Saturday, September 30, 2006

401(k) Default Regulations - Capital Market Assumptions

The Employee Benefit Security Administration of the Department of Labor used a simulation model to estimate the impact of the proposed 401(K) default investment regulations on retirement savings in the US. This work provides several capital market return asumption data points that plan sponsors could use as collateral support for their capital market assumptions or plan participants could use in forecasting retirement needs.

The model inputs were:
9.48% nominal average return on diversified equity (6.5% real returns)
5.8% nominal average bond return (3% real)
2.8% inflation rate
Equity standard deviation estimate was 18.44%

A 60% equity portfolio using these parameters would expect about an 8% return. This is around the mean actuarial assumed return for US defined benefit plans. One peer reviewer noted the equity return assumptions may be overstated over a 20 year horizon due to the current historically high P/E multiple and the absence of an explicit fee assumption. Individuals using these projections might to apply a 100-150 basis point haircut.

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Friday, September 29, 2006

FASB No. 158 - New Defined Benefit Plan Accounting Standards

Today, the Financial Accounting Standards Board (FASB) issued the final Statement No. 158 Accounting for Defined Benefit Pension and Other Post Retirement Plans. Per FASB, the funded status and costs associated with employer’s postretirement benefit plans were not readily available to investors in a complete or understandable way under the old accounting rules. The new accounting standard:
  • recognizes a balance sheet asset for a plan’s overfunded status or a liability for a plan’s underfunded status,
  • measures its funded status as of the end of the employer’s fiscal year, and
  • recognizes changes in the funded status in the year in which the changes occur through comprehensive income or changes in net assets for non-profits.

  • The industries primary objection to this standard was FASB's use of a Plan's Projected Benefit Obligation (PBO) rather than the Accumulated Benefit Obligation (ABO) to measure pension liabilities. One consulting actuary estimated that this change could reduce shareholder equity across large public companies with active Defined Benefit plans by almost 10%. Plan curtailments are certainly a rational response given this estimate.
    The PBO creates a higher liability than the ABO because it includes an estimate of future increases in compensation which are not current obligations. The industry belives the future compensation increase estimates would not qualify as a current liability under other FASB rules and shouldnt be included here. The FASB believes that the PBO fairly represents a Plan's contractual and economic obligation.

    The issuance of Statement No. 158 completes the first phase of the Board’s comprehensive project to improve the accounting and reporting for defined benefit pension and other postretirement plans. A second, broader phase of this project with potentially more damaging income statement accounting impacts on defined benefit plans remains.

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    Wednesday, September 27, 2006

    401(k) Safe Harbor Default Rules

    The DOL provides the following overview of their Investment Default Safe Harbor proposal. The full Proposal is available here.

    ERISA provides relief from liability for investment outcomes to fiduciaries of individual account plans that allow participants to exercise control over the investment of assets in their plan accounts.The proposed regulation deems a participant to have exercised control over assets in his or her account if, in the absence of investment direction from the participant, the plan fiduciary invests the assets in a qualified default investment alternative (QDIA).Assets must be invested in a “qualified default investment alternative” as defined in the proposal.
    • Participants and beneficiaries must have been given an opportunity to provide investment direction, but failed to do so.
    • A notice must be furnished to participants and beneficiaries 30 days in advance of the first investment, and at least 30 days in advance of each subsequent plan year, and must include: a description of the circumstances under which assets will be invested in a QDIA; a description of the investment objectives of the QDIA; and an explanation of the right of participants and beneficiaries to direct investment of the assets out of the QDIA.
    • Any material, such as investment prospectuses and other notices, provided to the plan by the QDIA must be furnished to participants and beneficiaries.
    • Participants and beneficiaries must have the opportunity to direct investments out of a QDIA with the same frequency available for other plan investments but no less frequently than quarterly, without financial penalty.
    • The plan must offer a “broad range of investment alternatives” as defined in the Department’s regulation under section 404(c) of ERISA.
    • Plan fiduciaries would not be relieved of liability for the prudent selection and monitoring of a QDIA.

    Qualified Default Investment Alternatives
    Under the proposed regulation, a QDIA must satisfy the following requirements:
    • A QDIA may not impose financial penalties or otherwise restrict the ability of a participant or beneficiary to transfer the investment from the qualified default investment alternative to any other investment alternative available under the plan.
    • A QDIA must be either managed by an investment manager, or an investment company registered under the Investment Company Act of 1940.
    • A QDIA must be diversified so as to minimize the risk of large losses.
    • A QDIA may not invest participant contributions directly in employer securities.
    • A QDIA may be a Life-cycle or targeted-retirement-date fund;Balanced fund; or Professionally managed account.

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    Thursday, September 21, 2006

    Fiduciary Investment Issues in 401(k) Plans

    This article from IFEBP reviews a fiduciary's resonsibilities relating to defined contribution (DC) plan investments, mitigating fiduciary liability for investment performance, and investment fees.
    "DC plan trustees can limit their potential liability by prudently investigating and evaluating potential plan investments, and by documenting the facts and reasoning that led to the decisions. Finally, DC plan trustees should investigate potential undisclosed fees and expenses that may be charged by their investment advisors. Trustees can further reduce their potential fiduciary liability by relying on the advice of an investment consultant and by structuring the plan to allow participant-directed investments in compliance with DOL regulations. After an investment decision is made, the trustees have a continuing fiduciary duty to monitor vendors and investments."

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    Tuesday, September 19, 2006

    Amaranth - A Deeper Level of Understanding

    An April 2006 article in ALPHA magazine spotlights SDCERA's CIO David Deutsch and his allocation of roughly $1.3 billion, or one fifth the Plans total assets, to an alpha engine portfolio. He decided to dispense with the fund of funds convention and save some "real money" self-diversifying by;
    "adding some big-name multi-strategy funds to the mix. It allocated $175 million each to D.E. Shaw & Co. and Amaranth Advisors in addition to giving $125 million to Silver Point Capital. In so doing, the fund demonstrated that it has deepened its level of understanding, vis-à-vis individual hedge fund strategies, choosing Amaranth for its arbitrage approach and D.E. Shaw for its quantitative models that include statistical arbitrage. Silver Point further diversifies the portfolio through its active investing and loan origination activities."
    The point - even sophisticated investors despite a "deepened level of understanding" still face uncertainty and the risk of large losses when allocating to levered funds. Amaranth was, in theory, a "multi-strategy" hedge fund. However, it's collapse suggests it's risks were not detected by an expert fiduciary's due diligence process. Smaller pension investors without sophisticated due diligence resources are at even greater risk that allocations to complex investment strategies could generate losses and subsequent fiduciary trouble.

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    401(k) Fee Lawsuits -II

    Groom Law group has published a follow-up on 401(k) Fee lawsuits.Their analysis concludes;
    "These cases represent the next development in the evolution of the law regarding fees and relationships between plans and their service providers. The potential impact of the cases on the structure and operation of plans is significant. Each of the complaints alleges that plan recordkeepers, consultants and TPAs are fiduciaries and imply that revenue sharing payments are plan assets. The retirement service industry as a whole would be greatly affected if a court were to agree."

    401(k)helpcenter has reviewed and summarized one of these complaints filed against Northrop Grumman Corporation, The Northrop Grumman Corporation Savings Plan Administrative Committee and Investment Committee, numerous corporate offers and their Board of Directors. They reval that similar suits have been filed against at least five other major Fortune 1000 companies with over a dozen more soon to follow.

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    Monday, September 18, 2006

    401(k) Fee Lawsuits

    The Seyfarth Shaw Law firm reported that Schlichter, Bogard & Denton, a plaintiffs’ law firm, filed a wave of complaints involving 401(k) plan fees.
    "These lawsuits target large 401(k) plans sponsored by large employers( in the Illinois & Missouri area) name the employer as defendant, and in some cases, plan fiduciary committees and their various individual members. In the "cookie-cutter" complaints, the plaintiffs allege a variety of breaches of fiduciary duties and prohibited transactions relating to fees paid by 401(k) plans"
    Seyfarth produced a Presentation on 401(k)Plan Fees for their clients. Plaintiff's attorney Keller Rohrback may be on the fee case as well. It is currently investigating companies that serve as "Investment Providers" for 401(k) plans and the company fiduciaries that retain them in order to determine whether they have breached their fiduciary duties under ERISA by, among other things, causing 401(k) plans to incur excessive management and administration fees or entering into improper fee sharing arrangements with mutual fund companies that are selected by them. (source: Plansponsor)

    The Plaintiff firm's must see their window to litigate fiduciary breaches on non-disclosed fees closing because of the new Form 5500 Schedule C disclosure rules to be implemented in 2008.When ERISA was legislated, its intent was to make all plan fees and expenses explicit and transparent. It did not anticipate the emergence of mutual funds and the practice of netting fees, including intermediary revenue sharing arrangements, against assets as is common practice today. This practice makes fiduciary oversight of fees very difficult both in terms of a sponsors ability to understand their own plan's fee details and in having access to comparable public fee data from their peers.

    Under the new Schedule C requirements Plans will have to provide more information about third-party financial relationships. Plans will have to identify all service providers that receive $5,000 or more from plan assets. Plans currently must report only the 40 highest-paid service providers. Also, if a plan fiduciary or “listed service provider” received more than $1,000 from a source other than the plan or the plan sponsor, the Plan would have to provide information about the payer, the services and the compensation. Listed service providers include contract administrators; securities brokerages; insurance brokerages or agents; and those providing custodial, consulting, investment advisory (plan or participants), investment or money management, recordkeeping, trustee, appraisal or investment evaluation services. Reportable compensation would include all brokerage fees and commissions, and any “float” or similar earnings on plan assets or deposits retained by the service provider as compensation.

    Tuesday, September 12, 2006

    CALSTRS Loads up on Real Estate

    The California State Teachers' Retirement System, the nation’s second largest public pension fund ($144 billion assets) will be significantly changing its asset mix. The new long-term asset allocation targets are: 40% US equity, 20% Non US equity, 9% Private Equity, 11% Real estate and 20% Fixed Income. The portfolio change shifts 6 percent of the portfolio from fixed income and 1 percent each from U.S. equity and cash. The real estate portfolio will see the largest increase at 5 percentage points; alternative investments will receive a 3 percentage point increase.

    This is a relatively large adjustment in the portfolio’s overall risk return profile which recognizes the increased returns the asset base must produce to fund liabilities. It seems to be an even larger long term bet that public markets returns will under-perform private markets.The Plan’s capital market estimates are nominally higher than what we would consider to be mainstream estimates these days, especially when using a 2.25% inflation rate. US and Non US Stocks 9%, US Bonds 4.75%, Cash 3.5%, TIPS, 4.5%, Real Estate 7.5% and Alternative Investments 12.5%. By way of comparison the 2006 Wilshire Report of State Retirement Systems used US and Non US Stocks 8.25%, US Bonds 5%,Real Estate 6.25% and Private Equity 11.75%

    Heroic asset allocations and capital market assumptions look like they can save the day but often just move the day of reckoning into the future.

    Friday, September 08, 2006

    Mutual Fund Selection - Fiduciary Fund Ranker

    Selecting mutual funds that outperform ex ante is notoriously difficult. Evidence suggests that the median alpha for actively managed mutual funds is negative, yet they continue to predominate the investment lineups of many 401K plans (as well as small pension plans & individual portfolios). Plan sponsor selection efforts have added some value however. Elton & Gruber found that although 401(k) plan sponsors on average selected funds with negative alpha, they selected funds that had smaller negative alphas than a random selection would produce. Plan sponsors and investors alike might improve the value of their mutual fund selection process by:

    1) Using a fund ranking process instead of a linear fund screening process that eliminates funds

    When searching for a mutual fund it is impractical to examine every available alternative. Many investors (professionals included) use a linear fund elimination process to reduce a large population of fund alternatives down to a manageable few. The full population of The funds for consideration are reduced by those which do not meet certain qualifying tests (ie. outperform market benchmark for 5 years or top half in peer universe over 5 years, etc.). This kind of screening certainly expedites the selection process but it also eliminates good investment options from consideration.


    2) Using multiple relative performance statistics instead of focusing predominantly on historical nominal returns,
    The universal caveat, "Past performance may not be indicative of future results" acknowledges the pervasive uncertainty facing investors. It does not recognize the substantive value differential between a cursory review of nominal returns and a comprehensive historical quantitative/qualitative fund review. Even John Bogle, the champion of indexing has said that “while you should disregard a single aggregate number showing a fund's past long-term return you can indeed learn a great deal by studying the nature of its past returns”.

    Investors should use a multi statistic and time horizon weighted fund ranking methodology where the full universe of funds can be inspected across a variety of customized time horizons and quantitative statistics. This method overcomes the naïve assumption in a fund elimination process that good investments must simultaneously meet all of a defined set of standards and that all investors value each of the screening criteria equally. This process also a better understanding of the nature, consistency and risks associated with each fund. These fund characteristics, unlike nominal returns tend to be persistent through time.

    We provide a partial sample of a Fiduciary Fund Ranker Domestic Large Cap Value Mutual Fund search below. In this model we weight each of the fundamental and performance statistics as well as the variety of time horizons in order to customize the ranking process to accommodate the characteristics of the asset class/styles as well as the objectives and preferences of each client investor.

    For each mutual fund class we collect relative performance statistics (correlation to the asset class/style benchmark, risk adjusted returns and downside risk measures, alpha and information ratios against generic and beta adjusted benchmarks, tracking error and fund batting averages as well as a few pieces of fundamental data. We then rank each fund by statistic and weighted time horizon. The total fund rank can also be adjusted to accommodate different factor weightings. For instance if a client were looking for a well diversified fund that well represented a particular style box and would not present significant monitoring issues we would begin the search by overweighting correlation, tracking error while looking for high risk adjusted returns and equivalent style and benchmark alphas.

    The Fiduciary Fund Ranker has limitations as does any purely quantitative process. While no selection process can overcome the uncertainty inherent in investing, this process can close the gap between investment expectations and outcomes, and improve the investment decision making process by assuring good investments aren’t arbitrarily lost in a screen and that a broad set of investment characteristics are used in the selection process. Importantly, it promotes interaction to provide a means to clarify investment objectives. Additionally it profiles and positions each fund in a peer universe in way that provides a very robust and technically supportable methodology for prudent fund selection under ERISA.


    Thursday, September 07, 2006

    DC Plans Underperform DB Plans by 1%

    A recent study by the Center for Retirement Research concludes that DB plans have outperformed DC plans by at least 1% since 1988 and that lower DC plan returns don’t fully reflect the investment allocation problems at the individual participant level that may further negatively impact their preparation for retirement.

    Thought the comparative asset allocation equations and return calculations were fairly imprecise and in some cases inconsistent with other sources(i.e. DC equity % allocations vary from 50% - 67% over the last 10 years vs. EBRI data suggesting DC equity has “varied narrowly (62% to 77%) over the past 10 years), we are not surprised by the overall return conclusion and, in fact, would expect the DC underperformance to be even greater. In addition to the fee structures there are probably several other fundamental reasons why DC plans should, on average, return less than DB plans:

    • Underutilization of Risky Assets – DC plans as a matter of liability control and to avoid participant confusion do not generally offer hybrid or high risk asset classes such as; emerging markets equity, real estate (REITS), or high yield bonds. In a disciplined asset allocation exercise characteristic of DB plan management these asset classes are often included to maximize returns/risk adjusted returns. Over the study’s 16 year horizon, the S&P 500 outperformed all of these other asset classes – narrowing the expected impact of this asset allocation differential.


    • Dependence on money market & stable value Products – DC plan fixed income allocations are predominantly in money market or stable value products vs. DB plans which use market value bond portfolios. Money market funds underperformed intermediate bonds by almost 4% annually from 1998-2004. Stable value products should be expected to under-perform intermediate bonds by some amount due to the “insurance” cost.


    • Indexing – Index fund management became firmly established in DB pension plans in the 90’s. The allocation of DC assets to index funds we suspect is lower than that of DB assets. This is likely reflected in both lower costs and the possible avoidance of negative alpha which is so prevalent in active management.


    We also do not find that the author’s data detailing participants lack of diversification lead us to the conclusion that “most participants face the risk of ending up with inadequate retirement income”. In fact, the lack of diversification in these plans may reflect very rational participant decision making for at least two reasons.

    First, the universe of plans in the study was constrained to those which included had complimentary DB and DC plans. Under these circumstances, a DC participant who also anticipates a DB plan benefit should consider the DB benefit a fixed income asset and therefore overweight their DC allocation to equity. For long tenured employees with a good accrued DB benefit, 100% equity allocation in a DC plan would not be unreasonable.

    Secondly, while we can observe the asset allcoation for the entire pool of assets dedicated to retirement liabilities in a DB plan, DC asset allocations often reflect only a portion of participant’s assets dedicated to retirement. Tax differences may skew how retirement assets are held. For example, it might be more tax efficient for higher income employees to buy and hold their equity asset in taxable accounts while holding their fixed income or stable value assets in tax deferred accounts to avoid higher current tax impacts.

    Wednesday, September 06, 2006

    Value vs Growth Investing

    We are seeing a number of institutional converts to value investing based on its "long term value premium". Of course, it is always easy to adopt a long run theory when short term performance makes it attractive. Nevertheless, a recent article in Plansponsor points out some interestng statistics re: growth style investing.
    • Value investing empirically has generated higher long term returns despite growth outperformance in over half of the last 110 quarters,

    • Growth investing is more volatile, the negative effects of which outweight its outperformance frequency,

    • As we confirmed in our study on active manager alpha, median growth managers exhibit higher historical alpha,

    • INTECH,Transamerica Investment Management; Sands Capital Management; Wedgewood Partners; and TCW Asset Management. RCM Capital Management were mentioned as top institutional growth managers.

    A very rational portfolio investment structure that would take advantage of these characteristics would be to overweight value beta(index) and underweight growth, but actively manage that mandate. This strategy makes particular sense as some of the best value managers have closed to new money.

    Saturday, September 02, 2006

    Dupont Pension Plan Cuts / SEC Proxy Disclosures

    Pension Boards over the past week have undoubtedly been discussing the recent Dupont pension announcement. This has been correlated to the tightened funding standards under the Pension Protection Act of 2006, though proposed new accounting treatment for pensions may be equally if not more distasteful to sponsors than the new funding rules. What has been generally overlooked, but has caught the eye of executives, is the dismantling of executive pension and SERP programs. As the WSJ reported:

    "DuPont Co. said it would cut its employees' company pension benefits by two-thirds after 2007, making the chemicals giant the first major company to reduce pension benefits since Congress passed new legislation touted as improving pensions' health…DuPont's $23 billion pension plans have a funding shortfall of $3.1 billion, but most of that ($1.8 billion) stems from pensions for executives, which aren't funded in advance, and its foreign employees, where funding isn't required. DuPont declined to say how much of the shortfall stemmed from executive benefits. Mr. Porter said the company will change the executive pensions to align them with changes in the pensions for non-executive U.S. employees..."

    Dupont’s alignment of their executive compensation with non –executive compensation may also reflect the fact that on July 26, the Securities and Exchange Commission (SEC) adopted new proxy disclosure requirements for executive compensation, effective for proxies filed in early 2007 (for calendar year reporting companies). The new rules broaden disclosure of corporate compensation and increase legal liability for this information. Two areas of executive compensation with weak disclosure requirements in the past; severance and pension plans, are covered in the new disclosure standards. Corporations like Dupont will now be weighting tightened funding standards, negative pension accounting implications as well as a higher level of investor scrutiny when trying to justify current executive and non-executive defined benefit programs.