Broadening the Definition of Health

The investment management and retirement services ecosystems are in for some significant changes in the next couple of decades. These changes will mirror the state of households in the pre-retirement and retirement life stages. Increasingly, a larger share of the US population will want a guaranteed monthly check to finance their monthly consumption liabilities versus a hopeful return. Unfortunately, neither the grocery store, nor the pharmacy, nor the mortgage company, nor the utility company, nor the gas station will accept the currency of hopeful accumulation. Households are going to want guaranteed income outcomes for life to live.

So what is causing these changes? Well, here are four factors worth remembering:
1) Aging of the US population – 65 million boomers streaming toward retirement
2) Increases in life expectancy – up to 80 now, and growing
3) Near extinction of defined benefit programs, and therefore pensions that guarantee income for life
4) A growing national debt that will restrict efforts to patch up social security, medicare, and medicaid programs

I recently became a Marketing Advisor to the Retirement Income Industry Association – RIIA, whose mission is to help retirement and investment management professionals understand the implications of these changes, to counsel them on how to prepare for this new paradigm, and to create a forum for exchange.

As households are increasingly responsible for all aspects of their own financial health (versus the days when many workers had a reliable pension), navigating the different sources of help is a daunting task. And the ramifications of doing a poor job can be catastrophic. I have always been surprised by the number of people who are willing to pay high mutual fund expenses (more than just fees) and are hesitant to pay for a financial planner who provides a holistic financial view, from income risk, to education financing, to tax efficiency, to pre and post retirement planning, to estate planning, and delivers wise recommendations. While financial health is not a pleasant topic for most people, financial health is a responsibility for any adult. It is analogous to maintaining good physical health with continuous annual check ups with a competent physician.

Financial advisors have a relatively poor reputation because they are all aggregated into one group. But they are not all the same. It is critical to differentiate between those that distribute or “sell” products, and therefore only need to comply with a “suitability” litmus test, versus advisors that have a fiduciary responsibility to their clients. Moreover, I believe that the interests of fee-only practices versus commission-based practices are better aligned to service households. A good financial planner can help to improve your financial health and enhance your financial literacy. And you can pass this financial literacy on to your kids, who will most likely face a much more challenging world when they must become responsible adults.

Financial Literacy and Adult Responsibility

I recently completed a financial planning course at Boston University. While the subject matter will passion few, the content presented is mandatory knowledge for any responsible head of household in the United States. It is extraordinary how many people don’t know what they don’t know or don’t want to know what they should know. Caveat: probably up to 50% of households in the US have insufficient assets to be concerned with some of the issues described below.

Within the context of today’s economic crisis and the expectation that government and household leverage will act as a drag on economic growth in the next decade or so, the course materials would prompt most responsible adults with families to ask themselves a number of questions. Here are just a few:

1) Do you know what your consumption will be in retirement and how this liability compares to your existing or future assets?

2) If you are “under-funded” or constrained by insufficient assets, have you thought through how you intend to fill the gap?

3) Have you and your spouse protected yourselves from disability – short and long term? What if you lost your job – do you still have disability insurance?

4) Do you have a will and a trust? If you don’t have a trust for your assets or your life insurance policy, why not? Do you understand how this will affect your kids? -think probate (time and money) and estate taxes.

5) How are you managing your assets and what expectations do you have? At what point should you modify your portfolio to ensure a floor for retirement based on your consumption expectations?

6) Have you considered a variable annuity and if so, what percent of your retirement income/portfolio should it/they represent? While these vehicles have had high fees historically (and a bad reputation), times have changed. Fees have come down and there are riders that guarantee income for life – so you won’t outlive your assets.

7) How much do you pay in fees for mutual funds (blended bps)? Are you chasing alpha through active mutual funds and do you really want to play that game?

These are just a few of the issues this class raised and completing the course certainly made me feel much more financially literate. And of course, I can now pass on best practices to my kids and help dear old mom and dad with their financial worries.

Chasing Alpha: A Homeric Odyssey?

The rationale for owning an active mutual fund is the manager’s success at achieving returns on a persistent basis in excess of compensation for risk. Investment professionals employ the term “alpha” to describe a manager’s performance relative to a market or asset class, often represented by a benchmark such as the Russell 2000. It is also used in anthropology to describe an individual with the highest rank. In the mutual fund world, every active manager wants to prove they’re an alpha. Male or female.

Academics and financial professionals have been arguing for years whether active mutual funds generate sufficient returns to justify their incremental costs. And research suggests that 3% to 25% are successful over time, depending upon the methodology used to estimate the rate. Fully loaded, these costs are generally 2-4% of capital annually, depending upon the asset class, which represents quite a steep hill to climb.

Let there be know doubt that some active managers do generate gross returns that more than cover the incremental cost of their funds. Those pursuing alpha, however, must remember one mathematical truth: in aggregate, alpha is 0 and once incremental costs are considered, alpha is negative. And since alpha appears to be the same in the mutual fund and non-mutual fund markets, the aforementioned statement holds true.

So what’s an investor to do? Well, I learned about an interesting approach to achieving alpha – investing in a fund composed of multiple active fund managers . There are firms that claim great competency in the selection of fund managers and some are quite credible. One I recently learned about is Russell Investments, a firm best know for indices. The beauty of this approach is that the fund does not commit to one active manager – it commits to dozens of active managers. And if you believe the firm knows something about picking managers that consistently beat their benchmarks and that diversification of fund managers mitigates the risk of pursuing alpha, this could be an attractive complement or satellite to a core passive portfolio.

So while alpha in aggregate is zero in gross and negative when adjusted for expenses, it may make some sense to add a multi-manager fund to your portfolio in the hopes that the firm can pick the best managers and that diversification will mitigate manager selection risk.

Turning Retirement Upside Down

I can remember five or six years ago reading the NYT, WSJ and listening to NPR where many politicians, economists, and journalists (often citing the positive experience of Chile and the great opportunity cost to Americans as the bourses of the world took off to the moon) recommended that the Social Security system be “privatized”. As I recall, average americans were to manage their social security “accounts” as self-directed investors, and by doing this, retirement outcomes would be superior. Of course, I won’t mention that fixed income returns were higher in the last ten years than equities. (at least this is what Robert Arnott published a few months ago)

Well, guess what? All I keep hearing about now is the need to reverse course from a pure defined contribution model where the investor takes all of the risk and assumes the cost back to an approach resembling the defined benefit model where the worker has a guaranteed stream of income upon retirement.

It is extraordinary that in such a short period of time, our world seems to have changed! From my point of view, the best model is probably a hybrid. And research I have seen on best expected outcomes suggest that some combination of annuity with self-directed/adviser directed mutual fund/ETF investing is probably best. This would provide some guaranteed income to retirees but also provide an opportunity to perform better than the insurance companies that sell you a variable or fixed annuity.

It seems to me that competitively priced annuities need to quickly find their way into qualified profit sharing programs such as the 401(k). From personal experience, understanding the terms of fixed and variable annuity products is extremely challenging. So you will certainly want to consider finding an expert if these types of analyses aren’t your cup of tea or carving out enough time to do the analysis yourself. Also, remember to consider diversifying the insurance companies you purchase products like these from – after all, their promise to pay you requires their solvency and even though the insurance company pays a premium for insurance themselves, I believe the pay-out from that insurance has a ceiling.

Of course, we may wake up in five years and find our world has changed again.

Best Outcomes: Paternalism vs. Freedom

Brightscope conducted an interview with Fielding Miller this week about the future of the retirement planning industry. Fielding considers the current environment a “bull market” for advice and specifically mentioned growing opportunities with Plan Sponsors who he believes are increasingly seeking quality financial advice for 401(k) participants.

There is little doubt that the current economic crisis (specifically the deflation of asset bubbles – housing market, bourses – and high unemployment), and the marked increase in the share of the US population classified as pre-retirement or post retirement age is heightening peoples’ anxiety over their financial stability and viability.

In a country like the US that generally abhors a paternalistic approach to government and has a culture that implicitly encourages conspicuous household consumption (since it relates so directly to self-esteem), developing a comprehensive plan to address the retirement plan challenge will be complex. I’ve lived and worked outside of the US and I’ve seen how other governments handle it. In France, for example, 25-30% of my paycheck disappeared before I paid income taxes to finance national health care and worker pensions. So to some degree, the country imposed forced savings on me and promised me a modest but guaranteed reward for my behavior – a pension. And while I paid for this pension, at least I knew it was coming which reduced my anxiety over the future. It is true that many European countries have insufficiently funded their national pensions and their aging populations will make matters worse; nevertheless, this does not change the point. And because my discretionary income was lower, I consumed less.

About 8 years ago, many pundits and economists were espousing the benefits of privatizing social security and giving Americans investment discretion over their own accounts. Unfortunately, history has demonstrated over and over that the majority of americans do not have the education, the temperament, or the desire to be self-directed investors. Moreover, Americans have shown themselves generally incapable of saving enough on a sustained basis for retirement. Certainly, the 2006 PPA’s provision to encourage plan sponsors to default 401(k) participant deferrals is a step in the right direction. Everything that I have read suggests that this has had a positive impact on savings.

So what else do we need to do? And here, I come back to Fielding Miller’s interview. Yes, this should be an excellent market for financial planning advice. But how are we going to deliver it to everybody, not just the elite 20% of the population? And what do we do about that small problem – people don’t save? And why don’t people save? Are we a culture of savers or spenders? Can we find a balance? Did this all start with Reagansim and can we become a more balanced nation even if China refuses to do the same? Thoughts? Am I asking the right questions?

More thoughts on this coming.

Target-date Funds and Complacency

Since qualifying as a QDIA under the 2006 Pension Protection Act and therefore providing fiduciary relief to plan sponsors, Target-date funds have attracted a significant share of new 401(k) net asset flows. This hyper-growth in net target-date fund flows reflects the default status of the funds and that many participants don’t bother to explore alternatives. And why not? If you read the messaging of these investment products, these funds are structured based on the risk profile of the participant and provide efficient and diversified portfolios.

Unfortunately, target-age funds present some troubling disadvantages. First. the last few years have demonstrated that these funds can create a false sense of security. Many of these investment products performed poorly in the 2007/2008 financial crisis and proved significantly more risky than many participants expected. In this sense, particularly for participants approaching retirement, the risk attributes of these funds did not match expectations. And this highlights a fundamental problem with these funds: it assumes that age is the only determinant of participant’s risk profile. A participant would certainly do better with a portfolio that took into consideration other personal attributes such as health, job security, income, expenses, total liquid assets, behavioral, just to name a few.

Another issue, which I alluded to above, is that all target-age funds do not possess the same characteristics. The is true of the glide-path (the rebalancing as the participant ages) as well as the characteristics of the sub-funds that the target-age fund is composed of. For example, not all fixed income funds are the same. Maturity length and quality will certainly vary as will value versus growth tilts for equities. To demonstrate this point, for the first 3 quarters of 2008, returns on target-date funds for 2010 retirement ranges from a 13% loss to a 28% loss. These differences on performance mirror differences in strategic allocations and in the characteristics of the included funds.

Last and perhaps most important – and here we return to the age-based portfolio construction issue – 401(k) target-date funds do not take into consideration assets that are in a participants non-401(k) accounts. The fund’s asset allocation may make sense based on the participants 401(k) account, however,it may make little sense based on a more holistic view of the participant’s assets.

What I would conclude (and I’m curious about what others think) is that participants are better off using personalized advice based on their unique attributes, beyond just their age.

Wirehouse or Independent? Will the DOL Ruling Change Preferences?

A few years ago, a well know executive in the investment management industry speculated that in the future, a higher percentage of financial advisers would prefer larger, non-independent structures i.e. the great wirehouse institutions such as Merrill Lynch, Morgan Stanley and Smith Barney. While driving my kids to school this morning, it occurred to me that just the opposite may in fact happen.

Why?

First, I think the new proposed ruling introduced by the Department of Labor last week would only allow fee-level advice (no commission for investment products) to 401(k) participants and IRAs. Would this not exclude advisers from the wirehouses and the Fidelity Investments of the world from advising retirement assets? Second, after this great recession, one could conclude that the trust engendered by the great wirehouse brands e.g. Merrill Lynch is tainted. People may now trust the local RIA more than the adviser from the big institution.

If this is the case, it may have implications for investment services companies wishing to reach intermediaries as a distribution channel. Sure, getting into the platforms of the wirehouses and broker/dealers will always be important. Will the relative importance, however, diminish, in favor of building mutually beneficial relationships with independents?

The Debate is Heating Up on Capitol Hill Over Investment Advice

Those who follow or have a stake in the financial advisory and retirement planning industries must be aware of the debate on Capitol Hill about the separation of advice from the sale of investment products. This debate heated up in January 2009 when the Department of Labor (DOL) attempted to clarify a cryptic and important element in the Pension Protection Act of 2006 that encouraged plan sponsors to hire financial consultants to work with 401(k) participants. On January 21, 2009, the DOL issued guidance on this question. The DOL said that brokers and reps affiliated with financial service providers would be permitted to offer this financial advice and, if I understand the legal issue, would be granted an exemption from Section 406 of ERISA. In the context of the Bernard Madoff scandal and the poor performance of 401(k) portfolios since 2007, many experts and legislators cried foul. How could advisers provide responsible, prudent advice, if their compensation depended on the sale of products that might not be appropriate for a participants or IRA holder?

There’s obviously a lot at stake here for a lot of people.

Let’s start with the largest stake holder – the American people who will one day need to retire and hope to live a comfortable and healthy post-retirement life. Most people are fighting to save and accumulate sufficient assets to live a comfortable retirement. I don’t see how advice from a broker or rep affiliated with an investment products company could be unbiased. These advisers may not be considered fiduciaries,depending upon the nature of their advice, and and very likely will be biased toward funds that increase their income based on incentives offered by their compensation plan. I have difficulty accepting the argument that there are sufficient controls in place to mitigate these conflicts of interest. And even if they are considered fiduciaries, the temptation will always be there. To ignore this, I believe, is to reject the realities of human nature and greed. Hasn’t history proven this over and over again?

Now of course, advisers need to be compensated when they deliver valuable services. But how many actually do? It is probably true that it is easier to extract payment from consumers when taken directly out of their funds through fees (out of sight, out of mind) versus paying a fee for advice which is much more transparent and accountable. And of course, paying a fee for advice is probably a much more advantageous approach since the consumer then knows their advice will be without bias caused by sales commissions for what may be less than appropriate products.

To illustrate the point, a participant with a portfolio of $100,000 would pay the same for a portfolio averaging 40 basis points (typically a more passive investment approach fosussing more on asset allocation and less on achieving alpha) and a $750 fee for professional advice versus an average 115 BPS with no specific fee for advice (in fact, probably less because of lower transaction costs and other hidden fees – some have estimated the real cost of the average large cap fund to be 200 BPS, and even higher for international emerging market funds). And again, in the scenario where a designated fee is paid for advice and the portfolio’s blended fee is low and product choice is without compensation-driven bias, the participant will be better off. This doesn’t even consider the value of planning and its positive impact on retirement outcomes.

So the DOL just issued a new proposed rule. More on that later.

Any thoughts?

Retirement and Investment Planning

About three years ago, I developed and implemented a relationship marketing plan for one of the largest asset managers in the world.    As part of this engagement, I extensively researched the investment professional audience, including financial advisers, wealth managers, and portfolio managers.  As part of this research, I read academic research e.g. Fama French and some books published by William Bernstein, John Bogle and a few others.

I’ve since moved on from this consulting practice, however, my interest in investment management and retirement planning continues.  So I’m starting this blog as a way to begin a dialog with others who care about the issues I’m going to address.  And while I do have some strong opinions about these issues, I invite others to participate in the debate so we can all be better informed.

So what are these issues?

First, a little background.  Today, most experts estimate that less than 50% of households will have sufficient assets to live a comfortable retirement.  And investors agree: according to an Alliance Bernstein study in 2009 , confidence in achieving a comfortable retirement plummeted from 2007 to 2009: from 62% to 38% for active investors, from 21% to 7% for accidental investors.  This change in sentiment (and the confidence levels were already fairly low) mirrors low or negative returns in the last five to ten years.  Indeed, despite continued deferrals, retirement account balances fell 17% between 2007 and 2009 (not to mention the effects of inflation).  To make matters worse, a Vanguard study in 2009 demonstrates that a significant number of investors are making poor investment decisions.  For example, 28% of accounts have 0% or 100% equity exposure.  For almost any lifestage or situation, we know this asset allocation is not efficient.

The facts show that individual investors manage their money poorly.  Why?  Well first, many believe they can beat the market and achieve  Alpha.  Well, truth be told, alpha in aggregate is zero.  So on average, investors will never achieve alpha and the fees they pay to active fund managers or for market timing transactions will cause them to fall well short of Beta.  A recent Fama French studyagain demonstrates that very few fund managers have the skill (3% according to their recent paper) to beat the market in the long run.

Second, many financial advisors provide advice that is either ill-informed or directed by financial gains and therefore conflicts of interest.  In fact, the Department of Labor and the Executive Branch are trying to change rules that eliminate this conflict of interest for advice to defined contribution programs and IRAs through changes to the Pension Protection Act of 2006.  More on this later.

Third, insufficient emphasis is placed on financial planning.   Individuals don’t like to discuss their finances or retirement and they don’t fully understand the financial planning process.  And when they seek help, many advisers simply recommend stocks or expensive mutual funds that pay them commissions.  Moreover, there is a  large under-served segment of the population that will not attract fee-based financial advisers because their accounts are too small.  And while they may attract commission-based advisers, the result is likely quite poor since the focus will be more on selling financial products and less on providing informed advice.

Well, that’s a start.  More to come.