics of all the funds with R2 of .95 or higher. I found 35 of these funds out of approximately 375 total Large Cap Value funds. My screen includes any fund only once regardless of whether it has multiple share classes while the article may include all share classes for every fund. My sample indicates about 10% of funds are indexers/closet indexers. To maximize the sample size I used an R2 measure form 2/2203 to 12/2004.

The average annualized return of the high R2 funds was 24.46% versus a Russell 1000 Value return over the same period of 25.79%. This is annualized under-performance of 1.33%. It may not surprise you to know that the average fund expense for high-R2 sample was 1.10%, accounting for the majority of that underperformance. The average excess return for the High R2 funds was about -1% ( with a max at +4% and a min at -5%). Tracking error (volatility of excess returns was a very low 1.95%. Average Beta (measure of relative market risk where 1.0 = market risk) for these funds was .99 as should be expected.

What does this tell us? That a number of investors are getting picked off by paying too much for funds sold as actively managed whose returns are largely driven by the market. It is very interesting to note the composition of the fund families associated with the majority of these high R2 funds. Each large mutual fund complex seems to have 1 while the wirehouses and insurance companies predominate the remainder. My thesis is that these funds are sold to the retail marketplace and are held in small 401(k) plans where minimizing the chances of benchmark underperformance maximizes retention and profitability for these firms.

1.10% is a very high price to pay for the market! If you have fiduciary responsibility for funds, understand how they correlate to their market benchmarks (by the way, low R2 can also mean you are using a bad performance benchmark) and, where possible, don't pay up to get systematic market exposure.

Sunday, February 20, 2005

Pension Consultants

The Sunday NY Times carried an article by Gretchen Morgenson on the Unmasking of Pension Consultants. The article points out the potential conflict of interest issues that a number of large pension consultants may have. 1 large public pension plan, the Public School Teachers Pension and Retirement Fund of Chicago is considering conducting a conflict of interest audit of its investment consultant, Mercer. Considering Mercer's lineage, Marsh & McClennan and Putnam that sounds like a prudent idea!

While there are some very fine investment consulting firms in the business, there are some that find many different ways to contribute to their shareholders bottom lines, some of which might be at the expense of client plans. From a pure economic perspective, pension consulting is not a tremendously leveragable or profitable business model. Fees are not extraordinarily large in relation to the human resource and firm capital required to service clients. In fact many of the top named regional firms operating today were spawned from a prior industry purge where brokers terminated their consulting businesses because of economics and/or conflicts. Many of these firms remain privately held and the better ones have chosen a unitary consulting business model to avoid potential conflicts.

Sponsors should be curious about why large public financial firms, given their portfolios of higher ROE, ROI businesses would be involved in a lower margin consulting business. The answer most certainly lies in the "leveragable" power of being a client gatekeeper. At its best, the gatekeeper can influence clients to consume additional firm services. Often times gatekeepers will introduce non-related service providers who engage in a kind of informal "quid pro quo" client referral relationship with the consultant. At its worst and probably most common, gatekeepers can secure agreements with money managers to direct trading business through affiliated brokers. Other indirect financial relationships can also be established. These trading arrangements and other relationships are often times disclosed in some very innocuous disclosures that are provided to prospects. The only appetite larger than a public companies desire to make money is its desire to protect itself via lengthy disclosures and indemnifications.

It would be extremely challenging for a plan sponsor to really determine if potential conflicts of interest are "actual" conflicts. Therefore, Plan sponsors would be well advised to work with consultants who do not generate revenue from any source other than client fees. Investment consultants are required to describe their business activities in their SEC filings. Be sure to review the ADV form I and II when reviewing a particular consultant. Also review or have your ERISA attorney review all client disclosure material very carefully, As a fiduciary, you will be held accountable for understanding this information.

Wednesday, February 16, 2005

American "Pie"

NASD announced today it is filing charges against American Funds Distributors (AFD) for directing brokerage commissions to firms that were the top peddlars of American funds products. NASD is charging AFD with violating it "anti-reciprocal rule" which was implemented in 1973 to eliminate arrangements whereby investment managers reward brokers for selling their products by directing trades and commission revenue to them. The NASD press release indicated there were trading allocations developed for each broker based on their prior year sales of American Funds. Though this is the first regulatory pie on their face, AFD's perspective on the issue seems to be that as long as they receive "best execution" on the trades then they have fulfilled their responsibility to the fund shareholders. From a fiduciary perspective, provided they have done so, they may have. In the pension world, trading commissions are plan assets and fiduciaries have a responsibility to ensure these assets are spent solely for the benefit of plan beneficiaries, should there be some collateral benefit elsewhere, sobeit. Pension fiduciaries invested with American Funds should at least keep an eye on this and secure documentation on Americans trading, directed brokerage and soft dollar policies.

This kind of arrangement should not be a surprise to anyone since AFD has chosen to use brokers as their primary sorce of product distribution. By gosh by golly how would you think they incent brokers to sell... a good informatio ratio?. Like it or not "quid pro quo" happens in many ways in the investment business. This particular way, though an industry norm, is probably just making the NASD sweat a little too hard. For once they want to beat the SEC and every state's Attorney General to the punch.

What has always surprised me about Amerian Funds is that they have a very fundholder driven culture and their institutional value system, at least from what I have been able to observe, is impeccable. Yet their products have always been sold by brokers and not bought by investors. The fact that retail investors must pay sales loads and the distribution system must be rewarded in this way combines the very worst in distribution practices with a high quality investment maufacturing organization.

Tuesday, February 15, 2005

Summing it up

Peter L Bernstein in an interview last year summed up the essence of investment intellect. The best investors understand the limitations on their ability to consistently forecast future markets. Good investors and investment fiduiciaries will nevertheless pay attention to a wide range of investment perpsectives and forecasts. This enables them to position their portfolios to be most effective across that universe of future outcomes.

  • Question: Over the course of your career, what are the most important things you'd say you had to unlearn?
  • Bernstein: That I knew what the future held, I guess. That you can figure this thing out. I mean, I've become increasingly humble about it over time and comfortable with that. You have to understand that being wrong is part of the process. And I try to shut up, you know, at cocktail parties. You have to keep learning that you don't know, because you find models that work, ways to make money, and then they blow sky-high. There's always somebody around who looks very smart. I've learned that the ones who are the most smart aren't going to make it. I don't know anybody who left investing to become an engineer, but I know a lot of engineers who left engineering to become investors. It's just so infinitely challenging.

Monday, February 14, 2005

Bill Miller's 2005 Forecast

Speaking of expert opinion, Bill Miller's 2005 Forecast focuses on many of the reasons he sees opportunities in the market while everyone else is prudently worrying about everything else.

Saturday, February 12, 2005

Stable Value - Win/Win or Win/Loose?

In today’s Barrons Jack Willoughby detailed the unraveling of stable value accounts (SVA) under the domain of the SEC. Despite the expiration of this segment of the stable value market, stable value investing remains a large and popular though functionally misunderstood part of the defined contribution marketplace. The article states “more than $350 billion worth of these funds rest in 401(k)s” and other sources suggest over 2/3rd of DC plans include a stable value option.

Who wins with SVA’s?
Similar to how you should evaluate any investment product, first understand the basic investment characteristics of the product and how the manufacturer, the distributer and the end investor make money. The goal is to gauge if the product’s economics are reasonably balanced by attractive investment characteristics that have real utility to investors. In other words... is the product bought or sold?

According the Stable Value Investment Association , SVA’s are designed to provide the safety of money market funds with the returns similar to intermediate bonds. This sounds very appealing and in fact may be…. depending on your time horizon, your “real” sensitivity to short-term market volatility and of course the design parameters of the particular SVA product available to you.

How do investors win?
Based strictly on general “asset class” parameters, structured products like SVAs should be attractive in the “short run” because as defined, they should (and most do) have a higher sharpe ratio (standard deviation/return) than either money markets funds ( SVA’s have higher returns similar risk) or intermediate bonds (SVA have similar returns less risk). As a long-term investment however, the attraction may fade and can indeed turn unattractive from a return perspective. Why is that? Because an SVA portfolio’s total returns should be those implicit in the underlying collateral less the insurance premiums paid over time to keep the portfolio valued at book in the short run. At the margin, investors should carefully evaluate if the perceived value they assign to short run price stability out-weights the lost returns due to the insurance costs. In theory, the volatility investors avoid in these products can be spent on additional higher returning assets such as equity. SVA investors can also win if the asset exposures and portfolio management of the SVA collateral is not available to them elsewhere and can generate realizable returns net of insurance cost in excess of intermediate bonds.

How do SVA manufacturers win?
SVA manufacturers win by their ability to collect very handsome revenues on a product that has very low fee transparency, very low consumer understanding and very low financial risk for them. Insiders recognize that guaranteed and stable value accounts provide high levels of ROI and can often subsidize other products whose pricing and attributes are more transparent to consumers. The SVA industry has had great success by over-marketing the portfolio value of short-term stability, by taking advantage of the laws of large numbers, by the natural laws of overwhelming investor conservatism and inertia and by designing contract constrains that work in their favor.

Since the 401(k) investing objective is generally long-term retirement investing, younger participants should be indifferent to the limited price volatility associated with fixed income investing since they will not be realizing any of the short-term volatility except on paper. However, the SVA industry focuses on safety (which by the way is usually defined as guarantee of principal..very few consumers focus on the credit risks associated with that guarantee) and panders to a naive and unproductive desire for “safety”. Participants should prefer the higher return characteristics of fixed income investments, unfettered by insurance costs, until they get close to retirement where price stability should then become a more important element in their asset allocation decision.

Companies that provide book value guarantees rent their financial capacity to deal with the conflict between meeting short-term liquidity requirements and maximizing long- term returns by investing in higher risk, longer duration and more illiquid categories of investments. These companies get paid premiums for absorbing these competing objectives and if they are good underwriters can pocket lots of the investment duration, credit and liquidity spread before posting credited rates on SVA’s.

To further reduce their risks, SVA sponsors must ensure that there is relatively small dollar turnover or low interest rate sensitivity in the SVA product. This is where the providers take advantage of investor’s natural conservatism and inertia (proclivity for many participants to keep their money in a safe investment and never touch it regardless of market conditions) and contract provisions that don’t allow competing accounts (i.e. money market accounts) or other restrictions on transferring money out of these accounts.

Many Defined Contribution SVA products are designed to be interest rate responsive so the risk of being “under water” is limited. This also tends to keep the account more competitive with money market rates in a rising rate cycle. The collateral behind these funds is normally higher credit quality and lower duration GICS and fixed income products. Unfortunately, this kind of SVA may offer the least long-term value to investors though they can certainly provide a very nice annuity to the sponsoring company. Long term-oriented investors with access to these “Win/Loose” accounts may be better off in an intermediate bond market index fund.

Some SVA’s might offer investors a Win/Win combination. Provided the underlying collateral pool offers access to markets and investments that smaller investors cannot access, provided portfolio management is effective, provided product cashflows have been beneficial and finally provided the fee structure and rate crediting process allow some of those advantages to leak through to the investor, then there can be a real and unique investing benefit from an SVA.

Generally, long horizon investors and those not particularly impacted by short-term volatility may not benefit from many stable value products. Unfortunately, that describes the average investor in these products. Consider one other perspective. Do prudent long-term oriented institutional investors (i.e. Pension plans) normally include SVA products in their asset allocations? Not usually. Why...as long term investors they find it uneconomic to pay up for short term volatility protection.

Investor Strategies -
Senior insurance executives I have known (predominantly actuaries who are ruthless at figuring out how to save a buck) invest their total personal fixed income allocations in a tax sheltered (401K) environment and keep the balance of their equities in non-tax advantaged accounts. This preserves the tax-advantaged nature of capital gains and allows income to grow tax deferred. The dissolution of stable value alternatives in an IRA environment may impact how you assess the value of rolling over 401(k) money into an IRA. If you happen to have access to an SVA in your 401(k), you should try to assess its productivity and utility to you.

As either a sponsor selecting an SVA or an investor considering an allocation, you should review the product parameters. If the collateral is shorter duration, very high credit quality and with credited rates highly correlated to money market yields etc you may be paying a lot for something of minimal long-term value. If you are accessing investments through the collateral pool which should have a higher intrinsic rate of return, and credited rates have been near or above high quality bond returns then you may have access to a risk/reward profile that you might want to retain. It is also important to understand the cashflows of the particular SVA product since portfolio return rates are sensitive to funding and distributions.

Other reading on SVA's:
Dwight Asset Management- SVA in a Rising Rate Environment

Friday, February 11, 2005

Reality Has Already Hit the Fan

Something smelled funny in the last article I last referenced on the average plan expected return reportedly at 9.1%. I consulted a nice reference resource for sponsors who are trying to judge the reasonableness of their own expected return assumptions. Goldman Sachs published a research report in October of last year (o4) which details the expected returns and asset allocations for a number of large corporate plans. This report shows an equal weighted expected average for 2004 of 8.5% and an asset weighted average of 8.7%. The report indicates that companies have been steadily reducing their expected return assumptions over the last few years so it is likely 2005 average expected returns might even be a tad lower. "The 2002 asset weighted expected return assumption for S&P 500 companies was 9.3%. That percentage fell to 8.7% for 2003".

Often times reality is not as dramatically different as some would like to think...but that may not make a good story.

Thursday, February 10, 2005

Market Experts have Low Expectations

Reuters reported from Geneva today that "US corporate pension funds, already struggling with a multi-billion dollar industry deficit have unrealistic expectations for investment returns that are likely to be well below their forecasts in 2005 leading market experts said". While I read this quite often these days and admit the logic for this position is credible, I can't say I am fully convinced.

Forecast investment returns for pension plans should correlate to the time horizon of plan liabilities. For many plans this planning horizon would be 25 plus years. When I think about capital market characteristics over that horizon I think it is shortsighted to extrapolate based on todays P/E ratio or dividend yields. There is a lot of uncertainty to overcome in a 25 year projection so simple historical statistics like a long term historical 6%-7% real return on equity seem as valid and probable as what the market experts are forecasting based on todays market conditions. On the other hand, if I were the CIO of a pension plan it would be to my advantage to "talk down" expectations for future returns. That strategy has the dual benefit of being credible and minimizes professional downside risk. Any rational person operating under a performance incentive system relative to a benchmark should be pessimistic when positioning the benchmark. We have been hearing about the "low return environment" since 2002 and have since had 2 very good market years. If this is low....give us more!!

I also am puzzled by a statement in the article which says that "US corporate pension funds have penciled in average expected returns of 9.1% in 2005, meaning many see their investments performing well above this level." Remember, corporate pension plans are generally audited. Other than my former ArthurAnderson friends, auditors I know like to see reasonable substantiation of expected returns and they get very nervous when they are asked to sign off on expected returns north of 9%. Anecdotally, I haven't seen a plan forecast return above 9% in a while though I am sure some still exist. Very hard for me to believe that 1/2 the US corporate pensions use expected returns "well above this level".

While it is interesting and thought provoking to see what the experts think..the one thing we can count on is watching the markets confound them as well.

Tuesday, February 08, 2005

Company Stock Anomaly

There a number of anomalies within the world of pension and retirement investing. One in particular flys in the face of the most fundamental standards of prudence and diversification.

Company Stock in Pension Plans
The congressional debates leading to ERISA were initiated after an Enron-like corporate collapse where hundreds of workers lost not only their jobs but also their pensions. The company was the Studebaker Corporation of South Bend, Indiana, a leading U.S. automaker. When the company went bankrupt the underfunded pension plan collapsed, leaving Studebaker retirees and employees without their jobs or their pensions. Congress crafted ERISA in 1974 to include funding and diversification principles that were designed to avoid future calamities like Studebaker. Congress put a mandatory cap on the level of company securities that would be allowed ( i.e. prudent) within a defined benefit pension plan. That limit was 10% of plan assets.
Anecdotally, we don't see many DB plans with sponsor's stock. The P&I annual survey indicated that only 1.5% of the top 1000 DB plans was allocated to company stock. While this minimal allocation may be because of fiduciary issue it is also very likely due to the fact that single stock exposures are naturally inefficient and expose plans or investors to uncompensated risk!

As Defined Contribution plans were rapidly growing, their Studebaker equivalent occurred, focusing attention again on participant protection. ColorTile, a large DC plan with 90% of it's assets in employer assets went bankrupt, leaving workers without jobs and devalued retirement accounts. The DOL assigned a Working Group on Employer Assets in Retirement Plans to study and make recommendations regarding this diversification issue within the DC realm. The group recommended limitations on certain employer assets though ERISA's duty to diversify does not to this day apply to all pension Plans. Congress allowed exceptions under ERISA for certain types of DC Pension Plans.

It is difficult to overstate the significance of diversification in investment theory. There have been a number of Nobel prizes related to the premise that there are large and virtually costless gains available by broad diversification... yet large single stock exposures continue to be allowed in certain retirement plans. Beyond incurring an estimated 70% additional risk for a non -diversified portfolio, participants also increase the large undiversifiable risk associated with their
employment.

The defenses for not limiting employer stock includes; the benefits of alignment of interests, "anything is better than nothing" and employees can act to diversify in their own self-interest. Despite these arguments, allowing undiversified portfolios under ERISA is bad policy and leads to bad investment practice.

Monday, February 07, 2005

Who makes out with M&A?

An article in the Sunday WSJ puzzled over how best to take advantage of the biggest M&A wave since the late 90's. It's very logical conclusion was to buy the investment banks like Goldman Sachs, who get a nice slice of the pie to negotiate these deals. This seems like sage advice after reading Nomi Prins book Other Peoples Money, The Corporate Mugging of America. Prins, a former Managing Director at GS provides a very detailed account of how the investment bankers facilitated many of the pump and deals done in the late 90's where the bankers and company executives got rich at the ultimate expense of investors. It provides eye-opening details about how greed and self-interest dominated an inbred association of bankers, corporations and government regulators and that gave us Enron, Worldcom etc etc etc. Her general warning is that the resulting corporate and regulatory reform has not gone nearly far enough. "Regulatory agencies continue to bless mergers without proper examination of how consolidated balance sheets impact financial transparency, how combined companies eliminate jobs and how the public is not served by fewer companies controlling vital consumer choice". After reading this you can't help but wonder...?

Saturday, February 05, 2005

What's a prudent asset allocation?

The prudence of a pension plan's investment decisions including it's asset allocation will be judged based on the "facts and circumstances then prevailing". For a defined benefit plan asset allocation the 3 general categories of facts and circumstances you should evaluate are:
1) the Plan's specific liabilities and cashflow characteristics,
2) long term risk/return outlook for and the interaction of investment asset classes,
3) what constitutes prudent practice within the industry.

One of the easiest ways to benchmark prudent practice is to review what other plan sponsors are doing with their pension asset allocations. Every year in late January Pensions & Investments publishes their Annual Plan survey. This is the 31st annual survey and it reports on the asset mixes of the top 200 and top 1000 (by plan asset size) Defined Benefit and Defined Contribution pension plans that respond to the P&I questionnaire.

The top 1000 DB plans had an aggregate asset mix for 2004 as follows:
  • Domestic equity 46%
  • Domestic fixed income 26%
  • Int'l Equity 16%
  • Intl fixed income 2%
  • Cash 1%
  • Private equity 3.5%
  • Real Estate equity 3.5%
  • Other 2%

Now, this is an aggregate 70% equity portfolio which is obviously not suitable for all plans. Your unique liabilities/cash flow needs and financial and risk appetites should determine your appropriate mix between risky and non-risky assets. What is universally relevant is the fact that these larger plans are aggressively utilizing risky assets, providing some perspective that larger more sophisticated plan sponsors continue to expect an equity premium. The asset mixes can also provide valuable guidance as to what the "industry" believes is prudent and optimal diversification by asset class. For instance, Int'l equity is 23% of total equity. Alternative investments (private equity/real estate) are about 10% of equity assets. Cash should have a minimal allocation in a long term oriented portfolio. Other trends identified in the survey:

  • Enhanced indexing is growing faster than indexing
  • Real estate allocations lost 6% when market value adjusted (plans are taking advantage of high prices)
  • International equity lost 1% when adjusted for market gains
  • Hedge fund growth was high in 2004 though it was slower than in 2003

There is other good material in the survey that can be used to identify investing trends and benchmark your portfolio.


Thursday, February 03, 2005

Here's what we got for $52,999,999

While my question (1/26/05 posting) on the results of the $53 million investor education program was in part rhetorical, an answer appeared in this morning's WSJ. George Daly, director of the Investor Education program resigned. The Fund's Board had been anxious to develop the program but George, who was hired in March, failed to deliver any detailed plans or reports. He was apparently too busy negotiating a midtown Manhattan lease from one of the banks involved in the settlement! So far nothing! ... Charles where are you?

Wednesday, February 02, 2005

If you dont want to loose the game ..change the rules

If you are not a bond geek you may not have been paying attention to this but according to the Wall Street Journal
  • "Lehman Brothers said it will change the way it calculates the ratings of companies whose bonds are included in its benchmark indexes. Lehman plans to add Fitch Ratings to its basket of rating services from July 1, and it will use the middle rating from the three ratings companies -- Moody's Investors Service, Standard & Poor's and Fitch -- when assigning issuers ratings. Currently Lehman uses the lower of the two ratings assigned by Standard & Poor's and Moody's to determine whether to include an issuer's bonds in its indexes. The inclusion of Fitch ratings will bring some respite -- at least in the short-term -- to beleaguered auto bonds and the precarious ratings position of the top two U.S. auto makers, Ford Motor Co. and General Motors Corp. Adding Fitch to the ratings basket is likely to buy the two corporate-bond giants more time in the Lehman Brothers Investment-Grade Aggregate Index, stemming a tide of forced selling that would otherwise have ensued in the event of further credit downgrades. In the investment-grade corporate-bond landscape, Ford and GM stand to gain the most with their precariously poised triple-B-minus ratings -- a notch away from speculative grade -- from S&P. Adding Fitch to the mix prevents their exclusion from the Lehman Brothers Aggregate Investment-Grade Index, a widely used benchmark for portfolio managers, even in the event of a downgrade to junk by S&P. Ford and GM are the second- and third-largest issuers of debt, respectively, in the Lehman Brothers U.S. Credit Index, accounting for nearly 5% of the index. Their drop to speculative-grade ratings would have marked a significant change for bond investors." The move to include Fitch ratings is "part of the evolutionary process of indices becoming more inclusive," said Steve Berkley, global head of the Lehman indexes.

Now, maybe this is a fairer way to evaluate credit quality but it certainly makes one wonder whether market self preservation was an objective as well. At a minimum, buying the investment grade bond market just became riskier.

Tuesday, February 01, 2005

Pension Reform - Financial Chemotherapy

President Bush's pension reform proposal may threaten pension plans, warns a report from the Employment Policy Foundation, a research group inWashington, D.C. Increased liabilities, premiums and administrative burdens associated with the President's proposal "could ultimately force many DB plan sponsors to freeze or terminate their DB plans," the report asserts. A key provision of the proposal would require employers to discount future pension liabilities using a Treasury Yield curve. A short-term interest rate would be used for workers near retirement and a long-term rate for younger workers. Consequently, says the EPF study, employers "could experience a 3.5% increase in reported pension liabilities for workers ages 55 and older and a 2% increase for workers ages 50 to 54." Firms in the manufacturing, transportation, utilities and communications sectors would be hit hardest, researchers suggest."Another problem arises when the interest rates are not averaged over a specified period of time," the report adds. "Under the proposal without a weighted average, pension liabilities will be much more volatile from year to year."The proportion of large employers providing traditional pensions dropped from 83% in 1990 to 45% in 2003, Hewitt Associates reports. While the reformation details remain rather sketchy, it is far from clear whether reform, intended to preserve the system, might actual eliminate it.