Tax Reform on the Horizon ? Probably Not

Representative Dave Camp (R-MI) has just introduced into the House Ways and Means Committee which he happens to chair the Tax Reform Act of 2014. You can read it here. Given that the Republicans only control one house of Congress and do not control the White House, the bill has little likelihood of passing. However, it gives notice as to where the party leadership may want to take tax policy.

After I've done my skim-through of the roughly 1000 pages, I'll try to comment here if it's worthy of any such comment.

It May Not be Politically Correct, but There are Gender Differences

It shouldn't come as a surprise to us that men and women are physiologically different. Come on now, I know my readers are smart. All of you worked this out before I said anything. But, lots of people have been surprised by this article and the FDA recommendations in it.

The FDA, for the first time, is recommending a different drug dosage for women than for men, although they go on to say that perhaps the reduced dosage is appropriate for men as well.  What surprises me is not that this happened, but that it took so long to happen.

Let's consider why.

Before drugs go on the market in the US, the FDA requires that they go through extensive research and clinical trials. Those are done almost exclusively on men. Why? To quote an FDA official whose name I cannot remember, "Women are hormonally inconvenient." In other words, because women monthly have significant hormonal swings, it is much more difficult to filter out the noise in the data.

Unfortunately, this means that much of the data that we actually have collected on drug efficacy and drug interaction may be somewhat accurate for men, but it's probably less accurate for women. And, as long as I am being politically incorrect, I would hypothesize that the same efficacy and interaction deficiencies that result from gender specific studies also result from the fact that studies have generally not been filtered by data such as ethnicity and blood type.

I've not done the research, so I am just guessing. But, my guess would be that people of different ethnicities and people of different blood types (among other differences) handle different drugs differently. It just makes sense.

So, what's in the future?

I don't really know, but this is my blog, so I get to hazard a guess.

Today, one of the current trends is genome mapping. Without having any particular expertise in the field, I understand that each of us has our own individual genetic map (perhaps monozygotic twins (identical) have the same genetic map, I just don't know). Surely then, the ideal medical treatment of each of us for a specific condition is different than for anyone else and those differences are based on our genetic maps. The data to develop these new medical plans of action will be here soon. Are we going to let hormonal inconveniences get in the way of better treatment plans?

401(k) Plans Without Matching Contributions Will Not Allow the Masses to Retire

I read an article this morning entitled "Encouraging Savings Without a Match." The article was informative enough and it did discuss the importance of getting workers to save. It discussed how auto features (auto-enrollment and auto-escalation) will have positive effects in allowing workers to accumulate balances large enough to retire someday.

The author and her sources are correct. Auto features will help, but they are not enough.

Why not?

Suppose I am a participant in a 401(k) plan and you are my employer. Suppose that in that plan, you provide me with a fairly measly (by today's standards) match of 25 cents on the dollar for the first 4% of pay that I contribute. That's not much; you're only contributing as much as 1% of my pay, but you are motivating (note the lack of use of the non-word incentivize) me to defer at least 4% of my pay. That means that 5% of my pay will go into my account. It's also a first-year return on my investment of 25% before I have even a bit of positive investment performance.

If instead, you provide me with a more generous match of 50 cents on the dollar for my first 6% of pay, the motivation for me to defer at least that 6% is even greater. And, of course, if you provide me with one of the nice safe harbor matches that are even more generous, I am motivated still further.

Auto-enrollment provides no such motivation. Without that motivation, when I hit a financial crunch (perhaps my new-fangled high-deductible health plan is not providing me with the risk management tools that I really need), the first place I may look to for an extra source of weekly or monthly cash is those 401(k) deferrals. Perhaps stopping them allows me to pay my rent or mortgage on time. Perhaps it allows me to make my car payments. Because I don't have an additional incentive beyond the holy grail of retirement to continue saving, ceasing my 401(k) deferrals sure feels like a good idea. And, once I stop, I probably won't start again.

From where I sit, most people today seem to live at or above their means where their means are characterized by their take-home pay. The old defined benefit-based system allowed people to retire because their take-home pay was perhaps a little bit less in order to pay for their retirement benefit which could be a fair amount more. The discipline in that was not employee-driven, but plan design and ERISA-driven.

Now, the motivation is largely gone and the discipline is largely gone. People are living longer and a lot of them are going to have to work for a long, long time.

AOL Reacts to Media and Employee Pressure

AOL had made a decision to follow in what many were calling the IBM mold. Rather than providing matching contributions in its 401(k) plan on a payroll period basis, it had decided to make single matching contributions after the end of the plan year. Therefore, employees who left during the year would not receive matching contributions.

The media were up in arms. Employees were up in arms. AOL gave in and is returning to its former policy of matching on a payroll period by payroll period basis.

And, this is big news!?

What really got to me about the media coverage was the spin that they managed to put on it. Employees could be losing out on the massive run-up on the matching contributions. Not said was that those balances could lose money as well. It's not fair that employees who leave during the year won't get matching contributions. What makes this fair or unfair? If you know the rules up front and you are evaluating leaving during the year, this should be one of your considerations.

How bad is it really? I'm going to oversimplify my example so that the math doesn't strain my brain. Suppose Employee Z has wages of $100,000 per year and a company matches 50 cents on the dollar on the first 6% of pay contributed. This is not an unusual design. Further suppose (and this is not quite right) that matching contributions are usually made on average exactly halfway through the year. Also assume that under the IBM design that matching contributions are made on the January 1 after the end of the year. Finally, assume that balances earn, on average, 10% returns (I want that investment adviser).

Suppose Z does not leave the company during the year. Then the difference during that year is is approximately 5% of $3,000. In other words, under the more traditional design, Z will have an account balance that is $150 larger. Yes, there are the effects of compounding, but this is really not as big a deal as the media made it out to be.

Surely, AOL has already determined how much money it plans to spend on its employees. if it spends more on the 401(k) plan, rest assured it will spend less somewhere else. It all comes out in the wash. But, it sure does make for an exciting story when a bunch of reporters, many of who think the plan is called a 401 [without the (k)], get a hold of it.

Really, it isn't.

Blip Theory -- The Downfall of 401(k) Outcome Theory

Most of the non-regulatory material that I read about 401(k) plans these days deals with participant outcomes. In fact, outcome seems to be one of the big buzzwords for 2014. We are suddenly talking about financial outcomes, health outcomes, and every other kind of outcome you can think of.

Don't get me wrong, I think it would be great if we all have wonderful outcomes. I just don't believe the studies that tell us how to get there.

In the typical piece that I read, I learn that in order to get the best outcomes, participants should begin saving at the beginning of their working career, increase the percentage of their pay that they save over time and convert their account balance (one way or another) to an inflation-adjusted annuity for longevity protection.

That's great. And, when a smart person models what will happen if a young adult follows this guidance, that person will always be destined to have a highly prosperous retirement.

But, it seems that very few people, even those who started saving when they were fairly young, are actually on target to have that very prosperous retirement.

Why not? What happened?

Life happened.

None of these models seem to reflect real life. In real life, people have periods of unemployment. During that unemployment, they stop saving. In fact, to the extent that those people have not also saved well outside of their 401(k), many will need to take distributions from those very 401(k) plans (paying income tax and the early distribution excise tax) just to stay afloat.

Where is this event in the models?

In real life, many young people actually do start to save at a modest rate and gradually increase the amount that they save. But, in real life, many of those people choose to have children and some will have them without having made a truly conscious decision to do so. Kids cost more money than anyone seems to think they will. That increase in savings rate often fails to be sustainable.

Where is this event in the models?

In real life, in 2014, an awful lot of people participate in high-deductible health plans. They are told that one of the great tax benefits of the modern world comes to people who put money away in a health savings account (HSA) to fund the high deductible part of their plans. This is a great idea as well, but real wages have not been increasing for probably the last 15 or more years. This model expects participants to save upwards of 10% of compensation in their 401(k) plans and an additional, say, $4000 per year in their HSAs. That's a lot of money. I think more people than not would tell you that this is just not feasible.

Where is this conundrum in the models?

Purchasing an in-plan annuity or taking an annuity distribution in your 401(k) is often an excellent idea. But, not all plans have them. Among those that do, many are not offered on a particularly favorable or attractive basis. The models that I have seen use a current, no-profit basis for converting your account balance to an annuity.

Where can I get one of these annuities on which an insurer makes no profit?

I'm all for wonderful outcomes. But, somebody needs to merge blip theory with outcome theory. Under blip theory, and I have never heard the term used before the morning of January 17, 2014, just as the road to hell is paved with good intentions, the road to wonderful outcomes is paved with potholes hereinafter known as blips. When models start including realistic numbers of blips, I'll start to believe the expected outcomes.

Anther Application of Modern Portfolio Theory

Modern portfolio theory deals largely with the allocation of assets between asset classes in a portfolio. The field, grown predominantly from Markowitz's concept of the efficient frontier has been a hot topic among both investment professionals and more casual investors alike during my time in the workforce (no, that doesn't take us back to prehistoric times, just close).

Essentially, the most significant outgrowth of this concept is that there exists a continuum of allocations that maximize expected return for a given level of risk, or conversely, that minimize risk for a given expected return. All of this, of course, is based on a large set of assumptions, in this case, capital market assumptions. Oversimplifying somewhat, what Markowitz, and after him others, discovered was that you can reduce risk in a portfolio while sometime even increasing longer-term expected return.

That's pretty cool. Part of what we learned is the value of populating a portfolio with uncorrelated and inversely correlated assets. Okay, John, what does that mean?

Consider a two-holding portfolio. Suppose each holding has an expected return of 8% per year and that their returns are well correlated. In other words, when one goes up, the other is expected to go up by a similar percentage. And, when one goes down, the other is expected to go down by a similar percentage. Essentially, your diversification is not. You're not getting any additional benefit from the second holding.

Suppose instead, your tow holdings are somewhat inversely correlated. In other words, they are neither expected to perform particularly well nor particularly poorly at the same time as each other. The expected return of each holding doesn't change. But, by decreasing the overall risk of the portfolio, you are able to increase the long-term expected return of the total portfolio by decreasing volatility.

Now that we've got that straight, let's change our portfolio. Instead of looking at financial assets, let's consider the insured lives of a health insurance company. While less is known about correlations of costs among diverse populations, it seems clear to me that a homogeneous population carries with it a higher risk to the insurer than one that is not.

As an example, consider a population consisting of 100 insured lives, all of them men between the ages of 65 and 75. Without doing any research to get the correct percentage, my past reading tells me that a meaningful percentage of them are going to get prostate cancer over the next 10 years. That's a largely unavoidable occurrence, or so I read, and the claims could all come at the same time.

How would an insurer manage that risk (other than reinsuring or hedging in some other way)? Suppose they cut their population of insured age 65-75 males from 100 to 10 and added in 90 other insureds. Some of them might be of the type that represent a very low risk, say 20-30 year-old males. Some might be women in their 40s, mostly past the age that they will be in the maternity ward.

What it seems that we will find is that the more diversification that our insurer has in its portfolio, the less volatility in claims it will have over time. This is good for them.

Under the Affordable Care Act (ACA), again somewhat oversimplified, health insurers must pay out at least 85% of their premium dollars in medical claims. Suppose they develop a set of premiums whereby they expect to pay out, on average, 90% of their claims. Further suppose that the 90% average has a standard deviation of either 5% or 15%. If I am doing my math correctly, then in the case where the standard deviation is 5%, our insurer will only have to pay rebates in about 16% of all years. In the 15% standard deviation case, however, they will pay rebates in 37% of all years.

In a nutshell, here is what this means. Our hero, if you choose, the insurance company will keep its full profit in either 84% (100%-16%) of all years or in 63% of all years. Before rebates, their long-term profits will be identical, but managing their portfolio for lower risk allows them to actually keep more of their profits.

Another application of modern portfolio theory?

The Useful and Not so Much of Wellness Programs

A friend and reader referred me to this New York Times article that discusses a DOL-commissioned study performed by the RAND Corporation and PepsiCo. The study looked at wellness programs to determine the relative values of disease management components and lifestyle management components.

I was surprised that the results were so glaring. I'll get into that difference in just a minute.

First, for readers who don't deal in this area every day, it's useful to explain what we are talking about here. Disease management programs target people with chronic illnesses by educating them about their risks, reminding them to see their physicians, and reminding them to take medications. Lifestyle management programs focus on things such as stress management and weight loss.

The study found that disease management produces very meaningful cost savings, but lifestyle management results in virtually no savings at all. First and foremost, the PepsiCo disease management program has reduced hospital admissions significantly, and hospital admissions are one of the leading contributors to high medical claims costs.

Personally, I think there is more to the difference than what appears in the NYT article. Consider a patient with hypertension (high blood pressure). That blood pressure can be measured. There are prescription drugs whose primary purpose is to get a patient's blood pressure under control. Taking that medication once a day is easy as long as you can remember to do it. For most people, since the medications usually don't have severe side effects, there is nothing discomforting about doing this. Patients see the improvements and they are happy. Statistically speaking, a person with normal blood pressure is less likely to be admitted to the hospital than a hypertensive person. And, blood pressure medication is not among the more expensive ones.

How about lifestyle management? How exactly would I measure stress? How exactly would I control my stress? How would I know that my stress was reduced?

To my mind, these are all largely indeterminable elements. I know when I feel less stressed, but it's usually not something that can be controlled. If I think I will have trouble paying my bills, I will be stressed. If I think I will lose my job, I will be stressed. If a family member is ill, I will be stressed. No stress management program can change this.

Looking at the numbers cited in the study, the disease management program saved nearly $4 for every dollar spent on it while the lifestyle management program saved only about 50 cents for every dollar spent. In total, the program saved nearly $1.50 for each dollar spent.

One could look at this in several ways. We could say that the program in total is working. We could say that PepsiCo should eliminate the lifestyle management component. What we can't say is that disease management doesn't work.