Archives: Articles

Paul Krugman, the Nobel laureate, Princeton economist and controversial New York Times columnist, revealed in a recent magazine profile that he and his wife liquidated their stocks ten years ago and now invest only in bonds or cash.

“It just takes a lot of work to think about it,” Krugman told an interviewer, “and at no point—except maybe early 2009, if I’d been really feeling daring, stocks really did look cheap.”

“We bought a couple of things,” [his wife, Robin] Wells said. “We bought muni bonds and some Ford Motor bonds. The thing is, if you look at it on a historical basis, even back in the two-thousands, stocks are not cheap.”

They may be selling themselves short. Someone like Krugman, a tenured professor in his mid-50s with a secure, “bond-like” income, might be wiser to balance out his personal “balance sheet” by diversifying into stocks.

Indeed, investors and their financial advisors risk missing half the picture if they limit their planning decisions to the familiar but narrow mixture of stocks, bonds and other financial assets that are in conventional investment portfolios.

Holistic approach
Instead, they should approach their finances more holistically, says Peng Chen, president of Ibbotson Associates. They should be thinking in terms of individual or household “balance sheets.”

Advertisement
How is a balance sheet different from a portfolio? As Chen explained in a presentation at the Morningstar/Ibbotson conference in Orlando last week, an individual balance sheet includes one’s human capital.

Human capital, as opposed to financial capital, consists of the present value of future earnings, the present value of future savings, and even the present value of Social Security and anticipated pensions.

“It’s the largest and most illiquid asset that people have,” Chen said. “It’s based on age and occupation. And, as you go through different life stages, it influences your investment decisions.”

Only when these assets are listed on an individual balance sheet, alongside liabilities like the present value of pre- and post-retirement expenses, is it possible to answer questions like: How much should I allocate to stocks and bonds? How much life insurance do I need? Should I buy a guaranteed retirement income?

One of the principal rewards of this approach is the realization that some human capital (like Prof. Krugman’s) is more predictable than others (like a real estate agent’s or a stockbroker’s).

That leads to the somewhat counter-intuitive insight that a person who chooses a low-volatility career in academics should go farther out on the limb of the efficient frontier than a real estate agent, who might have a natural appetite for risk.

Depending on his or her occupation, a person’s answers on a risk assessment questionnaire, if based solely on emotion or temperament, might lead an advisor to assign that individual an overly risky or overly conservative asset allocation.

Putting the present value of human capital and personal expenses at the center of the financial planning process, rather than at the periphery, leads to other insights as well, Chen pointed out.

Guaranteed products
By defining expected income and expenses, both before and during retirement, it helps people determine how much life insurance they should buy during their working years and how large an annuity they might need during retirement.

Chen also demonstrated that retirement requires a new way of thinking about the traditional efficient frontier of investments. In retirement, the efficient frontier chart must incorporate considerations like how much income the retirees will need, how much risk of an income shortfall they can tolerate, and whether they want to plan for a 20-year or a 30-year retirement.

For instance, a 20% equity, 80% bond portfolio might easily produce 20 years of adequate income, but not be as reliable over 30 years. Guaranteed products, such as immediate annuities or deferred variable annuities with lifetime income benefits, might be too conservative for a 20-year retirement, but essential for a 30-year retirement.

“Longevity risk is the biggest fat tail for individual investors to manage during retirement,” Chen said. “If you’re planning for 30 years, it would be foolish not to be looking at [annuities].”

Human capital has been the subject of research papers by Chen, Moshe Milevsky of York University and others in recent years. It is also the central theme of Milevsky’s book, Are You a Stock or a Bond: Create Your Own Pension Plan for a Secure Financial Future (FT Press, 2009).

© 2010 RIJ Publishing. All rights reserved.

Illiquidity was a prime suspect in the recent financial crisis. So it was curious to hear someone praise the virtue of illiquidity at the annual Morningstar/Ibbotson Conference in Orlando last week.

But when Roger Ibbotson talks, people listen.

The Yale School of Management professor, who founded the research firm of Ibbotson Associates in 1977 (and sold it to Morningstar Inc. in 2006), also has a nine-year-old hedge fund, Zebra Capital. One of its raison d’êtres: to exploit the “illiquidity discount.”

“We short all the exciting stocks,” the lanky, 66-year-old Ibbotson joked as he described Zebra’s preference for stocks with healthy earnings but very low trading volume and low prices.

Illiquidity, either in stocks or in bonds, should be viewed as an investment style distinct from capitalization, value/growth, maturity or credit risk, he said in plugging the Milford, Conn.-based Zebra Capital’s services.

Overlapping with the universe of alternative investments, these low-turnover assets include private real estate, distressed debt, hedged equity, natural resources, commodities, private capital and emerging market equities, Ibbotson said.

“Liquidity seems to have an impact on realized and expected returns across all types of securities and across all locations,” Ibbotson and Yale colleague Zhiwu Chen wrote in a June 2008 paper, “Liquidity as an Investment Style.”

Advertisement “Liquidity is valuable in any security, and the market seems to be willing to pay a high price for it,” they wrote. “Correspondingly, the market accepts a lower return for liquidity. Liquidity seems to be an investment style that is different from size or value. This result seems to hold up in almost any equity market subset and in any location.”

The flipside of the illiquidity discount is the liquidity premium. That is, investors are generally willing to pay more for a stock or bond that, for one reason or another, offers the kind of liquidity reflected in high-volume trading.

For any given size or style, the more illiquid the stock, the higher its historical (1972 to 2009) compound annual return, Zebra Capital’s research shows. Even among value stocks and small-cap stocks, the illiquidity discount appears to boost performance by an extra point or two. (See Data Connection on today’s homepage.)

Over those 37 years, for instance, the least liquid of the smallest small-cap stocks outperformed the most liquid, 17.87% to 5.92%. The least liquid of the largest large-cap stocks outperformed the most liquid, 12.29% to 9.46%.

Looking at value vs. growth stocks, the least liquid of the value stocks outperformed the most liquid, 20.63% to 12.33%, and the least liquid growth stocks outperformed the most liquid, 11.36% to 3.32%.

While high liquidity small-cap stocks underperformed high liquidity large cap stocks, 5.52% to 9.46%, high liquidity value stocks outperformed high liquidity growth stocks, 12.33% to 3.32%.

(Data showing whether or not these relationships held true during time periods smaller than 37 years was not immediately available.)

Much of Ibbotson’s talk was aimed at explaining portfolio behavior in the financial crisis. Contrary to conventional wisdom, he said, diversification in stocks and bonds worked during the crash—it just didn’t work as well as people expected it to. But a mix of stocks and bonds offered significant portfolio protections, as expected. “Stocks and bonds are great diversifiers,” he said.

Diversification within asset classes doesn’t work as well as most people assume, Ibbotson said. Many investors still misinterpret the famous 1986 Gary Brinson study on variations in pension fund returns to mean that differences in asset allocation account for 90% of portfolio returns.

In reality, systematic risk (also known as market risk, aggregate risk or un-diversifiable risk) accounts for as much as 70% of a portfolio’s returns, he said. Asset allocation, as commonly understood, accounts for only about 16% of returns.

“People don’t understand that diversification doesn’t take away the 70% caused by the market,” Ibbotson said. “That’s why they’re asking, ‘Why didn’t diversification work in 2008?’”

© 2010 RIJ Publishing. All rights reserved.

More than a year after suspending the Bush-era proposals for regulating investment advice in employer-sponsored retirement plans under the Pension Protection Act of 2006, the Obama Department of Labor has proposed its own regulations.   

Under the new proposed regulations, “Investment Advice—Participants and Beneficiaries,” plan participants may receive investment advice only from an advisor who is compensated on a “level-fee” basis. If the adviser uses a computer model to generate advice, the model must be “certified as unbiased.” 

The main difference between the Bush and Obama regulations would probably be too subtle for most laymen to detect. But it is expected to make a significant difference in determining who can furnish advice and who can’t.    

The two versions agree that a fund company investment advisor, for instance, who is hired by a plan sponsor to educate 401(k) participants, must be paid the same no matter which fund options he or she recommends to the employee. 

 The Bush proposal, however, exempts the advisor’s manager or broker-dealer from that restriction, so that the advisor could in practice recommend one of his employer’s funds over a competitor’s without breaking the law. The Obama proposal removes that exemption. 

Advertisement Without the exemption, it is expected to be more difficult for financial services companies, or their affiliates or the affiliates’ employees, to promote their products in the workplace. It could also conceivably hurt their strategic efforts to attract 401(k) rollover money to their firms when employees retire or change jobs.

The securities industry, which lobbied for the exemption during the Bush administration, has already voiced its displeasure at the prospect of losing the exemption.   

“We are disappointed the Department of Labor decided to move in this direction after having withdrawn the previous final regulations and class exemption,” said Elizabeth Varley, managing director, government affairs, at the Securities Industry and Financial Markets Association, or SIFMA, on February 26.

“The proposed regulation, if approved, will do little to expand American’s access to investment advice. Americans are seeking the best paths to saving and investing for their retirement and deserve rules that allow them to do so. Today’s move by [the Department of] Labor will hurt participants and investors, not help,” she added.

Attorney Jason C. Roberts, a benefits specialist at the Los Angeles law firm of Reish & Reicher, has written about the two sets of proposals. He described a scenario where the exemption might make a big difference to a fund company. 

“Let’s say you’re an XYZ fund company investment advisor getting paid a level compensation for running a participant’s data through a computer model. Under the exemption, if the computer recommends an ABC fund, you could easily venture away from the model, recommend an XYZ fund instead, and document the reason in some way,” Roberts said.

In another scenario, he said, an RIA (registered investment advisor) with a pension consulting service whose broker-dealer is owned by a specific financial services company might, under cover of the exemption, recommend plan options that would benefit the larger company without benefiting him directly. 

“There was a big push for this on the lobbying front by the conflicted companies,” he told RIJ, meaning companies facing potential conflicts of interest as providers of advice for plan participants.

“Under the Bush proposal, you would have seen a whole wave of players with conflicts of interest coming into the [401(k) advice] market. Anybody could see that the original proposal would not have been sufficient to prevent that. Now we’re seeing a paring back of that.”

Democrats have opposed the exemption from the moment—the Bush administration’s last day in office—when it was proposed. “Congressman George Miller (D-CA), Chairman of the House Education and Labor Committee, and Congressman Rob Andrews (D-NJ), immediately preceding publication of the final rule, stated that they would ‘use every tool at [their] disposal to block the implementation [of the regulation],’” Roberts wrote on his blog last year. 

“The issue with the broker-dealer ‘level fee’ consideration dealt with the affiliated firms of the advisor. In January of 2009, the DoL proposed that only the advisor was required to maintain a level fee arrangement, not the firms in which he/she was affiliated,” said Chad Griffeth, AIF, president of BeManaged, a plan sponsor advisor in Grand Rapids, Mi.  

“The concern created was: Where would the advisor be receiving the analytics and research for delivering advice to 401(k) investors? Probably from the affiliated firms, serving as the ‘back office.

“Hence, the potential was there for broker dealers, mutual fund companies, and insurance companies to create a ‘puppeteer’ effect, holding the advisor out to deliver level-fee advice while providing support/asset allocation services that benefited the firms potentially more than the participants,” Griffeth added.

In another provision, the new proposal restricts the use of historical performance of funds within a single asset class as a basis for recommending one fund over another, because performance is “a factor that cannot confidently be expected to persist in the future,” the Department of Labor wrote. It acknowledges, however, that different asset classes may have persistent differences in returns.  

The regulation contains a number of other safeguards against conflicts of interest, including:   

• Requiring that a plan fiduciary (independent of the investment adviser or its affiliates) select the computer model or fee leveling investment advice arrangement.
• Requiring that computer models must be certified in advance as unbiased and meeting the exemption’s requirements by an independent expert.
• Establishing qualifications and a selection process for the investment expert who must perform the above certification.
• Clarifying that the fee-leveling requirements do not permit investment advisers (including its employees) to receive compensation from affiliates on the basis of their recommendations.
• Establishing an annual audit of investment advice arrangements, including the requirement that the auditor be independent from the investment advice provider.
• Requiring disclosures by advisers to plan participants.

© 2010 RIJ Publishing. All rights reserved.

“Keep your hands off our 401(k)s!”

That’s how Americans are responding so far to the RIF (request for information) about lifetime income options for 401(k) plans that the Departments of Treasury and Labor published in the Federal Register at the beginning of February.

But by March 1, only 48 comments were posted at www.regulations.gov (Docket ID IRS-2010-0006) so it’s hard to say to what extent the responses were representative.

So far, no insurance companies or mutual fund providers had submitted their views. Companies that already offer in-plan annuities—MetLife, Prudential, and Genworth Financial, for instance—would be logical contributors.

Not all the comments were written in anger. Many were polite and well reasoned. Two or three even came from professionals, such as a plan sponsor and a financial advisor. But most of them seemed to reflect the latest strain of Tea Party populism.

Judging only by the first four dozen comments, many Americans apparently suspect that the Obama administration plans to confiscate 401(k) assets and somehow use the money to pay its bills, offering nothing but an unfunded promise of lifetime income in return.

Advertisement No shortage of anger
Two of the earliest comments to the RIF reflected the frustration and anger that so many Americans seem to feel these days:

“If this passes I will halt all contributions and close [my 401(k)] account with penalty. If I wanted Government bonds I’d buy them. You can thank Ben Bernanke and Tim Geithner for people not wanting the bonds.

“There’s a reason that the yield curve is steep and the short-term bonds keep going into negative yields, people don’t believe the government can fulfill its long term obligations. Cut the spending, cut the deficit and keep your hands out of our 401(k)!”

Here’s another in a similar vein:

“No, I’m not interested or willing to participate in any plan that would give the government control of my IRA, 401k, etc. in order to help offset the current administration’s deficit spending.

“I didn’t contribute funds to my retirement just to have them zapped away by the current group of profligate politicians and others on a wild spending spree, leaving me nothing for my old age…  I just don’t see how anyone could support it.”

Balances not big enough
Not all of the contributors were so incensed. A more deliberate contributor pointed out that most people can’t afford a decent annuity:

“It’s disappointing to see the DoL get involved in a vendor-driven product. The last vendor-driven initiative taken up by the DoL—the target date fund—had disastrous results in rewarding millions in fees to [a] very small group of mutual fund advisors.

“The annuity initiative seems to be a way for insurance companies to take their turn at the fee trough. The DoL seems to be buying the spin fed to them by the insurance companies that participants are somehow not given the option to purchase an annuity.

“The data is clear: people do not want annuities. People have three good reasons to avoid annuities:

1. 401(k) balances averaging $30,000 provide small annuities (around $2,000 yr) not worth the trouble.

2. All annuities force single entity credit risk (think AIG).

3. Excessive hidden fees. The big gorilla in the room is too small of balances. Let’s say to provide a typical DB pension of $30,000 a year you need a 401(k) balance of nearly $400,000. With an average balance in the $30,000 range and the vast majority under $100,000 even the best-constructed annuities would fall way short.

“With high unemployment causing leakage in loans and cashing out, 401(k) balances are growing very slowly. Almost all current annuities force participants to take single entity credit risk.

“If DOL pushes this option does this imply a government guarantee making all annuity providers? Too Big to Fail? Currently there is significant credit risk in all annuity providers as indicated by bond spreads. Annuities are currently regulated by State Insurance Commissioners. Providers flock to states with the most lax regulation.

“DOL should think long and hard before pushing participants into risky products that the government may have to bail out later.”

‘First, do no harm’
But others brought a more informed perspective to the discussion. James Hardy of Tacit Knowledge, a San Francisco software company, warned about the dangers of mandatory annuitization:

“As the plan sponsor/trustee for a 401(k) plan, I think having some form of annuitization available to plan participants would be nice and would make sense for some, some of the time (as with any investment choice).

“However, and I want to make this very clear—any annuitization option should not be mandatory, and it must not be conflated with safe harbor rules on default enrollment such that people are unknowingly forced into irreversible investment options when they are potentially not paying attention.

“Making any annuitization option mandatory or making it the only safe harbor choice for default enrollment of new hires would remove choice, possibly cause loss/hardship if the funds were needed and thus potentially violate the ‘first, do no harm’ ethos a plan sponsor choosing default options should have.”

Teach financial literacy
A financial advisor who described himself only as “David” pointed out that America needs more self-reliance, supported by financial education:

“I have been in the business of advising individuals and business owners about retirement planning for 24 years… Defined contribution plan participants already have plenty of lifetime income options available, and the burden of federal regulation on plan sponsors is a significant disincentive to employers to offer a retirement plan for their employees.

“The need that is not being adequately addressed is the need to accept responsibility for one’s own financial security, rather than depending on an employer, the governme nt or the public. People need more education, beginning in elementary school, of the need to spend less and save more, and how to invest wisely for the long term… Let’s put our energy and resources into educating the public.”

A lack of inflation-protection
A contributor identified as “DM” also tried to be constructive:

“Annuities are an excellent option. They provide lifetime income and allow individuals to determine how much they need to save to achieve a desired monthly income. States also provide protection, within limits, for this type of insurance. Consequently, this may require the use of multiple insurance companies to achieve an individual’s goal and, at the same time, protect the money invested in the policy.

“The downside is the lack of reasonably-priced inflation protection. Although available, it is too expensive to be practical. If more individuals were involved in the purchasing pool and the price came down, this would make a lifetime annuity even more attractive. Once the monthly income goal is achieved, it would provide piece of mind and limit the temptation to choose a risky alternative.”

Reduce taxes
Peter Bowler, writing from Akron, Ohio, suggested that an exemption from taxes would make annuities more attractive:

“Although I could support the idea of adding annuity choices to 401(k) plans, it is not any sort of final solution to the retirement income problem. What would be more helpful would be a reduction in taxes owed on distributions of all kinds that would preserve more of the capital so hard won over the years.”

Stop the export of U.S. jobs
David Young, no address given, answered four of the 39 questions posed by the Labor and Treasury Departments, then offered some direct observations related to the macroeconomic outlook:

“Question 1: Payments must be indexed to inflation (i.e., maintain constant purchasing power over time).

“Question 2: My strongest concerns are conversion cost (i.e., converting to an annuity in a low interest rate environment), plan fees and counterparty risk. Are there steps that [federal] agencies could or should take to overcome at least some of the concerns that keep plan participants from requesting or electing lifetime income? Other than leaning on the Fed to stop holding interest rates artificially low, I can’t think of anything.

“Question 8: Plan sponsors can vet potential annuity providers before offering their products to employees. This may give employees greater confidence in a particular annuity seller and their products.

“Question 13: Should some form of lifetime income distribution option be required for defined contribution plans (in addition to money purchase pension plans)?

“Yes; however, whatever action is taken with respect to offering a lifetime income option, it must remain just that-an option. There should be no conversion requirement imposed on defined contribution plan participants.

“If so, should that option be the default distribution option, and should it apply to the entire account balance? No, it should not be the default option and it should not apply to the entire balance.

“To what extent would such a requirement encourage or discourage plan sponsorship? I think offering the option, and associated plan communications about this option to employees, would be sufficient.

“General Comments:

1) The retirement security of all workers would be enhanced if government policy did not facilitate the export of U.S. jobs. A start would be to address the mercantilist polices of our East Asia trading partners.

2) ‘Good jobs provide wages that support families, and rise with time and productivity.’ Odd; productivity has risen over past 10 to 20 years with no appreciable increase in inflation-adjusted wages. Perhaps DoL and Treasury should examine why this has occurred.

3) The Department of the Treasury could promote economic growth, stability, and economic security by stopping the direct and indirect bailouts of insolvent financial institutions.

© 2010 RIJ Publishing. All rights reserved.