Fiduciaries, Expenses, ETFs and Timespans

Introduction

Apparently the favorite interview press query at the Academy Awards is “what are you wearing?” The answer, according to script is the designer’s name. However, this is an incomplete description of the garment. The question and answer works in a sound bite commercial world for some but does not tell us anything as to the talent of the actress (or actor), the role portrayed, and most importantly how the performance worked. This is an example as to how we use labels to convey a familiarity of topic knowledge and “being in the know” exclusivity. The media, government agencies, and some investors also use labels in the same way and these could be traps in terms of making sound long-term investment decisions.

Fiduciary

This week the US Department of Labor produced a 208 page document which I actually read. The full title is “Fiduciary”; Conflict of Interest Rule - Retirement Investment Advice. In brief summary the document mostly discusses the appropriate disclosure of compensation arrangements by various investment intermediaries. As both a registered investment advisor and an employer of other fiduciaries, I read this as a cynical document. One of the definitions of a cynic is that he or she knows the price of everything and the value of nothing.

The investment process at the professional level is long and often difficult in terms of coming to present conclusions from past performance and the surrounding analysis. (It is worthwhile that the Securities and Exchange Commission requires a cautionary statement to be appended to investment performance claims that past performance does not guaranty future performance.) I am sympathetic to the government’s desire to help investors, in particular ones investing for retirement. They believe that disclosing various ways that the investment system has found to receive compensation is useful. This is like the true statement that at some future point we all will meet our maker.

The real problem is that the professional community has been unable to fully identify the system-wide cost of investing, from securing a relationship, lifetime training and servicing, all of the administrative expenses including legal and tax professionals, as well some recognition of the standby costs to have these services available for when they are needed. In aggregate, I don’t know  what the real costs are. 

For many individuals the biggest single investment in their lifetime is the purchase of a home. Before the pressure of competitive pricing, the “going in” costs are quoted at 6% + closing costs. (I have often said “protect me from a ready to move-in house.” Within the first couple years of ownership perhaps another 10% or more may be spent converting the home to what we really want.) Thus realistically I view the true cost of a new home as the transaction price plus 10-20% a few years out. I suggest that the true cost of the time and efforts of all professionals dealing with your retirement capital is probably in the same order of magnitude on a much larger amount.

With the exception of performance fees, no one attempts to recapture these kinds of costs on the surface when investing retirement money. This does not mean that these service provider costs are not there or that they are a great deal lower than residential real estate transaction costs. Traditionally the investment community has recognized that there was a customer barrier to charging up front the lifetime expenses of a transaction. Thus, the favored way to earn compensation is first to receive annual payments which if the accounts stay with them long enough; e.g., 10-20 years, payments may reach equivalent to residential real estate expenses. The second way is to have many more transactions than the average real estate broker, which in turn probably means a significant increase in marketing costs.

The hope of the financial community is that investing for an individual’s retirement is a long-term effort and can receive periodic payments to make the effort worthwhile. Getting back to the cynic (who similar to the Department of Labor, is focusing on price disclosure) like many in the investment community wants to be paid on the basis of value received. Financial professionals have not been very good at demonstrating the value received beyond relatively few performance fee contracts which often are counterproductive by emphasizing shorter term performance. Without this ability, all too often the investment community charges relatively nominal amounts on the surface and has found methods to get additional compensation other ways. The DoL wants these to be fully disclosed. Good luck. The hope is that analyzing fully identified expenses will become the model of retirement investing behavior.

As a continuing student of investing and the investment communities, I think there is a substantial chance that when one restricts the price of a service the value provided in that service declines. What may happen is that instead of the title of fiduciary being something of an honorific, it will identify those that can’t make enough money by being good investors. If there is any chance that I am correct, those with small amounts, albeit growing, of retirement capital will find it difficult to get a high level of service. (Under these conditions some employer-sponsored savings plans; e.g., 401(k), 403b, and 457 plans may be modified to accept additional investments from existing and retired employees who will be able to keep their retirement capital relatively safe within their plans for their lifetimes. We would be interested in working with them on that prospect.) 

Exchange Traded Funds (ETFs)

Many people throw around this term, but don’t understand the differences between these vehicles. Most of the money in ETFs is in beta-matching products attempting to replicate various published indices. These indices were never designed to be prudent portfolios or to  meet specific investment needs. A smaller group (in terms of assets) but much larger in terms of numbers of funds are indexed to various sectors or in some cases to various investment factors. These presuppose that the creators of these profits selected correctly those stocks (or in some cases bonds) that will now and in the future capture the essence of the sector or factor. I question whether anyone can predict the future well enough to lock into future investments. Finally there are ETFs and ETNs (Exchange Traded Notes) that are “super-securities” used as a way to capture the general movement of items that don’t trade frequently or have enough liquidity; for example bonds of various qualities and duration, very small companies, emerging market securities, and commodities. As one can easily see, each different type of ETF or ETN is sufficiently different that labeling the same thing can be misleading. At some future date I will discuss the practice of managing accounts exclusively with these products.

TIMESPAN L Portfolios

          Regular readers of this blog are aware of my TIMESPAN L Portfolios^®.  A unique benefit of this construct is its ability to enable the management of capital through single-purpose beneficiary portfolios that allocate investments over specific timeframes and risk tolerances.  TIMESPAN L Portfolios can be a suitable strategy for defined contribution retirement plans, non-profit organizations and family wealth. 

          A visual example and description of TIMESPAN L Portfolios is available in hard-copy.  Qualified institutional investors: Please send me your mailing address and a brief description of your interest to aml@lipperadvising.com .

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Labor Activity Needs Protection

Introduction

The nature of humans is to labor to make better and safer lives for themselves and their families. The unfortunate image coming out of today’s school systems and many of its union-dominated teachers is that manual labor and skilled labor by employees is to be celebrated only on Labor Day in the US and similar holidays elsewhere.

I see labor all around. Certainly the homemaker producing meals, keeping house, and often serving as the household purchasing agent is laboring. Laboring also are the portfolio managers who are acting, along with others, as stewards for the retirement funding of employees. Many of these put in more hours than some that are punching a time clock or equivalent.

On Labor Day 2014, I think we should be thinking about how to make all that labor a better value. At the first level we should see how to improve unemployment and under-employment. At the next level we should be paying attention to retirement funding. Finally, almost all laborers desire to take care of beneficiaries after they are gone. This post will share some of my own thoughts on each of these topics.

Mismatched openings and job seekers

As someone who speaks with various employers and particularly entrepreneurs about their future progress, I often learn about the need to fill particular positions within their organizations. Often they cannot fill existing (or more importantly new positions) not because applicants don’t have the required skills. If the employment decision was left to a computer match procedure, it is estimated that all or almost all the roughly four million job openings would be filled very quickly. But that is not the case when are faced with hiring fellow humans.

I don’t know where so many of these applicants get their work-related attitudes; whether from their families, friends, or their teachers. The first hurdle is that the world or others owe them a job. The second is that they have pre-conceived notions as to the conditions of employment which they think they should dictate. In many cases they do not grasp how a commercial organization functions to provide what the clients expect and need. Too often they anticipate that their co-workers will make room for them and coach them on the first day as to how the work and social elements really work.

I believe that everyone within an organization is a salesperson meant to convince every contact that his or her firm is absolutely the best organization to meet people’s needs. We are all involved with sales and service. People who want to join a firm need to feel loyalty to the firm, its customers, managers, and fellow employees. The sad truth is that there is not enough of these people, thus a number of the openings will not be filled.

The cost of vacant jobs

The economic and financial impacts of not filling the vacancies are significant. As long as people are unemployed the cost to the society will be high in terms of taxes paid and more significantly a shortfall in consumer purchases. There are also, at this time, important investment implications to the unfilled openings. Organizations will not be operating at optimum productivity levels. Profit margins will be less than what they could have been. Today there is concern that profit margins, not profits, have reached record levels. If these slip, even with higher sales generated profits, the valuation afforded these stocks will decline, as they will be viewed as more cyclical and thus could lose their place in some portfolios.

Profit margins are under pressure in numerous employers and particularly in health and financially oriented concerns today. Due to increases in compliance and supervisory responsibilities, companies are being forced to hire good but unproductive people in terms of bringing in more sales. This is hurting existing margins. When we combine these pressures with much more restrictive activities mandated for the financial community the results are significant layoffs at numerous banks and other financial firms. Major clients are already seeing a decline in the levels of service and supervision. I suspect that this trend will continue unless there are major changes in regulation.

Retirement funding awareness

One of the potentially major upticks for labor in the US is the ability to influence its own retirement funding. The switch to Defined Contribution plans from Defined Benefit plans can produce a retirement account that more closely represents what the specific employee wants from the available alternative options rather than being bundled with all other employees. The various 401(K), 403b and 457 plans leave the responsibility of choice to the individual. These plans need to be carefully constructed in terms of levels of contributions, matches, vesting, fees and expenses.

I am pleased that according to BrightScope, the Number One plan based on these characteristics in 2013 was the Second Career Savings Plan for the National Football League and the NFL Players Association that I have advised as to the construction of nine specific fund accounts.

The reason for the nine accounts was to allow the Players to decide how they wanted their money to be invested, in a collection of mutual funds or separately managed accounts that generally clone their advisor’s funds. Other retirement accounts that we manage are customized to the needs of the employee base. However, all investors including retirement plans are exposed to both stock and bond markets. With that thought in mind, we all should ask whether there are parallels between Labor Day 2014 and Labor Day 1929.

As was noted in The Wall Street Journal, both days had just past the 2000^th day of a bull market. In the case of the earlier market it continued to rise in September and started its cataclysmic decline in October 1929 to recover in December but the damage had been done to the confidence in the market and eventually the economy.

Should employees and other investors totally jump out of the market with the belief that they will jump back in at materially lower prices?

The great portfolio manager, Peter Lynch, who built such a great record at Fidelity, is quoted as saying that more has been lost by investors trying to execute such a maneuver than the size of the losses at the bottom. In addition, I would be particularly careful investing substantially in high quality bonds now. Instead of celebrating that the purchasing power of bonds is now stable to perhaps rising which will help the long punished retirees, the central banks such as the Federal Reserve, the European Central Bank, the Bank of England and the Bank of Japan are very much interested in raising the rate of inflation to spur more risky investment as a way to create jobs. If they are successful, the purchasing power of bond principal and interest will decline. Based on their past record they may not be successful.

Helping beneficiaries

All of us who are looking to the future for the benefit of families and others such as universities, hospitals, and other non-profit groups need to invest over multiple time spans. In prior posts I have discussed our Lipper Time Span Fund Portfolios which are designed to meet the different needs of beneficiaries. With the measurable possibility of a significant market decline sometime in the next five years we have created a Replenishment Fund Portfolio concept (REPPORT) to replenish the capital that will be spent over the next two years to meet operating needs by the Operations Fund (OPPORT).

The Replenishment Portfolio probably has a mixture of equities and fixed income funds or securities with a maturity of five or fewer years. With the recognized risk of a significant decline and Peter Lynch’s warning, a conservative approach is warranted. At this point I would select funds that invest in companies that have relatively little debt but compared to others have high returns on assets, equity, and invested capital.

At the other extreme in terms of time spans, the Legacy Fund Portfolio should be looking into funds that invest in companies that are spending wisely in research and development plus intelligent brand building. If these companies do spend wisely they will be creating the kind of unassailable position often called the protective moat. At that point they should be producing substantial excess capital, fulfilling Warren Buffett’s favorite structure of a company that has both a moat and a fortress. On the way their financial ratios are unlikely to match those found in the Replenishment Portfolio.

Question of the Week:

 

Where and how are you finding new good people to hire?
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Copyright © 2008 - 2014

A. Michael Lipper, C.F.A.,
All Rights Reserved.
Contact author for limited redistribution permission.

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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No Guarantees in Fiat Currencies or Retirement

One of our younger relatives told my wife and me years ago that he couldn’t settle down because he had “too many questions in his head.”  Unknowingly he repeated what market sages for years have stated, that the market needs “certainty.”  Thus both the young and the wise are grappling with an unknown and perhaps more correctly, an unknowable future.

To answer our basic concerns, the strongest human marketing powers in business, government, science, and religion have repeatedly provided generally accepted guarantees that answer our concerns. During the current period of global neurotic economic stress, one wonders whether the title of Andy Grove’s book, “Only the Paranoid Survive”  is relevant. I am suggesting that as with all well-marketed messages, guarantees provide necessary comfort, but they may not be complete in each individual case. Given the uncertainties facing the modern world, the backing behind each guaranty needs to be understood.

Briefly this blog will touch on some of the accepted guarantees involved with retirement income and the value of money. As usual at the end of this blog I will suggest investment implications to these views. (Many of the views expressed will be provocative and will hopefully generate feedback.) 

The Promise

The heart or essence of any guaranty is the promise that under specifically-stated events or occurrences a predetermined reaction will automatically be triggered. In effect, the promise is a contract, often ill-defined or in some cases not even written down. As time passes, what is remembered is what someone believes to be the promise, without any review of the contract. In typical wedding vows, the only exit is by death. There is no mention of actions and attitudes that lead to today’s large number of divorces. In Europe and elsewhere, the fear of either the marriage contract or divorce has led to a large portion of the population living together for extended periods of time rather than marrying.

Retirement Income

Rational people for ages have been saving money, in part to meet a future period where they will no longer be sufficiently economically active to provide for their own needs. For centuries hoarders have converted much of their stash of wealth into savings. In turn some or all of their savings have been entrusted to various financial instruments and institutions. Since the 19^th century and that great “humanitarian” Otto van Bismarck, people have increasingly relied on taxing authorities to supply retirement income.  (Bismarck created the first social security system which would pay retirement income starting at age 65. He picked that age because he believed that very few would reach that age.) In a more modern era, recognizing that most employees would not have enough discipline to save for themselves, companies would defer some current compensation to be paid out later in retirement. Unfortunately, these two sources, the government and various employers, represent the bulk of the expected retirement income for those that had a career of working. For the most part these people are not worried now and don’t expect to be worried in the future because they believe that they have been guaranteed these payments.

These guarantees are increasingly being issued by some  entities  that are having their own financial difficulties. Most federal and some state and municipal governments around the world are operating at a deficit. We, the citizens, consciously or involuntarily are consuming more from the government than is being taxed. Almost all now recognize that this deficit production cannot continue forever. The two standard solutions are to cut expenses or raise taxes. Somewhere in between these two difficult choices there is a stop-gap measure of changing the payment schedule assumed by the government.  Delaying debt repayment to foreign borrowers can lead to materially higher borrowing costs in the future. One can see the possibility that the government could materially change the net effective payment of social security payments. After all, it is difficult or almost impossible to sue the US government without its permission. Most beneficiaries may not realize it, but social security payments are already effectively means tested. The amount of the payment which becomes reportable as taxable income is based on the level of other income received. Remember that half of the benefit received came from your employer or you as self-employed. Changing the date of full retirement is another way of changing the shape of the government debt. For some time I have warned all of my young employees that they should view that FICA (social security) taxes withheld from their pay and matched by their employer are tax payments and they will be unlikely to receive any real retirement income from their tax payments.

What is probably a larger problem for some is the so-called Pension Guaranty Corp, a government body that is meant to guaranty some pension payments for corporate pension plans of bankrupt US corporations. With the government proclivity to bailout pre-packaged bankruptcies of companies with large union member work forces, the guarantor will run out of money and will have to raise fees on those declining number of defined benefit plans or get an infusion from the US Treasury through an act of Congress. Both are uncertain.

Other ways to save are through various financial instruments directly or thru financial institutions. These are only as good as their continuing credit conditions.

Bottom line:  the various sources of retirement income are not perfectly secure under all conditions. The prudent saver needs to be aware that the expressed guarantees have some limits.  

The Value of Money

In the US, much of life’s activities are ultimately measured by colored pieces of paper approximately 6 by 2 ½ inches called the dollar. The pretty paper which circulates around the world in various denominations has little face value, but has substantial spending and trading value based on the belief that there is some almost universally accepted value because of a series of ill-defined guarantees.  Thanks to President Nixon,  the US dollar no longer has direct backing of gold or even now a fixed basket of currencies. As long as others will exchange goods and services for these painted pieces of paper, the dollar and other fiat currencies have value. Around the world the dollar trades against other currencies 24/7. In theory the Federal Reserve currency  has the vastly expanded Fed balance sheet as backing. These are supported by various issues of  US Treasuries that are the debt of the US government. What makes this curious to a financial analyst is that we have never seen a published balance sheet for the US government. We can speculate as to the enormous value of the government’s real and intellectual property. Most of us don’t know the size of the debt against these assets, particularly the future contingent debt. Value-oriented investors regularly arbitrage the difference between a quoted price and its intrinsic value. I cannot perform this equation as I lack any sort of precise knowledge as to the value of the dollar other than what is trading for now versus other currencies, including gold. Thus, I do not recognize fiat currencies such as the dollar have a guaranteed conversion price.

The Terrible Link

Both the value of future retirement income and the value of the dollar are linked to the rate of future inflation, which itself has no guaranty. The value of the current dollar, euro, pound, yen, and Renminbi is exclusively based on what they can buy today in the way of goods and services. If one isn’t going to spend currency today, one must be concerned as to its future value. Often its future value will be dependent on the path of relative prices. This is particularly true for the retired when an expenditure is likely to draw down retirement income or capital. As these are unknown or probably unknowable, I seriously question the certainty of both currencies and retirement capital that people are using.

 Investment Strategies in a World of Questionable Guarantees

First is my guaranty. My guaranty is that I won’t guaranty any specific future scenario or strategy that will produce only winners.

Second, in a period of increasing uncertainty, excessive concentration is dangerous. 

Third, as I believe significant inflation is eventually probable, I believe up to a quarter of one’s portfolio should be in an inflation defensive mode to include TIPS and selected foreign treasuries of up to five year maturities issued by  small population/commodity rich governments with small to no deficits.

Fourth, all equities should have a global orientation. These companies should have some of these characteristics: exporters, foreign operations, net royalty recipients and managements that think beyond their local borders.

Fifth, technology developers and users should play dominant roles.

Sixth, put at least 25% of your or your clients’ portfolio into stocks of companies that are more flexible than their large competitors. This puts one into smaller capitalization securities.

Seventh, as only a few mutual funds are constructed exactly along these lines, a portfolio of funds that appropriately counterbalance their portfolios will be needed and selected carefully.

Feedback Sought

Please share with me your thoughts on the guarantees discussed and or how one should construct a portfolio for such uncertain times.

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