Are You Sleeping? Who is Managing the Compensation Risk?

Risk management used to be viewed with a somewhat jaundiced eye. It was something that the geeks did. I know, at your company, you just didn't need it because you understood your business better than some guy with a fancy degree, a pocket protector, and an HP-12C.

While companies had full-time risk managers and even risk management departments before then, this mad science really came to the forefront in the early 2000s. Suddenly, companies were seeing that risks that they had taken, especially in the area of leveraging themselves perhaps a bit too much, were starting to bite them in their proverbial hind quarters.

With that, the CRO or Chief Risk Officer, became the new sought after geek. Here was a person with specialized training who could look after the store, so to speak. If the CRO approved, then the CEO and CFO had a special comfort that all would be well.

Yes, CROs, as a group, do have specialized training. They tend to be smart people who can model the risks of a veritable cornucopia of corporate transactions. But, even the smartest person doesn't have the capacity to consider every possible risk. Sometimes, they are just not aware of certain risks. Sometimes, the other departments take actions without consulting the CRO and his staff because they just don't think the particular decisions has a risk potential that hits that threshold.

Perhaps that department was Human Resources. I know, you think I am wrong; by the early 2000s, the Risk Management Department was heavily involved in working with pension plans. Well, I am focused on a different part of Human Resources here, the part that develops compensation programs.

Way back when, you know, about 25 years ago, a typical bonus program worked something like this. Everyone in the program had a target bonus -- some percentage of their base pay. To go with that target bonus, you had a set of goals. They were, in theory, set up so that you had a roughly equal chance of exceeding your goals or of falling short. And, your bonus was typically capped, on the upside at twice your target and on the downside at zero.

Ah, theory, what a wonderful concept.

Picture yourself as a manager. You have three employees to review for their performance in 2011. Let's call them Larry, Moe, and Curly. Larry has always been a star performer. Each year, he has exceeded expectations. But, in 2011, Larry did not have a good year. He fell short of every goal. But, somewhere in your mind, although you can't quite put your finger on the exact cause, you think there must have been extenuating circumstances. You are sure that Larry will have a good year in 2012, and what's more, you don't want to lose him to a competitor. So, on your 1 to 5 scale with 5 being the best, you grade Larry as a 3.5. You tell him that he is being rewarded for a prolonged period of high performance, but that he needs to step it up in 2012.

Moe has always been your man in the middle. He's been a consistent performer, always meeting goals, but rarely exceeding them. But, Moe has those intangibles. They are not in his goals, but you just have to reward him because he makes everyone around him better. In 2011, Moe exactly met his goals, but because of that special something, you gave him a rating of 3.5.

Curly has been your problem child. Each year, he has been the laggard of the three, but you have kept him around both because the team has been meeting its goals (due mostly to Larry) and because of his wonderful sense of humor. Curly keeps you laughing and he is just so likable. Finally, for the first time, in 2011, Curly beat his goals. You gave him a rating of 3.5

Let's look at what happened. Your team exactly met its goals. Yet, you awarded each team member with a rating that gets them a bonus of 125% of target. Hmm?

And, then in another year, business was really good. You find out that the bonus pool is going to be really big. Curly had another very good year. You give him a rating of 4.5. Moe had a better year than Curly, and you know that somehow, Moe also contributed to Larry's success this year, so you give him a 4.9. But, Larry, oh Larry, had the year of a lifetime. If Moe got a 4.9, there is no rating that does Larry's year justice, so you take it up the line to get Larry a bonus of 3 times target. And, because business was so good, it gets approved.

But, the next year, the economy goes into the tank. Nobody meets their goals, and in fact, the company lost money. It would like to have a negative bonus pool, but that can't happen. And, all of your employees tried really hard, so you want to give them something. You beg to your superiors just as every manager is doing, but where will the money come from?

As time went by, companies survived this strange concept where everyone got a bigger bonus than they really deserved. So, it became accepted that there was really no upside limit to bonuses, at least not for the top producers.

But, I digress for a brief commercial. If you haven't read Michael Lewis's book, The Big Short, then you should. To a large extent, it shows how having no upside limits to incentive payouts encourages absolutely ridiculous risk-taking. Without giving away the whole book, people were making and taking 12-figure risks on bets that they didn't understand. Hmm?

And, they were being rewarded for it. People who had budgeted incentive payouts in the range of several hundred thousand dollars were suddenly getting 8-figure payouts. They were betting on these wonderful instruments known as credit default swaps, and most of them were taking what turned out to be the wrong side of the bet. But, the risk management people didn't understand them either. In fact, very few people did.

So, now we are really in 2011, very close to the end of it, in fact. Managers with explicit incentive compensation plans will be facing the same issues all over again. Far more visibly, Compensation Committees will be facing the same issues all over again.

Let's peek in at a deliberation as the Compensation Committee decides how much of an incentive payout to give to CEO Lou Abbott and CFO Bud Costello. The company didn't have a great year, but neither did any of their competitors. And, Abbott and Costello, everyone knows, are legends in the industry. We really can't afford to lose either one of them. Last year wasn't too good either. We really can't risk losing them over a bad incentive payout. Let's give them something extra this year and we'll go harsher on them the next time their scheduled payout would be huge. [Hopefully, this behavior isn't occurring in any real Compensation Committees, but you never know.]

Do you think the Compensation Committee will remember?

So, here's the deal. In a bad year, bonuses in total may be more than the company can afford because they can't afford to pay out that little and risk losing people over it. In a mediocre year, bonuses in total may be more than the company can afford because everybody had something positive about their year. And, in a great year, the risk-takers won and they will get bonuses so big that the company will pay out more than it can afford.

And where is the Risk Management Department to ask who is managing the compensation risk?

CBO, We Have A Problem

Sometime back, I wrote, not with admiration, about the Congressional Budget Office (CBO) and the 'scoring' rules that our Congress has burdened it with. Essentially, they don't adjust for inflation and they don't do dynamic scoring. Or, said differently, they are required to treat each bill as its own micro-economy, forecast for only 10 years, and  generally not reflect inflation. This approach allows the Congress to manipulate bills so as to score them as cost-neutral, or even as cost-savers, when in reality, everyone, including both Congress and the CBO, know that they are going to cost us a lot of money.

How much money? Does the number 15 trillion mean anything to you? The federal debt, according to the debt clock is now just above that number. It's a big number. It has 12 zeroes in it. It also has two other digits to the left of those zeroes.

I would posit that these rules and Congress' manipulation of these rules are responsible for a significant portion of that 15 trillion. In fact, and I'm just guessing (no calculator or spreadsheet in action here, not even any mental math), if I had to choose an over/under amount, more than half of that 15 trillion in debt has accumulated from flawed scoring.

I'm not saying that the CBO does poor math, in fact, they are very good at it. What I am saying is that the constraints that they are required to follow have caused the United States to underprice the costs of various bills by a really big number and I am guessing (that means that I don't know, but my brain now fully caffeinated for the day has estimated) that this number in the aggregate is more than half of 15 trillion dollars!

When I try to hide my political biases, I usually work in alphabetical order and I'm going to do that here. In this case, the Democrats are incredibly guilty of having gamed this system ... and they know it. In this case, the Republicans are incredibly guilty of having gamed this system ... and they know it. Most of the public doesn't know it. There has never been a public outcry. There should be.

So, what does this have to do with employee benefits? The good folks at the Employee Benefits Research Institute (EBRI) have a nice little chart (actually it's not so little) that they call Employee Benefit Tax Expenditures -- White House Fiscal Year 2011 Budget Estimates. It shows that the tax expenditure (that's a fancy name for the amount of deductions that people and corporations get on their taxes, either through deductions or through tax exemptions) for employer contributions for health care benefits in FY 2011 is in the neighborhood of $175 billion and  similarly, for employment based retirement plans, it's about $110 billion. That's $285 billion in total. The mortgage interest deduction for the same year is about $105 billion. So, employee benefits are a really big culprit.

I bet my readers know that those numbers go up every year. Of course, they do, inflation makes them go up, doesn't it? Suppose we adjust for inflation. Then, what happens? Well, EBRI can help us out with that as well. Here is the url for a spreadsheet (http://www.ebri.org/pdf/publications/books/databook/Table 5.2 Inflation Adjust.xls), and you'll have to copy and paste this one, that shows what happens when we adjust for inflation. Look at the spreadsheet. Find me a major element that decreases on an inflation-adjusted basis. You can't do it, can you? And, therein lies a problem of just enormous proportions.

The 10-year cost of many of these bills is understated because the CBO isn't allowed to use assumptions that faithfully project the cost. And, because cost increases tend to (read that as virtually always) significantly outstrip inflation, using virtually any 10-year cost projections for a bill that is expected to last for a long time (think Social Security or Medicare, for example) represents among the most significant frauds ever perpetuated on the American taxpayers.

Yes, I said it. It's a fraud.

It's time for the taxpayers to stand up to Congress.

I haven't used song lyrics in this blog for a while, but I'm going to go back to the Vietnam War era for this one. With thanks to Jefferson Airplane,

got a revolution got to revolution 
Who will take it from you 
We will and who are we 
We are volunteers of america

Change volunteers to taxpayers and ...

Another Survey Says

The benefits community in the US loves surveys. Large consulting firms love to do surveys. Presumably, their clients like this information, or at least someone thinks they do. The benefits news consolidators (you know, the publications that scour the internet for benefits news for a daily newsletter) love to tell us about these survey results.

This is all good. Or, at least, this could all be good. These surveys, though, have their problems.

• Questions are often poorly worded
• Possible answers either cover too much territory or not enough territory
• Press releases summarizing survey results seem to disassociate cause and effect
• Survey populations may not be unbiased
• Surveys inevitably are constructed to produce the findings that the surveyors think should be produced

Questions are often poorly worded

This is a no-brainer, but the world at-large doesn't seem to mind. I saw a survey question recently (the group had not been bifurcated yet into people who liked versus those who disliked their consumer-driven health plan (CDHP)) that asked "What do you like best about your consumer-driven health plan?" The possible answers were something like:

     a. my quality of care is higher
     b. it costs me less
     c. I can choose my own physician
     d. it promotes a culture of wellness

My immediate reaction is to ask where is e: none of the above? Let's look at the possible answers. Anybody who says that their quality of care is higher under a CDHP must be hallucinating. What would make it higher? If you can choose your own physician, why would they provide better care when you are in a CDHP than they would under a traditional health plan?

If you say that it costs you less, I would ask you less than what. Yes, the premiums are lower than they would be in an HMO, for example. On the other hand, they are higher than they would be if you had no insurance at all. Isn't this like having a deductible on an automobile insurance policy? If you choose a higher deductible, your policy costs less. But, in the health care policy, you usually don't get to choose your deductible. And, in the case of high-deductible health plans (HDHP) which are typically the cornerstone of CDHPs, the deductible is typically higher than most people can effectively budget for.

If you say that you can choose your own physician under a CDHP, that is true, but can't you choose your own physician under any health plan? It's true that your care may not be covered by the plan, but for many people, if that is really the reason they are in a CDHP, I would say that they are quite misguided.

Do you really think that CDHPs promote a culture of wellness? If I were texting, I would reply "lol." According to a recent Aon Hewitt survey (oops, now I am citing a survey), 35% of participants in CDHPs are sacrificing medical care because they cannot afford their part of the cost under these plans and 28% are postponing it for financial reasons. FACT: that is not indicative of a culture of wellness.

Suppose I think the CDHP that I have been forced into just plain sucks. How do I answer this question?

Answers cover too much or not enough territory


In the last section, I managed to deal with answers that don't cover enough territory. Sometimes, they go the other way and cover too much.

I took a survey recently about automobiles. The survey asked me a series of questions. For each question, I was supposed to answer on a scale of 1-13, with 1 meaning I strongly disagreed and 13 meaning I strongly agreed. Come on, people, 1-13? Do they really think that ten minutes into a survey, I can rate things on that fine a scale. They asked me if I would consider buying a Lexus when I next purchase a vehicle. So, perhaps I went through a train of thought like this. Lexus makes a very good car. They are stylish, safe, high-performing, and dependable. They are also expensive. Would I consider buying one? Yes, I would probably consider it, but I really don't want to spend that much money on a car, so how strongly would I consider it? Hmm, is that a 5 or a 6 or a 7 or an 8 or a 9 or a 10? I don't know. If it was on a 1-5 scale, I could probably happily fill in the little button for a 3. But on a 1-13 scale, that would be equivalent to a 7 and I just don't know if I'm a 7 or not.

Press releases ignore cause and effect


I saw another survey (if I could find the actual survey again, I would cite it here) recently that said that fewer companies were funding (informally) their nonqualified deferred compensation (NQDC) plans. The headline said something about recent guidance on corporate-owned life insurance (COLI) being the reason for this. Hmm, the survey had no questions in it about why fewer companies were funding their NQDCs. And, further, I'm not sure what recent is, but I can't find any recent COLI guidance that would affect funding of NQDC plans. Perhaps the authors of the surevy had a bias?

Survey populations may not be unbiased


Suppose a large consulting firm does a survey. In my experience, they send the survey to a nice cross-section of large companies. Perhaps it looks something like the Fortune 200 plus all of that firms clients not in the Fortune 200 that generate at least $1 million in annual revenue for the firm. Of the companies surveyed, who do you think are the most likely to answer the survey? Could it be the consulting firm's large clients? Aren't they the ones most likely to actually open the survey? Who are least likely to answer the survey? Could it be the companies that have recently fired that large consulting firm?

Do you think that the results of this survey might be a little bit skewed? Do you care? I do.

Surveys inevitably are constructed to produce the findings that the surveyors think should be produced


Suppose you ran the health care consulting practice at a large consulting firm. Further suppose that you are a big proponent of consumerism. In fact, you have built your consulting firms health care consulting practice around CDHPs. You ask your survey group to do a survey around health care plans. You want to be able to make a bold statement in a press release that shows how wonderful CDHPs are and for all the reasons that you have been touting.

Do you think you will make sure that the questions have at least a small bias that will lead to your desired result? If the findings come back differently than you had hoped, do you think you will publish the results as is, or will you find a way to tweak the results? Will you tout the portion of the results that support your practice or will you be unbiased in how you release the survey results?

I don't need to answer those questions for you. You don't need to answer them either. We all know the reality.

These surveys ... they do have their problems.

The Cynic In Me Says Watch Out For the Health Insurance Industry

Yesterday, I attended the Traveling Seminar in Atlanta put on by the Conference of Consulting Actuaries. Well, actually, I instructed for part of the day and attended for part of the day. It's a really good day of continuing education and I would highly recommend it even if I am one of the instructors. You can read more about here so that you can see why perhaps you should attend a Traveling Seminar next year.

But, that's not my point in this post. I'll get to that in a second. One of the four sessions yesterday was on health care in the US, essentially health care reform, PPACA, or whatever glorious name you might choose to attach to it. As I listened, I noticed some analogues between the Dodd-Frank Act that was intended to keep the financial services industry in check and PPACA which among other things appears intended to keep the health insurance industry in check.

So, I digress. Dodd-Frank created lots of new rules. In fact, 2800 pages or so of legislation has a tendency to do this. Among other things, it restricted some of the practices of the banking industry that lawmakers had judged were pretty nefarious. The banking industry saw that its profits, especially on the retail side were declining. So, what did the banks do? They started to put more and different fees in place. Some of them, such as the $5 per month (that was usually the number, I think) fee for using your debit card even once, faced public uproar and outrage and were repealed. But, they are finding other ways that will not be so in your face. If you ever find out about them, you won't like them, but chances are that you can't find out whether they are in your bank's disclosures or not.

So, what does that have to do with PPACA? Well, the more I listened to yesterday's presentation, the more I heard about health insurers losing some of their margins. And, many of them have shareholders to report to. And, those shareholders expect profits. And, the profits may be ready to decline. So, my message to you is that since the health insurers can't easily deal with declines in their profits, they'll have to get them back somewhere ... somehow.

So, ladies and gentlemen, I don't know how they will do it. But, hold onto your wallets. The insurers need their profits. They are in business, after all, to make money.

Thank You

Tuesday, November 15 will mark one year since I started this blog. In the immortal words of Casey Stengel, "You could look it up." Since I will not have the opportunity on Tuesday, I thought that I would reflect a bit this morning on my first year as a blogger.

Frankly, I don't recall why I started. I do know, though, that I was really excited when I found out that someone who was neither my wife nor my child had read what I had written. Now, one year later, I have nearly 12,000 hits. People that I have never heard of have e-mailed about things I have written and none of them have been death threats. People that I do know have written me and have been very complimentary.

When I first started, I had some thoughts about what I would blog about. I was going to have a heavy focus on analyzing new laws and new regulations. Well, the lovely folks at Treasury and Labor didn't read my mind. They forgot to give us much in the way of new regulation. And, Congress, they can't get anything passed, so expecting to see new laws to analyze was nothing more than a pipe dream

So, I have evolved. I have done a lot of observational writing, perhaps patterned more after Freakonomics than the Harvard Law Review. Well, in all honesty, it's been neither, but I have tried my best to inform and to entertain, but perhaps most of all, to make you think.

It's been fun. I like to think that I am not the traditional math geek in that I can construct a proper sentence or even paragraph when I choose to. So, writing is often relaxing. Yet, at the same time, some of my thought pieces make me think as well.

And, no I'm not quitting this blog (or my other one either). It's not easy every week, though, to come up with two or three blog posts with which to entertain myself and hopefully be worth reading for at least a few of my readers. So, as I thank everyone who has taken the time to stop by to see what in the world my most recent ramble is about, I beg for these things:

• Keep reading. I love my readers.
• Comment some. It's not hard and it doesn't take much time. I'd like to know what you think.
• Give me blog post ideas. 
• Figure out why mass distribution newsletters such as NewsDash and BenefitsLink don't pick up my posts (I've tried) and convince them to do so once in a while. I know that my drivel is more worthwhile than some of what they do circulate.
• Refer your friends to my blog. I'll even settle for referrals to your pets.

Thanks again for reading.

Public Pensions Are Not the Problem

I hear it all the time: public pensions are a big problem. On TV, I hear that "we" just have a 401(k) plan, why should government workers have a pension plan? I'll answer that question and talk about the real problem that public pensions have been made to become.

Understand as I write this that I am a fiscal conservative by nature. While there is a place for some benefits that are more socialized than some others might think, I don't, for example, espouse that our employers, public or private, should be responsible for our entire welfare.

That having been said, let's consider a young potential worker, Kelly (I figured I would use an androgynous name because I haven't decided yet if I want to make Kelly male or female, or if I even care). Kelly is considering two job offers, one with a private employer and one with a public employer. This may not be an unusual scenario.

The private employer offers Kelly a nice package to start with. It includes all this:

• $60,000 base pay
• 2 weeks paid vacation and 10 paid holidays
• A consumer driven health plan (Kelly doesn't know what that means, but does know that it is a health plan) where the employer pays 75% of the total cost
• A 401(k) plan with a match of 50 cents on the dollar for the first 6% of pay that Kelly contributes

Assuming that she (I decided to make Kelly female) elects the health plan and defers at least 6% of her pay to her 401(k) plan, the total annual employer cost of the package being offered to Kelly is approximately $60,000 (base pay) + $4,615 (paid time off) + $4,500 (health plan) + $1,800 (401(k)) = $70,915.

The public employer offers Kelly a very different package. It includes all this:

• $50,000 base pay
• 3 weeks paid vacation and 15 paid holidays
• A traditional indemnity health plan for which the employer pays 90% of the total cost
• A defined benefit pension plan that if funded ratably over a full career for Kelly will cost the employer (on average) about 5% of pay

Again, assuming that she elects the health plan, the total annual employer cost of the package is about $45,000 (base pay) + $5,769 (paid time off) + $9,720 (health plan) + $2,500 (pension plan) = $67,989.

NOTE: I have taken fairly wild guesses on the costs of the health plan. They should not be used as representative of any particular plans nor should the be used as representative of the costs of any particular plans.

The values of the two packages are close enough that Kelly may have some career and lifestyle choices to make. But, we will leave Kelly for the moment as her career decision does not really matter to us.

The first thing that does matter, however, is that the two potential employers have similar costs of employment, however, they choose to allocate those costs very differently. The second thing that matters is the pension plan. Note that I said that the public employer was going to fund that benefit ratably over a full career. When this is done on a percentage of pay basis, it typically comes from an actuarial cost method known as (Individual) Entry Age Normal. In this case, the 5% of pay is what is known as the normal cost, or the annual cost of the benefits being allocated to the present year.

Wow, that was an earful. I'll slow down the technical stuff.

My point is that a public pension plan, at least in every jurisdiction of which I am aware, can be funded rationally. As part of that rational funding, the plan sponsor (whoever represents the sponsor) must first allow the plan's actuary to choose reasonable actuarial assumptions, including those for discount rate, salary increase rate, rates of termination, disability, retirement, and death, and any others that are appropriate to the plan and its population. Second, the plan must be funded using an actuarial cost method that takes into account future pay increases and is reasonable in its allocation of benefits to an employee's past service, current service, and future service with the employer. Third, regardless of the leeway allowed by the law, the sponsor must ensure that the plan is funded rationally every year. The cost is the cost. You don't take a year off from funding so that you can build a new skate park, especially since the mayor's son is a competitive skateboarder. 

The problem is that most public plan sponsors have not taken this approach. They have been neither reasonable nor rational. Much like the US government, especially under the last two presidents, public plan sponsors have taken the approach of running up obligations that perhaps could have been paid for as they were accrued, but were instead left for a future generation.

Therein lies the problem. The public pension is only its face.

And the Survey Says ...

I read the results of a survey on defined contribution (DC) plans this morning. Among its findings was that participants understand what the number/date in the name of a target date fund (TDF) means. I don't want to call out the name or author of the survey here because it did have some good information. What I do want to cite is that the conclusions may not be as valid as the authors suggest.

I'll bet you want to know how I can say such a thing. Even if you don't, I am going to tell you. Roughly what happened was that survey participants were contacted by telephone and asked a series of questions. One of those questions was (approximately) asking what the 2030 means in the term Retirement 2030 Fund. Again, approximately, the choices were:

1. The approximate date at which a participant expects to retire and begin drawing down the account balance for retirement income.
2. The approximate date at which a participant expects to retire and roll over the account balance to an IRA.
3. The approximate date at which the participant wants to spend the money freely.
4. I don't know.

Frankly, two of these (1 and 2) sound like good choices. The other two do not. That person could somehow divine one of the two correct answers (1 and 2) from the four choices given does not suggest much about the person. The survey authors seem to think it does.

I think I could have authored the survey in a way that would have shown that nearly 100% of respondents understand what the 2030 means. That's right, nearly 100%. 

I want to change the choices. I'll keep #s 1 and 2 as they are. But, I am going to change #s 3 and 4 to be these:

• The next year that the Cubs will win the World Series.
• The next year that NBC will win the ratings battle against ABC, CBS, and Fox.

See how silly it can get. Everyone knows that the Cubs just don't get to win the World Series. There is a curse, and it is stronger than the one that plagued the Red Sox. And, clearly, NBC is more likely to finish 5th in a 4-horse race than it is to win the ratings battle. 

Or, I could make these choices 3 and 4:

• The year at which a participant will have enough money in their account to retire comfortably.
• The year at which the fund will convert from an account balance to a level annual retirement payout.

Now, my guess is that between 50% and 60% of respondents would get this one right. And, remember, if choices were chosen randomly, 50% would choose either 1 or 2. So, I don't think that respondents really get it.

There is much education still to be done.

Final DOL Investment Advice Regulations

On October 25, the Department of Labor (DOL) published final regulations on the provision of investment advice to individual account plan (generally defined contribution or DC plan) participants and beneficiaries. You can read those regulations yourself on the DOL website, you can get a highly technical explanation on the website of most law firms that have an ERISA practice, or you can read about them here. I know which one will be the easiest read for you.

These regulations have an interesting genealogy. They implement provisions of the Pension Protection Act of 2006 (PPA). Proposed regulations were first issued under the Bush administration in 2008, withdrawn and reproposed under the Obama administration in 2010 and have now been finalized.

In discussing this final regulation, I am going to refer to the 2010 proposed regulations as a starting point. For those who are not familiar with the proposed regulations, I would love to refer you to an earlier blog post, but I wasn't blogging then. In any event, I think you'll get the gist as you go along.

Generally, providing advice of this type to plan participants [or beneficiaries] would be a prohibited transaction under ERISA (from here forward in this post, when I refer to participants, that term will include beneficiaries unless I say otherwise). However, PPA provided an exemption for two specific types of advice -- model-driven and flat-fee. The final regulations make two noteworthy changes (a few readers may not agree that the second one is a change, but just a re-interpretation) for model-driven advice.

• To the extent that employer securities are an investment option, they must be included in the model unless the participant directs otherwise. I'm not sure how this can be effectively implemented.
• The proposed regulations indicated, at least to me, that a model could not consider historical returns. Again, to me, this would have directed a bias toward index funds. While index funds may be very appropriate, a regulated bias to them seems inappropriate. The final regulations change the language so that any "generally accepted investment theories" may be used. Presumably, this would include a reference to historical returns.

Again, the statute and regulations under PPA allow for two types of what I have referred to as conflicted advice. That is, it is advice that would be provided by someone who may not be an independent third party. The exemption for flat-fee advice is largely what it seems. To qualify, it must satisfy four pretty simple criteria:

• At a minimum, it uses generally accepted investment theory to take into account historic risk and returns of various asset classes over defined periods of time.
• It takes into account fees and expenses associated with the investments.
• The adviser must solicit pertinent information from the participant and the participant must provide that information. At a minimum, that information includes:
• age
• information that could relate to life expectancy
• current investment options
• tolerance for risk
• investment style or preferences
• other assets and sources of income
• other information that seems relevant
• The adviser receives no direct or indirect compensation for this advice other than a fixed fee from the participant.

A computer model in order to qualify must satisfy seven basic criteria:

• At a minimum, it uses generally accepted investment theory to take into account historic risk and returns of various asset classes over defined periods of time.
• It takes into account fees and expenses associated with the investments.
• Weight the factors 'appropriately' (whatever that means) used to estimate future returns of the various investment options under the plan.
• The adviser must solicit pertinent information from the participant and the participant must provide that information. At a minimum, that information includes:
• age
• information that could relate to life expectancy
• current investment options
• tolerance for risk
• investment style or preferences
• other assets and sources of income
• other information that seems relevant
• Use appropriate (undefined term) criteria to develop portfolios of available investment options under the plan.
• Ensure that there is no bias to recommending investment options that may financially favor the financial adviser or an affiliate.
• Consider all investment options under the plan [including company stock] unless the participant asks that particular options be excluded from consideration.

Because the final regulations require model-driven advice to consider all available investment options under the plan (unless the participant requests otherwise), I would read this to include all employer securities and target date funds (TDFs). In fact, the regulations say that "The Department [of Labor] believes that it is feasible to develop a computer model capable of addressing investments in qualifying employer securities, and that plan participants may significantly benefit from this advice. The Department also believes that participants who seek investment advice as they manage their plan investments would benefit from advice that takes into account asset allocation funds, if available under the plan. Based on recent experience in examining target date funds and similar investments, the Department believes it is feasible to design computer models with this capability."

I am glad that the DOL finds this to be feasible.

Finally, the producer of a computer model to be used to provide investment advice must receive a written certification that the model meets all of the applicable requirements from an independent (independence was not in the proposed regulation) eligible investment expert. Such expert must have the requisite technical training or experience and proficiency to make such certification. [I have no idea who makes the decision on whether or not the expert has these amorphous qualifications.]

Such certification (not a fiduciary act according to the regulation) must include the following:

• Identification of the methodology(ies) used to determine that the model meets the applicable requirements.
• An explanation of how those methodologies show that the model meets those requirements.
• An explanation of limitations, if any, that were placed on the eligible expert in making his or her determination.
• A representation that the expert has the requisite training or experience and proficiency to make such determination.
• A statement that the expert has determined that the model meets all of the applicable requirements.

In jest, perhaps an expert is anyone who can figure out how to do an appropriate certification.

To qualify for either exemption, advice must meet a five-prong test:

1. It must be authorized by a plan fiduciary not related to the adviser
2. It must be independently audited annually with the audit results issued to the adviser and the plan fiduciary. The fiduciary adviser selects the adviser who notifies the authorizing fiduciary of the audit requirements.
3. The fiduciary adviser must provide appropriate disclosures to comply with all securities laws.
4. The transaction must occur at the sole discretion of the requestor.
5. Compensation must be reasonable and no less favorable to the plan than an arm's length transaction.

The regulations also specify a plethora of requirements related to disclosure and record maintenance. So, once again, a participant being advised under one of these exemptions will be given a host of forms to [just] sign before being given advice. Perhaps more useful would be the adviser having a discussion about this information with the participant and the participant making an affirmative statement in writing that such conversation had taken place, but I don't write the regulations.

Failure to comply with these regulations would result in an excise tax of 15% of the amount of the prohibited transaction. The DOL views this as putting significant teeth in the regulation. I am less than convinced. 

In any event, the regulations are effective 60 days after publication in the Federal Register. I have yet to see people lined up waiting to use them.

I Wish I Had Such an Investing Mirror

Everyone seems to be coming out with new and groundbreaking research these days. Well, maybe not. Everyone is coming out with research, but perhaps it is neither new nor groundbreaking. I did read a different take on defined contribution (DC) investing at Wellington Management's website.

The summary of their piece suggests that an additional percentage point of investment return at age 55 is nearly 4 times more powerful than at age 30 because of the increased asset base. It further suggests that "[P]lan sponsors should be thinking about how to construct a robust menu of investment choices that will facilitate an improved investing experience and outcome."

Wow!

There are some great phrases in there. I hate to disparage this summary more than others, but take a look at those words: "facilitate an improved investing experience and outcome." Isn't that really the same as saying that plan sponsors should have a fund menu that produces better returns on investment?

Duh!

Back to the whole point of this blog post, though, and I may get fairly technical for a moment, generally, when a pool of assets is invested in such a way as to increase the likelihood of generating higher investment returns, this is done by taking on more risk. At older ages, this goes against conventional wisdom which says to take less risk. Let's take a more geeky look.

For years, much of portfolio analysis has been done, oversimplifying somewhat, using a normal distribution (bell curve) of occurrences, or if you prefer, a mean-variance model. By way of example, this suggests that if you have an investment with a mean rate of return of 7% per year with a standard deviation (square root of variance) of 9%, then your average (and most likely) rate of return is 7% and that roughly 70% of the time, your annual rates of return will fall between -2% and 16% (+/- 1 standard deviation). Suppose you take on more risk for more return so that your mean is now 8% and your standard deviation 11%, then roughly 70% of the time, your annual rates of return will fall between -3% and 19%.

I want to look at three concepts now that perhaps direct added risk to the higher return portfolio (beware, these may not be for the faint of math):

• Geometric versus arithmetic returns
• non-normal distributions
• fat left tails

Geometric versus arithmetic returns

Let's consider three sets of annual rates of return, all of which average out to 7% per year (add up the 10 years and divide by 10) on an account balance of $100 (no new money coming in):

1. .07, .07, .07, .07, .07, .07, .07, .07, .07, .07
2. .115, .105. 095, .085, .075, .065, .055, .045, .035, .025
3. .025, .035, .045, .055, .065, .075, .085, .095, .105, .115

In case 1, we wind up with an account balance of 196.72. In cases 2 and 3, we wind up with an account balance of 196.01. This is equivalent to an annual return of approximately 6.9614% which is less than 7.00%.

Suppose we add in annual contributions of $10 per year on the last day of that year. Let's see what happens then. Now, case 1 leaves us with an account balance of 265.80, case 2 with an account balance of 259.76, and case 3 with an account balance of 270.69. The average of cases 2 and 3 is an account balance of 265.23. From this, we can learn two things: 1) the additional risk decreases our expected final account balance; and 2) Wellington is correct that more leverage is attained from later investment returns, whether that leverage is positive or negative.

Non-normal distributions

So, you think I've been pretty geeky thus far. It's about to get more geeky. 

Perhaps there have been two reasons that we have historically assumed that investment returns have been distributed normally; that is, they follow a normal distribution. First, it's simple. Second, and far more technically, there is this wondrous concept in probability called the Central Limit Theorem. Oversimplifying a whole bunch, it says that a probability distribution of a number of random occurrences that is really, really big (apologies to Ed Sullivan) will revert to a normal distribution. Hold on, occurrences of investment returns are not random. They have outside influences. 

Fat left tails

So, if these returns are not normally distributed, how are they distributed? Well, we don't have an infinite number of occurrences to look at just yet, but real data suggests that the mode is somewhat right of center (the most common occurrence is a return higher than the mean), but that there are fat left tails (there are a significant number of occurrences (way more than 5%) that fall in the range that we would have expected under a normal distribution to be in the worst 5% of all annual returns.

So, if we return to our cases 1, 2, and 3 from above, there is probably more downside risk than our earlier calculations had demonstrated (I'm not going to re-do the math, just trust me on this one if you can't envision it). This implies that chasing higher returns later in life will give you a greater chance of retiring with a really big account balance, but on average, that same account balance will be lower. In fact, on average, it will be much lower.

Back to common sense

At the end of the day, you need to make your own investment decisions. If you think that you can increase your returns by taking on only tolerable additional amounts of risk, then this may be a good strategy. But, unless you really understand the risks that you are taking, don't go chasing after these additional returns late in your career just because you think you have a robust menu of investment choices that will facilitate an improved investing experience and outcome ... whatever that means.