Monday, March 31, 2008

CT Small Business 401(k)/Retirement Plans -SB652

The reality of the small plan retirement marketplace is that many retirement plan alternatives (both plan structures and service providers) exist, but they can be far from optimal for many businesses. Their characteristics often impede a plan sponsor’s desire to establish them or a participant’s ability to maximize their retirement security through them. The proposed State of CT defined contribution plan could provide a meaningfully superior alternative in the small plan market. It would offer both a “real” competitive advantage to small businesses adopters in CT as well as benefit all small plan sponsors and participants by forcing existing plan providers to “up their game” against a highly visible retirement plan alternative with a strong investment structure.

Since the passage of ERISA legislation over 25 years ago there has been a monumental shift in the country’s retirement system away from defined benefit plans toward defined contribution plans. This shift in retirement responsibility to the individual has been accompanied by substantial technological changes in both retirement plan administration and asset management. Technology, product and process changes have created stunning efficiencies, to the point where the cost to manage and administer marginal increments of retirement assets is probably quite close to zero. Unfortunately, these cost and efficiency advances have been arbitraged primarily to the benefit of sponsors and participants in the larger plan market where the scale and resource has been available to expedite realization of these benefits.

Plan sponsors and their participants in the small plan market are facing their new and highly complex retirement planning and savings responsibilities using a complex patchwork of retirement plan vehicles and an inefficient market of retirement plan providers with legacy fee structures and investment products that can severely undermine their best efforts. The current proportion to which small plans are disadvantaged is hard to quantify because of service bundling, investment subsidization and obscure fee disclosures but a reasonable estimate could be in the range of from .5% to over 2.5%. This includes both the impacts of higher fees and the opportunity cost of investment limitations. Some, though not all, of this inherent difference is artificial, unnecessary and unfair. It continues to exist because of structural inefficiencies in the retirement plan market that small retirement plans can't easily overcome.

Market efficiency is implied by some groups simply based on the fact that there are a multitude of retirement providers trolling the small business community for clients. However, the notion that the mere presence of multiple competitors forces retirement market efficiency presumes that buyers are fully informed, have sufficient experience and resources and the pertinent information to make optimal retirement plan decisions. This assumption couldn’t be further from reality! Despite what ERISA demands of them, plan sponsors, particularly small businesses, often know very little about retirement plan administration and generally assign a higher priority to other business demands that require their time and capital.

Our experience suggests that it is nearly impossible for retirement plan sponsors without specific skills and background to meet the substantial fiduciary burden to acquire, understand and validate all the information that is necessary to prudently evaluate competing service packages as required of them by ERISA. Consequentially, small market plan sponsors, without the resources to hire unbiased experts, often either rely on other far simpler decision making heuristics or potentially conflicted, non fiduciary outside resources. In most cases, they simply avoid the decision to implement a retirement plan all together.

Structural inefficiency in the retirement plan market is propagated by information asymmetry and conflicts of interest.

Plan sponsors often don’t fully understand their fiduciary responsibilities given the highly technical and legal nature of the regulations that bind them. For instance, ERISA imposes obligations on plans and their fiduciaries to “act with the care, skill, prudence and due diligence under the circumstances then prevailing that a reasonably prudent person acting in a like capacity and familiar with such matters would use in the conduct of an enterprise of like character and with like aims.” Trying to derive actionable practice from relativist language like this would be inconceivable for the inexperienced.

Plan fiduciaries must act prudently and solely in the interest of plan participants and their beneficiaries in establishing fees and appropriate services with retirement plan providers. The practices of product bundling, asset-based fees and the utilization of revenue sharing and internal investment subsidies to offset retirement plan provider’s costs of administration has made it very difficult for plan sponsors to fully understand fee structures. This lack of transparency makes an objective evaluation of competing products and services at best expensive and often impossible for unassisted retirement plan sponsors.

Perhaps the most impenetrable exercise for plan fiduciaries is determining which investments to make available to plan participants. The small business employer is responsible for prudently selecting and monitoring investment options made available in the plan. Plan sponsors generally do not possess the specialized skills and information required to appropriately evaluate the quality and potential of investment products offered to them.

Finally principal-agency conflicts infect many small market retirement products which are designed to maximize the vendor’s revenue rather than the best interests of the plan sponsor or participant.

In complex markets, like the retirement plan market, which require specialist knowledge, the arbitrage process, whereby information and efficiency gets broadly incorporated into products and prices, takes years and years. This has not fully occurred in the small retirement plan market. In an inefficient market, prices, products and services do not represent the best value.

In an inefficient market, the proposed State of CT defined contribution program could offer a number of valuable benefits to small retirement plans:

•deliver certain of the technological and structural benefits of administrative and asset management scale,
•deliver a productive, cost effective and well, diversified set of investment options including ongoing monitoring for effectively zero marginal cost
•provide the flexibility and greater benefit of a 401(k) plan in terms of its higher deferral opportunity, potential loan provisions, flexible vesting schedule, a Roth option and no required employer contributions in some cases as required by other simpler plan alternatives,
•provide a well known “brand” that would be attractive to sponsors who would avoid the decision to adopt a plan based on other issues.

The State of CT has a vested interest in helping it small business base become more competitive and its workers as well prepared for retirement as possible. The proposed State sponsored retirement plan could be a unique step in shifting industry dynamics to afford all future retirees, regardless of their employer size, the best opportunity that can make available under current laws, to maximize their retirement security.

Continuing to ignore or subsidize segments of the retirement plan industry operating in an inefficient market is unproductive. Plan sponsor inertia and diverse businesses needs for a range of retirement solutions will ensure that market opportunities will continue to support a wide range of retirement plan employers in the State. The State should move ahead with the proposal based on the fact that it could expand retirement plan coverage in the small employer market.

Monday, March 10, 2008

Selecting Investment Experts - I

Marc Faber, a noted investor, once remarked “Investors want to believe in an "expert", in the same way the sick will often believe in a faith healer. They want a clear opinion about the future direction of the investment markets, without any recognition of the fact that, at least 50% of the time, deference to such views will lead to significant losses, as, no matter how diligent we "experts" are, we nevertheless remain largely ignorant of the future.”

When investment fiduciaries select investment managers/funds for their portfolios they must address two essential questions. Can expertise in active investment management add consistent value to their portfolio and, if so, what recognizable characteristics can be used to identify that expertise?

Scientific research addressing these questions may help fiduciaries answer these questions. Time magazine ran a recent article The Science of Experience on the value of experience and expertise related to the presidential race. The article distilled the findings of research by Anders Ericsson, a 58-year-old psychology professor at Florida State University, and fellow researchers who have studied the question of what makes people really good at a given pursuit. Their studies have been published in The Cambridge Handbook of Expertise and Expert Performance. This reference is a compendium of studies from over scientists who have studied exceptional performance using scientific methods across a wide variety of domains which included stock picking. In reviewing other references to this topic here and here,the following general conclusions are made:
“The trait commonly call talent is highly overrated”
"Consistently and overwhelmingly, the evidence showed that experts are always made, not born”
“10 years is a necessary minimum to achieve expertise in most fields though it doesn't guarantee success”
"The number of years of experience in a domain is a poor predictor of attained performance."
“practice makes perfect …the amount and quality of practice were key factors in the level of expertise people achieved”
“when it comes to choosing a life path, you should do what you love — because if you don't love it, you are unlikely to work hard enough to get very good”
When it comes to stock-picking the general results may not be that surprising. “Ericsson notes that some entire classes of experts — for instance, those who pick stocks for a living — are barely better than novices".

A specific study on this topic The Enigma of Financial Expertise: Superior and Reproducible Investment Performance in Efficient Markets identified in the NY Times Freakanomics blog was authored by Ericsson, Patic Andersson and Ed Cokely. This study provides both good news and bad new for those who want to believe in investment experts. While there is clear evidence that investment skill exists within a subset of investment managers, the aggregate costs of investing overwhelm the aggregate value of investment expertise.
“Our review demonstrates reliable and reproducible effects of consistently superior performance in investment and forecasting even for markets that are consistent with the efficient market hypothesis (Fama, 1970, 1991). With the possible exception of the advantage of trading by insiders, the advantage offered by expert investors is too small to allow profitable transactions, yet sufficiently large to show reliable gross abnormal returns, before the costs of the transaction ( recently estimated at $100B across the market) are subtracted. From the point of view of expertise research we find that there are consistent individual differences among experts, with experts exhibiting specialization, and demonstrating superior and reproducible investment and forecasting performance.
In identifying investment expertise, the study suggests that specialization in particular industries, strategies or companies are correlated to superior investment performance.
“the superiority demonstrated by expert investors and analysts can be traced to deeper and more accurate knowledge about companies, a finding consistent with evidence from other domains of expertise like accounting and medicine. In fact, virtually all experts are remarkably specialized, such as scientists working on very constrained research problems, elite musicians only playing a limited repertoire on a single instrument, and expert athletes only excelling in one type of sport.
Specialization in particular industries and in-depth (insider) knowledge about specific companies would be recognizable markers related to reproducibly superior investment performance according to this work.

We will provide additional thoughts on the markers of investment expertise in a related post.

Monday, March 03, 2008

The 8% Solution

Let's say you are using an actuarial assumed return of about 8% for your pension plan... like many other plans in the US. Then, let's say your auditor asks you why?

Give them page 4 of this , not page 18 of this!