Monday, October 26, 2009

A Scary Halloween Retirement

Halloween is a something different for everyone and holds a fascination for most of us. In fact, Halloween might just be the best holiday to describe your retirement plan. A little scary, a little frightening, unknown dangers and hidden surprises and whatever is at the end of the darkened tunnel might just scare us more than we had imagined.

Retirement planning has become a very much a trick or treat landscape to navigate. Numerous products will be found in your 401(k) plans in the near future that might not prove to be the best solution for the investment dilemma your retirement accounts are in. And with Halloween just around the corner, perhaps we should look at some of the treats in your bag.

This is retirement planning the likes of what you may not have anticipated. Trick or Treat Retirement Planners!

Retirement Planning: Looking for that Moment

So How Much is Retirement Going to Cost?
Attempting to predict what your future needs in retirement will be is as easy as looking at your current spending and debts. How much of those bills will you be carrying into those golden years?

If you look at your retirement plan as a risky undertaking, something you can orchestrate to be in the right place at the right time - or better, diversified enough that no one place hurts the whole of your investment plan - then you will find yourself looking to stocks as a greater portion of your portfolio.

If you still want to add a conservative element to your plan, I suggest that any new investment contribution should be directed towards that, a move preferable to diverting funds away from another investment. The key isn't increased risk, it is maintaining levels of risk that allow portfolio growth and it is increased contributions.

More on this article from Paul Petillo, Managing Editor, can be found here

Friday, October 23, 2009

The Index Fund Conundrum Inside Your 401(k)

I do a popular radio show every Friday morning with Gina and Kat on MomsMakingaMillion. Each week, the topic progresses a little closer to a full understanding about your 401(k) – if that could ever fully happen!

This week, the ladies asked me: You talked about the risk of too little risk last week. This week I understand you want to take a look inside a 401(k) plan. A friend of yours was having a problem.

Yes we did discuss risk and the risk of too little risk. But the real risk might be lurking not in how you invest but in where you put your money in your 401(k). In fact, what your plan offers may be so limited that your choices boil down to good and not-so-good.

Let’s start with this: Most common, garden variety 401(k) plans offer index funds, lifecycle funds and if you are fortunate, actively managed funds. Plans can be big and small with thousands of options or just a few.

Life cycle funds represent a group of offerings focused on a particular target year that you would like to retire. These are essentially actively managed funds that shift, at least in theory, from aggressive to conservative investments over the course of your career.

Actively managed funds tend to pick a sector, such as large-cap stocks, and focus their investment prowess to the best possible return.

Index funds are designed to track an index of stocks (or bonds), ranging from the top 500 companies to indexes that track the smallest.

But before I tell you about how index funds can differ (which might seem odd, considering an index fund essentially attempts to mimic the published index) I want to talk about a person who wrote me last week. Although her email sounded panicked, she knew that there was little she could do about what her 401(k) plan was doing to her portfolio.

She told me she had chosen four funds in her 410(k) to invest in, the bulk of which was directed towards a small cap index and a mid-cap index run by Merrill Lynch. She believed, and rightly so, that this would be where the recovery would take place. These funds had always done well she told me, and when the markets turned sour and her funds were brutally beaten down, she kept her investment dollars streaming in.

Because markets do recover and her investments remained consistent, her portfolio value is now within a couple of thousand dollars of her year end balance in 2007.

Her concern was a change her plan sponsor was making in those funds, switching to another group of funds offered by Northern Trust. The reason according to a notice she received from her plan sponsor was the cost of fees.

Focused on Fees
In general, index fees should be as low as possible and here is why.
The idea is simple:
1.There is no trading to be done between the time the index is set and the next time it is adjusted;
2.There are no research fees;
3.And inside your 401(k), there should be no 12b-1 fees (the cost of advertising for new investors paid for by the current investors);
4. And lastly, because the company, in her case it was Kroger, the fiduciary responsibility (what a plan sponsor does is based on the assumption that it is best for the employee's future) demands the best deal.

That would be in a perfect world. Not to pick on her company's plan, but it doesn't fair very well when they are searched for using BrightScope, a retirement plan quantifier (information about their invaluable service can be found here) and this had her worried. Just because she has a plan, doesn't make it the best of all worlds, simply the one she has to live with.

Her plan was shifting her small cap index fund (with an expense ratio of 0.15%) to one that offered to track the same index but at 0.06%. At first glimpse, this seems like a good move. Lower fees are always good. Second glances however show how poorly the new fund offering has done compared to what she had before. Her new fund has a year-to-date performance of 12.52%; her old fund had chalked up a 29.83% return. Year-to-date, the Russell 2000 index of small cap stocks has racked up an impressive 22.43%.

Why would they do this, she asked? Other than being able to suggest that they are trying to do all they should for you, substituting one index for another based simply on fees, there seemed to be no clear answer. It is troublesome to be sure but not uncommon. It is also evidence that not all indexes are created equal or cost the same.

Index funds are subject to all sorts of influences. Fees run the gamut from absurdly low to ridiculously high. There is also the pesky probability of tracking error, a problem some fund managers get into as they try to outperform the benchmark. This tends to increase the expense ratio by forcing more trades and increased research. But it might also allow the index to outperform.

Keep in mind, your index fund does not buy every stock being benchmarked. An S&P 500 index generally has only about 75% of the stocks on the list in the portfolio. How much of each is often the reason for the disparity in returns. A Russell 2000 index fund has only about a third of the companies listed.

Most people think of Vanguard Group when they think of index funds. But their much-touted S&P 500 index fund carries an expense ratio of 0.15%. My friend’s small-cap index fund, the one that did so well, charged her the same as this less risky S&P 500 index fund cost.

Add to that, there is relatively poor information available to her even through her plan. A great many of the funds offered inside your plan are not offered to individual investors making information gathering difficult. Plan information is improving but comparisons are still hard to make. She was more upset that no one asked her if she would like to switch.

Not All Plans are Created Equal
Looking inside your 401(k) is never easy. For Boomers (and anyone focused on retirement), it can be especially difficult. You are torn in many cases between necessary risk and the fear of that risk. Your portfolio may not have recovered as quickly as my friend's did but consider the option of too little risk as one not worth taking.

There are basically only two ways of achieving the goals you may have set. You could increase your risk and/or increase your contribution. If you do the later, you can use the additional funds to purchase something more conservative while leaving your original contributions, the funds directed towards more risk, intact.

You should remember that if your plan offers only index funds and lifecycle funds (target-date funds), chose the index offerings. If your plan offers choices beyond index funds, choose the actively managed funds across a range of disciplines (large-cap, mid-cap, small-cap and international). In some cases, the fees might even be as competitive as the index fund that tracks them.

In the end, my friend did nothing. She had one of those not-so-good plans. Her only option was to increase her contribution to make up for the unrealized returns.

Paul Petillo
Managing Editor/

Thursday, October 22, 2009

Retirement Planning: Your 401(k) and Taxes

Writing for Boomer Retirement, I suggested that there could be some incentives added to the 401(k) plan that would make this all-important retirement vehicle much more attractive to those who under-invest or for those who fail to use their 401(k) at all.

As we all know, 401(k)s are not going away. But it is debatable as to whether this sort of defined contribution plan will be able to exist in the same form it has for almost three decades. Although, if you use it correctly, it can mean a much more secure retirement. So why haven't more people used it?

I suggest that it hasn't been around long enough, not enough people have been exposed to these plans to make the long-term effect work and the incentives are simply too small for the average investor to understand. Read the full article here.

Wednesday, October 21, 2009

Retirement Planning: Is It More Than We Thought?

is the anticipation of retirement clouding your vision? Do you make projections about your 401(k), how much it will be worth and how much of the optimistic balance will be available to spend? Do you know the difference between accumulation and decumultation?

Probably not. Today, writing for the Boomers Retirement blog, I discuss some issues that you may not have known about your retirement forecasts. It is as much about what you enter retirement with (liabilities) as what your 401(k) balance can support.

Read the full article here.

Tuesday, October 20, 2009

Pick Me Up, Dust Me Off: The More Tax Friendly 401(k)

William Bernstein writing for Barron's foresaw the future of the 401(k), this country's most ubiquitous retirement plan. “The 401(k) is likely to turn out to be a defined-chaos retirement plan.” And so it goes. Almost nine years after that comment was penned, the 401(k) has, for the most part, turned out to be a failure for most, a disappointment for some and far too much work for those who use it to its fullest.

This is based on numerous reasons, almost all dealing with our own, largely undefined and for the most part, beyond description approaches to investing. We are all over the place, trying to attach method to our madness and sound reasoning where there is none. This means that there is an investor class and the rest of us.

Unfortunately, we don't have to be exiled to the outside. But keep in mind, despite your best efforts, you will never be completely admitted to this elite group. Don't worry, many of those who are members are there by accident, something time will uncover and because of the nature of the class, they too will be kicked to the sidelines. In many respects, we are simply spectators.

Pensions are not dead although they are quickly becoming something of the past, relegated to the obviously smarter workforce, the union laborers. These folks admit to not knowing about where they should put their money, so instead of directing their own fortunes, many let trusts operate the investments.

(This is where a group of concerned folks gather, the employers and the union and determine where the best place to invest is. And statistics have shown, that in many instances, they do better than companies do when they hire "professionals". Also damning any chance at success is the interest the company has in the pension and how it relates to their balance sheet.)

This is sort of a forced retirement with the laborer giving up pay increases for pension contributions. And in the case of the trusts, it generally works like a charm. There are exceptions, particularly during labor disputes and troublesome negotiations when the welfare of the member is often second to the economics of the contract.

And in the three decades since its inception, we have proven the concept more or less incorrect. We are forward looking creatures that mistakenly attribute possibility to reality. In many instances, we have pre-determined how much we will need, how much we will need when we retire and how much we will need to save to get there. We have the whole plan sown up. That is until there is a bump, or in some instances, a really big bump jostles our fragile framework to the core.

Companies have shirked their fiduciary responsibility time and again. They enlist plan sponsors who are hellbent on squeezing every dime they can from every nickle invested. These fees, some hidden, some acknowledged are often higher than the individual investor might pay. And because the funds you choose form are locked inside a structured plan, shopping around is limited to what is on the shelf. In the land of choice, the plan that needs to have the most options is closed to competition.

The 401(k) appeals to our herd mentality, driving up our gains (at least on paper as we chase the hot funds and the sizzling picks our cubicle neighbor has chosen) and driving our losses further as we try and stop the bleeding. We look at these accounts as money saved (which it isn't) and add to the debacle and withdraw or borrow against these accounts.

And we like to blame. It is also in our natures. Which is why some feel as though the 401(k) hasn't been given enough time to work. Yet those who have a pension, what I have referred to as the great economic stabilizer for many Americans who have them, have seen their fortunes in their post-work years remain stable. You have to realize, these plans were designed for those who had nowhere else to go with their high level of earnings. This tax-deferred portion of the tax code was custom made for this group. And it would have been for us as well except that we don't have enough time in the plan to make it work the way it was designed.

We haven't contributed enough either. To reach the portion of pension payment using your 401(k), you would have to retire with three times your current balance, provided you took advantage of all the free (matching) funds and maxed the plan out. Now the matches have gone away and fewer people bother with the maximum contribution. The catch-up clause is just wishful thinking.

So can this thing be fixed? Yes and no. If 401(k)s are only worthwhile when you retire, why then do the changes to these plans, improvements that make it easier to keep invested and stay invested have to come from the government? Talk has been shifting towards some sort of government run pension plan or an exchange where employees can by some sort of guarantee (adding a new player to the retirement game, the insurance company). Neither of these is feasible.

Nothing says participate like less taxes and this sort of incentive offers some easily projected numbers that are easy for even the lay-est of investors to understand. Matching contributions may not have lured sideline investors because it meant money out of "pocket" or less in the budget.

The IRS could act to make all 401(k) plans more tax friendly.

Based on the fact that 401(k)s are essentially tax events, the wrong agencies are stepping in to try and fix an IRS problem.

Here is what I suggest: Consider making the tax deferred deduction on the 401(k) contribution twice what it currently is and you will, in essence, give the employee a raise. You could force a minimum contribution and surprisingly, it might not even be noticed. As many of you already know, 5% barely changes your take home pay. But getting an additional deduction would.

The IRS could take it one step further by then fixing the withdrawal tax table. Many of us don't know what we will be taxed when we retire because we don't know what we will be able to withdraw. The IRS could place a 5% cap on anything under $20,000 a year, 15% for all additional annual draw-downs. Upper tier investors would want to pile in and this would have the net effect of raising all investor boats. (To recover much of this lost taxable revenue, reducing the contribution limit by a thousand dollars to $15,500 would force those who could invest that sort of money to pay the taxes and put the money in a Roth. My roughest calculations show that it would add $10 billion a year to the coffers, offsetting the increased deductions.)

The IRS could also penalize those tax returns (in the nicest way possible) and tax any over payments in excess of $500. This would be directed to a group 401(k) that would be directed towards a state sponsored target date fund (even though I don't like them much, for this purpose, they may be custom made). When the person applies for retirement benefits, this fund would be added to their benefits and because it was already taxed, it would could not be taxed again. Applicable tax rates for 401(k)s would also apply on any interest gained.

Harsh medicine? Perhaps. But the end result would be more money to spend now, more money to spend later and more money that many would not have. All by changing the tax code.

Thursday, October 15, 2009

Can You see What They See?

It Should be Easier
There are numerous obstacles that keep us from building enough wealth in our 401(k) plans. The first is as simple as beginning to invest in your retirement future. This is stressed frequently and with good reason. The earlier you begin investing, the better situated you will be for retirement in the far-off future.

The second hurdle is how much to invest. I suggests that no matter how poorly a plan you have with your employer, setting at least 5% of your pre-tax income (a number that does not have much of an impact on your take-home pay) is better than not investing at all. For first time 401(k) investors, who may need as much of their paycheck as possible, this is a good start.

The third hurdle is the company match. This is used as an incentive to get you to put some money away for your future by offering to match the first couple of percentage points. Some companies do not do right by their employees when they match only with their own company's stock or if they have lowered or withdrawn the match due to the "economic downturn".

And the last hurdle to these beginners is where to put their money. Not all plans are created equal and not all investments in these plans are worthwhile. That doesn't mean you should ignore the opportunity to invest, it simply means that your choices are not as good as they could be. This is particularly troubling if you are an older investor who may have gotten a late start or if you have changed jobs and are now enrolled in a less than adequate plan.

Finish reading this post here.

Tuesday, October 13, 2009

Understanding Risk - The Risk of Too Little Risk

Last week, on the radio show I appear on as a regular guest, I suggested that instead of trying to determine what your risk tolerance was, you should instead think about what makes you anxious. This anxiety tolerance takes a more introspective view of who you are rather than what your investments might be doing. It requires, among other things, that you turn off the media.

Streaming into your living room is an after-the-fact representation of what the markets are doing. Even real time reports are not so much real time as a tool for edgy traders to plot their next move. If you really care about what your retirement accounts are doing, in terms of what they will provide ten, twenty or even thirty years down the road, looking at this type of data will force to re-examine what you may have previously thought was a good idea.

Although there is a science to investing, it is far less competent at coaxing the truth or any sort of conclusion fro the available data. The markets, pushed by human emotion (even if it is pre-programmed into a computer via modeling) fail to give you a true perspective, something that you would consider concrete, undeniable and/or truthful. This sort of representation is enough to make even the most savvy investor squeamish.

The knee-jerk reaction, the one a vast majority of investors are considering or have already begun is a move back to less risk. As banks fail, as markets gyrate, and as the recovery, albeit jobless, begins, some basic things should be kept, not in the back of your mind, but in the forefront.

No risk means saving. This is the traditional approach to keeping your money close at hand, for emergencies. It comes with risk as well. There is the inflation risk. Currently at or around zero, inflation strips the value of your dollar by making it worth less in the future. Without the interest that savings provides, each dollar saved will have less buying power. In an inflationary environment, that interest paid to you must beat inflation (even if you use the historic reference point of 3.5%).

And it must beat taxes. These will always rise, if not right up front, the increases will be felt through the products we buy, the business we conduct or the income we earn. No risk, in other words, has some risk and it is mostly on the downside. (That doesn't mean should abandon the emergency funds you are currently funding or stop you from getting one started.)

Your anxiety (or risk) tolerance may be forcing you to look for investments in your retirement accounts that take more risk than is desirable. Before we look at those types of investments, it is important to note that the reason you invest in your 401(k) is to provide income for a time when you no longer want to work (or work doing what you are doing).

For many of you, this has meant turning to the ever-present and often innocuous retirement calculator online. You enter into these tools, your current balance, which according to the latest Employee Benefits Research Institute report, is about $74,148 for the average 40 year-old. (The study reports data as of the year ending 2008.) While this down over 25% from the close of 2007, that figure represents a 35% increase for the investor in this age group since 2003.

The report also indicates that this was in-line with the stock markets performance over the same period. If you suffered less, it was due to diversification and the ability of the 401(k) to supply ongoing and consistent investment. This diversification was found using equity investments as the primary driver for the growth in these portfolios. In terms of asset allocation, 40% of this group allocated 80% or more of their assets to the equity markets, down only slightly from their years as a twenty-year old. (This group also owned about 11% of the remaining portion of their portfolios in their own company's stock.

These contributions are, as one might expect, greater in your investment youth. Or they should be. Investment returns (and sometimes losses) are the result of many of the changes in portfolio valuations. Even after the losses experienced in this age group's portfolios (28.5% in 2007-2008 and 5.8% in 2001-2002) the average account over a ten year period had increased 94%.

I have suggested that you should contribute at least 5%, company match or not. If you begin with that average balance of $74k, in 25 years you will have breached the $250,000 mark using a conservative approach which has about 50% of your portfolio invested in equities. Reduce your exposure to bonds in that portfolio to 15% or less, and the same time span could leave you with a balance of four times as much.

In terms of risk, 2008 was a game-changer. While 64.5% of those with plans in 1998 found equities the most desirable of investments, by 2008 this sentiment had shifted to 41.9% with the shift to a more balanced approach such as lifecycle funds (an increase of over 300% and to bond funds, which posted a 100% increase from a decade ago. Although we are looking at the forty year-olds, the sixty year olds made essentially the same moves as their counterparts twenty years their junior.

Using a retirement calculator, based on a generous 5% withdrawal when you retire, at age 40 or younger, will not produce the retirement income (based on a growth rate of 8% after you retire, beginning with zero and ending with a balance of $250,000 and an inflation rate of a modest 3.5%) you might imagine. If you can live on $14,446 in the first year (excluding Social Security and if you are fortunate enough, pension payments) then you are on track. This will however, draw your balance to zero in thirty years or less, if your investments fail to meet the 8% mark, year over year.

2008 also brought a dramatic increase in the number of loans on these plans (90% offer some sort of loan available). Eighteen percent of you tapped these provisions with, the report cites, an average outstanding balance of $7100. This may have been money you thought you needed at the time. But what it represents has a far greater impact in the future.

So why are so many individuals shifting to a less riskier (less anxiety inducing) form of investment? Perhaps they simply do not know what they are setting themselves up for in twenty or more years.

There is the argument that these more conservative investments utilized by retirement investors are not as risk free as previously imagined. This could put an additional drag on perceived outcomes you and your calculator have projected.

All bonds, essentially an extension of credit are compared to what the US Treasury issues. The difference between what a bond yields against this measure suggests the creditworthiness of the bond. In other words, the closer the bond to the US Treasury, the safer it is.

And as we say safe, we also remind you what we have previously discussed about safety. Without some risk, the chances that your money will grow are greatly diminished.

While this complicates the purchase of a bond individually, it makes bond funds much more attractive and some respects, slightly more risky. And in lifecycle funds, the employment of bonds lowers the risk of too much equity while possibly increasing risk where safety is sought.

What if, as Eric Fry of the Daily Reckoning suggests, the creditworthiness of the US Treasury comes under pressure? It is extremely important to bonds that it have a good benchmark to use. He writes: "Are foreign sovereign issuers becoming MORE credit-worthy or is the US government becoming LESS credit-worthy? Or is it a little bit of both?"

This type of risk may undermine the best intentions of the retirement investor and those who invest for them from a direction they will be mostly unprepared to handle. Not only will the return they are seeking be less than than they need to get to where they are going, there is a possible risk that they will receive far less than they anticipated. Fixed income may not be so fixed.

There is a risk to the equity markets because of this possibility. Yet it is still one worth taking. Even if your anxiety tolerance will not let you go beyond the simplicity of an index fund, you will fair better over the long run that those who shift gradually to a more balanced approach with an increasing amount of bond type investments. I'm not adverse to adding to your portfolio a fund that offers even more diversity (even a conservative choice) but in many instances, investors simply reallocate existing contributions when they should, for the best possible balance, increase their contribution and direct these increases to the more conservative product.

There is a distinct possibility that too little risk will not perform as planned.

Friday, October 9, 2009

What's Your Anxiety Tolerance?

For those of you may not know already, I appear on a radio show with Gina Robison-Billups from and Kathleen Bellucci of Pension Solutions every Friday morning. Lately we have been talking about how the listeners should approach their 401(k) plans.

Today's show will pose the following question (which you can hear here if you like) or simply read my answer below.

The question: How does someone choose the funds that suit their needs…risk tolerance???

Good question and something I have discussed at length on the website, in articles I have posted and commented on and at length in all of my books. In fact, I devote an entire chapter of my next book on the topic.

And still, after all of the academic papers, research, books and such, we still can’t pinpoint what risk is. We know that we try and figure out how much we can tolerate, hence risk tolerance. What we don’t understand is why it changes over time, with cultural shifts and economic upturns and downturns. If you knew how much risk you could handle – and get a good night’s sleep in the process – why would it change?

I’m thinking that a better term for it would be anxiety tolerance. We all know what makes us anxious. According to Robin Marantz Henig, writing for the New York Times magazine, “anxiety is not fear, exactly, because fear is focused on something right in front of you, a real and objective danger.” Investing is dangerous but not a danger. Ms. Henig suggests being anxious is “fear gone wild”.

This she says happens when we are confronted with novelty and threat. For many of us, this past year is unlike anything we have ever experienced and certainly threatened our investments and our retirements.

So how do we cope with anxiety tolerance or find out what ours is? I’ve given it a lot of thought and figured out that most of us are anxious about some decision or another. Investing is no different. Even savvy investors worry. Vanguard recently published their own worries suggesting that Investors not get too giddy with the recent market upswing.

My suggestion to you if you are feeling anxious: You should invest consistently, good times or bad, up market or down. If you have a broad selection of funds and you are feeling anxious, keep investing but for the time being, use a total market index fund. At least you will be capturing something.

So risk is hard to define. But what makes you anxious is not. Using the index fund when you are feeling worrisome will also lower you risk at the same time.

Wednesday, October 7, 2009

Adding Less Risk: The Safe Harbor Option

There is no easy answer for how much risk is too much risk or too little. In the aftermath of this past year, plan sponsors are looking for a way to insure that those close to retirement have the money they invested over their careers there when they need it. The key word is insure. And it is the industry that offers this sort of product that is being considered as a possible option. But are annuities the option worth considering?

One of the most difficult things to do is provide protection for already accumulated money in a defined contribution plan. Currently, even in what the industry refers to as megaplans, the options are limited to targeted-dated funds or some sort of option that offers fixed income protections. These types of options adjust the level of stock market exposure as the employee ages, shifting from more aggressively invested dollars to more conservative investments.

The reason for the increased popularity of these products is the result of a Congressional mandate. Target-dated funds were made the default investment for those entering the workforce replacing other less retirement oriented funds such as money market accounts. This allowed the worker to begin investing for their retirement in what the industry called the best option for those who do not know what to choose.

But now, with the focus on asset preservation rather than the typical asset accumulation, a particular concern for older workers nearing retirement, the pension industry is considering annuities. There are several problems with this, first and foremost being the involvement of the insurance industry.

Annuities are designed to be purchased as a stand alone product that provides guaranteed income. The insurance company makes certain commitments to how much you will receive in retirement from accumulated assets. The cost of this quasi-investment/insurance product is high in the first seven years of the purchase and the underlying investments made by the insurer are designed to provide the insured with a lifetime income.

The introduction of such a product in your defined contribution plan presents all sort of problems, not only for plan administrators but for the participants as well. According to Pensions and Investments Online, this would involve tweaking the already suspect target-dated funds. (I say suspect in large part because they have yet to prove they are able to do what they were designed to do.)

PIonline suggest that these target-dated funds could allow their investors to buy "slivers" of an annuity from several insurers. This would keep some of their money invested even after they retire and some of it as guaranteed income.

The second option and probably the most costly would be to offer a "guaranteed lifetime withdrawal benefit". This would essentially allow the investor to roll the assets they have accumulated in the annuity where the insurer would offer income based on a high water mark withdrawal based on a certain percentage. This would, insurers suggest, provide income even when the market moves in unsavory directions during retirement.

Robert Reynolds, chief investment office at the conservative Putnam Fund has been making noise since taking over the once powerful investment house. Among his proposals:

Mr. Reynolds would like to create "a national insurance charter and an FDIC-like fund to back up lifetime income guarantees". This will essentially force employers and employees to consider this option. The FDIC-like fund, not federally insured but instead insurance company guaranteed would offer protections for assets already accumulated.

Involving Washington is the trickiest part of his proposals. He would like Congress to add tax incentives to both employees that participate and employers who offer matching contribution "that would require "employers to offer a lifetime income option, either through annuities or other insured methods".

Of course for such a move to pass muster, the insurers would need to have set "caps on the equity exposure in target-date funds as they become mature". Such action would need the support of legislation that would "require employers to enroll all of their workers in 401(k) plans automatically and increase their contributions over time." This would put pressure on the smallest of firms to comply, a costly maneuver and force the largest firms to take away what some feel is the most important aspect of the 401(k) plan: choice.

This would also jeopardize the portability aspect of the plan. Few insurers would continue to cover an employee after they leave a firm and would probably not participate in a rollover to an individual retirement account (IRA). The reason: no former employee would continue to pay the outsized costs on an individual basis which could be spread over a large group inside a 401(k) plan.

“Usually after a tough period like this you're presented with an opportunity to make the system better,” Mr. Reynolds said in an interview. “We need to fix 401(k)s, which have become the retirement plan of this country. At Putnam, we want to get out in front of the issues.”

This is scary talk indeed.

Sunday, October 4, 2009

Risk: It is What You Don't Know that Matters

We speak often about transparency, how your 401(k) should be easy to understand, how the mutual funds in the plan should be up to the task of providing you with good options that cost as little as possible and how knowing these things will grow your investments. It is all about disclosure. And your retirement future.

I bumped into this anonymous morality tale about these topics, okay about how not revealing important information to those involved can place you in a compromising situation, one that we were all in just a year ago.

Consider the story of the naked wife.

A man is getting into the shower just as his wife is finishing up her shower when the doorbell rings. The wife quickly wraps herself in a towel and runs downstairs. When she opens the door, there stands Bob, the next door neighbor. Before she says a word, Bob says, “I’ll give you $800 to drop that towel.” After thinking for a moment, the woman drops her towel and stands naked in front of Bob.

After a few seconds, Bob hands her $800 dollars and leaves. The woman wraps back up in the towel and goes back upstairs. When she gets to the bathroom, her husband asks,…

“Who was that?” “It was Bob the next door neighbor,” she replies. “Great!” the husband says, “Did he say anything about the $800 he owes me?”

Moral of the story:
If you share critical information pertaining to credit and risk with your shareholders in time, you may be in a position to prevent avoidable exposure.

Thursday, October 1, 2009

The Risk of Less Risk

As Ben Bernanke, the Federal Reserve Chairman testifies before Congress, we will come to the conclusion that there is risk, we should do something about it and we still have no idea exactly what. Referring to the problem as systemic risk, both in the creation of firms seeking to reach, through acquisition, the "to-big-to-fail" status and the inability of one agency to oversee every player in this complicated, global game of finance, Bernanke admits that we are far from where we need to be but much closer than we think.

There is absolutely no doubt in anyone's mind, this is bigger than one agency. Even the ability to provide oversight to this sort of mechanism creates a risk in itself. The Fed will admit it has learned a great deal.

Top of those now known facts is that numerous other participants in the financial world, those whose regulation falls under the purview of other agencies/regulators who, because it was not previously needed, failed to look at the leverage and risk some of their charges were assuming. Insurance firms and lending institutions that fell outside of what the Fed was trying to watch, slipped through the regulatory cracks. It is now known that these firms provided just as much in terms of financial disruptions as did the banking system.

President Obama has suggested that the central bank be the primary torch bearer in this effort to provide stability. The ability to understand the complexities of this type of problem should fall to those who can make the best decision. But the question of how quickly the Fed can react, outside of increased regulation and policing of the regulatory follow-through, has never been an attribute of this agency.

While the world has never experienced this kind of downturn, one where risk was sold as predictable and eventually collapsed under its own promises, the aftermath of such activity does justify the need for some reaction.

So how does Mr. Bernanke describe the harness he has determined is needed: consolidated supervision. This allows the Fed to take the lead and offer some much needed protections.

Many of the decisions the Fed makes are reactive. The Fed has proven in numerous circumstances that its decisions take weeks, often months to find their way into the system. This time-lag can be costly in a marketplace that responds to news now. It also relies on the predictive powers of the central bank, the ability of these bankers to spot the problem long before it becomes a problem and to move without causing a panic. Not exactly in the Fed's wheelhouse.

I'm not seeing how this could be done to the benefit of everyone concerned. Mr. Bernanke shows his concern as well: "Unfortunately, the current regulatory and supervisory framework for systemically important payment, clearing, and settlement arrangements is fragmented, creating the potential for inconsistent standards to be adopted or applied." Consumers will ultimately find this sort adoption of rules to be expensive.

As banks begin to anticipate the future of what these agencies adopt, pass down costs will further restrict any recovery in the short-term. The stock market, suffering from "yeah, but" syndrome, an affliction that allows you to second guess every piece of good news and discount every piece of bad, will not be phased. The markets will instead see this much the way they see the continued unemployment, limited growth because of it, and tighter lending requirements: a bump in the road.

But will any of these proposals eliminate systemic risks? Risk comes from uncertainty and the Fed is too smart to try and wipe away this sort of activity. Investors have to believe, if wrongly so, that the markets offer enough risk to warrant their participation. "Yeah, but" not too much that they get blindsided by something they could not possibly have anticipated.

We tend to think of investors on a personal level, believing that our participation in these risky endeavors is acceptable, even encouraged. Even after all we have been through, we still want to believe that somewhere, someone is watching over us. It is the comfort of this regulation, humming in the background that let us down and now, retooled, it is supposed to revitalize that trust.

So how does this play out in the long-term? Probably better than we might anticipate. Most businesses have become as lean as they possibly can. Their ability to borrow still remains more costly than it should and new leverage and capitalization requirements by both borrowers and lenders will make the process of regrowing the economy slower. Which is probably a good thing.

We have gotten swept up in the speed of business without allowing us the opportunity to examine motives and risks. The slightly slower pace that another regulatory door will provide should make the long-term health of the marketplace more welcoming. Money is returning to markets because it has no place else to go. To create a healthy investment environment, this has to stop. Money has to want to be invested, not forced.

The risk of less risk is threefold: a slower moving system, a more expensive system, and lesser short-term rewards for participation. The glory days are behind us and had anyone been able to see the future, they most assuredly would have suggested "yeah, but". But in the long-term, we could experience less severe downturns, more or better prolonged gains and a healthier retiree (at least from a financial standpoint).

The "yeah, but" syndrome will carry us forward for quite some time. But as all long-term investors know, we will soon forget. Let's hope those in the position to be the regulators don't.