Thursday, February 28, 2008

Public Pensions - What Crunch



Municipal pension plans are under pressure as noted in a recent WSJ article Dear Crunch, Wish You Werent Here.

"With interest rates low, stock markets uncertain in the credit crunch and real-estate prices falling, government pension funds are facing a brutal investment climate. As a result, some state and local governments are feeling the heat."

While the dynamic and temporal nature of politics and the disciplines required for sucessful long term pension funding may not always integrate well, the current public pension plan funding situation may not be be as dire as portrayed by funding statistics. The National Association of State Retirement Administrators publishes an annual compendium of public pension plan data that covers 85% of the assets and participants in state and local goverment pensions in the US.

The most recent Survey Summary indicates that funding ratios have declined from over 100% in fy 2001 to 86% in fy 2006. Funding ratio's are usually stated as the ratio of an actuarial value of plan assets over plan liabilities. Actuaries commonly use 'smoothing' or 'averaging' methodologies for public pension plans to calculate an actuarial value of assets, which is intended to make this value less volatile than the market value of assets. Averaging or smoothing is generally designed solely to reduce contribution volatility and improve funding predictability.

The characteristic of a smoothed actuarial asset value for a plan with substantial equity is that it is higher than the comparable market value through bear markets and lower through bull markets. Looking at the pattern of capital market returns over the past 5 years, smoothed actuarial asset values may continue to rise as they phase out the substantial market losses of 2000-2002 and phase in the strong investment gains from 2003.

An exhibit, reproduced above from the study, compares the actuarial asset valuations to market valuations of plans included in the study. The significant number of public plans with excess market value over actuarial value indicates that, all other things being equal, public plans may already have some funding level improvements "in the bank".

Finding the balance between current fiscal needs and funding long term commitments across taxpayer generations remains a distinct challenge for public pension plans. The nature of politics, human behavior and the capital markets virtually guarantee that not all plans will meet the challenge. This should not imply that most wont.

Wednesday, February 27, 2008

Should Fiduciaries Invest Like Warren Buffet?

The duty to act prudently is one of a fiduciary’s primary responsibilities under ERISA. With this fiduciary responsibility, there is also potential liability. Fiduciaries who don’t adhere to the basic standards of prudent fiduciary conduct may be organizationally and personally liable for Plan losses. Fulfilling these responsibilities requires expertise, particularly in an area such as investments. Lacking the expertise, fiduciaries should employ professional investment strategies.

In a February 15, 2008 interview with students from Emory's Goizueta Business School and McCombs School of Business at UT Austin, Warren Buffet remarked on investing and the value of diversification.

“If investing is your game, diversification doesn’t make sense. It’s crazy to put money into your 20th choice rather than your 1st choice. If you have a harem of 40 women, you never really get to know any of them well. Charlie (Munger)and I operated mostly with 5 positions. If I were running 50, 100, 200 million, I would have 80% in 5 positions, with 25% for the largest.”
Unfortunately, ERISA fiduciary prudence requires diversification to minimize the risk of large investment losses to a retirement plan. Though adequate diversification is not specifically spelled out in ERISA, it would be determined on a facts and circumstances basis using recognized generally recognized investment standards. By example, the Investment Company Act of 1940 provides some guidance on legal diversification and industry concentration. Section 5 of the 1940 Act requires that mutual funds elect to be classified as either "diversified" or "non-diversified". As a diversified fund, the Fund is limited as to the amount it may invest in any single issuer. Specifically, it provides that “with respect to 75% of its total assets, a diversified fund may not invest in a security if, at the time of purchase and as a result of such investment, (1) more than 5% of the fund's total assets would be invested in securities of the issuer of such security, and (2) the fund would hold more than 10% of the outstanding voting securities of such issuer” exclusive of cash and Us government securities. In contrast, a "non-diversified" fund is defined by the 1940 Act to be any fund that is not a "diversified" fund.

This implies that a "diversified" fund would have a minimum holding of at least 20 investments. Other studies suggest that 90% of the benefit of diversifying against unsystematic or stock specific risk would be derived from portfolios holding 15 – 20 stocks.

“Over the past 50-60 years, Charlie and I have never permanently lost more than 2% of our personal worth on a position. We’ve suffered quotational loss, 50% movements. That’s why you should never borrow money. We don’t want to get into situations where anyone can pull the rug out from under our feet”
Good investment governance relies on establishing investment performance benchmarks. However, fiduciary benchmarking processes can serve to “pull the rug out from under the feet of fiduciaries”, turning quotational or unrealized losses into realized losses. This happens on a fairly regular basis as fiduciaries exit investments for not meeting performance benchmarks. The reference benchmarks are often not reflective of the nature of correlated investment. Benchmarking is particularly ineffective for concentrated portfolios which contain substantial unsystematic risk such as WB's. In these cases, fiduciaries are forced to choose between either not employing a significant procedurally prudent process or ignoring its results. Neither option would be very defensible in the event of a poor investment outcome.

Despite his extraordinary success, fiduciaries would have to think long and hard about their exposure before singularly employing Warren Buffet's unique investing strategies.

“If you are a professional and have confidence, then I would advocate lots of concentration. For everyone else, if it’s not your game, participate in total diversification. The economy will do fine over time. Make sure you don’t buy at the wrong price or the wrong time. That’s what most people should do, buy a cheap index fund and slowly dollar cost average into it. If you try to be just a little bit smart, spending an hour a week investing, you’re liable to be really dumb.”

Thursday, February 21, 2008

CT Small Business 401(k) Plan

Pioneering legislation has been proposed in the State of Connecticut which would allow the State to provide 401(k) plans for; small companies with less than 100 employees, non profit organizations and the self employed. The proposal is designed to reduce plan administrative costs for small businesses by leveraging the existing employee base and purchasing power of the State of CT. The State of CT offers a very attractive defined contribution plan for state employees. This model might be extended to small employers to make their retirement benefits more competitive with larger organizations.

Retirement investing is not a statistical “fair game” for many small investors and retirement plans because of a fragmented market, information asymmetry and principal/agency conflicts. These biases virtually guarantee that investor’s interests are subordinated to the interests of a cornucopia of providers and intermediaries in that market. Large retirement plans have the investment and financial resources to manage these issues. Small market retirement plans typically aren’t aware of the issues and may not have the time or resources to effectively manage them.

Small market 401(k) plans have been underserved and subject to pricing and servicing inefficiencies. Efforts to deliver lower costs, more independent investment expertise, disciplined quantitative investment processes and fiduciary best practices to smaller retirement plans could substantially improve the level of retirement sufficiency for many.

Sunday, February 17, 2008

Managing Investment Uncertainty - A Fiduciary Requirement

Managing uncertainty is an investor’s primary occupation. In scientific models uncertainty is categorized as either aleatory or epistemic. Aleatory uncertainty refers to random errors or, for our purposes, the random variations inherent in capital markets. “Random walk” in the markets cannot be reduced by evaluating more data points or having better information. Its role can be managed, though not eliminated, by basic statistical concepts of variability, probability and expert judgment. On the other hand, epistemic uncertainty or systematic errors stem from a lack of knowledge, inaccurate or incomplete information or flawed models. Systematic bias, which we refer to as selection bias in the investing process, can be either informational or procedural in nature.

Selection bias can distort the conclusions drawn in investment evaluation based on the way investment data is calculated, presented, evaluated or processed by investors. Selection bias probably accounts for a significant amount of investment under-performance as well as fiduciary risk. The prudent expert standard of care required of investment fiduciaries accommodates uncontrollable randomness in markets. It does not tolerate preventable selection bias. A requisite level of knowledge, information and analytical process necessary to overcome selection bias is required of investment fiduciaries. A sample of selection biases include:

Branding Bias - investors often use brand as a heuristic in their investing decisions since the indicia of investment quality are not readily apparent. Marketing studies show that familiar brands have an advantage in competitive, commodity like markets. Branding reinforces recognition and can become a “proxy for quality” in complex products like investments. Icons for investment quality, such as fund ratings, conspire with product branding to bolster investor’s perception that investment quality & suitability can be evaluated at a glance. Minimal diversification of investment managers in products or investment programs can indicate branding or other selection bias.

Universe Bias – many investors are presented with investment fund universes that have been pre-screened to facilitate their investment selection. In general, the best attainable portfolios in terms of risk/return efficiency are diminished when investment universe constraints are imposed. Our experience suggests that constrained fund universes can reduce diversification benefits and potential alpha. Since optimal investment selection can be subverted by other interests in investment screening, fiduciary investors have an obligation to understand any economic or quantitative selection biases that have been applied to their investment selection universe. Open fund architectures provide a richer palette from which to build efficient portfolios.

Fee Bias - there is significant regulatory and legal activity around fee presentation & disclosure in the 401(k) domain. The prevailing bias has been to bundle investment, administration and intermediary fees into net returns and provide disclosures about the bundled fee components in collateral literature. The majority of investors don't/won't read collateral no matter how simple. What investors will react to are explicit detailed service charges on their quarterly statements. When it is clear to investors that they are purchasing services, they will be more motivated to ensure they and their plan sponsors are purchasing efficiently. In other sectors of the economy such as healthcare, where consumers have choice and can control cost, falling costs and increasing productivity follow.

Benchmarking Bias – benchmarks are an important investment policy tool used to determine relative performance of portfolios and investments. To provide relevant information, a benchmark should be a viable passive investment strategy and it should have similar asset class and styles proportions as the implemented fund/portfolio. Improperly constructed benchmarks lead investors to mistake beta for alpha and under-performance for out-performance. Our research suggests inappropriate benchmarking is a large source of phantom “alpha” and selection bias in investor portfolios. Use of customized style benchmarks, benchmark correlation testing and timing/selection performance attribution are indicative of processes designed to overcome this bias.

Performance Presentation Bias – What investors see depends on what they are shown. Cumulative returns (i.e.1, 3, 5 year) can suffer from return smoothing and “endpoint bias”. Cumulative compound annual growth calculations smooth out returns through the time period. Any significant excess performance creates the illusion that the fund has consistently outperformed and hides characteristics such as return consistency and volatility which should be important to investors in setting ex-ante return expectations. Similarly, the particular time periods and starting points for which investment performance data is shown can drastically alter investor’s perception of fund quality. The ubiquitous presentation of cumulative investment returns can disguise more than it can reveal. Use of rolling return periods, backward graphing, annual period return evaluations and a mosaic of other statistical performance information can help investors overcome data presentation biases.

Fiduciary investors can’t overcome random bias in the capital markets. However, a prudent expert standard of care compels them to overcome systematic uncertainty, such as selection bias, in their investment decision making. Selection bias is rooted in low levels of investor awareness and knowledge. It can be propagated through behavioral manipulation and statistical artifices which pander to investor’s desire for simplicity. Evidence of selection bias is obvious to a prudent expert and therefore represents a source of risk to investment fiduciaries. Mitigating this risk can be as simple as opting out of the selection process by utilizing a passive investment strategy or investing resources in improving the investment selection process.

Wednesday, February 13, 2008

Retirement Annuities - Investments or Insurance

Several recent studies have pointed out the economic value and higher adoption rate potential for deferred retirement annuities (“DRA”). These are annuities which could be purchased prior to or at retirement and would commence paying income at a predetermined age later in retirement. Their cost would be a fraction of an immediate annuity and their product characteristics could help overcome some of the behavioral obstacles to annuitization.

Economic and quantitative based research indicate that immediate annuities provide the most “utility” for retirees by helping them smooth the consumption of resources over their lifetime, unconstrained by limited lifetime resources. However, historical annuitization rates have been very low. Unfair actuarial costs, a high liquidity premium and framing are thought to account for this economically irrational behavior.

Unfair actuarial cost - George Akerlof and other researchers propose that adverse selection in the annuity markets contributes to this puzzle. Adverse selection arises due to information asymmetry. Individuals know their level of risk but the insurer does not. This informational advantage motivates “bad risks” to annuitize, thereby driving up costs and prices which in turn repel “good risks”. A Deferred Retirement Annuity, while still subject to adverse selection, could broaden the insured pool using the intuition that the smaller the financial bet needed to annuitize, the more individuals with average mortality would voluntarily annuitize. Greater institutialization of products that include this component could reduce biased actuarial costs.

Liquidity premium - Individuals apparently assign a very high premium to the liquidity inherent in a lifetime savings portfolio. In approaching an annuitization decision, the cost of foregone liquidity is often perceived to be much higher then the risk of poverty should they outlive their retirement savings. One estimate of the cost to give up liquidity and earnings potential for longevity insurance was between .25% and 1.55% per year. Gong & Webb in their 2007 study calculate that: “a household planning to smooth consumption through its retirement would need to allocate only 15 percent of its age 60 wealth to an ALDA with payments commencing at age 85, holding the remainder of its wealth in unannuitized form to finance consumption from age 60 to 85”. A cost shift of this magnitude could make annuitization a relevant choice for many more individuals.

Framing - Brown, Kling, Mullainathan and Wroble focused on the behavioral aspects of this decision in their 2008 study. They suggest that the investment context in which annuitization is often presented could be a source of its rejection. “Survey evidence is consistent with our hypothesis that framing matters: the vast majority of individuals prefer an annuity over alternative products when presented in a consumption frame, whereas the majority of individuals prefer non-annuitized products when presented in an investment frame”.

Annuitization seems to be most often approached in the financial planning process as an alternative investment decision where payback periods and returns depend largely on how long an individual lives. Similar to Social Security in that it has a large insurance component, both are often evaluated based on their investment breakeven payback rather than for their insurance or consumption utility. It seems likely that a partial annuitization would more easily be framed and accepted by individuals as an insurance or consumption decision where the payment is akin to an insurance premium rather than a capital investmnent.

Deferred Retirement Annuities could mitigate a significant and individually unmanageable risk for retirees (longevity). They could also provide the psychological comfort of maintaining a liquid asset pool and reduce the potential risks of inappropriate consumption through a fixed term spending period. The choice to meld an insurance component with an investing component in retirement plans would be superior to 100% of either option for many individuals.

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Sunday, February 10, 2008

Retirement Planning - Playing Catch-Up

Economics is premised on the assumption that choices reveal true preferences—that the choice of A over B indicates that the individual will in fact be better off with A rather than with B. If consumers' choices are to a large extent arbitrary, then the claims of economists that free markets will lead to maximum well-being are substantially weakened. Market institutions that maximize consumer sovereignty need not maximize consumer well-being”. Dan Ariely – Behavioral Economist. MIT Advisor to BoulevardR

There is abundant academic and empirical evidence suggesting the shift to consumer driven retirement will not optimize consumer well being due to behavioral impediments and generally low investment interest and acumen. This issue is well recognized and has been partially addressed by regulators and the retirement industry via “fiduciary immunization” for automated contributions and prepackaged lifecycle driven investment products. 401(k) plan auto-enrollment and utilization of target retirement funds can overcome some level of investor inertia with regard to savings and investment decisions. However, these tools are limited in their ability to ensure retirement sufficiency across a wide range of investor circumstances and preferences.

Retirement planning is the process by which individuals specific circumstances and goals are used to bring retirement inputs (savings levels, investing strategies, retirement age) into equilibrium with their retirement outputs (retirement lifestyle and duration). Since this process is self initiated, inherently complex, costly to outsource and requires effort to collect collateral information, it is avoided by many individuals. To avoid triggering investor’s avoidance behaviors, many retirement planning tools available on the web seek relatively little input. Basic age, salary, savings, income goals & investment /inflation assumptions are required to provide an estimate of retirement savings needs. Beyond merely creating an awareness of potential retirement funding gaps, the realistic shortcomings of these tools may exceed their value.

A new generation of web based retirement planning tools is emerging that may better bridge the gap between ease of use and utility of results. For instance, Boulevard R has developed a “lifestyle driven” retirement planning tool. The tool begins with an intuitive retirement goal setting front end that can be easily customized by users. Developing appropriate saving & investing decisions through identifying specific “lifestyle” cash flow liabilities is consistent with institutional pension planning disciplines. Boulevard R then solicits other cash utilizing goals along with basic census and financial data before providing a picture of retirement sufficiency. The tool encourages and facilitates planning iteration, which is absolutely essential in providing individuals with a feel for the leverage and variable implicit in their assumptions.

Boulevard R’s underlying assumptions were mostly transparent and reasonable. With regard to investments, very few institutional investors use an average historical equity return assumption (10%-11%) as a go forward estimate. Additionally, lifestyle driven investing conventions suggest a post retirement investment earnings estimate of 8% is quite aggressive.

Nevertheless, BoulevardR seems to combine strong technology, a basic though robust retirement planning structure and principles of behavioral economics to create an engaging and useful retirement planning product for those who are neither detail analytics or financial advisor outsourcers. Continued progress in this direction and for this particular audience will be necessary for a successful transition to consumer driven retirement.

Note; Matt Iverson, BoulevardR co-founder, responds & expands via comment

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Friday, February 08, 2008

LDI - Lifestyle Driven Investing

January’s equity sell-off and interest rate declines sparked a resurgence in the topic of LDI or liability driven investing. LDI employs pension plan liabilities as a performance benchmark rather than the traditional total return measure using indexed assets. The fundamental argument for LDI is that real economic risk eminates from a mismatch between the correlation of a plans assets and liabilities. Correlation mismatches create volatility in Plan funding and sponsor balance sheets. Sponsors have a strong preference for stability and certainty in both these areas. The decision to seek stability has a trade-offs. The primary one is a reduction in long term returns by shifting from an equity based total return strategy to a fixed income based LDI strategy. Stability effectively costs returns. The fundamental concepts behind LDI and the stability vs. return tradeoff is equally applicable to individual retirement planning. There are at least several elements that individuals must employ to follow an LDI “lifestyle driven investing” strategy.

Identify the Liabilities – Since future liabilities are the benchmark, a good approximation must be available. Actuaries prepare these for pension plans. The plan liability analogue for an individual would be their required post retirement income need. These are the “liabilities” an individual must fund. Individuals often don’t solve the savings and investing equation for a specific required retirement income need. They simply let their retirement liabilities emerge, constrained as a byproduct of their earlier savings and investing decisions. This is backwards and inconsistent with LDI. To apply lifestyle driven investing, individuals must specify their lifestyle “liabilities” in terms of both required dollars and duration (longevity). Lifestyle Driven Investing requires starting with the end in mind.

Identify Acceptable Lifestyle Volatility - Pension plans can choose from a full spectrum of investment strategies to fund their liabilities. High equity strategies at one end of the spectrum provide the promise of lowest long term cost via the maximization of the equity return premium. The cost of this strategy can be significant funding and balance sheet volatility for the sponsor. On the other end of the spectrum, pension plans can match their liability cash-flows with corresponding fixed income assets or derivatives to effectively immunize plan surplus from changing interest rates to stabilize their funding and accounting. This reduces the volatility related to asset liability mismatches but leaves the sponsor with more out of pocket responsibility for funding the Plan.

Lifestyle Driven Investing presents similar tradeoffs in retirement distribution for individuals as pension plans face in their funding decisions. Individuals can choose a higher long term retirement lifestyle or a lower, but more certain periodic lifestyle. Equity investing will allow individuals to enjoy a higher long term post retirement lifestyle (i.e. higher average income or longer average duration) with perhaps more volatility with regard to the timing of periodic distributions. In good market years individuals can withdraw more while in poor market years individuals should withdraw less. Lower risk fixed income investing can provide more certainty around distribution patterns but at a cost of a lower average lifestyle (ie less income or shorter duration).

Lifestyle Driven Investing calculus simply suggests that certainty has cost. If individuals have more flexibility in their retirement decisions (when to retire, annual spending), they should be equity investors and can enjoy an elevated retirement lifestyle.

Thursday, February 07, 2008

International Diversification

Evidence continues to support the value of international equity investing, despite higher correlations due to globalization and the integration of the global financial products markets. However, January 08 returns (US -Russell 3000 -6.1%, MSCI World ex US -9%) tend to confirm that, in market downturns, when investors want the benefits of covariance the most, markets become highly correlated.

A Wharton School study on international diversification suggests" the average small-investor portfolio has 10% to 12% of its equity investments committed to foreign stocks". This might underestimate investors international exposure by the significant foreign equity allocations that many funds, categorized as US equity funds, have made on behalf of their shareholders. It also may not account for the surge of cashflows into international funds in 2007. Of an aggregate $950B in 2007 flows, a net $200b was in international vs. a net -$.60B in US equity. $600b went into money market funds.

Regardless of the statistics, the fundamental intuition behind the value of international investing is that investors gain by effectively doubling their investment opportunity set.