Tuesday, August 30, 2011

Where are the Jobs and What Creates Them?

Clearly, late in the Bush Administration, the US started a severe recession. I don't think that anyone will argue with me that we were in a recession then. When did the recession start? I'm not sure, and for purposes of this post, it doesn't matter. Similarly, early in the Bush Administration, we were in a recession. At some point, that recession ended and we had a recovery (the exact timing doesn't matter for purposes of this post). Many say that we are currently in a recovery (some would argue with that, but that's not the point).

My point is that during the recovery that began likely sometime in 2002, something was missing. If we are in a recovery now, the same thing is missing. It's a four-letter word, but it shouldn't be an ugly one -- JOBS. And, to the extent that there are jobs, many who are taking them are moving into lower-paid jobs than they were in during their previous period of employment. Said differently, unemployment didn't come down as quickly as we might have like in the early part of this century. And, when it did come down sharply, underemployment (employment in a lesser job than one held previously) was rampant. Similarly, now, even among people who are finding re-employment, many are earning far less and working more than they were before they were laid off.

So, what happened? Recoveries used to bring jobs, lots of good jobs. I remember what it was like finding work in the very early 80s -- in two words, not good. I remember what it was like finding work in the mid 80s -- lots more jobs, lots of good jobs. In the early 90s, it was tough to find jobs. By the end of that recession, good jobs they were aplenty.

The economy has changed. You may or may not be a fan of his, but Thomas Friedman wrote a book called The World is Flat that talked about it. In 1981, it wasn't practical to move large chunks of a company's work from the USA to India or another Asian country. Communications were difficult. Your choices were by telephone when both parties were awake at the same time, something called Telex which was neither cost-effective nor particularly useful, or something that I remember from days of yore called "air mail." Fax machines existed, but they were not prevalent. E-mail was just starting to come on to the horizon, but it was neither common nor cost-effective.

Now, I often wonder what a telephone is. Even in the business world where verbal communication has its place, you just don't find that much of it. Most communication is done via e-mail or instant message. Being on different continents typically only slows things down by seconds. Being in different time zones is rarely an impediment. So, US jobs disappear.

When they reappear, to my view, they fall into two categories -- lower-paid and previously non-existent. The first of those is easy to comprehend. Let's consider the second.

I listened this morning to some sort of a jobs expert. I didn't hear who exactly she is, who she represents or what her credentials were. But, she was talking about companies that are hiring. Of the five that she mentioned, two are among the so-called Big 4 accounting firms. When asked why they are hiring, she brought up the name of an old 'friend': Dodd-Frank.

You remember Dodd-Frank. I have ranted about that law many times here. Perhaps it and its nearly 3000 pages of new rules has its place, but one thing that is certain is that it has placed an incredible added compliance burden on not just financial institutions, but virtually every large company in America. But, where there are losers, there are winners. In this case, the winners are those who can assist with that compliance burden. And, from where I sit, none appear to be bigger winners than the Big 4 (this is not meant to disparage the accounting profession, just a statement of what I believe to be fact).

So, jobs have been created by government intervention. If you are a fiscal liberal, you are thinking of course they were. If you are a fiscal conservative, you are thinking that a few were created while millions were lost. The purpose here is not to debate that issue, but to figure out how to create them.

I know. You are waiting for the answer.

You know what. If I had the answer, my blog readers would not be the first to know. Sorry, but that answer would be way bigger than this blog.

For those few people who delight in seeing what I may be ranting about on any given day, this blog is taking a well-needed vacation until after Labor Day. Check back then to see what's new, exciting, trendy, or just aggravating.

Friday, August 26, 2011

Change. Change, Change. Change From Fools

A friend of mine changed jobs recently. You probably have a friend who has changed jobs recently as well, whether it be by choice, or by job elimination. In my case, I asked him about it. I wanted to understand the motivation. I learned that, at least in his situation, there were lots of motivating factors. Some are uncontrollable. For example, if your company is in an industry that is harder hit by the bad economy, well stuff happens. Others are controllable. In this post, I want to focus on them.

Can you imagine working for a firm where in your entire career there, you never receive a communication that is truly about your career development? Contrast that with a firm where after you accept an offer, but before you start, you are already getting career development e-mails. What is the marginal cost of doing this? I am going to guess that on a multi-billion dollar balance sheet, the cost doesn't even affect the rounding. What is the benefit of doing this? The improved morale that comes from this sort of corporate behavior will increase productivity to the point where the income statement is materially improved.

Can you imagine working for a firm where press releases are primarily about the organizations that you sponsor? Contrast that with a firm where press releases are about your clients' or customers' successes from the work that your firm does for them or the products that your firm produces for them. As an employee, which would make you feel more proud of the company you work for? Which would make you feel more proud of the work that you do?

Can you imagine working for a firm where during your entire career there, to your product line leader, you are nothing more than a name or a number, and they are not sure exactly who you are or what you do? Contrast that with a firm where your product line leader takes a personal interest in you during your first couple of weeks. And, at this firm, it's not because you are being treated differently, that's just the way she chooses to operate. Which firm will get more out of you?

So, at this point, I've discussed three issues. Between the three, I don't think there is enough there in hard costs to change the rounding in the balance sheet or the income statement. But, the benefits fo doing so, on the other hand, appear to be enormous.

The working world has changed. Management used to have far more intuition to it and perhaps fewer metrics. Before the computer age that we are in now, we just didn't have so many metrics at our fingertips. It was harder to measure the micro effect of each action that we took, to we didn't. We looked instead at macro effects of a pattern of behavior.

I remember, at my first real job (actually this happened in some of my consulting jobs, but my observation is that this behavior had stopped at lager firms by the mid-90s), each employee, on their first day on the job, got introduced around. It was part of a pattern of creating a team-oriented work environment. Sure, it took a little bit of productivity on that day away from both me and the person showing me around, but I think it was more than made up for. But, in today's world of micro metrics, there is a cost to an experienced person introducing a junior person around, so it just doesn't happen.

We used to celebrate successes together. But, the celebration, measured on a micro basis has a cost with no benefit. Now, at some firms, unless you are an executive, you don't even find out about the successes.

Perhaps I am the one who is wrong. I don't think so.

Monday, August 22, 2011

Of Course It's Time for a Better QDIA

The Pension Protection Act of 2006 (PPA) brought us lots of new terms and concepts. One of the more controversial has been the qualified default investment alternative or QDIA. Essentially, what it did was to require participants who did not make affirmative elections otherwise in defined contribution (DC) plans to be defaulted into a QDIA. On an ongoing basis, and oversimplifying somewhat, the Department of Labor (DOL) regulations give plan sponsors three broad alternatives in selecting their QDIAs:

  1. Age-based funds
  2. Risk-based funds
  3. Managed accounts
Our observations suggest that the most prevalent have been age-based funds, largely in the label of Target Date Funds or TDFs. In a nutshell, a participant picks a year in which they expect to retire, rounds to the nearest multiple of five, and voila, they have a fund. Or, in the situation where a participant is defaulted into a TDF, the plan document uses the same algorithm and without the active consent of the participant, his or her money is in a fund.

The companies that serve as both DC recordkeepers and asset managers love this. To my knowledge, they all have TDFs that they actively market as part of their recordkeeping bundles, and each of these families of TDFs are proprietary funds of funds. In other words, a Fidelity TDF is composed of Fidelity funds and a Vanguard TDF is composed of Vanguard funds. The same could be said about the other asset management firms who are also DC recordkeepers. Perhaps there are one or two out there that do not fit the mold, but I am not aware of them.

This is not to denigrate the current state of TDFs, but I think we can do better. And, so, in fact, do plan sponsors. In a November 2010 study commissioned by PlanSponsor and Janus Capital, only 34% of plan sponsors (down from 57% in November 2009) thought a TDF was the best QDIA available for their DC plan. Or, stated differently, nearly two-thirds of plans (clients) don't like the product that is being pushed upon them. If you were a car manufacturer and two-thirds of potential consumers didn't like your product, you would likely need a bailout. If you made computers and two-thirds of the users thought your machines had the wrong features, you would need to re-think what you were producing.

Well, the large players in the market don't appear to see the motivation to re-invent the TDF, so as I am wont to do, I am going to consider the re-invention for them.

Today, when a participant is defaulted into a TDF, the sponsor (and recordkeeper) uses one data item to make that decision -- age. You would think that was the only data point they had. Well, if Bill Gates and I were both in the same DC plan, we would probably both be defaulted into the 2020 Fund. And, trust me, Bill Gates and I are not in the same financial circumstances. I know you find this shocking, but it just isn't so. The fact is that we do not have the same net worth as each other (I'll leave it up to my readers to work out who is worth more).

But, assuming that we were active participants in the same plan, here is some other data that our plan sponsor would have on us:
  • Compensation
  • Years of service with the company
  • Account balance
  • Rollover balance
  • Savings rate
  • Gender
  • Whether our jobs are white-collar or blue-collar
  • Accrued benefit in a defined benefit (DB) plan, if our employer sponsors one
  • Whether we are eligible for company-provided equity
Each of these is likely to have an effect on our readiness for retirement at any point in time. Let's go through them quickly to see how.

Compensation. That's an easy one, but in general, the more money that an individual makes, the more likely it is that they will be able to retire earlier as compared to later.

Years of service. Continuity with the same company tends to result in larger DC account balances and larger DB accrued benefits making it more likely that a participant will be able to retire at a younger age.

Account balance and rollover balance. The bigger your balance, the closer you are to your retirement goal.

Savings rate. The more you are saving, the less time it will take you to get from where you are to your retirement goal.

Gender. Without regard to other factors such as health and family history, women will, on average, outlive similarly situated men, and therefore need a larger account balance to fund their retirements.

White-collar or blue-collar jobs. Studies done by the Society of Actuaries have shown that white-collar workers outlive blue-collar workers. This suggests that white-collar workers need larger account balances at the same retirement ages.

And, the other two elements may do more to affect the appropriate asset mix for a participant.

Accrued benefit in a DB plan. Accrued benefits in a DB plan can be thought of as a fixed income investment. That is, their value grows (largely) at a discount rate. Having a large DB accrued benefit means that the remainder of a participant's account balance could, and perhaps should, be invested more aggressively.

Access to company provided equity. If a meaningful portion of your compensation is in the form of equity, then you tend to possess a significant undiversified asset. This would suggest that your TDF should have significant diversification.

Again, who has this data? Your employer, the plan sponsor does. Combined with age, this list of parameters could give your employer ten data points with which to appropriately place you in a TDF instead of one. In the coming world of TDFs, this is what should happen.

Perhaps the TDFs of the future will not have years attached to their names, but instead will have letters, numbers, or some combination of the two. And, perhaps, these ten data items (or others like them) can be used as part of an algorithm to place participants into their proper TDFs. 

Finally, while we are redesigning, do we really think that any one asset management firm has a monopoly on all the best funds? I don't think so. Without naming names, I have an opinion on some of the best fixed income funds available in the marketplace. Surprisingly enough (not really), none of the firms that manages those fixed income funds also has, in my opinion, the best large cap equity funds, international equity funds, and real estate funds. So, wouldn't our new age TDFs be better if composed of funds from a variety of providers? I think so. And, if we suddenly had reason to believe that the great-performing real estate fund that we were using in our TDFs might no longer be as great (the main portfolio manager decided to retire), wouldn't we like to have the ability to change real estate funds? I think so.

It's time. Who is going to start the trend?

Thursday, August 18, 2011

What is Really Causing High Rates of Unemployment?

This is one of the most controversial topics of the day -- unemployment. One thing is clear: unemployment rates are high. I need to give a special warning before moving on that the opinions given in this post are not those of my employer and may not even be my own. I am simply positing that there may be some hidden causes that we have never considered. I'd like for you to think about them. Maybe, you will agree with what I am saying even if I don't agree with myself (I might agree with myself, I'm just not sure).

In order to understand this, we need to understand how the rate of unemployment is calculated. Essentially, it is a fraction the numerator of which consists of those people who are currently unemployed (you are considered unemployed if you are not considered employed AND you have actively looked for work in the previous 4 weeks) (you are considered employed if during the survey week you either worked for pay or profit or you would have worked except that you were on vacation, ill, having child-care problems, taking care of a family or personal obligation, on maternity or paternity leave, involved in a work dispute, or prevented from working by inclement weather) divided by the total number of people who are either employed or are unemployed. In other words, if you are not currently employed, but you are not looking, you are not in the fraction.

OK, I don't think I've really said anything controversial yet, but give me a chance.

Think about how unemployment rates are calculated. If someone had been looking for work for two years, but is so despondent that they have given up, they are no longer considered to be unemployed. Hmm?

So, who is responsible for the current high rates of unemployment? Is it former President Bush (43)? The Democrats would tell you that. Is it current President Obama? The Republicans would tell you that.

I am going to posit that the blame needs to go to four places (remember, I may not agree with what I am saying):

  1. Financial Accounting Standards Board (FASB)
  2. Pension Benefit Guaranty Corporation (PBGC)
  3. The internet (no acronym needed)
  4. The credit markets
I know. You think I've lost it. Stay with me for a few minutes. I'll tie this all together ... or not ... I promise.

Way back in the 80s, most American workers were covered by corporate pension plans, defined benefit (DB) plans if you prefer (for those young readers, DB plans used to be prevalent and 401(k) plans were virtually non-existent). Financial accounting (balance sheet and income statement) for these plans was done under APB 8. For the most part, that meant that a company recorded a charge to earnings for any contributions that it made to its plan. For CFOs, this was palatable. But, the FASB said that companies needed to switch to accrual accounting under FAS 87. Later (by about 5 years), the same FASB said that companies needed to switch to accrual accounting for postretirement medical benefits under FAS 106. So, what happened? Companies moved swiftly to get rid of their pension plans and postretirement medical plans. I'm not saying that FASB was wrong, I'm just saying that this is what they did and what happened, partially as a result of this action.

FASB didn't create quite enough turmoil to eliminate all the plans that were gone. But, the PBGC picked up where FASB left off. You see, the PBGC is a governmental organization, but it needs to be self-sustaining. So, the premiums that it receives need to cover the benefits that it pays to former participants in plans of largely bankrupt companies. The PBGC was a major influencer in the move to change the funding rules for defined benefit plans. Once upon a time, US corporate pension plans were generally funded on a projected basis. That is, an actuary would project benefits into the future, discount them back using a set of actuarial assumptions and assign some piece of the related obligation to the past, the present, and the future. The PBGC's thought was that plans needed to be funded in a way to limit the PBGC's liabilities. That meant market interest rates and accrued benefit funding. What it also meant, initially, was multiple competing funding rules that produced peaks and valleys in funding patterns for corporate DB plans. Later on, when projected funding went away entirely, companies saw funding as even less predictable. More plans disappeared. I'm not saying that the PBGC was necessarily wrong, just that this is what happened.

Now, what could the internet have to do with this. Recall that in the late 90s, everyone started to get on the internet. And, everyone included start-up firms that provided for online trading platforms. So, people started day-trading. And all was good, as the prices of tech companies went up, up, and away (remember the 5th Dimension?). But, more often than not, those day-traders spent that money. And, the day traders were far too in touch with the 5th Dimension, but they forgot all about Blood, Sweat and Tears (what goes up, must come down). Margin calls abounded and so did loss of capital.

And, then there were the credit markets. I bought my first house in 1985. I had to put 20% down. And, my mortgage payments (plus property taxes and homeowner's insurance) couldn't exceed 28% of my pay. Before that, I had applied for my first credit card in 1979. I got turned down, not because I had bad credit, but because I had no credit at all. Fast forward to 1999. You wanted a house, you took out a first mortgage for 80% of the value of the house and then a second mortgage for another 15% of the value of the house and perhaps a third mortgage for the last 5% of the value of the house or perhaps even more. And, remember that 28% that I mentioned. Forget about that. By 1999, you were qualifying for those mortgages so long as the sum of your mortgage payments, property taxes and homeowner's insurance didn't exceed 50% or sometimes 60% of your pay. And, that credit card that I couldn't get in 1979 ... in 1999, I could have gotten a deck-full (as in 52) of them if I had wanted. The application process? We'll send you a card and you activate it.

Well, we've seen the results of all of these unknowing conspirators, haven't we. 15 years ago, if you asked workers who were in their early 40s at what age they would retire, a fairly large number of them would have told you in their late 50s or early 60s. Those same people are now in their late 50s. Very few of them are retired. Further, very few of them think they can retire in the next five years. Sadly, an awful lot of them don't think they will be financially able to retire in the next 15 years.

So, what has happened? 15 years ago, we knew roughly how many people were going to be trying to enter the workforce today. We were worried, though, that with all the baby boomers retiring, there would not be enough new workers coming into the workforce to fill those jobs. Something happened along the way. The baby boomers can't retire. Instead of too many jobs for the workers, we have too many potential workers for the jobs.

I know that you want to blame it on Obama, or if not, you want to blame it on Bush. But, I am saying that blame may be misplaced. The Four Horsemen of the Apocalyspe (FASB, PBGC, internet, and credit markets) have come into town and ruined our ability to retire. And, with that ruin, has come significant underemployment. Perhaps when we listened to the 5th Dimension instead of Blood, Sweat and Tears, it should have been Richard Kiley singing "The Impossible Dream" (if it's before your time, check it out on YouTube, it's a Broadway classic). Perhaps it doesn't matter. Perhaps this is the new reality.

Tuesday, August 16, 2011

D&O Insurance to Cover Clawbacks -- Should it be Legal?

The Dodd-Frank Bill, signed into law by President Obama last year, makes significant changes to the financial services industry. It was written and passed in response to the financial services crisis of 2008-2009. It's upward of 2000 pages, and frankly, it's not an interesting read. Lots of the stuff in there only adds to the bureaucracy and frankly, will do nothing that was intended by the bill. That is, either it puts no teeth in penalties, or it is disclosure that has value roughly equivalent to the yen right after World War II. Readers may recall that I have ranted several times about the dreaded pay ratio disclosure in Dodd-Frank Section 953(b). To me, that is the ultimate example of uselessness in Dodd-Frank.

Among the more controversial provisions are the clawback rules in Dodd-Frank. Without going into gory detail, a clawback is the required repayment of certain items of compensation when an organization goes into significant financial stress (usually bankruptcy) or when the organization's financial statements contain material misstatements. Under Dodd=Frank, in certain of those circumstances, there is a rebuttable presumption that such events are the fault of the CEO, CFO, and Chairman of the Board unless they can demonstrate otherwise. In such cases, compensation may be clawed back for several years.

Many find this rule to be draconian. Others find it to be uninforceable as the executives may no longer have those amounts. Who will pay them in those cases?

While it may not be readily enforceable, to me, the intent of this rule is correct. If you are the CEO, CFO, or Chairman of such an organization, you should have had some control over the events that occurred. If you didn't, then barring very unforeseen circumstances, it is highly likely that one could argue that you were asleep at the wheel. (I'll grant that there are circumstances such as natural disaster whose damage far exceeds any insurable limits. But, in those circumstances, I would hope that the presumption of guilt could be rebutted successfully.) If that happens, then it seems right to me that your incentive compensation should be clawed back.

Now there are insurance brokers who are looking to make money off of this. And, frankly, I don't blame the brokers. They are in business to make money, and what they are doing seems to be legal. But, should it be?

What they are doing is selling Directors and Officers Insurance (D&O) to insure against such occurrences.As I said, this appears to be perfectly legal. I don't think it should be. You just should not be allowed to insure yourself against your own malfeasance or fraud. If you can, then there is suddenly no penalty for bad behavior.

To me, this is a disturbing trend. While I am rarely one to ask for more government intervention, here, in my opinion, it is sorely needed.

Thursday, August 11, 2011

Will the Super-Congress Kill Your Benefits?

If you haven't been hiding under a rock, you know that Congress reached a budget/debt deal last week that was signed into law by the President. Well, they sort of reached a sort of deal.

They increased the debt limit by more than $2 trillion and they cut spending by about $2.5 trillion. Except that they didn't. You see roughly $1.5 trillion of that savings is yet to be decided. The dreaded Super-Congress (three each of Senate Democrats, House Republicans, Senate Republicans, and House Democrats) is charged with coming up with a plan to find that other piddling amount. If they can't do it by November 23 of this year, then the nuclear option kicks in (stop your wishful thinking, nothing inside the Beltway will be nuked). In oversimplified terms,  the nuclear option will make pre-specified cuts adding to roughly $1.5 trillion. And, those pre-specified cuts will come to a large extent to each party's sacred cows -- defense spending and entitlement spending.

So, somewhere between November 22 and November 23, the Super-Congress will miraculously reach agreement. Remember, you heard it here first.

Thus far, we know the names of 9 of the 12 members of the Super-Congress (the 3 House Democrats are yet to be named). Perhaps more important, we know the names of the co-Chairs: Senator Patty Murray (D-WA) and Representative Jeb Hensarling (R-TX). To say that there is common ground between these two is roughly akin to saying that Kennedy and Kruschev were best friends. I'll let you guess on the details.

So, why am I writing about this in a blog that is usually devoted to benefits and compensation? I'll get to that soon, but I am glad that you asked.

As the Super-Congress gets named, various members have deigned to give interviews to the media. The Democrats say that entitlements need to stay as they are and that the wealthy need to pay more taxes. The Republicans say that the defense budget is critical and that new taxes are not on the table.

Where they agree, though, is that we have too many tax loopholes. Their may not be agreement on what constitutes a loophole, but you can't have everything.

I don't recall where, but I read somewhere that the three largest tax expenditures are these (in no particular order):

  • The mortgage interest deduction
  • The employer deduction for health benefits for employees
  • The combination of the employer deduction for retirement benefits for employees and the tax-free build-up of assets in trusts for qualified retirement plans
The first one, in my opinion, is a goner. Not in its entirety, but above some limit, there will be no tax deduction for mortgage interest. And, there will be no deduction for interest on any but a primary residence. Again, in my opinion, as this has been floated before without tremendous resistance, this seems obvious.

The other two, they are in serious trouble. And, if either or both suffer, so will you, the American worker.

Let's use an example to illustrate. Suppose your cash compensation is $100,000 per year. Let's estimate then that the total cost of your employment to your employer (before tax deductions) is $140,000 (this number may be high or low, but it's not a bad representation). Presently, your employer gets a tax deduction for virtually every dollar of that. So, assuming a 35% marginal tax rate, that means that after $49,000 in tax deductions, you cost your employer $91,000 per year.

Are you with me?

Again, in very round figures, suppose your health and retirement benefits cost your employer $15,000 per year (before the effects of tax deductions). At 35%, the deductions for that will be $5,250. So, eliminating these deductions will cost your employer $5,250 (with respect to your employment). Do you think you are going to continue to get the same benefits? Think again. For most of you, the answer is no, or perhaps it's NO!

Your employer is going to cut its contribution to your benefits to save that $5,250. So, the value of your employment package will decrease by about $5,000 on a baseline of $140,000. That's a little more than 3.5%. Oh, you don't think that sounds like much? In this economy, how long does it take you to get a 3,5% pay increase? For many of you, that could be two or three years.

So, how can this happen. Well, the Republicans will swear up and down that this is not a tax increase and they will tell you that they have held to their pledge to not increase taxes. The Democrats will fight hard to ensure that this change does not apply to the lowest paid workers and that its effect progressively increases as a worker's pay increases, probably phasing in completely somewhere around $150,000 of cash compensation.

And, the chosen twelve will shake hands and know that they have saved their sacred cows, and each side will go back to its constituency and say that it has won. Don't believe them for a second. The losers will be you and me. The losers will be the American workers who "get up every morning to the alarm clock's warning, take the 8:15 into the city" (I know, Bachman-Turner Overdrive was a Canadian band, but the lyrics fit).

Remember, you read it here first. 

Tuesday, August 9, 2011

IMHO: Why Congress is the Wrong Body to Fix The Financial Crisis

Congress will never fix the financial crisis. At least, this Congress with their current rules will never fix the financial crisis. My profession could do better ... much better.

Let's consider the incredibly stupid negotiated settlement of one week ago. It raised the debt limit and allowed us to continue to prosper. Bullfeathers!

Moody's and Fitch affirmed their AAA credit ratings for the US although both (to my memory) have given us negative future outlooks. Then, Standard & Poor's came through and downgraded the US credit rating to AA+. And the President squawked. And the Republicans squawked and the Democrats squawked. Sure, S&P has a fairly recent history of mis-rating companies and various financial instruments. But, look at those mis-ratings. For the most part, they rated debt too optimistically. That is, they gave AAA ratings when B- might have been more appropriate. You can't find as many situations where they gave a B-, but AAA was justified.

What does this all have to do with actuaries, my profession? I'm getting there, hold on just a minute.

So, we had this great debt deal. It is to cut something like $2.5 trillion from the baseline budget over the next 10 years. Here is the problem. Roughly $1 trillion of that is specified and that amount is largely backloaded (meaning the cuts come toward the end of the 10-year period as compared to the beginning). The other $1.5 trillion will come from the Super-Congress, 12 hand-picked Congresspeople (Senator Reid (D-NV) picks 3, Senator McConnell (R-KY) picks 3, Rep Boehner (R-OH) picks 3, and Rep Pelosi (D-CA) picks 3) will need to get together and find the other $1.5 trillion. That is, when they get back from their vacations, they will start work on this. And, if they don't find that trillion and a half, then some pre-determined cuts (not particularly specific) will kick in.

Can you imagine running a business that way? Can you imagine running your household that way?

There is this apparently nerdy little group called the Congressional Budget Office (CBO). Each time that Congress is going to vote on a bill with financial implications, the CBO gets to score it. And, by rule, the CBO scores it over 10 years with static assumptions, compared to a baseline, and with no discounting for the time value of money.

Where are the actuaries when we need them?

Do you know how stupid the results that such a process produces can be? Consider health care reform (PPACA, if you prefer) for a moment. According to CBO estimates, it is supposed to save money. Bullfeathers! The system can be manipulated. When you start the revenue raisers in Year 1 and start the expenditures in Year 4, is the annual expenditures do not exceed roughly 1.4 times the annual savings (once the expenditures start), then the law saves money. How does that work? 10*1=10. 7*1.4=9.8. Voila, savings! Of course, Years 11 through 20 (by the same math) have expenditures of 14 and savings of 10 producing a large cost, but that's not part of the CBO forecast.

Where are the actuaries when we need them?

Suppose we gave this problem to actuaries. What would they do differently?

  • They would make assumptions about things like inflation, growth in the economy, growth in savings and expenditures, discount rates.
  • They would do more than a 10-year forecast (actuaries do forecasts all the time called actuarial valuations that tend to forecast costs more than 75 years into the future).
  • They would use Actuarial Standards of Practice.
  • Where the assumptions that were used were not those of the actuaries, but were chosen by someone else (Congress), the actuaries would disclose that fact, and would either concur with the assumptions or say which ones they did not concur with.
  • To the extent that they found the assumptions chosen by Congress to be unreasonable, the actuaries would estimate the answers based on reasonable assumptions as well.
  • All of these calculations would be disclosed.
Where are the actuaries when we need them?

When individuals aspire to become actuaries, they take a series of examinations. These exams are not easy. The competition is tough, and while I'm not sure what percentage of candidates passes each exam these days, 25 years ago, a number of the exams had fewer than 40% of candidates pass. That is 40% of a group that is generally considered pretty smart. And, that is on just one exam in order to get to the next one which may also pass fewer than 40% of candidates.

How about Congress? How much training does a typical Congressperson have in financial matter? Does the number ZERO come to mind? It does for me. Yet, they are the ones who are going to fix our problems, albeit using flawed methods. Bullfeathers!

Where are the actuaries when we need them?

Friday, August 5, 2011

Debt Crisis, Part 2 -- Invading the Pension World

Effective July 1 of this year, a new law became effective in the State of Rhode Island which gives municipal bondholders priority in municipal bankruptcy cases. Yes, towns and cities go bankrupt. For those of you who like your citations, you may marvel in the intricacies of Chapter 9 of the Federal Bankruptcy Code. For the rest of us, suffice it to say that it can be done.

There is a smallish town in Rhode Island called Central Falls. It has about 19,000 residents and has been paying out nearly $300,000 per month in pension checks. Starting next month, it will pay out about $100,000 less.

Nobody died. Nobody told the town that he didn't need his pension anymore. Central Falls filed under Chapter 9. Pensioners need to line up with every one else. They are going to get a haircut of about one-third.

Is this legal? I suppose it is, but if you really want to know, you need to ask an attorney who is familiar with Rhode Island law. This is not an ERISA issue. This is a governmental plan. So, while your favorite ERISA attorney in some other state may have a strong opinion, chances are that he or she doesn't know the ins and outs of Rhode Island law and the Constitution of the State of Rhode Island.

I am going to assume that this is all legal. If I assume it's not, then I would have to blog about something else today.

Let's consider the implications. If you are a potential bondholder, municipal bonds in Rhode Island are pretty safe. If you are a rating agency, these same bonds are far safer than the general credit of the town. If you are an investor, you will likely consider municipal bonds in Rhode Island as part of a safe fixed income portfolio. The bonds of these municipalities will probably yield a lower interest rate in the future.

What about the pensions? There has long been a debate in the pension community about the proper funding and funded status of public pensions. On the one side (let's call them the public pension traditionalists or PPTs for short), the argument has been that public pensions don't need to be fully funded. They have an essentially infinite lifetime. Their sponsors have peaks and valleys in tax revenues and the pension plan is just one of the items that must line up for funding along with public safety officials, roads, parks, and the like. In fact, most residents would tell you that those other items deserve priority. They affect every citizen on a regular basis. They make the town livable.

On the other side are the Financial Economists (FEs). They argue that when you offer a pension to an employee, you are, oversimplifying somewhat, taking a loan from that employee. By funding that pension, you are placing into escrow a pool of assets. The FEs would argue that the market value of assets in that pool should equal the market value of liabilities. The PPTs would disagree, perhaps saying that increases and decreases in the market value of liabilities are largely due to external forces (rises and falls in interest rates) that are not overly relevant to this ongoing pension plan.

You know what? For most public pension plans, I can argue that the arguments of both sides have their merits. (By the way, there is a bill (PEPTA) pending in Congress that would purportedly improve disclosure and therefore funding of municipal pensions. It's not the answer, but if you want to read about it, you can read my take on it here.)

In any event, Central Falls is not the only public entity in the US in financial trouble. And, of those, Central Falls is not the only one with a severely underfunded pension plan. In fact, there are many. But, Central Falls is in Rhode Island. And, Rhode Island has this new law. In my opinion, many other states will copy this new law.

Consider what will happen when employees find out. Those often ultra-generous public pensions may not be safe, or at least not as safe as we thought they were. Will public employees insist on higher pay? More generous benefits (other than pensions)? Will they just leave municipal employment for the private sector?

And, what of private pensions? They have more well-defined funding rules. For the most part, benefits in those plans are guaranteed by the Pension Benefit Guaranty Corporation (PBGC). But, there is a lesson to be learned. Let's separate those plans into a few categories:

  1. Well-funded ongoing plans of thriving companies where the plan's obligations represent only a small part of the company's balance sheet.
  2. Poorly-funded frozen plans of struggling companies that, because of their size, represent a significant drain on the company's balance sheet.
  3. Everywhere in between.
With regard to group 1, even the most ardent FEs might tell you that such a company can withstand blips in its pension plans, even large blips. The company runs the pension, but the pension doesn't run the company.

With regard to group 3, it depends on where that company and its pension plan fall on the continuum between groups 1 and 2. Certainly, the PPTs are more likely to be on the side of letting the economy take its course while the FEs will likely want to see assets in high quality fixed income instruments matching the plan's obligations.

As for group 2, they are in trouble. To a large extent, the pension plan runs the company. Due to the relative size of the plan, the company's P&L is driven significantly by pension expense. And, the balance sheet and the company's ability to borrow to run its business will be largely driven by the state of its pension plan. Even the most fervent PPTs would probably admit that something drastic needs to be done to manage this risk.

Private pension funding rules, as most readers know, have lots of smoothing techniques available to them in funding calculations. Smoothing techniques are wonderful tools to help a company manage its cash flow. At the end of the day, however, a plan does have a market value of liabilities. Different individuals may have different opinions on how to calculate that market value, but it is there somewhere. And if that market value of liabilities is getting ready to swallow up the company, then there is truly "Danger, Will Robinson!", significant danger. 

Readers should be reminded that what I write here is usually my own opinion (sometimes I use literary freedom to offer up ideas with which I do not agree), and sometimes not even that, but should in no event be attributed to anyone else. But, the issues in this particular piece are real. I rarely use this blog as an advertisement, but in this case, I am going to, for just a moment. I know of a company that happens to be a leader in helping clients manage their retirement plan risks. In fact, they are good enough to send me a paycheck once a month. Please contact us if any of these issues hit home for you.

Tuesday, August 2, 2011

Prudence in Light of a Credit Downgrade

Paraphrased somewhat, ERISA tells us that a plan fiduciary should handle plan assets in the way that a prudent man would. Historically, many have found that to mean some or all of these:

  • Don't take wild risks
  • Generally invest in higher-quality fixed income instruments
  • In tougher times, take the flight to quality as the returns that you may be giving up will more than be made up for by the comfort of knowing how safe those assets are
But, wait! The flight to quality, often seen as a movement to invest in US Treasuries, is producing negative returns that will likely get more negative as interest rates rise due to debt downgrade. But, you knew that was going to happen, didn't you?

So, did you pull your plan assets out of US Treasuries? If you didn't, was that prudent?

I don't know.

Think about it. Tell me what you think.