Friday, May 26, 2006

401(k) Asset Allocation

Dealing with suboptimal asset allocations in participant directed plans is an important issue, second only to getting participants to increase their contribution rates. The traditional industry solution to this has been participant education. However, the effectiveness of education based on empirical results has been limited. A product solution, target retirement funds, seems encouraging and is becoming very popular. Julie Agnew at The Center for Retirement Research at Boston College studied two other approaches to this issue; “On line advice” and managed account services.

Preliminary findings suggest managed accounts have more universal appeal across demographics , gender, employment status and salary while on line advice seemed to appeal more to full time higher salaried employees. This research might be helpful in matching your plan population to the most effective advice model.

Thursday, May 25, 2006

401(K) Plans - Can You Afford to Retire

The portion of the recently aired PBS special, “Can You Afford to Retire” which captured the heart of the issue for me was the footage showing the faces of the plan participants who were sitting through a traditional 401(k) enrollment meeting. Their blank expressions, as they were being told they were responsible for their own investment futures, were very reflective of why participant directed investment programs will continually lead to suboptimal results.

Perhaps, instead of running traditional enrollment meetings, Plan sponsors should present the PBS special “Can you Afford to Retire” to their participants. The program is available on line. While the program may not have presented a truly balanced portrait of the issues involved in the retirement dilemma, it will certainly elicit a strong emotional reaction from viewers. This would help overcome some of the disinterest and inertia that pervades so much 401(k) participant behavior today.

This approach, in conjunction with product solutions such as target retirement funds, which make investment diversification and reasonable asset allocation available to everyone, could bring the average 401(k) plan participant much closer to where their retirement goals.

Tuesday, May 23, 2006

Have Faith in Quality

If you have been monitoring your retirement plan investment funds you may be very dissatisfied with the performance of a number of funds that are widely held in many Plans. Before you terminate what may be a good investment, consider what has been happening in the market and how you can evaluate funds that are positioning themselves for an eventual reversion to quality growth investing as the economy flattens and market volatility increases.

Growth stocks have severely underperformed over the last few years and mutual funds focused on this investment style have lagged along with them. In fact, many high quality growth stocks have become so attractive that they are no longer solely owned by traditional growth managers. Top value managers have been taking advantage of these relative value opportunities despite the fact that their returns have been severely punished because of it.

In fact, Joe Rosenberg, in an interview with Barrons this weekend, feels that: “we now have a situation where some of the largest companies, that were overvalued 6 years ago but have continued to grow earnings at10% -15% a year, are completely unloved on Wall Street..if I were a relative return manager this would be a no brainer for me. I’d love to run a large cap portfolio because these growth stocks are cheaper relative to the overall market than at any time in my experience on Wall Street”

In selecting or monitoring investment funds for your pension plan that may be positioned to take advantage of this situation look for those holding companies with sustainable competitive advantages, a strong record of consistent earnings growth and those trading at attractive historical valuations. Examples include; General Electric, Citigroup, Wal–Mart, Johnson & Johnson, American Int’l Group. These large cap companies are rated A+ by Standard & Poors. Another useful source of high quality stocks to screen your mutual fund is the SIVY 70 List complied by Michael Sivy of CNN Money.

Holding out a little longer on funds positioned for a market reversion to classic quality growth may make a lot of sense.

Monday, May 22, 2006

404(c) Myth or Magic

Fred Reish nails down common misperceptions about 404(c),

404(c): Myth or Magic by Fred Reish
What you think you see may not be what you get

Next to the prudent man rule, 404(c) is perhaps the most discussed—and perhaps least understood—provision in ERISA. Does 404(c) offer mythical hope or magical protection for fiduciaries? As you might suspect, it is some of both: Read on. First, if the conditions for 404(c) protection are satisfied, it is a defense to some, but only some, claims of fiduciary breach in participant-directed plans, like 401(k)s and 403(b)s.

However, it doesn't protect against many fiduciary breach claims, most significantly a claim for losses due to a failure to select investments prudently and to monitor and remove inferior investments. As the DoL stated in
Advisory Opinion 98-04A:

"In connection with the publication of the final rule regarding participant-directed individual account plans, the Department emphasized that the act of designating investment alternatives in an ERISA section 404(c) plan is a fiduciary function to which the limitation on liability provided by section 404(c) is not applicable."

So, even if a participant directs his investments, if the loss is due to the poor performance of an option that should have been removed, the fault (and liability) lies with the fiduciaries and not with the participant.

What does 404(c) protect against? In a nutshell, it offers a shield against imprudent participant investment decisions. As an example, consider a 25-year-old who decides to put his account in the money market fund—and keeps it there for 40 years. Or a 65-year-old who invests his entire account in an aggressive growth fund and loses significant amounts in a bear market. In a 404(c) plan, the fiduciaries will not be legally responsible for the imprudence of those decisions. However, if part of the underperformance was attributable to the imprudent selection or retention of the particular investment option, the fiduciaries would be responsible for that part, even in a 404(c) plan.

So, as you can see, 404(c) is a myth in the sense that many people believe that it protects fiduciaries from all investment claims by participants. However, it offers some magic because it can transfer legal responsibility for investment decisions to the participants.

Let’s consider the flip side of that statement. If a plan doesn’t comply with 404(c), then the plan has transferred the power to direct investments to the participants, but the legal responsibility for the prudence of the investments stays with the plan fiduciaries. Is that possible? In the Enron case, US District Judge Harmon concluded, in language that was brief and to the point:

“If a plan does not qualify as a 404(c) [plan], the fiduciaries retain liability for all investment decisions made, including decisions by the Plan participants.”

In its “friend of the court” filing in that case, the Department of Labor formally stated its long-standing position:

“The only circumstances in which ERISA relieves the fiduciary of responsibility for a participant-directed investment is when the plan qualifies as a 404(c) plan.…Under ERISA §404(c)…a fiduciary is not liable for losses to the plan resulting from the participant’s selection of investment in his own account, provided that the participant exercised control over the investment and the plan met the detailed requirements of a Department of Labor regulation [that is, the 404(c) regulation].”
(PM Note – this is important in the context of auto-enrollment where default investment options are selected by the plan sponsor – under the current rules, the plan sponsor is the fiduciary for the default funds since the participant would not likely have been deemed to have exercised control)

So, yes, it is possible; in fact, it is the law. To make matters worse, in my experience, most plans do not satisfy the
20 to 25 conditions for 404(c) compliance, although surveys show that the vast majority of plan sponsors think they are complying with the 404(c) conditions. That suggests that committee members and other fiduciaries may be in for a rude awakening if they are faced with claims of investment losses because of imprudent participant decisions.

Having said that, the first and best course of action is for fiduciaries to work to make sure that participants are well-invested. Using a sports analogy, these efforts would be a good “offense.” My observation is that the easiest way to accomplish that goal is with professional assistance: age-based lifecycle funds, risk-based lifestyle funds, or managed accounts. Fiduciaries should work with their providers to make sure that the participants understand those options and are using them.

However, from a risk management perspective, your plan also should have a good defense—and 404(c) provides just that.

Fred Reish is managing director and partner of the Los Angeles-based law firm of Reish Luftman Reicher & Cohen.

Thursday, May 18, 2006

NYLife acquiring ICAP

Finding good money managers, particularly in the mutual fund domain, has always been challenging. One of the qualitative factors to look at is the ownership structure of the money manager. Privately held firms are, by design, less conflicted between the purely economic and often short term goals of shareholders and the business and investment staregies which, over the long run, are in the best interests of the investors. Said another way, when good investors also own their firms, it is more likely that the quality and discipline of the investing process will overide ownership concerns about short term profitability.
The agency issues and conflicts embedded in a public shareholder - investor dynamic ofetn ruins good money management.

The WSJ reported this morning that Institutional Capital Corp - ICAP- has agreed to be acquired by NY Life. ICAP is a strong shop with many of the characteristics one should look for in a money manager. Though NYlife is a mutual company, the risk of overleveraging, overmarketing and disincenting the ICAP investment team becomes a new risk for ICAP investors with this transaction.

Wednesday, May 17, 2006

If Not Pensions...Social Security??

The PBS special “Can You Afford to Retire” which aired last evening provided a pretty discouraging glimpse of the future for retiring boomers. One of the more disturbing underlying trends that wasn’t directly addressed but seems to be prevalent among both the individuals portrayed on the program as well as those who joined the discussion board is the monumental problem of both lost pension plans and lost jobs. There seems to be an increasing incidence of baby boomers who are turned out of corporations and cant find replacement positions that put them anywhere near the financial glidepath that they had counted on to fund their retirements.

To make matters worse, the bedrock financial claim most retired Americans expect to rely on, Social Security, continues along a path of financial decline. Alicia Munnell, who appeared on the program, provides a review of the 2006 Social Security Trustees Report. Her summary:

The 2006 Trustees Report reconfirms what has been evident for two decades — namely, Social Security is facing a long–term financing shortfall. Changes in the underlying assumptions are unlikely to eliminate the problem. Although future rates of immigration, disability, mortality, and real wage growth are uncertain, switching any of the individual assumptions to the Trustees “low cost” scenario closes only part of the gap. Therefore, this problem can be solved only by putting more money into the system or by cutting benefits. There is no silver bullet.

Tuesday, May 16, 2006

Hewitts 2006 DC Plan Study

As reported today in the WSJ/PlanSponsor, Hewitt’s “ 2006 Universe Benchmarks- How Well are Employees Saving and Investing 401(k) Plans” study examined the saving and investment behavior of more than 2.6 million eligible employees and more than 1.7 million active participants based on empirical data across over 130 large defined contribution plans, with an average of 20,000 eligible employees in each plan. Key findings were:

Automatic enrollment increases participation.. The study found that, in 2005, the average participation rate for plans with automatic enrollment was 14 percentage points higher compared to the participation of plans across the entire Hewitt Universe.


The participation rate of low-tenure, younger, and lower-wage employees dramatically increases when workers are automatically enrolled in their 401(k) plans. Under auto enrollment, participation was 30 percentage points higher for workers with less than one year of tenure, and participation was 21 percentage points higher for workers with less than $20,000 in annual salary. Meanwhile, for workers ages 20 - 29 participation was 22 percentage points higher under automatic enrollment. In spite of these statistics, enrollment for younger, lower-tenured, and lower-salaried workers remained relatively low.


Auto enrollment is highly effective at improving participation levels but cannot guarantee high quality of participation. About one-quarter of participants had a nominal total plan balance at the end of 2005. Younger, lower-tenured, and lower-salaried participants are most likely to contribute in a nominal way, which Hewitt attributes in part to nominal deferral percents in auto enrollment programs.


The use of Lifecycle portfolios that utilize auto-rebalancing is helpful to workers. The study finds that workers are still prone to not rebalance their assets on a periodic basis. There are many reasons why 401(k) participants do not rebalance or reallocate their portfolios on a periodic basis, Hewitt found. Participants may confuse rebalancing and reallocation with market-timing, which they have been told to avoid.


Company stock remains the single largest holding for participants in plans with company stock. As in prior years, the average participant's largest holdings in 2005 were in company stock (21.9%), GIC/stable value (18.2%), and large US equities (18.2%). At the same time, participants’ allocation to non–US equities increased in 2005. The average participant had 6.1% of balances in international and emerging market equity funds, up from 4.4% in 2004.


In 2005, the average defined contribution plan in the Hewitt Universe offered 14 funds diversified across eight asset classes while the average participant spread his or her 401(k) investments across 3.9 asset classes.


In 2005, 67.2% of eligible employees participated in their defined contribution plan.

Monday, May 15, 2006

Can You Afford to Retire?

I attended a webcast of an EBRI pension conference where clips from the PBS program (Press release below) were shown. Should be a very interesting program.

www.pbs.org/frontline/retirement

The baby boomer generation is headed for a shock as it hits retirement: Boomers will be long on life expectancy but short on income. The two main private sector strategies for funding retirement -- lifetime corporate pensions and 401(k) style employee contribution plans -- are in serious trouble. FRONTLINE correspondent Hedrick Smith (The Wall Street Fix, Is Wal-Mart Good for America?) investigates this looming financial crisis, and the outlook for middle class Americans, in Can You Afford to Retire? airing Tuesday, May 16, 2006, at 9 P.M. ET on PBS (check local listings)."I think this is a crisis in the making," says Professor Alicia Munnell, director of the Boston College Center for Retirement Research. "I think 10 or 15 years from now, people who approach their early sixties are simply not going to have enough money to retire on." "I would say, unless you're fortunate to be in the upper-income quartiles, that you're probably going to be in for a very rough ride," adds Professor Jack VanDerhei of Temple University and the Employee Benefit Research Institute. "You're not going to have sufficient monies to pay the predictable expenses -- your housing, your utilities, your food -- plus the potential catastrophic medical care costs." In America today, half of the workforce is not covered by any private sector retirement plan, 30 percent have employee contribution plans like 401(k)s, 10 percent have lifetime pensions, and 10 percent have a mix of pensions and 401(k) type plans.To maintain their standard of living, experts say, Americans with pensions or 401(k) type plans need to accumulate at least six to ten times their annual pay before they reach retirement. This requires saving 15-18 percent of their salary, every year, over 30 years. Instead, says VanDerhei, typical retirement-age Boomers with 401(k) plans have only half that much saved up -- enough to live on for about seven years. With an average life expectancy of 17 years when they hit retirement, many middle class retirees may be living only on Social Security for almost a decade. "Most people we interviewed have no idea what it costs to replace a lifetime pension," says Hedrick Smith. "And they don't realize that as they're living longer, there is an impact on their nest egg.""The nightmare I have," says pension expert Brooks Hamilton, "is the vision of people ... outliving their retirement income, and being down to Social Security, and inflation eats them up." Hamilton feels that the impact of this crisis may go beyond individuals' standard of living. "What holds up our economy ... is consumer spending. When retirees are 20 percent of the economy and run out of money, then `poof' there goes the economy."Can You Afford to Retire? reports that the past quarter century has seen a massive shift in the cost and responsibility for retirement saving from corporations to employees. According to the U.S. Department of Labor, in 1978 workers put in only 11 percent of total contributions, and corporations, 89 percent; by 2000, the employee share had leapt to 51 percent and the company share had fallen to 49 percent. One major driver behind this shift is a corporate bankruptcy strategy that enables companies to terminate lifetime pension programs. "Bankruptcy is a way to take legal promises and burn them," says Professor Elizabeth Warren, a Harvard specialist in bankruptcy law. "Chapter 11 has become an effective tool for reorganizing a business.... [But] it's like a knife on the surgeon's table. Bankruptcy is the official, federal, formal way to take legal promises [and] just slice them off."FRONTLINE takes viewers inside the story of United Airlines, whose bankruptcy left tens of thousands of workers with reduced pensions. United's pension plans had been underfunded by nearly $10 billion, and during its bankruptcy process, those liabilities were dumped on the Pension Benefit Guaranty Corporation, a federal agency now running a $23 billion deficit. Robin Gilinger, a 42-year-old United flight attendant, says she expects to work five to 10 years longer than planned, now that her United pension has been reduced by nearly 30 percent and other benefits have been cut. "I feel very uneasy about where I'm going to be in 20 years," Gilinger says, "And I'm afraid that I'm going to end up having to work my golden years doing things that I didn't necessarily want to be doing."

Saturday, May 13, 2006

Defined Benefit Plans-Industry Update

There has been substantial activity over the past quarter related to pension accounting and funding reform. In early March, conferees met to reconcile the Senate and House versions of pension reform legislation. The industry had been anticipating a final bill by April 15 which coincides with the first due date for quarterly plan contributions. At issue is the benchmark rate used to determine contributions. For some plans, that rate would revert to the 30 year Treasury rate instead of the more favorable high grade corporate bond rates. The conferees now concede that the bill will take longer then expected.

The Financial Accounting Standards Board recently released its exposure draft on the reporting of benefit liabilities for public comment. The new disclosure standard, SFAS 132 (Revised), Employers’ Disclosures About Pensions and Other Postretirement Benefits, replaces a previous statement of the same title and number issued in 1998. SFAS 132R, the “new” SFAS 132, retains essentially all of the disclosure requirements of the original but includes new disclosures. The major thrust of the standard is disclosure oriented rather than measurement or recognition oriented. It would require sponsors to make the difference between the fair value of plan assets and the benefit obligation to retirees a balance sheet item, thereby increasing pension plan transparency. Towers Perrin estimated that the Fortune 100 companies would have been required to recognize $331 billion of additional liability according to these rules at year end 2004. Additionally, the draft requires that funds' values be assessed on the same dates as other assets or liabilities.

Phase 2 of the FASB pension accounting project will address all aspects of accounting for pensions and other post retirement benefits. This phase could have a more onerous impact on a company’s earnings, thereby further accelerating plan freeze and termination activity. For now, the impacts relate primarily to balance sheet related debt covenants and possibly employee/shareholder communication for public firms. For Example, the Wall Street Journal estimated that these changes could add $68 billion in unrecorded liabilities to GM’s balance sheet generating shareholder equity of negative $43 billion.[i] If the European experience with this accounting trend is any guide, liability driven investing strategies may begin to creep into the consciousness of defined benefit plan sponsors over the next few years.

If you are considering freezing your defined benefit plan, the Employee Benefit Research Institute performed a study that may be of interest to you. The study, entitled Defined Benefit Plan Freezes: Who’s Affected, How Much and Replacing Lost Accruals was undertaken to determine the level of future contributions necessary to immunize participants from the loss of their future defined benefit accruals. Though there was significant variability in the output based on plan terms, participants circumstances and earnings assumptions, the median annual contribution required to indemnify a participant in a frozen defined benefit plan was estimated to be in the 7% - 8% range (assuming 8% investment earnings).

[i] WSJ, 4/5/06, For GM Pension Accounting Shift Could Dwarf Gain on GMAC Deal