Friday, March 18, 2005

US Pension Crisis Avoidable

Worried about your DB plan funding? No's some asset allocation advise for you!
Where were you 20 years ago when we needed you Guy?

UK Pension Crisis Avoidable With Greater Alternative Investment Allocation March 17, 2005 ( - The UK pension funding crisis of the 1990s that saw the end of many final salary schemes could have been avoided by allocating more assets to alternative investments, and venture capital fund of funds a manager has said. If UK pension funds had allocated the same amount to alternative investment as their American counterparts, according to Guy Fraser-Sampson of Mowbray Capital, a venture capital fund of funds, the funding crisis could have been avoided. According to reports from Dow Jones, Fraser-Sampson - speaking at theNational Association of Pension Funds investment conference in Scotland -suggested that investments in alternative investments, especially venture capital, could have saved many final salary plans."Underfunding today is a direct result of dreadful asset allocation decisions by UK pension funds over the last decade or more," Fraser-Sampson reportedly said. He suggested that if allocations had been around 20% in European venture capital after 1993, returns would have been around 13.4%, significantlyhigher than the 6% seen. This would have made plans 98% funded, instead of50%, according to Fraser-Sampson. He suggested that going forward, UK pension funds, if they want to see returns that do more than keep the fund at the status quo, should allocate more to alternative asset classes, specifically private equity.

Wednesday, March 16, 2005

Senate Pension Forum

The Senate Finance Committee and the Senate Health, Education, Labor andPensions (HELP) Committee held a pension forum on March 15, to discuss "the retirement system of the future." Presenters at the forum included a mix ofparticipant advocates and labor unions as well as plan sponsors and service providers. All of the speakers agreed on the importance of the defined benefit pension plan system and indicated their support for the "three-legged stool" of retirement security - i.e., Social Security, employer-sponsored pensions, and private savings - while many of the plan sponsors predicted that the defined benefit system was in danger of extinction. The speakers did not agree on measures necessary to expand plan sponsorship or to make it more affordable and attractive to corporations.The speakers also agreed that the low rate at which Americans save for retirement was a disturbing trend. However, they did not agree on ways to encourage or preserve savings. Speakers with labor and participant advocacy backgrounds preferred mandates, such as mandated matching contributions on plan sponsors, others favored greater education or investment advice. Labor and advocacy speakers expressed concern regarding stagnation of wages, downward pressure on benefit programs, worries over old-age poverty, globalization, lack of benefits for contingent or part time workers, need for rules regarding hybrid plans that protect a worker's expectation of their benefits, and better funding by plan sponsors. One of the researchers said that the move in the U.K. to require plan sponsors to move their investments solely to bonds had resulted in a 65 percent freeze /termination rate in their defined benefit plans. In addition, he noted thatU.K. companies that had employees in the U.S. were now discontinuing their plans for the employees in the United States. Business and service provider speakers expressed concern regarding the impact that upcoming pension funding reform could have on the ability of a plan sponsor to budget and predict its pension plan contributions. The need for legal certainty on hybrid plans and conversions to hybrids was equal to the need for stability and predictability in funding, they said. All supported having a strong defined contribution system and were looking for ways to increase participation and reduce leakage. Speakers noted that businesses generally oppose increased burdens on plan sponsors such as additional non-discrimination rules or tests or reduced vesting schedules. Automatic enrollment was universally supported as were other ways to improve savings through 401(k) plans and the importance of annuitization. The business and service providers speakers predicted, however, that if the flexibility of employers to change or discontinue offering their plans were restricted, there could be a rush to freeze and terminate their retirement plans.

Tuesday, March 15, 2005

Dow Jones 401(k) Plan

Timothy Middleton provided a review of the Dow Jones 401(k) Plan on MSN. For 401K plan sponsors this provides some valuable insight into one of Fidelity's large cases.

The major issue I see with this plan is the exclusive use of Fidelity actively managed funds. This is always a sign that the sponsor could be more engaged and could be leaving some value on the table. In addition, one primary lesson that should have been learned over the last few years is to diversify by manager in case of past or present indiscretions. It is probably not surprising to find that many vendors with proprietary funds serve up the “dogs” of the industry in their ‘alliance programs”. The worse they look the better the vendor’s funds look. Fidelity has a limited menu of alliance alternatives in the smaller market but at this plan size virtually any other outside fund should be available to the Plan. There should be better or at least very different alternatives in some of the larger categories like Large Cap Value or Growth. While Fidelity has some top choices in certain asset classes and styles (i.e. Fidelity Diversified International), they don’t offer outstanding active management or diversifying alternatives in all areas.

Some of Fidelity’s best actively managed funds are not in the lineup. If you are going to pay for active management and stay with Fidelity funds …get their best! Fidelity Blue Chip and Equity Income, though they provide core exposures, are expensive index funds with very high correlations to their bench-marks as you noted. Where is Fidelity Low Priced, Capital Appreciation or Contrafund? These funds at least offer some hope of paying their way and adding some extra value in the end.

Since hard dollar administrative fees can’t go below zero, the more proprietary and actively managed funds in a lineup, the more participants will be padding Fidelity’s bottom line. Economic leverage in the asset management business is huge. It costs virtually nothing to add a marginal dollar to an existing portfolio strategy. This lineup looks like it could be a financial bust or bonanza for Fidelity depending on how participants use the funds. A typical diversified 60% equity all indexed portfolio would cost about .25% in this Plan while an estimate for an all actively managed portfolio using the same asset allocation would be more like .66%. Let’s say a provider like Fidelity could do quite well by providing services to a $1billion dollar plan for .20% ($1,732,000), that leaves anywhere from $433,000 to almost $4,000,000 left over depending on the funds utilized.

Despite some of these deficiencies, the DJ Plan looks superior in some important respects to many Plans I see.

The DJ plan has very good index coverage of the core capital markets – This alone should help Plan investors avoid lots of unnecessary expense and allow them to build a good core portfolio. Many plans and providers either don’t provide indexation alternatives at all or only provide an S&P 500 index. In my opinion, the availability of index alternatives in US Equity/Int’l Equity/Bonds is far more valuable than having additional marginal asset classes like high yield and emerging markets available. Institutional investors wouldn’t strategically allocate more than 10-15% of a total portfolio to these asset classes while the remaining 85% of the portfolio could be positively impacted by index exposure. The issue here lies with the participants. They should be heavily indexing given many of the actively managed Fidelity proprietary funds.

Uninvolved participants can get diversified portfolio coverage in either active or index flavors with the alternatives provided in the Plan. While I am not a big fan of the Freedom funds I do acknowledge that the asset allocation value of these funds probably out-weight any negative product characteristics when the alternative for many uninvolved investors is to let their balances sit in money market funds or worse.

The 401K industry needs major revamping to allow participants better access. I think the cost bundling paradigm is one of the largest obstacles to more rational Plan management. Plan sponsors and participants alike should demand that administrative and recordkeeping expenses be unbundled from investment expenses. This would take some of the economic incentive out of pushing active management to subsidize plan costs. It would also create more robust competition by making the market easier to understand and negotiate in for plan sponsors.

Monday, March 14, 2005

Pension Plan Research Data

Greenwich Associates just posted press releases on two new research. We have discussed the fiduciary issues and risks related to company stock in previous posts. The asset allocation data is useful for benchmarking your DB plan assumed rate of return and asset mix.

Defined Contribution Plans

  • DC plan participants at large corps. still have 23% invested in company stock
  • Fewer $250MM or larger plans used company stock to make DC contributions in 04
  • DC participation rates topped 80% in 2004.
  • Demographic trends, potential pension accounting regulations, and economic realities will make DC plans the sole private-sector retirement vehicle.
  • Allocations to international equities within DC plans fall far short of those in DB portfolios.
  • Despite widespread adoption of Internet tools by plan sponsors, only a small fraction of participants use the Internet advice tools available to them.
  • Nearly two in five DC plan participants leaving small and midsize companies and a quarter of the departing participants at larger companies cashed out their plan assets in 2004.

2005 Asset allocation Study

  • U.S. funds decreased their expected rates of returns on all major asset classes
  • Fixed income expected returns fell from 5.9% in 2002 to 4.9% in 2004.
  • Equity return expectations dropped from 8.2% to 8.1% .
  • Equity real estate return expectations dropped from 8.2% in 2003 to 8.1% in 2004
  • Private equity return expectations fell from 11.3% to 11.1%.
  • Public funds lowered their hedge fund return expectations from 9.2% to 8.5% and corporate hedge fund expectations fell from 9.1% to 9%.
  • International equity allocations grew from 11% in 2003 to more than 13% in 2004.
  • Hedge fund allocations grew to 1.6% of plan assets over the past 12 months.
  • Real estate allocations increased from 3.6% to 3.8% of total plan assets.
  • Private equity allocations increased from 3% to 3.4% of total assets from 2003 to 2004

Sunday, March 13, 2005

401(k)s Inadequate - Not just a diversification issue

The enormity of the conclusions drawn by an academic study on the inadequacy of investment choices in 401(k) is getting journalistic attention based on several references to the study I have seen over the last few weeks. Liz Weston reports on MSN that:
  • "A study of 401(k) plans released last month found that 62% failed to offer enough plan choices for workers to build adequately diversified portfolios.The cost of inadequate diversification is huge. Workers who had enough choices, and who used them properly, averaged annual returns of 10.7% over a 20-year period, according to the study, which was conducted by professors at New York and Fordham university business schools. That compares to the 7.5% averaged by the workers with inadequate plans."
  • Other conclusions drawn by the study include:"The funds included in plans are riskier than the general population of funds" and "index funds chosen by 401(K) plan administrators are on average inferior to the S&P 500 index funds selected by the aggregate of all investors"

The authors of the study, Martin Gruber, Edwin Elton and Christopher Blake selected a sample set of 401(k) plans and compared those plan investments against a hypothetical set of 8 market indices distinct in style, asset class and adjusted for management expenses (after determining this bundle of indices represented an optimal efficient frontier). The researchers conclude that the majority of 401(K) plans do not offer the breadth of capital market coverage of their "efficient" 8 asset class benchmark and therefore offer inadequate choice.

The inadequacies in 401(K) plans may be partially attributable to asset class scope but the study doesn't reflect the economic and practice issues that probably contribute much more to the inadequacies than scope of choice alone. Key issues I see are in the study are:

Sample bias- the middle decile plan size in the study was $25MM. This is at the low end of most large vendors core markets. The study also excluded any plan with separate investment accounts or commingled funds. These vehicles are important in capturing the positive economic leverage in asset management and applying it to plan servicing costs. Simply put..plans that only use mutual funds, as in the study, will likely have the most constraints and issues primarily because the economics of these investment alternatives are less attractive to non proprietary plan providers in the 401k market. Plans in this size range using only mutual funds often have fairly tight constraints on investment scope and choice. Smaller plans investment expenses are higher as a % of plan assets and fund alternatives are more likely to be from the same investment fund families or providers. Economics rather than performance tend to drive the fund alternatives available in the small market. This reflects the reality that that investment expenses cover over 95% of total plan costs including administrative and recordkeeping and that plan service costs as % of plan assets is higher in the small market. Significantly, both plan sponsors and participants do not want to see/pay for plan service costs separately. This issue creates plan inadequacies by making overall economic considerations primary in determining the investment choices made available and selected by plan sponsors.

Benchmark Index expenses don't cover plan servicing costs-The authors adjust their benchmark portfolio for typical index expenses. This unfairly benefits the benchmarks on a comparative basis since typical index expenses do not cover the costs of plan servicing and recordkeeping while the actual actively managed funds in the study must....either indirectly through the higher margins in proprietary investment products or directly through higher priced advisory mutual shares with 12b-1 fee revenues. I believe the bigger adequacy issue as being underrepresentation and utilization of index funds for existing asset classes in 401(k) plans than the availability of additional asset classes like high yield or emerging markets. Plan economics are behind this issue as well. Active management of investments provides more fees to subsidize plan service costs and provide margins for the investment managers/fund family. A recent Greenwich study found that large DB plans allocate about 16% to equity indexing while small and midsize 401(K) plans allocate only 6%

Correlation is higher when funds are concentrated within a fund family - These same facts can explain why the study concludes that the 401(k) plans are riskier. It was noted in the study that the sample fund variances were actually lower than in a random sample. The higher correlations explained the higher overall risk. Higher correlations among the sample funds seems consistent with the economically driven incentives to keep plan investments within a proprietary fund lineup or within a fund family that offers the best economics to the plan or the provider. The clustering of investments this way minimizes manager diversification and likely causes more holdings and investment strategy overlaps between funds in a plan creating inadequacy.

ERISA mandates that Pension plans provide their participants with a sufficient set of investment alternatives such that they can construct diversified portfolios that suit their circumstances. Evidence indicates that, from an ERISA perspective, the majority of plans do provide sufficient choice. Changing the paradigm so that plan servicing costs could be isolated and charged to participants separately would facilitate broader investment offerings and plan sponsor fund selection processes which would probably yield more index and fund alternatives as well as broader choice. All these elements would contribute to greater 401(k) plan adequacy.

Saturday, March 05, 2005

Are you paying for high alpha or bad benchmarks?

Clumsy benchmarking and incomplete performance disclosures are probably two of the largest factors contributing to the sustained predominance of active investment management in small to mid sized pension plans and the retail environment.

Over the course of many institutional investment evaluation engagements I have discovered that much advertised or implied active management alpha can be better attributed to high benchmark misfit than high investment skill. Benchmark misfit refers to the asset class and style differences between the fund and the benchmark to which it is compared. An aspect of the asset management business which is troublesome thought not surprising is that benchmarking, full disclosure and performance evaluation is not a mission critical competency for the sell side. I haven't concluded whether this results from a deliberate intent to deceive or simply the fact that good benchmarking is too complicated and nuanced for often impatient and uneducated investors. Probably elements of both. .Suspiciously, the bias in benchmarking or information delivery always tends to accrue to the benefit of the manager or seller rather than the investor. Examples of misdirection abound. I was told recently by a large pension provider that if their client wanted to see portfolio level historical returns they could only get it by engaging one of the firms affiliates? Some asset managers/pension providers must feel that client specific cumulative historical returns and fair benchmarking can only serve as constant reminder that a client has underperformed. If any attention in these settings is paid to performance it is often only at the individual fund level. The benefit of this practice is that as soon as an underperforming fund is removed from the portfolio, the negative performance is gone as well. This why you may see many investment choices in a sponsored program with under 3 years of actual performance but 3 and 5 year composite numbers that look very strong. New funds with good historical results are used to attract new money. Fiduciaries should insist on seeing portfolio level cumulative actual performance against a reasonable portfolio level benchmark.

The S&P 500 is used quite often as a measure for US equity performance ( regardless of market capitalization or style in the actual portfolio). However, one rarely (make that never) see a Large Cap US equity strategy benchmarked to a diverse global benchmark where the asset class diversification and return characteristics favor the benchmark. I have often seen strong investment out-performance for products presented on a cumulative performance basis covering substantial time periods. What may not be presented are the annualized returns over the cumulative period. This information can clearly demonstrate the amazing leverage a single and possibly accidental annual outperformance can have on long term results. Another "trick" involves setting an investment policy cash target of 5% or so but never allocating more than 1% in cash for liquidity. Actual portfolio performance against a policy benchmark in this case automatically includes the tailwind of the long term risk premium of equity/bonds over cash. If investors do get paid to take systematic risks(over the long run) then, including assets with more systematic or market risk in a portfolio than in its benchmark should guarantee outperformance and possibly less risk over time ( other things being equal). This happens to be the kind of risk-free bet that many managers are getting paid very handsomely to disguise.

I agree with Ron Surz that benchmarking and peer universe generation is very prone to leading investors to wrong conclusions either through incompetent generation or purposely skillful manipulation. There are several large institutional pension investment programs that base their "fiduciary ratings" heavily on peer universe rankings. Unbelievably, in 80-pages of process and comparator information you will not find a detailed description of how the peers were selected and who they are. In lieu are vague references to some creditable firm which approved the reasonableness of the selection process.

Take care in looking at performance. The better it looks the longer you should look.