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Reish & Reicher, the Los Angeles law firm that specializes in employee benefits and ERISA issues, has issued a bulletin on target date funds, with comments on last month’s guidance on TDFs from the Securities and Exchange Commission and the Department of Labor.   

“We expect that the SEC proposals will be adopted much as proposed. We also expect that the DOL’s checklist and QDIA amendments will be consistent with the Bulletin and the SEC proposals,” the bulletin, from Fred Reish (pictured at left) and his associates, said.

“The initial effect should be to educate plan sponsors and participants about asset allocation, glide paths and target date differences. We believe the long-term effect will be that plan sponsors and advisers will focus on the needs and characteristics of the covered workforce and the design differences of TDFs.” 

Reish and Reicher recommended that plan sponsors protect themselves by asking:

• Is the TDF line- up designed to be aggressive, moderate or conservative? Is that appropriate for the particular workforce?
• Is it appropriate if most participants are defaulted (e.g., an automatically enrolled plan)?
• Does the glide path go “to retirement” or “through retirement?”
• If “through retirement,” are the participants aware that the plan sponsor made that decision for them?

“From a legal perspective, the critical point is that fiduciaries need to engage in a prudent—and documented—process to make each of those decisions. A prudent process can produce a range of acceptable decisions. The failure to engage in a prudent process is a fiduciary breach,” the attorneys said.

The SEC’s Proposals

In summarizing the government’s proposals for remedying the issues associated with target date funds, Reish & Reisher wrote:

• The SEC’s proposal would require marketing materials for a target date fund that includes the target date in its name to disclose the asset allocation of the fund among types of investments.

• The types of investments—such as equity securities, fixed income securities, or cash—would need to appear with the fund’s name the first time the fund’s name is used.

• The SEC’s proposal would require target date marketing materials to include a prominent table, chart, or graph that clearly depicts the asset allocations among types of investments over the entire life of the fund.

• These proposals would also require a statement:

• Explaining that asset allocation changes over time.
• Noting the asset allocation eventually becomes final and stops changing.
• Stating the number of years after the target date at which the asset allocation becomes final.
• Providing the final asset allocation.

• The SEC’s proposal would require target date marketing materials to include a statement informing the investor:

• To consider the investor’s risk tolerance, personal circumstances, and complete financial situation.
• That an investment in the fund is not guaranteed and it is possible to lose money by investing in the fund, including at and after the target date.
• Whether, and the extent to which, the intended percentage allocations may be modified without a shareholder vote.
• In addition, funds would be required to add a statement in their marketing materials warning that the funds come with risks and should not be chosen based solely on investors’ retirement dates.

• Further, the proposal would amend the commission’s antifraud guidance to state that marketing statements suggesting that investments can be chosen based on a single factor or that investments are simple and require no monitoring can be misleading.

Another perspective

Ron Surz, president of PPCA Inc. and Target Date Solutions in San Clemente, Calif., who has written about target date funds for this publication, commented in recent days on the Reish & Reicher bulletin. He suggested that, for fiduciaries, merely complying with proposed SEC guidelines won’t necessarily be enough to fulfill their responsibility to participants. 

“Much of [the bulletin] reads as if the regulators think plan participants are choosing target date funds, but they’re not. Even those who are not defaulted into target date funds do not really choose from among the various available target date funds. Their choice is limited to the funds that the sponsors make available to them, and this choice is, it would seem, typically made out of convenience,” Surz wrote in an email to RIJ and others.

“Fred’s concluding remarks, advocating a prudent process, assume the best from fiduciaries, which is the right thing to do although I think it’s more complicated than that.

“Here’s what I think is going on… TDFs are a Qualified Default Investment Alternative (QDIA). Plan sponsors think any QDIA is a safe harbor, so they’re all good—regulatory prudence. Or if they are concerned about picking a particular TDF, how can they go wrong with the name brands everyone else uses, like Fidelity, T. Rowe & Vanguard—procedural prudence. Also, Plan Sponsor magazine has determined that most plan sponsors base their TDF selection on their advisor’s recommendation—delegated prudence.

“But at the highest level either plan sponsors, or their consultants, but preferably both, need to care about substantive prudence—picking the best. Regulatory checklists and required fund disclosures may give fiduciaries pause and should encourage substantive prudence. In other words a prudent process will hopefully lead to enlightenment, but the process alone is no guarantee.”

© 2010 RIJ Publishing LLC. All rights reserved.

Back in the 1990s, when the first target date retirement funds were launched, I didn’t think they’d be a runaway success. Frankly, the concept smelled like a marketing gimmick. Brilliant, but reeking of gimmickry.

The decision-makers at the fund company in whose catacombs I worked at the time seemed to share my skepticism. Vanguard put more faith in its “life strategy” funds, a still-available stable of funds-of-funds that aimed for a target risk level, not a target retirement date.

Focusing on target-risk, I think may still be a more defensible idea than focusing on target-dates. As we have since learned, there is no magic in the target date concept. It was not a formal concept. It was not standardized. It had no track record to commend it. But it had much more sizzle than the target-risk concept.

I don’t have the mathematical or economic chops to tell you exactly why the TDF concept didn’t strike me as technically sound. But it seemed to resemble a blind form of market timing. Regardless of your thoughts on market timing, you must agree that it’s not pin-the-tail-on-the-donkey. 

Putting a date on a fund didn’t seem right. In my experience, the equities market doesn’t behave like a railroad line, with stations neatly placed five years apart. No conductor strides the aisle, shouting “New Rochelle” or “Rye” and reminding riders to gather up their bags. Only Social Security works that way.

In any case, the smarter investors don’t think of themselves as ticketed passengers on the market train. They think more like members of Butch Cassidy’s Hole in the Wall Gang, who arranged to jump on and off the train (with greenbacks and gold) while it was between stations.

Nonetheless, investors began pouring money into Fidelity’s (with all due respect) pioneering target date Freedom funds. Other fund companies, including Vanguard, soon introduced their own fleets of TDFs. The rest is history.

By enshrining TDFs as qualified default investment in qualified plans, the Pension Protection Act of 2006 introduced an element of moral hazard into the equation. The government stamp of approval, with no manufacturing standards attached, was an invitation for negligence if not abuse.    

The market crash of 2008 and 2009 demonstrated however that TDFs wore no clothes of invisible magic thread. But magic had been implied. Though fund managers may never have explicitly promised that TDFs were a panacea for retirement savers, many investors clearly believed (as Senate hearings last year revealed) that TDFs would provide them with a soft-landing into a pillowy retirement.

The very fact that the TDFs were dated fostered the belief that they would eliminate the terrible sequence risk that millions of people face as they approach the so-called retirement “red zone” and try to lock down a secure nest egg. That’s what made TDFs so successful. But the financial crisis showed that TDFs did no such thing.

Sure, TDFs rebounded in the past 12 months, along with other balanced funds. But they provided no special service to their owners (especially not to those who paid five percent loads when they bought them). 

Subsequently we witnessed the inevitable federal inquiry and now (see cover story) the inevitable proposals for new regulation. The regulations will undoubtedly lead to disclosures that nobody will bother to read and that future SEC commissioners won’t bother enforcing (other than to enforce the publication of the disclosures).  

I have no beef with financial innovation, as long as it doesn’t cost much. TDFs have generated lots of business for the funds industry. And they may eventually produce better outcomes for individual investors and plan participants than those folks would or could have achieved on their own.

But TDFs have always been more a sales strategy than an investment strategy, and we should recognize that.      

© 2010 RIJ Publishing LLC. All rights reserved. 

Perma-shills have been claiming of late that the stock market is now trading at an enticing valuation. Their main evidence for this, as they are fond to claim, is that the forward Price to earnings multiple is 12 times next year’s earnings for the S&P 500. And, of course, a 12 PE multiple makes stocks cheap and the overall market a buy.

But for investors who want to accurately assess that number, there are two issues they should be aware of. First, the PE ratio isn’t a good measure of the near term direction for the market. And second, nobody knows what the forward PE will actually be. Some pundits like to use that forward looking number because, when corporate earnings are projected to rise-as they almost always are-the PE ratio will look better.

So let’s get into some real numbers that will help determine if the market is indeed cheap.

For Q1 2010, the PE ratio on the reported trailing twelve month earnings for the S&P 500 is 15.5. Historically speaking, the average PE ratio on the S&P is about 15 times earnings. So therefore, if one isn’t promoting an ebullient guess as to what earnings will be in the future, the market is currently just fairly priced on a PE basis. Also, the PE ratio on an inflation adjusted average over the previous ten year period has ranged from 4.78 in December of 1920 to 44.2 in December of 1999. With such a wide range of valuations, it is difficult at best to make a case to buy or sell stocks solely on a PE basis. There are other factors like; the direction of inflation and interest rates that are necessary to consider when evaluating the PE ratio.

Some market cheerleaders also like to use the inverse of the PE ratio called the earnings yield when comparing stock prices to bonds. They say; with the current earnings yield being 6.4% and the Ten year note yielding around 3% that stocks are a great value. Again, there are problems here too. Firstly, investors don’t earn the earnings yield as they do with dividends. And as mentioned, the earnings yield is merely the reciprocal of the PE ratio. The fact that the yields on government bonds are significantly below the earnings yield on stocks is merely an indication of the egregiously overvalued state of the U.S. debt market.

Rather than pick one or two statistics like the forward PE ratio or the earnings yield to convey an opinion on stocks, here are several important facts that will help you decide the future direction of the market.

A good metric to determine the valuation of stocks is the dividend yield. The current dividend yield on the S&P is a paltry 2.1%. The historical average dividend yield is a much greater 4.36%. The lowest dividend yield was 1.11%, which was reached in August of 2000. The highest dividend yield was 13. 84%, this was achieved in June 1932. Therefore, on a dividend yield basis, the market is currently significantly overpriced. To add salt in the wound of those low yielding stocks, tax rates on dividends are scheduled to increase significantly in 2011. Maybe that is the reason why all the cash sitting idle on corporate balance sheets isn’t being sent back to investors in the form of dividends?

According to the Investment Company Institute, mutual fund cash levels are at a decade low. Cash levels as a percent of assets reached a cyclical high of 12% in 1991. Today, that ratio is less than 4%. With mutual funds already nearly fully invested where will the money come from to take stocks higher?

The Fed’s balance sheet is at a record high $2.3 trillion. The unwinding of that balance sheet will send interest rates on their $1.1 trillion In Mortgage Backed Securities (MBS) soaring and will thus further damage the real estate market, stifle earnings growth and depress GDP growth. The Fed must also find buyers for all that MBS debt. This will crowd out investments that would have normally been made into stocks.

Household debt and the Gross National debt have never been at or above 90% of GDP at the same time. For the first time in U.S. history, that is the case today. Along with the massive deleveraging that still lies ahead for both the public and private sectors, the Treasury must auction off close to $9 trillion in debt each year to cover our ballooning deficits and to satisfy rollovers. This will further crowd out investments that could have been better placed into the stock market.

Once you view the real numbers on PE ratios and dividend yields it is hard to make an argument that stocks are cheap. And given the low levels of cash that exist at mutual funds and the crowding out of private investments that is taking place from the government, investors will find it difficult to assume the market can produce a sustainable rally of any real significance.

The only disclaimer here is if the Fed embarks on another doubling of its balance sheet in an attempt to crush whatever life is left in the value of the U.S. dollar. Then, in that case the market may rally in nominal terms. But you had better own precious metals and the companies that pull the stuff out of the ground if you want to earn a positive return after inflation.

Michael Pento is Chief Economist for Delta Global Advisors and a columnist at greenfaucet.com.

© 2010 RIJ Publishing LLC. All rights reserved.

Here’s a well-kept secret: the Social Security Administration today offers one of the best investment options anywhere. This great deal allows individuals to add to the Social Security annuities that they already qualify for at age 62. Since the classic pension plans that used to provide workers with private annuity payments until death are fast disappearing, this option gets more valuable by the day.

This add-on, like the basic Social Security annuity, is as insured as an investment can get, doesn’t fluctuate with the stock market or economic downturns, and rises in value along with inflation. The rate of return is decent too.

So where’s the rub? This option is buried in Social Security’s overlapping and confusing provisions. That’s why so few people who could really use this extra protection end up understanding, much less buying, it.

My suggested reform: daylight this hidden concoction of provisions and convert it into an open, understandable, and far more flexible option. Doing so would favor saving and reward work while better preparing elderly people for their very high likelihood of living to age 80 and beyond. And it needn’t cost anything.

How? As part of a broader Social Security reform of the retirement age. Instead of confusing notions of early retirement at 62 and normal retirement at 66, surrounded by formal “earnings tests” and “delayed retirement credits,” adopt a simpler annuity option. (Stay tuned for some definitions of terms, but keep in mind that the very fact that most people misunderstand how all these provisions interact proves the need for reform.)

Under my plan, the Social Security Administration would simply tell people their benefit at a specific retirement age (either an earliest age or a “normal” age). Then it would show a simple set of penalties or bonuses for withdrawing money or depositing it with Social Security. It could fit on a postcard.

Although not essential, I would sweeten the deal for people who not only delay benefits but also work longer and pay extra taxes. With this additional option, the penalties would be higher and the bonuses greater for workers than nonworkers. For instance, the employee portion of Social Security tax could be credited as buying a higher annuity. These extra bonuses could be financed by making the up-front benefit available at the earliest retirement age a bit lower for higher-income beneficiaries who stop working as soon as possible. This combined strategy backloads benefits more to later years when people are older and frailer, and it encourages work—an approach I have advocated, as does Jed Graham in his recent book, A Well-Tailored Safety Net.

The simple, easily understood bonuses would basically be annuities with higher payouts than standard Social Security benefits. They could be purchased whether a worker quit work or not. As people can today, many would purchase these fortified annuities by forgoing all their Social Security checks for a while. But, unlike today, they could also specify how much of their Social Security check they would forgo or send a separate check to Social Security.

How would the poor fare under this new approach? To protect them, let’s increase minimum benefits under Social Security so most lower-income households end up with higher lifetime Social Security benefits—regardless of what other reforms may be undertaken. Say, for example, we accept the additional option of lowering the up-front benefit for those who totally stop work as soon as possible in their 60s by 10 percent but bump up a minimum benefit to $900. Then someone who used to get more than $1,000 could get less in those early years but has a great option for beefing up the annuity in later years. Someone formerly getting $1,000 or less would not lose out at all, even in early years of retirement.

Helpful employers (or 401(k) account managers, financial planners, or banks) could help workers take advantage of this great annuity option. As one example, they could easily map out a range of schedules for drawing down private assets or taking partial Social Security checks for a couple of years in exchange for better old-age protection—higher annual, inflation-adjusted payments—in later years.

Setting up a similar payout trade off today is sometimes possible if you’re not easily discouraged, but you wouldn’t get much credit for additional taxes. In fact, you can even send back Social Security money received in the past to boost future benefits. (Who knew?)

Too bad most people believe that if they hit age 62 in 2010, the “earnings test” they face is a “tax” up to the age 66 that reduces benefits by 50 cents for every extra dollar they earn between $14,160 and $37,680. But that’s what they think, and they calculate this “tax,” add it to their other tax burdens, and quickly decide that they’re better off retiring. Yet, that’s not really right. In truth, if they forgo some benefits now, they have just bought an additional annuity, and their future annual Social Security benefits go up permanently by roughly $67 for every $1,000 in Social Security benefits they temporarily forgo for one year.

Today, those age 66 to 70 have different options than when they were younger than 66. This only adds to the confusion. They no longer must purchase the annuity (face the earnings test) if they work, but they are free to take a delayed retirement credit—this time, $80 in every future year of retirement for each $1,000 of Social Security benefit forgone for one year . But they often don’t realize that they don’t need to start benefits at retirement. By living off other assets awhile, even a month or more, they can convert some of their riskier assets into a higher Social Security annuity asset.

Just to further complicate things, Social Security administrators often tell people to “get your money while the getting is good” when, in fact, it’s risky to draw down benefits too soon when one member of a typical couple is likely to live for 25 or 30 years after age 62.

The type of reform I’m proposing could never be timelier. Had more older individuals taken advantage of this simplified option before the stock market crashed, they’d be a lot more secure today. Similarly, folks retiring today with many of their assets tied up in either risky or very low return investments could sleep better if they take this option.

Why wait? Let’s redesign and simplify the Social Security super-structure surrounding retirement ages, related earnings tests, and delayed retirement credits. Let’s help more retirees build up additional annuity protection in old age, make more transparent the advantages of delaying benefits, reward better those who work longer and pay more taxes, and create simpler and more flexible options for depositing different sums of money to purchase larger annuities in Social Security.

The Government We Deserve is a periodic column on public policy by Eugene Steuerle, an Institute fellow and the Richard B. Fisher Chair at the nonpartisan Urban Institute. Steuerle is also a former deputy assistant secretary of the Treasury. The opinions are those of the author and do not necessarily reflect those of the Urban Institute, its trustees, or its sponsors. 

© 2010 RIJ Publishing LLC. All rights reserved.