From a new SIEPR report on the grotesque pension underfunding problems at California’s major plans, a chart comparing the stated and adjusted shortfalls at CalPERS, et al. Source: Going For Broke

I had planned to write a piece on the limits of diversification, at a time when the underpinnings of almost every asset class is based on the twenty-five year bull market in interest rates.  However, the following article from The Economist is well-presented.

All bets are off

Oct 30th 2008
From The Economist print edition

Spreading the risk has spread the losses

Illustration by S. Kambayashi

THERE is such a thing as a free lunch. That, at least, is what pension funds have been told in recent years. Diversify into new asset classes and your portfolio can improve the trade-off between risk and return because you will be making uncorrelated bets.

Boy, did pension funds diversify. They bought emerging-market equities, corporate bonds, commodities and property, while giving money to hedge funds and private-equity managers with their complex strategies and high fees.

The idea was to “be like Yale”, the university endowment fund run by David Swensen, a celebrated investor, which started to diversify into hedge funds and private equity in the 1980s. Compared with other institutional investors over the past 20 years, Yale had very little exposure to conventional equities. It also produced remarkably strong returns.

But those who thought Yale had found the key to success have been disappointed. Every one of those diversified bets has turned sour this year. In retrospect, it looks like the strategy had two problems. The first was that all risky assets were boosted by the same factors: low interest rates and healthy global growth. That encouraged investors to use leverage, or borrowed money, to enhance returns. The result was what Jeremy Grantham of GMO, a fund-management group, describes as “the first truly global bubble”. As confidence has unravelled, investors have been forced to sell all those asset classes simultaneously, driving down prices across the board.

The second, and related, problem is that some of the asset classes were quite small. Initially, this illiquidity was attractive since it seemed to offer more alluring returns. And as more investors became involved, their liquidity duly improved. But they still suffer from the “rowing boat” factor. When everyone tries to exit the asset class at once, the vessel capsizes.

Furthermore, some of these asset classes were always likely to be driven by the same factors as stockmarkets. Private-equity funds, for example, give investors exposure to the same kinds of risks as quoted companies, only with added leverage.

So was the whole idea of diversification a write-off from the start? The strategy’s defenders say no. They argue that pension funds (and other institutional investors) had made too big a bet on equities in the 1990s. When the bet went wrong with the bursting of the dotcom bubble, funds went into deficit.

They accept that, in a crisis, correlations head towards one; in other words, all asset classes (except government bonds) tend to fall together. But the diversifiers have three counter-arguments. The first is that any correlation less than one is still worth having. Hedge funds may have performed badly this year but their losses have been far lower than those of equity markets.

Second, there is a difference between short-term correlations and long-term ones. If you take a five- or ten-year view, it still looks as if property, commodities and the rest offer some diversification benefits. They did so during the equity bear market of 2000-02, for example.

Third, consultants like Colin Robertson of Hewitt Associates argue that diversification does work when it is applied in a sophisticated way. There is no point in diversifying if the investment does not offer a genuinely different source of return (much of private equity falls into this category) or if the asset is already overvalued.

Yet even allowing for this, diversification has surely not offered the benefits most pension funds expected. Indeed, it may have had perverse results. In the old days, with equities trading at below-average valuations, funds would now be on a buying spree. They could afford to ignore the short-term risks because of the long-term nature of their liabilities. Pension funds thus acted as an automatic stabiliser for the market.

This time round, that does not seem to be happening. One reason may be accounting changes which make pension-fund managers more focused on the short term. Another, however, may be the strategic drive to diversification. The Wall Street Journal has reported that CalPERS, America’s largest public-pension fund, has been selling shares to meet commitments to put more money into private-equity firms.

The final problem with diversification has been the cost. Investing in quoted shares via an index fund is very cheap—a fraction of a percentage point. But diversified asset classes cost more to trade and involve higher management fees, expenses that eat into pension-fund returns.

So perhaps diversification has been a free lunch after all. Not for the pension funds, but for the fund managers.

Teachers in West Virginia offer a valuable lesson for what not to do
By JENNIFER LEVITZ

Wall Street Journal
August 4, 2008

Seventeen years ago, West Virginia school employees joined millions of workers nationwide in a shift from a pension plan that guaranteed a monthly check, to a retirement-savings plan that would make the teachers, bus drivers, custodians and other staff responsible for their own investment accounts.

“It was horrible,” says Judy Hale, president of the WestVirginia Federation of Teachers union. Most felt poorly informed, and they invested too conservatively, putting the largest sums of money into a fixed-rate annuity, a safe but low-yielding option that typically is inadequate for building a nest egg.

As employees began to retire, most balances were pitifully small. So on July 1, after a vote authorized by the state legislature, 14,871 school employees, or 78%, switched to the old-fashioned pension plan.

After the vote, teachers were “jumping up and down and crying in the halls,” Ms. Hale says.

The school employees put their mistakes behind them, but their experience stands as a cautionary tale for employers and employees across the country. As large numbers of workers are starting to retire with 401(k) or 401(k)-like plans to support them, what happened in West Virginia is a window into exactly how things can fall apart for workers, and it serves as a wake-up call for figuring out how to avoid having plans go as badly off track as this one did.

Many workers with retirement accounts have built nest eggs far bigger than they ever imagined possible. But unknowledgeable ones often are far short of comfortable retirements — and they don’t have the option the West Virginia teachers did of appealing to state legislators to get them out of their investing mistakes. On top of all this is the havoc that the current bear market may be wreaking on older workers’ accounts if they are too aggressively invested in stocks.

Around the country, a few big employers have ditched retirement-savings plans and returned to traditional pensions. The pace of big companies abandoning pension plans appears to be slowing as well.In 2007, 54 of the 100 largest U.S. employers offered an old-fashioned pension plan to new workers, down from 58 in 2006, according to Watson Wyatt Worldwide, a management-consulting firm in Arlington, Va. That 7% decline compares with a 14% drop as recently as 2005.

But there is little question that retirement-savings plans,which have proliferated since the 1980s, are here to stay. Only 21% of full-time employees had an old-fashioned pension plan in 2007, down from 54% in 2004, according to Transamerica Center for Retirement Studies, a nonprofit corporation funded by Aegon NV’s Transamerica Life Insurance Co.

“A 401(k) gets employees to the right place if they’re using it right,” says Pam Hess, director of retirement research at Hewitt Associates a Lincolnshire, Ill., consulting firm, adding: “We still have work to do.”Improvements ushered in by the 2006 Pension Protection Act are still being put into place by many employers, such as automatically enrolling new workers and providing investment advice. More employers also are offering account-management services, annual rebalancing of accounts to keep investments in line with designated asset-allocation targets andtarget-date funds that adjust their holdings from an aggressive to a conservative mix as workers age.

Challenges clearly remain: At the end of 2007, the median 401(k) account balance for people age 60 and above was $34,420, according to Hewitt, meaning half of the group had balances even lower. To be sure,some retirees have other savings, including money rolled into individual retirement accounts from 401(k)s at prior employers.

But studies are starting to document that traditional pension plans, which typically are overseen by professional money managers, outperform programs in which workers control an investment account, like401(k)s. Between 1995 and 2006, “defined benefit” pension plans, so-named because they give retirees a specified monthly benefit, outperformed defined-contribution plans, in which the employer makes a specified contribution to the worker’s account, by about one percentage point a year, for a cumulative dollar difference of nearly 14%, according to a June report by Watson Wyatt.

A Church’s Change

The United Methodist Church last year moved its 36,000 clergy and lay employees back to a traditional pension, realizing that “with ministers, really their talents are in creative areas, and often not in investment areas,” says Ron Gebhardtsbauer, an actuary in University Park, Pa., and a former trustee with the church’s pension board. Barbara Boigegrain, general secretary of the church’s Evanston,Ill.-based pension board, adds that the church didn’t believe it was fair that its employees “were at the whim of the markets.” Those who retired in the bull market of 1999, for instance, generally had a better nest egg than those who retired as a three-year bear market ended in 2002. “We care desperately that they have an adequate income in retirement — and income that they cannot outlive,” she says.

Beginning in the early 1970s, school employees in West Virginia were enrolled in an old-fashioned plan, with benefits calculated by a formula that took into account compensation and years of service. But after the pension plan faced funding shortfalls, it was closed to new enrollments as of June 30, 1991. The defined-contribution plan was set up to take care of new hires, and existing employees were given theoption of sticking with the old plan or transferring into the new one.

Under the defined-contribution plan, the state contributes 7.5% of each employee’s annual eligible gross pay, according to the Web site of the state’s retirement board. Employees have flexibility in terms of their contributions: While the state requires those in the pension plan to contribute 6% of pay into the state fund, those in the savings plan can contribute as little as 4.5% — a selling point to those who want greater take-home pay.

Of course, a smaller contribution has the effect of holding down the account balance. As for the state’s 7.5% contribution, it is more generous than in the average private-sector 401(k), where the most common fixed match is 50 cents per dollar of an employee’s contribution up to the first 6%, according to the Profit Sharing/401k Council of America, a nonprofit organization in Chicago. In contrast, to fund the defined benefit plan for the teachers, the state of West Virginia aims to contribute 15% of annual gross pay for people hired before July 2005 and 7.5% for those hired after. In general, a typical payout in the West Virginia pension plan is an amount equal to 2% of an employee’s peak salary multiplied by years of service.

Sales at Lunch

The West Virginia plan initially offered stock and bond mutual funds, a money-market fund, and an annuity, in this case from Variable Annuity Life Insurance Co., or Valic, a unit of American International Group Inc. In addition to the Valic annuity, current offerings include funds from Capital Group Cos.’ American Funds unit, Federated Investors Inc., Fidelity Investments and Franklin Resources Inc.

From the start, most employees favored the annuity. Some say they were swayed by Valic’s sales force, which included former educators and school employees who went into the schools during the workday to talk about the option. “These people came during your lunch or during your planning period basically to sell the program,” says Debra Elmore, a third-grade teacher in Ansted, W.Va.

Ms. Elmore acknowledges knowing little about investing. “Oh, Lord no,” she says. “I had no idea.” She set up her account so that 85% of her contributions would go into the fixed-rate annuity. “I just thought,’Well, these are safe. Let’s stay there.’ ”

AIG spokesman John Pluhowski says the insurance company hires former school employees to sell its products to schools “because the education market is important to us; educators know the needs and concerns of educators.” He says the representatives were “not authorized or directed to give investment advice; they were only authorized to sell a fixed-annuity contract.”

Anne Lambright, executive director of the state’s retirement board, says that the board offered “some general education” about investing to employees, but that “not everyone took advantage of it.” She acknowledges that advice was limited and that much of the information employees received was probably from the companies selling the products. “I’m not sure how much information they got in terms of
comparison between products or stocks and bonds,” she says.

At one point, about two-thirds of all assets in the plan were invested in the fixed-rate annuity, according to the board’s annual reports. For the first two years, the annuity offered an annual return of 8.5%, but then it dropped to 4.5%, according to a state official. Mr. Pluhowski says the 4.5% is the guaranteed minimum return, while the higher percentage was based on then-market conditions.

By 2005, complaints from employees and the union about low balances in the defined-contribution plan had mounted. State officials closed the plan to new participants and reopened the pension plan to new hires. The following year, school employees voted on whether to end the defined-contribution plan, but a state court later deemed the vote unconstitutional because those satisfied with the plan would have been forced to return to the old-fashioned pension plan. This spring’s election was couched differently:  Workers voluntarily could elect to transfer their account into the old pension plan, provided that at least65% of current employees wanted the transfers to be permitted.

The threshold easily was cleared — in part because as of April 30 the average account balance in the defined-contribution plan was $41,478, and of the 1,767 employees over the age of 60, only 105 had balances of more than $100,000. “Our members were going to run out of money five or six years into retirement,” says Ms. Hale of the teachers union.

Some retirement experts say another problem that surfaces in 401(k) plans is the “red-truck syndrome”:  Plan participants use some of their nest egg at retirement to buy something they always dreamed of having. Teresa Ghilarducci, an economist at the New School for Social Research in New York, says many workers take their 401(k) in a lump sum and have difficulty making it last. She says the West Virginia case “shows the nation what is wrong with everyone’s 401(k),” including a lack of investment knowledge and fiscal discipline.

State Investigation

Meanwhile, West Virginia’s state auditor and attorney general have announced that they are looking into whether Valic made misrepresentations to induce employees to invest in its annuity, with the attorney general appointing four prominent state lawyers as special assistant attorneys general to help with the investigation. Also, Valic and AIG are co-defendants in a civil lawsuit seeking class-action status in county court in Moundsville, W.Va. The lead plaintiff, a teacher, accuses Valic of fraud, alleging the company misled employees to get them to invest in a “commission-driven” product.

AIG denies wrongdoing. Mr. Pluhowski declined to specifically discuss the lawsuit or the current state investigation, but says, “We are confident we met the obligations we were contracted to provide.” Hedeclined to say how much employees were paid for sales of the annuities, but says that “no plan contributions were used to pay commissions.” West Virginia’s insurance commissioner investigated Valic’s sales practices in 2002 and cleared the company, saying it had found no misrepresentations by Valic agents.

Teachers returning to the pension plan will receive reduced benefits to reflect that they’ve contributed less than other state workers over the years. But they will have the option to make catch-up contributionsto “buy back” the full benefits.

Ms. Elmore, 46, says she realized her disappointment in the defined-contribution plan when she received a letter from the state’s retirement board in April projecting that, at age 60, she would have a big-enough nest egg to provide her with $1,571 per month for her life. By contrast, the letter projected, if she voted to go back to the defined-benefit plan, she would receive a projected monthly payment between $2,656 and as much as $3,050.”I jumped on it,” she says. “I was just worried.”–

Who can blame an investor for taking to the bottle?

Andy Pick, a 49-year-old stay-at-home father in Atlanta, recently bypassed the stock market for liquid assets — $120,000 in champagnes. He bought 400 bottles, mostly 1996 vintage, that he says he plans to “sit on” for 10 or 15 years and then sell at a profit.

“It sure beats looking at a Merrill Lynch monthly statement,” he says, adding, “The worst thing that could happen is that I drink all of it.”

Given the gyrations in the financial markets, some investors are abandoning stocks and bonds and seeking refuge in unusual alternatives — parking spaces, for instance, and condos in Peru. Sales of exotic livestock are up. The U.S. Mint has seen a gold-coin rush.
Associated Press

Peggy Parks invested in alpacas, which she believes have a better outlook than most mutual funds.

Investors have long turned to hard assets in market downturns, the idea being that if you invest in something real, it won’t disappear, even if its value declines. But analysts say this downturn is different in that real estate, the most traditional safe haven, is also sinking. Between July 2006 and July this year, home prices dropped 19.5%, according to the S&P/Case-Shiller 20-city composite home price index.

After the market dropped in January, Steve Borter, the 56-year-old president of a heating-and-air-conditioning company, did invest in real estate, but not the usual sort. He became landlord of a single parking space in Chicago. He bought a 12-by-20-foot spot in the Field Harbor Parking Garage for $29,000 and rents it out. “The stock market is indicative of a lot of uncertainty. With a parking space, at least you end up with something,” he says.

Peggy Parks, a 49-year-old auditor in Johnstown, Pa., turned to an unusual farm animal. “I’ve lost a fortune in stocks, and my 401(k) is falling through the floor. I feel comfortable in alpacas,” she says. She invested $56,000 in a small herd that she believes has a better outlook than most mutual funds because of the animals’ breeding potential.

The national Alpaca Registry Inc., in Lincoln, Neb., says registrations are on pace to rise 7% this year and currently stand at 140,297. Ms. Parks says a female of “medium quality” can fetch $10,000 and that prices have been rising, supporting her hopes that she’ll see a profit on her alpaca portfolio in five years.

Tangible Assets

Financial firms are reporting that a growing number of retirees are rolling their money out of ordinary individual retirement accounts — commonly stocks, bonds and mutual funds — and into self-directed IRAs, where almost anything goes. “We’ve had people invest in a cypress farm in Costa Rica, and a condo in Croatia,” says Tom Anderson, president of Pensco Inc., a San Francisco firm that has $3.3 billion in self-directed IRAs under custody. He says 20% more assets flowed in over the past three months than in the same period a year ago.

The New Gold Rush

Pat Roque/Associated Press

See images from fortune seekers and spenders world-wide.

In Centennial, Colo., Tim Boykin, 56, a retired engineer, says he pulled his entire nest egg of nearly $1 million out of stock and bond funds in August and put it into a self-directed IRA. He invested some of the money in his niece’s company — which is building condos in Lima, Peru. While analysts warn that real-estate investments in emerging markets are risky, Mr. Boykin says he has done his research and remains confident: “I can see pictures of the land. I can see steel. I can see people working. When I put my money in a fund, I see a big list of things that don’t sound good.”

Ruff Times

Not everyone thinks alternative investments are a great idea. The Alabama Securities Commission over the weekend issued an “investor alert” urging caution. People are “panicking,” says securities director Joseph Borg. He worries that investors who yank their money out of the stock market are prey for con artists hawking things like phantom oil wells.

Mr. Borg, past president of the North American Securities Administrators Association, adds that in past market downturns he saw people turn to chinchillas, worm farms and super-breeds of rabbits. Emus, too, were big. “Eventually, people got tired of them and just let them go,” he says. “To this day, you’ll be in West Texas and a big emu running wild will just come up next to your car.”

Hard-asset gurus like Howard Ruff, a best-selling author who rose to fame in the inflationary 1970s, are convinced their moment has come again. “This is a big, big time, a very big time — and this is just the beginning,” says Mr. Ruff. He has been advising people to buy bags of pre-1965 U.S dimes and quarters, which are 90% silver and in limited supply.

Gold coins also are in great demand. Last week, the mint suspended sales of American Buffalo 24-karat gold coins because it can’t keep up with soaring sales. Last month, a record 14,000 bidders — 17% more than the previous high — turned out for a coin-and-currency auction in Long Beach, Calif., that generated $35 million in sales.

Bob Sale

Bob Sale, a Blue Bunny brand ice-cream distributor in Colorado Springs, Colo., says he purchased American Eagle gold coins last week after his 401(k) retirement account tanked. “Holding them in your hand is like no other feeling,” he says.

Mark Craddock, manager of Comic Book World, in Florence, Ky., says stock-market investors also are turning to superheroes. “There’s kind of a buying frenzy” in vintage comic books, he says.

The “Silver Age Comic Book Pricing Index” of 32 frequently traded ’60s comics, was up 14.2% in the 18 months ending in July, while the Standard & Poor’s 500 stock index was down 11% in the same period. Mark Haspel, president of Certified Guaranty Co. in Sarasota, Fla., which grades comic books, often for investors, says it’s on track to handle 200,000 books this year, up from 150,000 in 2007.

“Spiderman is going to be here in 20 years — he’s not going away,” Mr. Haspel says.

Sounds terrific.  Does it work?  No.

It is standard financial planning gibberish to create a portfolio compiled from historically-derived investment returns and volatility.  And in spite of the disclaimers, the typical lay client has the distinct understanding that these investments are appropriately conservative, and will provide a lifetime of security.

Unfortunately, the only assured investment returns are from fixed income investments held until maturity.  Stock and bond investment returns cannot be managed, or adjusted like the temperature on a thermostat.  The returns are not guaranteed, and in a bear market, the portfolio (and all future income) can be devastated.  Frankly, the entire approach is disingenuous, since the portfolio is constructed to address a target nominal yield, rather than the yield necessary to maintain purchasing power (which is the only reason to take investment risk in the first place).  So even if the target yield is achieved over time, the client may still run out of money if inflation requires a much higher investment rate of return.

Individuals are by no means the only investors vulnerable to the siren song of high yield with low risk.  The sub-prime mortgage crisis was fueled in part by institutional investors with the same perspective.  Endowments and pension plans must plan for an eventual payout, and implicit in the calculations is some estimation of minimum and aggregate rate of return.  During the low return years, when even the highest fixed income rates were insufficient, the sub-prime and collateralized debt obligation packages offered an unbeatable combination of high yield and low statistical risk.  The institutional investment demand enabled the creation of all those now-worthless debt products.

Even today, it is standard practice among institutional investors and their consultants to evaluate money managers and hedge funds on their ability to deliver high compounded returns with low volatility, as if risk and return are utterly unrelated.  They are not.

Over the last few years, there has been quite a bit of d the research and found it interesting, but largely dismissed it because I felt it did not apply to me.  After all, I have an MBA, have worked on the Street for 25 years, and am pretty self-aware.  I understand the whole fear and greed bit.  I have a methodical approach to the markets, and the apparent irrationality of the “masses” is just not me.

On the other hand, there are too many systems traders and hedge funds with unbelievable long-term track records, too long and too good to dismiss as luck or chance.  They have amassed billions largely through internal compounding at incredible rates of return- and so it is obvious they are doing something different.  As I read interviews with many of these traders, there is a similarity of approach that is, directly or implicitly, statistically based.  That is, if the objective is a high rate of consistent annual compounding, certain money management techniques are unavoidable.

Then there is my own track record.  I have not amassed billions.  Every now and then I will own one or two poor investments that undermines the overall performance for the year.  And there have been a few great  investments that I recognized at exactly the right time and the right price, ultimately appreciating manyfold.  But did I reap those windfalls?  No.  I sold too soon.  And I realized that my emotional response to the markets, not my intelligence, defined my investment performance.

So I created a little system for myself, to mimic the money management approach of the big guys.  For example, follow the trend.  Markets are efficient but not random.  I would deliberately cut my losses at a predetermined amount and let the profits ride on the stocks that kept rising.  Sounds pretty obvious (which, by the way, is the opposite of what every financial planner counsels.  Rebalancing involves selling winners and reinvesting in the losers).  Amateurs lose by keeping their losers, pros lose by selling their winners too soon.  I was no sucker.  I would follow the statistics.

I couldn’t do it.

I bought a collapsing stock, thinking I was buying cheap, but it only became cheaper; thereby violating rule #1: losers average losers.  I would buy a stock that was “too low” and sell a stock that was “too high.”  Like I knew.  When a stock fell below my sell point, I rationalized why I shouldn’t sell and over-rode my system.  Sometimes the stock rallied back, but a few times it kept falling, which only served to elicit further rationalization.  Many times an investment would rise and fall back repeatedly, so that on the next rise, I  sold and grabbed the money – and then watched the stock continue to triple in price.  It was a tremendous eye-opener.  I was every bit the sucker as the “masses.”

Successful investing often requires what is most uncomfortable, and often most unnatural.  Particularly in the current market, the safest investments may appear to be the most risky, and the riskiest investments appear to be the most prudent.  I have incorporated a simple rule in my own trading:  never sell outright.  I am now forced out of a position by one of two types of stop orders.  A stop loss is placed upon the initial buy, on the assumption that if my initial premise is wrong, the stock will fall and I will cut my losses.  The other is a trailing stop.  If I am right and the stock rises, the stop loss order will trail up behind the stop price.  I can then capture all the gain that is possible, until the run finally reverses and the trailing stop is triggered.

Not that I blame the Home Depot salesman.  He is a tool salesman and he sold me a tool.  He did not call himself a carpenter, and I did not expect him to build my house.  Not every profession is so straight-forward.

Apparently salesmen no longer exist in the financial services industry.  My insurance agent is a Certified Retirement Specialist.  My accountant is a wealth manager.  Actually, several realtor friends are now wealth managers. The bank teller insists upon referring me to their investment advisor.  Trusted advisors offering comprehensive solutions.  Except every solution involves the exclusive purchase of their product.

The securities industry creates this illusion because most clients will no longer hire a salesman.  But they will hire an advisor.

A few facts worth noting:

• Anyone with a securities license is legally defined as a salesman.
• A licensed salesman is employed by a securities broker/dealer (regardless whether they call themselves “independent”).  There is a sales manager.  There are sales quotas.  The broker/dealer determines what can and cannot be sold to investors.  In fact, the broker/dealer permits the salesman as little discretion as possible.  Why?  Because the broker/dealer is liable for the “advice” of the salesman.
• Salesmen, and their firms, have only two goals.  Earn a commission.  Do not get sued. Regulators require all investments to be “suitable” for the client.  So the salesman will require new clients to sign a document describing their goals and objectives. And if the client loses money and attempts to complain, that trusted advisor will bring forth the signed document and claim he is just a salesman following orders.  And win in court.
• Salesmen are your trusted advisor… until it’s time to actually offer advice.  And then they will expressly NOT offer advice.  They will offer a selection of their firm’s “packaged products” (the actual name given to mutual funds, etc.).  Because no one can predict the markets.  My god, that’s market timing.  How can anyone know such a thing?  You are wiser.  A long-term investor (which I submit is the greatest legal defense strategy ever devised.  If you ever lose money, it’s your own fault.  You didn’t wait long enough).  The basket of packaged products invariably represents an extremely expensive form of indexing.  Something any investor can do on their own.  For free.

Just my opinion.  Of course, I could be wrong.

Fascinating article, can be read on the Pimco website