Another Sub-Par Year for Target Date Funds -- What to do Now

The S&P 500 gained about 2% during 2011. The Barclay's Aggregate Bond Index had an increase in the neighborhood of 8% for 2011. According to a Morningstar survey as reported by the Wall Street Journal, the average 2015 Target Date Fund (TDF) lost nearly 1/2 of one percent during 2011. To state the obvious, that's not good. At the end of this article, I'll give you one take on a solution. Until then, we look at the problem.

What's going on here? Shouldn't a plan participant within five years of retirement expect to do better? Or, are the funds in the 2015 TDFs allocated so as to avoid any significant losses at the risk of giving up the upside?

I am not in a position to analyze the contents of every 2015 TDF out there. I know about a few of them from having looked at prospectuses, in some cases because I had the opportunity to invest in them myself. But, I have also discussed the makeup of some of these funds with people who either sell them or manage the investments.

DISCLAIMER: What I am discussing below here are purely generalities about the TDF market. I am neither condemning nor endorsing any particular TDF. Further, my comments don't reflect information about any particular TDF. What you read into what I say is at your own peril.

Whew, it feels good to get rid of that disclaimer. I hate those things. On the other hand, I don't want to get sued for making an innocent statement that gets taken the wrong way.

First off, most of the large TDFs are proprietary funds of proprietary funds. What does this mean? Well, suppose you are invested in a TDF offered and managed by WSWAARGIC (that's We Say We Are A Really Good Investment Company for anybody who was wondering where the firm got its name that just rolls off the tongue). We will call them WSW for short. Take a look inside the WSW TDFs. Each one uses WSW equity funds and WSW fixed income funds. In fact, 100% of the assets in the TDFs are actually in WSW funds.

Now, we all know that WSW is a good money manager. We know this because our employer wouldn't have chosen them if they weren't really good. Just how good is WSW, though? In looking a little bit deeper, we see that the WSW 2015 Fund is invested in 7 distinct asset classes through 7 WSW funds. Of those 7 funds, 4 have been top quartile over the last 5 years. That's pretty good. Another 2 have been in the second quartile over that period. That's not bad. But, the seventh fund has been in the bottom quartile. It's the so-called Core Bond Fund and it makes up a good portion of the allocation for the 2015 Fund. The problem is that WSW doesn't really have a fund to replace it in the TDF and WSW insists that this is a short-term blip and the Core Bond Fund will improve.

As someone who plans to retire in three or four years, how do you feel about this? I'd bet that you wish they had worked out the Core Bond Fund problems outside of the TDF and replaced it with some other company's core bond fund.

But, most TDFs don't work that way. The managers tend to look for what they think are the best available investment options WITHIN the proprietary group of funds. Some observers think that they may not even be looking for the best, but just the most expensive, but I'll leave that for the reader to decide.

I'm going to go under the assumption that if you as a plan sponsor are using a TDF as your qualified default investment alternative (QDIA) that you think it's the right choice as a QDIA. Even so, are you in the right TDF? Suppose that instead of a proprietary TDF, you had a custom TDF consisting of (we'll use 7 as the number again) seven funds in seven asset classes where all seven funds were relatively low-cost, yet historically high-performing funds that have not had recent manager changes or other disruptions. These funds exist. Morningstar might call them 5-star funds. With this TDF, you would need someone to help you set it up, manage it and rebalance it, but all that can be done. From a participant standpoint, they would get better funds for lower fees ... and isn't that what a 401(k) plan is supposed to provide?

Cassidy Retirement Group Expands Westward

Cassidy Retirement Group is pleased to announce our newest consultant, David Kershner. David, a Fellow of the Society of Actuaries and an Enrolled Actuary is located in sunny Phoenix, AZ. He can be reached at david@cassidyretirement.com or (480)577-4665.

We look forward to David helping us expand our presence in the western part of the country.

What Does it Mean to Review Something?

I've had a fairly long career in consulting to this point, and I don't expect it's real close to its end. Over the course of that career, I've had lots of work reviewed and often reviewed the work of others. The question that I would ask is this: "When someone asks you to review their work or when a client asks a third party (you may be the third party) to review your work or the work of another, what should that entail?"

Clearly, step one is to make sure that the work that was done is correct. Other important tasks for the reviewer are to make sure that the work product is appropriate for its intended use and appropriate for its intended audience.

How about checking to make sure that a document or report is well-written? I think that is part of a review as well. But, where does that start and where does it end?

If the original author will be the signatory, does that give the reviewer license to alter the author's style? In my opinion, it does only if the original style detracts from the intended purpose. On the other hand, it does not, in my opinion, give the reviewer license to re-style a piece solely because he or she has a different style than the original author.

How about word usage? Should the reviewer express their own opinion by making word changes where the two words have identical purpose? This one is a little bit trickier. Suppose the author has used the word "will" and the reviewer changes it to "shall." What do you think? I think the reviewer is making a change for the sake of looking important. On the other hand, the reviewer does need to consider the intended audience. If the original author, for instance, has used the term phonetic syzygy (I was grasping for something fairly obscure), would the reviewer be within his license to change that to alliteration. I think he would, because most audiences (I don't think) have any idea what phonetic syzygy is, so the word change would make the document more readable.

When the whole concept gets really sticky is when you are a third party reviewer being compensated to do that review. If you don't make many changes, are you earning your keep? Is it okay that you are saying that the author did a good job?

I think most of us struggle in this regard. If we are asked to do a review, most of us seem to feel as if we have come up short when we return the document in a less than bloody state. As an author, I despise this. When I'm a reviewer, I hope that my original authors hate it when I do the same.

Many of you had the fortune or misfortune (it's your opinion) of reading the works of very different authors during your schooling. Consider, for example, Messrs. Faulkner and Hemingway, widely considered two of the great American novelists. You may have an opinion as to which of the two was better. I do, but my opinion here doesn't really matter. The point is that if Faulkner had been asked to review Hemingway's work or conversely, and the reviewer had pushed their style upon the work of the other, then America would have been short one style of writing.

At the end of the day, if you are asked to review, do your job. Doing more than your job is probably not your job.

The Social Security Tax Cut May Not Apply to You

Congress has reached a new level of confusing the American public. We have the new 2-month Social Security tax cut. And, it applies to all working Americans (except those like Senators and Representatives whose wages as elected officials I think are exempted from Social Security). So, for the months of January and February, we all get a decrease of 2% in our Social Security taxes. Fantastic!

Now, for some explanation. Generally, a person pays into the Social Security system at the rate of 7.65% of pay up to the Social Security Wage Base (I believe that is $110,100 for 2012). Above that level of wages, a person pays in at the rate of 1.45% of pay. And, for each dollar that a person pays in, their employer pays in an equal amount. If you are self-employed, you are both the employer and the employee, so you pay both parts.

Now, that sounds unfair, doesn't it, that you stop paying in the Old-Age, Survivor and Disability Insurance part (the first 6.2%) after your pay reaches the wage base? Well, you do need to consider that any pay that you receive that is above the wage base is not used in computing your eventual Social Security benefit. For those who are still with me, the other 1.45% is used for Health Insurance, i.e., Medicare.

Here is the good and fair news -- we all get that that cut in our OASDI (the 6.2% piece) during the months of January and February 2012 from 6.2% to 4.2%. But, some of us are deemed to apparently have no need for the extra 2%, so we have the honor of getting to pay a recapture tax, an increase to your federal income tax.

Yeehaw, gotta love it, a recapture tax. I know, what in the world is a recapture tax. Read on, poor reader.

Start by dividing $110,100 (the wage base) by 12 (to get a monthly rate) and you get $9,175. Double that to get a two-month rate and you are up to $18,350.

Now, suppose your Social Security wages for January and February are more than $18,350. [For those who aren't sure, Social Security wages look a lot like your gross pay before taxes are taken out. If you pay for certain welfare benefits on a pre-tax basis, they get taken out. And, if you defer compensation to a 401(k) or similar plan or even to a nonqualified deferred compensation plan to the extent that the amount is vested, those get included.]

If you are fortunate enough to still have your Social Security wages for that two-month period exceed $18,350, then you have the honor of paying a recapture tax calculated as follows:

1. Subtract $18,350 from your Social Security wages for the months of January and February combined. If the answer is 0 or less, then this doesn't apply to you. If the answer is greater than $18,350, then call it $18,350.
2. Take the result from step 1 and multiply it by 2%
3. This is the additional income tax that you will owe for 2012 and it is called a recapture tax.

Think of the scenarios. Lots of companies pay bonuses for your performance during the previous year (2011, in this case) during January or February. For people with base pay less than $110,100, your bonus could put you into recapture territory. Maybe you are fortunate enough to be entitled to a really big bonus for 2011 paid during January or February 2012. It might run through recapture territory into I-Don't-Owe-Recapture-Taxes-On-This Territory. And, then, there are the people whose bonuses will get paid during the first half of March. They get the old-fashioned treatment.

Got it? Good!

Now, think about your paycheck. If you are like lots of Americans, the payroll of your company gets handled by an outside provider. And, miraculously, once a week, once every two weeks, once or twice every month, the right amount of pay gets deposited electronically into your checking (or savings) account. Hmm, do you think that will happen now?

The IRS thinks that it may not. In fact, they have already published rules for companies and individuals that mess this up. Doesn't that just build up your confidence?

So, why do we have this nonsense? In my opinion, it's all because our government no longer chooses to govern. Instead, the two major parties wage a constant battle to see which can find a way to embarrass the other. Does it matter if a law is a good law? Of course not. Does it matter if the law can be administered? Of  course not. Does it matter if the law says what it is purported to say? Of course not.

The Democrats appear to have won this game of shame. It's not their first win. But, Republican lovers shouldn't feel left out. They have won the shame game about the same number of times.

So, now we have a middle-class tax cut ... unless your bonus gets paid at the wrong time, or unless you make too much overtime during January and February, or unless ...

To LDI or not to LDI

I saw an interesting article today. It said that 63% of pension execs (whatever execs represents in this case) are now using an LDI approach for pension funding. I saw an article on the same site that asked the question, "If LDI is so great, how come more funds aren't doing it?"

"I see", said the blind man who knows that LDI stands for Liability Driven Investing. In a nutshell, pension funds that employ this technique seek to mitigate funded status volatility by having a portfolio of assets that varies with moving interest rates in essentially the same way as the plan obligations move.

I first discussed LDI with a client in (I think this is the correct year) 1998. At the time, this company's US pension funds had an overall funded status well in excess of 125% on any measure. The technique that I discussed with them didn't have such a catchy name though. I think we called it duration modeling (doesn't sound too catchy, does it). The good news -- that company adopted what came to be known as an LDI strategy and never fell into the morass of underfunding suffered my most US pension plans. The bad news (for participants anyway) -- the company eventually froze their plans to save money.

Back in the very late 90s and early 2000s, I gave some speeches on the topic. I always heard the same response from the naysayers -- roughly, do you mean to tell me that you think interest rates are going to go down? These naysayers were generally the absolute return people. Despite all the logic, they didn't seem to understand that even if you thought that interest rates would go up (they didn't over the next 10 years or so), probabilistic or stochastic analysis showed that for most plans, you would be doing a far better job of risk management by matching assets with liabilities.

Let's consider. Suppose that in 75% of all cases, you thought interest rates would go up and in 25%, they would go down (let's assume that in very few would they stay the same and we will just split them evenly between the two groups). Unfortunately, especially under the new PPA funding regimes, the worst possible scenarios for plan sponsors -- the ones that might put them out of business -- all occurred where interest rates fell and the plan sponsor chose to not match assets to liabilities. In the more positive (return) cases, the group that matched didn't do as well as the group that bet that interest rates would go up, but even so, they should have been able to sleep better.

You see, the matching, or immunizing, group, was coming close to ensuring that their required contributions would not be enough to cause corporate financial ruin. Yes, they were taking away some of their upside potential, but isn't that what risk management and insurance are all about? When you insure your home, for example, you know that you probably won't have a large claim. So, you are spending money on insurance that you probably won't recover (essentially decreasing your upside potential). On the other hand, if you do have that large claim, you'll be glad that you had that insurance, and that's what LDI is all about.

Sadly, so many companies that knew this was the correct approach for them resisted and many of them either had to reduce benefits, or in some particularly severe cases, were essentially put out of business by their pension plans.

It's not worth all that. If you still have a US defined benefit plan, at least consider your risks and see what you might do to mitigate them.

Things I Learned on the Road

I know, I haven't blogged much lately. But, I have an excuse. It's tough to blog when either you can't stop coughing or when you are spending your whole day driving around town. That's two excuses -- take them or leave them -- but they are the truth.

In any event, while I've been out there, I ran across a few consistent themes. Here is a summary:

• There are a lot of 401(k) plans out there in America, but many of them are pretty darn small.
• Some of these plans have average account balances of less than $5,000 and they are not brand new plans. That frightens me.
• Among much of the advisor community, there are three types of retirement plans: defined contribution (primarily 401(k)), defined benefit (mostly frozen of one type freeze or another), and cash balance
• Notably, cash balance appears to be a new concept primarily for doctors and lawyers (I found this interesting)
• Many people in the retirement plan advisor community speak in code, or should I say Code. They discuss the distinction between being a three thirty-eight (that's actually 3(38)) and being a three twenty-one (3(21)). It must make for interesting discussion over drinks when the question they are considering is whether to take on responsibility for investment decisions or not.
• Another word that gets tossed around is fouroheightbeetwoo. That's 408b2 or more precisely, the fee regulations under ERISA Section 408(b)(2).

I had always heard that actuaries spoke their own language and that they couldn't (or wouldn't) translate it into English. For some of us, that's very true, but many of us use common everyday language as often as is practical. We only revert into technospeak when we have no other alternative (or when we are sufficiently language-deficient that we are incapable of using our lack of mastery of the language to find a suitable alternative).

To look at the other side of things, though, these advisors are pretty much the everything on retirement plans to small (and nearly small) business owners. They have to know the participant side, the employer side, the recordkeeping side, the investment side. It's not easy to know all that stuff, and to stay on top of it. And, some of those people are really good at it.

The next time I write, I'll try to give you something of more substance. In the meantime, for those of you are celebrating holidays before you see my words again, I wish you the merriest of Christmases, the happiest of Chanukkahs, and a wonderful end to 2011 and start to 2012.

Be safe and be well.

Nondiscrimination Testing Revisited

Yesterday, I read an article written by David Godofsky of Alston & Bird (a large law firm headquartered in Atlanta) on nondiscrimination testing in 401(k) plans. If you are interested in this topic, I would commend you to read it. It is very well written. It's almost interesting. And, like very few pieces that I have seen on this topic that has been written by an attorney, David gets it right, even the math.

You see, David has an unfair advantage. I'm not sure when he became an attorney, but I do know that he has been an actuary for a really long time. So, unlike most attorneys that I know, he gets the numbers. And, unlike many actuaries, he gets the law.

So much for praise of an attorney. While he gets the technical stuff right and keeps it interesting, I am going to explain to you where David goes wrong. He compares testing to a peanut butter and jelly sandwich, and puts that sandwich in a positive light. I know this will be anathema to many, but peanut butter is the single worst food ever created. It smells bad, it tastes bad, and it has a bad texture. That, by the way, is either opinion or fact, and the early voting returns say it is fact, although I am afraid that opinion may come on strong. In any event, to add to the problem, he doesn't even serve anything to drink with his abomination.

Retirement plan nondiscrimination is clearly more elegant than that which applies only to 401(k) and similar plans. If Mr. Godofsky is serving PB&J with his testing, the testing that I refer to is more suited to foie gras served with sauternes.

You get the picture? His is packed in a metal lunchbox with Fred and Wilma staring at you. Mine is presented by a trained server and is only for the most discriminating among us. And, oh yeah, mine costs more than his.

Before I move forward, though, I need to warn you that just like foie gras and sauternes, neither most actuaries nor most attorneys understand nondiscrimination testing. I taught this lovely topic for more than ten years, so I saw the misconceptions.

Now, we get technical and explain to you why this process should not be left to the sous chef and the apprentice sommelier, but rather to the masters. While I am not going to go into the really gory details, this is probably about to become the single most technical topic (although I prefer to think of it as elegant) that has ever appeared in this blog.

It all started with Internal Revenue Code Section 401(a)(4) which spells out one of the requirements that a trust that forms part of a retirement plan be qualified (exempt from tax): "[I]f the contributions or benefit provided under the plan do not discriminate in favor of highly compensated employees (within the meaning of section 414(q)). For purposes of this paragraph, there shall be excluded from consideration employees described in section 410(b)(3)(A) and (C)."

That sounds pretty simple doesn't it? You wonder what nondiscriminatory means in this context, don't you?

I'm so glad you asked. You see, without explaining everything, there are two ways that a plan can be nondiscriminatory in the amount of benefits or contributions that are provided:

1. Have a safe harbor design
2. Prove it

Let's suppose that we choose to prove it. In the simple case, we will consider each employee in the controlled group. And, then for each one, we will calculate both that employee's normal and most valuable rate of accrual. Normal generally means life annuity at normal retirement age. Most valuable generally means qualified joint and survivor at the age at which it has the greatest actuarial value. This is not a simple determination. 

Then we take the employees and we put every one of them on a grid defined by his or her normal and most valuable accrual rates (by the way, if you think this is too easy so far, there are multiple measurement periods that can be used to do these calculations, and we can choose to impute permitted disparity or not). Let's assume that in our grid, the highest rates are in the upper left or northwest corner. We get to take people with similar accrual rates and group them. Then, we define a rate group for every highly compensated employee (or group of highly compensated employees). A rate group consists of every employee who sits neither south nor east in our grid of the rate group in question. Once we have done that, we determine a ration percentage for that rate group defined loosely as the ratio of 1 to 2 divided by the ratio of 3 to 4 where 1, 2, 3, and 4 are as defined here:

1. the number of nonhighly compensated employees (NHCE) in the rate group
2. the number of nonexcludable nonhighly compensated employees in the controlled group
3. the number of highly compensated employees (HCE) in the rate group
4. the number of nonexcludable highly compensated employees in the controlled group

So, now we have a percentage for a rate group. We need to get a percentage for every rate group. And, then we need to take the minimum of all those percentages. And, after that, we need to compare that minimum to the threshold percentage for the coverage test that we used and if our minimum is above that threshold percentage, then we pass.

Hold on, what's all this about coverage percentages?

Well, you see, a plan also needs to satisfy the minimum coverage requirements of Internal Revenue Code Section 410(b). And, this section has two tests (you only need to pass one). But, the tests have different threshold percentages.

Let's look at them. Under the ratio percentage test, you again take the ratio of 1 to 2 and divide it by the ratio of 3 to 4 like we did above, except that now in the numerators, we have numbers benefiting under the plan. To pass the ratio percentage test, your threshold is generally 70%, unless you are using snapshot data which is a subject for a comparison of restaurants rather than foods (snapshot data looks like fast food while complete data looks like fine dining). But, suppose you fail the ratio percentage test, or when you are doing your nondiscrimination testing, your rate groups don't clear the 70% hurdle. Then, you will want to use the average benefit test.

It's a nice little test. It has two parts, the average benefit percentage test (ABPT) and the nondiscriminatory classification test (NDCT). And, the NDCT has two parts. To run the ABPT, you combine generally all plans of the employer and determine an accrual rate (or contribution rate) much like we did above for each employee in the controlled group. Then, you take the average over all the NHCEs and divide it by the average over all the HCEs and take the average for the NHCEs and divide it by the average for the HCEs. If it's at least 70%, you pass this part.

On to the NDCT. One part of it is that the group of people covered by the plan has to be a nondiscriminatory classification. It's hard to know exactly what this means, but two examples may help. A plan that covers all the employees working in Grand Fenwick probably has a nondiscriminatory classification. A plan that covers all the employees with purple hair and orange eyes may fail to be nondiscriminatory.

The other part is a version of the ratio percentage test, but with a lower passing threshold. What is that threshold? I'm so glad you asked because you have to figure it out. Just follow these simple steps:

1. Determine the percentage of employees in your controlled group who are NHCEs. Call this the NHCE Concentration Percentage (NHCECP). 
2. Round down to the next lower integral percentage unless you are already at an integral percentage.
3. Subtract that answer from 100.
4. Multiply that answer by 0.75.
5. Add that answer to 20, but don't let your new answer go above 50.
6. This is your safe harbor percentage.
7. Subract 10, but don't let this answer go below 20.
8. This is your unsafe harbor percentage.
9. Halfway in between the two is your midpoint.
10. If your ratio percentage is at least equal to the safe harbor percentage, you pass.
11. If your ratio percentage is less than your unsafe harbor percentage, you fail.
12. If you are between the two harbors, you are in the Sea of Facts and Circumstances and only the IRS can tell you if you pass or fail.
13. The midpoint is generally the threshold for your rate groups.

That sure was fun, wasn't it?

Well, sometimes after you have done all that, you still don't pass. And, that's when you really need to rely on tricks of the trade.

Don't do it yourself. This is dangerous stuff. Talk to the master.

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