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You Can't Become Rich In Your Pocket Until You Become Rich In Your Mind | ||||
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Now that we know exactly what money is owed and when, investments are selected accordinglyLEAVING LAS VEGAS States, municipalities, nonprofit organizations, and public and nonpublic companies all can offer defined benefit plans. Many plan sponsors, either for fear of lawsuits or because they truly wish to do the right thing, do not adopt the position taken by the gambling company president we just described. In a lot of cases we have found that the actuarys role is simply misunderstood. The actuarial assumption is perceived as a target growth rate for the assets. For example, most plans in the late 1990s had actuarial assumptions ranging between 7% and 8%. Between 1995 and 1999 the average annual rate of return for pension plans in the United States ran between 15% and 28% per year. So in good market years most plan sponsors assumed that they were accumulating huge surpluses. What was not talked about were the liabilities that were also increasing at a record rate. This is no different from the problem we face with Social Security. We have an aging baby-boomer population that is going to live longer than any other generation so far. As Social Security will be drained, so will pension benefits. Furthermore, any perceived surpluses disappeared as 2000 went down as the worst year in pension history.3 While liabilities grew at 25.96%, average pension assets fell 2.50%,4 putting employee benefits in the hole 28.46%this as the clock keeps ticking on boomers who are going to want their money from these plans. Compounding the problem even further is that corporate and noncorporate (states, municipalities, nonprofit organizations) America is watching their balance sheets closer than ever. The path of least resistance is to rely on actuarial manipulation to keep as much cash flow as possible from being siphoned off into a pension plan. At a moment when funds in Social Security, Medicare, and prescription drugs are drying up when corporations, states, municipalities, and nonprofit organizations are pinching pennies and are unable to supplement employee benefits we are being thrown a lifeline in the form of a new dominant investment system. The strategy a pension plan needs to employ to take advantage of it will not only help to ensure a plans solvency and ability to continue to pay its beneficiaries, but will legitimately maximize the plans growth and lower the amount of contributions, or costs, that fall in the lap of the plan sponsor. Source: PLANSPONSOR, Defined Benefit Survey, 2002. Note: Return targets for defined benefit plans are similar across all plan sizes, at 8.65% on average. Actual returns, however, are a different story, with an average overall return in 2001 of -2.78%. Returns in 2001 were a far cry from their targets but were nonetheless stellar as compared to the S&P 500. The solution to the problem is outlined in the following. Over $200 billion of pension assets have already adopted this strategy. It takes advantage of the new investment culture while protecting promised benefits. Like all things productive, simplicity and common sense are what makes it effective. Step 1 We obtained census data from our clients that allow us to segregate both the active and retired employees into age groups according to how old they are and how long before they retire. For most companies we came up with at least four cells or categories that look like this: or more Step 2 The amount of money that is owed to each group is calculated. In financial jargon this is the future value of present liabilities. From this data an index can be constructed, specific to the plan, telling us day by day what the true liabilities are. Step 3 Now that we know exactly what money is owed and when, investments are selected accordingly. This is called matching assets with liabilities. This is a common-sense approach. It is no different than if you had a balloon mortgage coming due in eight years. You simply set aside money in the appropriate investment to ensure that the funds are available to cover that liability. A financial planner or accountant helps determine how much money should be set aside and how fast it needs to grow to meet this obligation. This is called the discount rate. Because a pension plan has so many obligations, the liability index monitors all of them together. Just as you would check the performance of the investment made for the balloon mortgage, to be sure it was growing at the rate it is supposed to, the pension plan compares stock, international and emerging markets its performance against its liability index. The plans discount rate is determined by using the rate of high-quality zero-coupon bonds. The Financial Accounting Standards Board (FASB) and the Securities and Exchange Commission (SEC) have been saying for years that the method just outlined is a very good idea: The objective of selecting assumed discount rates is to measure the single amount that, if invested at the measurement date in a portfolio of high-quality debt instruments, would provide the necessary future cash flows to pay the accumulated benefits when due. Notionally, that single amount, the accumulated post-retirement benefit obligation, would equal the current market value of a portfolio of highquality zero coupon bonds whose maturity dates and amounts would be the same as the timing and amount of the expected future benefit payments.5 The SEC staff believes that the guidance that is provided in paragraph 186 of FAS 106, for selecting discount rates to measure the post-retirement benefit obligation also is appropriate guidance for measuring the pension benefit obligation. . . Rates that cannot be justified or are just too high will be passed on to the SECs enforcement division for further action. The enforcement division could require restatement of the companys financial statements, as well as seek to impose civil or criminal penalties.6 Why is the method we have outlined for managing pension plans new if guidance mandating it was set up over a decade ago? The answer is that pension plans were given a 15-year grace period to get into compliance. That period is over. When FAS 87 was enacted, corporate pension funds were allowed to amortize(straight line) their current surplus or deficit over the remaining service period of employees, or 15 years whichever was greater, starting between 1/1/85 and 1/1/87. For most companies, they had a pension plan surplus back in the middle 80s since liabilities had higher discount rates then and equities had performed well. This surplus amortization has boosted earnings for the last 15 years. The year 2000 financials saw the end of this amortization for many companies suggesting 2001 earnings and beyond would suffer accordingly due to the loss of this earnings support.7 That there has been no rush on the part of pension plans to create liability indexes and invest the assets in accordance with a prescription of accepted investment methodology can be explained by referring back to our anecdote at the outset of this chapter. You saw how far we got in Las Vegas. The Department of Labor (DOL) is supposed to enforce the rules, but there are over six million private pension plans with over $5 trillion in assets covering over 150 million beneficiaries.8 The DOL is not given the resources to enforce the rules. Plan beneficiaries, however, have the right to know how the pension plan is being managed. They have the right to see investment policy statements, how the plan is being invested, and what the strategy is for addressing all the issues we have discussed. A plan beneficiary does not have to rely and should not on an annual statement (some participants do not even get this) derived from an actuarial report that projects what their cash flow at retirement will be. The number could have been created with smoke and mirrors, and the promised benefits could evaporate into thin air. There is an agency called the Pension Benefit Guaranty Corporation (PBGC) that charges companies a flat rate premium per employee that is intended to insure pension benefits. The intentions of this government agency are good, but as is true of Social Security, the money may not be there to cover the scope of the problem that looms ahead. The solution is for every pension plan to adopt the procedures that we have outlined. An alternative course would be to hope one gets at the head of the line when the guaranteed payments are handed out. Roll the dice. THE MATRIX There is a careless belief on the part of legislators, economic leaders, and most dangerously plan participants themselves that the 401 (k) has come of age as a sound investment tool and the average Americans best hope of assuring themselves a steady flow of retirement income. Or so 401(k)s were described in the opening remarks of a congressmans speech at one of the thousands of forums on retirement planning that are held every year in the United States. The confidence in this view flows from our democratic convictions that people should have the responsibility for controlling their own destiny because they alone know what is good for them. Of course this is true. So a retirement plan that puts workers in control and allows them to assume responsibility for their retirement income . . . by directing their own investmentsas it is described on the first page of a booklet on 401(k)s published by the U.S. Department of Labor s Pension and Welfare Benefits Administration has definite appeal as a solution to the retirement planning crises. That in most cases the control that workers have over their 401(k)s is an illusion and that the investments that they are given permission to direct are circumscribed by a twisted mass of self-interest that grows like an abscess on an originally well-intentioned concept is where perception and reality part company. If we are talking about a 401(k) plan where the total account balances of all the employees that participate add up to a sizable sum of money, you will find in many cases that even as the participating workers are told over and over that they are in charge, their collective assets are used to pull strings, grant favors, boost egos, and advance careers in a total disregard for the effect this will have on the growth of the employees money. This is not to say funds are being misappropriated or pilfered from workers accounts. That would be easier to detect and to punish. The problem is far more insidious. It occurs when decision makers directly involved with the plan (this may be company owners, CFOs, CEOs, company administrators, treasurers, or human resource people) grant the business of handling the 401(k) account to financial services merchants without regard for the investment needs of the participating employees. The fact of the matter is that plan participants can invest only in what is offered in their menu of investment options. The selection of these investments and the vendor that is contracted to provide them is as highly charged a political football as any presidential election. Often those in charge of a companys 401(k) know that they are rubbing up against more money than they will ever see in one place at any time again in their lives, and they use it to advance their own agendas. We have seen 401(k) businesses awarded to golfing buddies, relatives, and in one case to the girlfriend of the married-with-children owner of a company. Frequently the people being gifted with this business know nothing of investing. In one case a new CFO of a company with a $120,000,000 401(k) plan gave the account to his brother-in-law who had been a surveyor eight weeks before. (This is legal. By passing a simple test and paying a fee, you can go to work at many mutual fund, bank, brokerage, and insurance companies.) Although it is allowed to happen every day, clearly these people are not equipped to be decoding what sorts of things 401(k) plan participants have a choice of investing in. The other group of people who decide what employees can invest in are the 401(k) decision makers at the sponsoring company. Only the largest corporations may have their own in-house investment advisors, experienced and trained to do nothing but watch over their companys 401(k) options. At most companies it is the treasurer, CFO, chief operations officer, vice president of administration, or a human resources manager who is already overworked and has the additional responsibility of the 401(k). The people in these capacities with whom we work on a daily basis rely on us to assist them in selecting the investment options for their 401(k) plans. They readily admit that they do not have the time or, if they do, the qualifications to make such decisions on their own. At bottom they truly have the best interest of their employees at heart. Another attitude prevails among corporate 401(k) decision makers. For each one that is well intentioned, there seem to be two prima donnas who set themselves out as investment gurus. They study the faddish magazines of pop finance, become the groupies of mutual fund companies, and try out their experiments on their companys 401(k) plans. They dimly understand that executing the investment process is hard and difficult work when the needs of just a single individual must be considered, much less trying to accommodate hundreds or thousands of employees. Instead of a systematic process, they rely on their gut we hear this a lot or the research they do during their break to determine the investments their employees will be able to use to ensure that steady flow of retirement income as promised in the U.S. Department of Labor booklet. The mocking of 401(k) participants takes a different form when a menu of 30, 50, or over 100 mutual funds are offered. This confers not control but confusion. It is unfair to encourage people to put hardearned dollars into a 401(k) when there is no rhyme, reason, or process available to them to manage that money. Participants in these plans were told to hang on, themarket always comes back, during the volatility of 2000-2002. Many are still waiting because they do not know that there is no longer a themarket; they dont know we are in a new investment culture; and if they did, they cannot be sure where the funds they have invested in put their money. To give the appearance that plan sponsors are taking seriously their fiduciary responsibility that affords their employees control over their retirement assets, an interesting bit of theater is often carried out. The players will be those in charge at the company, who will often include a few of the rank and file just to demonstrate how democratic the system is. Usually these people are so intimidated by being able to rub elbows with management that they play along, not knowing what the game really is. The other players will be representatives from two or three financial services companies who are invited to explain how their 401(k) programs work and why they are superior to the competition. The idea is to demonstrate that the company has no conflicts of interest and is trying to select the best set of investments and services for its 401(k). The production will be noted and recorded in company minutes just in case some renegade employee actually wants to know how his or her money wound up where it did. Of course, the whole production is a sham. It had already been decided which investment company would get the business, long before the other vendors were invited to perform. The paperwork had probably already been signed. It is in this way that 401(k)-plan business is given in exchange for favorable mortgage rates or corporate loans, a better deal on insurance, either corporate or private, or maybe just to return a favor. |
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