Sunday, June 10, 2012

Winning Life with Your Retirement Capital

The greatest American horse race for three-year olds was run this past weekend, the Belmont Stakes.  As many of you may already know, I count my “misspent” youth learning to handicap (analyze) races; Belmont Park in suburban New York was one of my centers of learning. Shortly after the famed Secretariat won the race by 31 lengths and the Triple Crown in 1973, I started my firm, Lipper Analytical Services to apply some of the analytical lessons to the study of mutual funds. I was addicted to analyzing criteria to find winners.

A winning life

Some 39 years later, I realize that the process of developing a person’s retirement capital in part defines for an individual and his/her beneficiaries, whether or not one had a winning life. The accumulated retirement income in the senior portion of life will determine whether one is independent, a burden to family, a ward of the state or some combination of the three. Thus, I believe the production of retirement capital from which retirement income will flow is of critical importance to all individuals and to the society in which we live.

The defined benefit dilemma

Pension plans benefits are  obligations of the pension sponsor or employer. Obligations are treated as liabilities that are part of what the various credit rating agencies evaluate in making their credit ratings judgments. Lenders often use credit ratings to confirm their risk judgments. The level of risk is an important component in assigning an interest rate on current and future loans to the employer. Often the smaller the pension liability the lower the interest rate. Currently, employers with debt on their balance sheets may want to reduce the risks in their pension plans by favoring high quality fixed income with relatively short maturities as likely to decline the least of other investments in a down market. This judgment is based on the past and could very well be in complete opposition to a plan’s investment advisor who may believe this is the exact time to increase the plan's exposure to the risk of market forces. The dilemma for the employer is whether to rely on past history to reduce risk or to look at what appears to be an historic opportunity to buy stocks at what in the future would be recognized as great prices. My instinct is to go with the opportunity. This is not just because of my US Marine Corps training that the best defense is to attack, but also because I am familiar with another mathematically accurate analysis, utilizing "least  squares” procedures. 

"Least squares” analysis

Least squares analysis is a procedure that various analysts use to determine the best fit of a line that will be equidistant from a field of many different observation points. My concern today is that we are in a period of an unprecedented volume of inputs. I am aware that single or multiple extreme observations could for example, radically change the slope of the least squares line and produce a radically different expected growth rate. When we experience the unexpected, we are likely to experience even more unexpected results. For instance, older employees can, perhaps, take comfort from a conservative pension plan as the chances of getting the "promised" benefit is relatively good. Younger employees however might feel the opposite. Their pension provider may not have bought cheap growth assets when they were available. Thus in later years the employer may have to contribute more than normal amounts of money to offset their lower earlier returns. The question for these now aging employees becomes whether the employer can meet its pension obligations without starving the company’s future growth.

A rough rule of thumb for younger potential employees rating their future employer

I am going to suggest one analytical tool that might be used as a point of departure, though many may disagree with this approach. One of the ratios that is available on most defined benefit pension plans is the funded ratio of plan assets compared with the actuarial calculations as to what is owed over time. Many plan sponsors want to keep this ratio at or slightly below 80%. Above that level they lose some flexibility in meeting payments. A ratio below 70%, could cause credit ratings to drop. In a very simplified calculation, pension funds can show the amount of money invested in equities or other large risk featured investments. Particularly at this point of time when the stock market has been generally flat for more than ten years, sponsors who have an equity ratio approximately the same as their funding ratio are positively future oriented. They believe that they will experience growth. A risk ratio below their funding ratio suggests, perhaps for good reason, they are being cautious. Perhaps the real value of this rule of thumb is that in a second level discussion, it would show a serious interest in the long-term financial health of the prospective employer.

What choices should be included in defined contribution plans?

The various options offered in 401k, 403b, and 457 plans is something of a balancing act between paternalistic fiduciary views and the desire to let the individual saver choose from all available options permitted by various regulations. Most of the options offered come in a mutual fund format with two notable exceptions, directed brokerage accounts and various types of annuities.

The US Department of Labor has indicated the minimum of options to be offered to include a high quality, short-term fixed income fund that is often translated to be a money market mutual fund or a stable value fund. The minimum number of funds is four with at least one equity fund. At the other extreme, for awhile a number of plans offered over 200 funds from a number of providers. Studies have shown that too many choices confuse participants. Further, the history of plans is that most of the money is in relatively few funds. (I suggest that any fund that does not garner 5% of the money should be a candidate for being dropped.) Each of my plan clients is different due to the beliefs of the sponsor and the perceived needs and general investment sophistication of the workforce. In a generic sense my approach is to start with the oldest type of fund, a balanced fund, with stocks as the majority asset class and fixed income for the remainder. This fund should be used as the default alternative. Some may suggest to use target date funds for this need. My problem with these vehicles is not with their portfolios, but based on studies too many of target date fund investors don't fully understand them. If there is an effective individual advisory function at work, target date funds could be added to a moderately large list. I would like to have at least two fixed income funds, both high quality and preferably US Treasury-oriented, one short-term and one intermediate.  In addition I would add a TIPS fund. In terms of equity funds I would include a Large cap and a Small cap fund with at least one of them focused on growth. A stocking-picking fund without constraints would be a nice addition. Notice I did not label the choices as domestic or international or manager-selected global funds. These are becoming less distinctive as choices today.

Investors should have their own individual investment accounts

There are two reasons for this belief. First and foremost, the individual account can select when to accept tax consequence transactions and, at least for now, gains will be taxed at the tax advantaged capital gains rate rather than the ordinary rate that will be due when the withdrawal period begins from these savings plans. Second some of the product line extensions that I do not feel are appropriate for these fiduciary savings plans, could well be useful in an individual's own account.

Using leading equity funds

Many individuals avoid funds with large unrealized capital gains for their taxable investment accounts. In my new Reuters column,  I recently asked whether there is a penalty box for funds that have had great long-term investment performance.  The answer may have some relevance for investors and beneficiaries of retirement income.
What are your reactions?

How are you planning to overcome your retirement capital concerns?
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