Unlike many, I have long felt that money market funds possess credit risk.? Does that mean that I don’t own money market funds?? I have a lot of money in money market funds, but I review the holdings of my funds to make sure that there are no “yield hogs” in the funds that might imply unreasonable risk.? I don’t go for the treasury only funds — I am willing to take ordinary high quality risk, so long as the managers aren’t doing anything to weird with structured products, ABCP, etc.
Money market funds break the buck when the market value of the instruments drops below 99.5% of par.? That rarely happens, though in this environment it is a risk, if a fund hasn’t availed itself of the cheap insurance offered by the US Treasury.
The real risk comes when a fund “breaks the buck” and allows withdrawals at par for a time, leading to a “run on the fund.”? My proposal says this: When a fund “breaks the buck,” it announces a credit event.? It tells shareholders that they have lost money, and to protect the interests of all shareholders, all shareholders will suffer a small capital loss.
Whatever the fairly calculated NAV is when a capital loss is announced, the new NAV would be 100.25, and the number of shares reduced to the level that supports that NAV.? If the value of the assets has been accurately calculated, and there are withdrawals, the premium to NAV should rise, not fall, for the remaining shareholders.
No one will like the concept of a credit event in money market funds.? That said, the idea would have many salutary effects on money market funds:
It would eliminate runs on the funds.
It would get people used to the idea that there is some risk in money market funds, though limited.
It would eliminate the need for the government to intervene and insure money market funds.
It would allow some money market funds to take more risk, and offer more return.
The cost would be minimal, most of the time losses would be 1-2%, which would be paid for through interest in less than a year.
Now, my main application was money market funds, but there are two other areas to consider.? Area one: short-term income funds.? Here is my poster child.? Under my proposal, instead of freezing redemptions, units are eliminated for the capital losses to the degree that it is not in the interests of anyone to liquidate assets.? A run on the fund would increase the NAV relative to the price.
Here’s area two: stable value funds.? I’ve written about this before, but stable value funds possess more levers to continue operating, even when the NAV drops below 99.5% of par.? Stable Value funds don’t typically reveal the NAV, and when the NAV is lower than the price, they lower the credited rate relative to the earnings rate in order to bring the two back into balance.
But what if a Stable Value fund is in a deep hole?? What if the credited rate is nearing zero, and investors are fleeing, worsening the problem?? My view is that at some threshold for NAVs the Stable Value funds have to announce a credit event and reduce units.? That value might be 96-97% of par, with a revaluation of units around 101-102% of par.? Even if there is no fleeing, the excess would be amortized into the credited rate over time.
On the negative side, this could lead money market funds, short-term income funds, and stable value funds to be more aggressive.? That said, it would encourage invest to analyze these funds that are not riskless, because they could undergo devaluations.
For those who hold pseudo-cash through money market funds, short-term income funds, or stable value funds, you need to be aware that they are not riskless, and that in their present form they may deliver capital losses, and more so if withdrawals are not limited.? My proposal provides an orderly way for recognizing and dealing with those losses in a way that does not require the government to step in with guarantees.
My friend Cody put out a piece today on not investing in the company that you work for.? 95% of the time, that is correct.? Since this blog is about reduction of risk, I advise all readers not to increase their risk by risking their retirement funds on the the company from which they derive their wages.? That said, here is the other 5%, from a RealMoney CC:
Roger is dead right when he says to diversify. My broad market strategy has 35 stocks in it. Biggest position is Allstate (boring, huh?) at 5%. Most of the rest are around 2.5%, with about 15% cash.
There have only been two times that my wife has suggested that I do something with respect to our investments. Both were when I let a position grow too big. The first was the St. Paul, when I worked there. The other is my only private equity holding: a company which makes the best commercial lawn mowers in the world (my opinion). She was right both times, in my opinion.
The secret to investing is risk control. Don’t make a move that could knock you out of the game, and over the long run, you can make decent money as you compound your gains.
If I compare my investing to baseball, I would say that I try to hit singles. Playing home run ball leads to too many strikeouts, and the strikeouts hurt more than the home runs help. Not only do you lose money, you lose confidence to stay in the game.
So, play the game with a margin of safety. Diversify broadly, and maybe, just maybe, buy some bonds too, to even out the ride. (I have an article coming on my bond holdings in the next month…)
Position: long ALL
There are exceptions, though, and I will point three of them out.? 1) Executives often have to buy company stock; but they are beiong paid to take risk for the good of the shareholders.? 2)? Occasionally, when your company is out of favor, and you know it has a strong balance sheet, it may be time to buy.? That’s what I did with the St. Paul back in 2000, and it paid off well.? 3) If you understand your business better than anyone else (very rare), and you are in a fast growing industry, the stock of your company can be a good deal if the general market has not discovered it yet, and bid the stock price to high P/E ratios.
Aside from that, do not invest in the stock of your company.? Why put your retirement at risk?
Pensions are complicated.? Necessarily so, because of the wide numbers of parties involved, and the contingencies involved (mortality, morbidity, asset returns, insolvency) over a long period of time.? Anyone who has had a cursory look at the math (or regulations) behind setting pension liabilities, contributions, etc., knows how tough the issues are, and why real experts need to handle them.
I’ve worked at the edge of the pension business for much of my career.? I have designed defined contribution plans, created stable value products, done asset allocation for defined benefit [DB] plans, terminal funding, and other incidentals.? That said, I am a life actuary [FSA], not a pension actuary [EA].
Tonight’s main issue revolves around a good article by the estimable Matthew Goldstein of Business Week.? Steve Waldman, filling in at Naked Capitalism, commented on the article as well.
Here’s my take: it is legal today for companies to shift their pension liabilities to life insurance companies in the Terminal Funding business.? All they have to do is send a description of the liabilities of the plan to the dozen or so companies that are in the business with adequate claims paying ability ratings, and the companies will send back an estimate of what they would require as a single premium payment to take on the liabilities.? Low bidder wins (and loses — he mis-bid).
So, why don’t plan sponsors take the life insurers up on this?? Easy.? The cost of buying the annuities from the insurers is more expensive than the amount of assets in the trust.? For those companies that are overfunded, they don’t care to terminate — it is a great benefit for their employees.
Terminal funding was most common in the late 80s, when companies could terminate DB plans, and any excess assets would revert to the company.? Then the law changed, and most excess assets would be taken by the Federal Government.? Another reason why overfunded plans do not terminate — the excess assets are valuable to the plan sponsor, but are trapped assets.? They are valuable because they give flexibility, and reduce future contributions.
Why is it more expensive to buy annuities from insurance companies than the assets on hand in the trust?
The main reason is that the plan sponsor gets to assume the rates he will earn on plan assets (within reason).? That rate will almost always be higher than the rate that an insurance company can invest at after expenses.? Pension funding rules are significantly more liberal than life insurance reserving and risk-based capital rules.
Insurers must mainly invest in bonds, whereas pension funds can invest in any asset class, subject to the prudent man rule.
Insurers must keep surplus assets to keep the company sound through downturns.? Pension plans have no such requirement.
Insurance companies have profit margins and overhead that pension plans do not.
Often there are funky, hard-to-value benefits in the pension plan.? Subsidized early retirement is the simplest of those.? The insurance companies don’t have a good way of pricing them, so they toss out some guesses.? Often the winner is the one that ignored the cost of the odd ancillary benefits.
Now, for a proposal from the Treasury to be effective, they somehow have to wave their hands at the issues that I just put forth.? Even if they allow other regulated financial companies to take over pension plans, they have the following issues:
Who is responsible for shortfalls?
Does the company taking over the plan have to put in some subordinated capital to give them “skin in the game.”? (Essentially, the life insurers have to do that today.)
How do profit incentives work?? Do they accrue inside the plan as a buffer against shortfalls, or do excess earnings (however defined) get immediately? or over time paid to the buyer of the pension liabilities?? (You can guess what the liability buyers want.)
How do underfunded plans get transferred compared to adequately funded plans?? Hopefully the plan sponsors of the underfunded plans have to pony up to fund them at levels that are adequately funded, then they can transfer them.? It would be a sham to transfer underfunded plans to an entity that says that can fund the plans because they have an ultra-aggressive investment strategy.? The blow-up will leave behind even bigger deficits.
Call me a skeptic here, while I call the head of the PBGC a Pollyanna.? To Bradley Belt: If you think this will solve your underfunding/insolvency problems, think again.? Only through high risk investment strategies succeeding can all of the underfunding be invested away.? Ask this: how would you feel today if the plan sponsors of underfunded plans all adopted highly risky investment strategies?? You would worry.? Well, unless the liability buyers have skin in the game, you will worry just as much after the sale of liabilities.
Sometimes I think politicians/bureaucrats believe in magic.? Some little tweak, a loosening of regulations, and poof!? The problem goes away.? It is rarely that simple, particularly when you are dealing with the math and complexities of long term compound interest, which in my opinion are inexorable.? (Kind of the inverse of compound interest being Einstein’s eighth wonder of the world — it is a wonder when you are compounding assets looking forward, without liabilities to fund, but when your discounted liabilities are greater than your assets, my but that eighth wonder of the world fights you fiercely.)
Now, I’m not going to discuss this at length, because I am getting tired, but the Wall Street Journal had another pension article this week.? A good article, and I must say that I don’t get how the practices described are legal.? The anti-discrimination rules were put into place to deter this issue.? Why they are not enforced here is a mystery to me.? Regulated pension plans should not be able to invest in the debts of non-regulated pension plans.? To allow anything else, is to make a mockery of the regulations.? (Another reason why regulated and non-regulated financials should be separated.)? The Treasury has anti-abuse rules that they can invoke against such practices.? Why don’t they use them?
My guess is that the Bush administration doesn’t care about the issue.? Perhaps the next President will care more.? And, with respect to the sale of pension liabilities, my guess is that that gets left to the next President and Congress, who will not allow the practice as proposed.
PS — One last note: what would be fair, if pension liability buyouts are allowed, is to allow participants the option to roll their net assets into a rollover IRA.? Back in the 80s, many people got burned by less than creditworthy companies who bought their pension liabilities and went belly-up themselves.? It is a normal aspect of contract law that you can’t take a debt and transfer it to another party unilaterally, unless the creditor consents.? So it should be in pension liability transfers.
A large-ish number of people have asked me to write this piece.? For those with access to RealMoney, I did an article called The Fundamentals of Market Tops.? For those without access, Barry Ritholtz put a large portion of it at his blog.? (I was honored .) When I wrote the piece, some people who were friends complained, because they thought that I was too bullish.? I don?t know, liking the market from 2004-2006 was a pretty good idea in hindsight.
So, a number of people came to me and asked if I would write ?The Fundamentals of Market Bottoms.?? Believe me, I have wanted to do so, but some of my pieces at RealMoney were ?labor of love? pieces.? They took time to write, and my editor Gretchen would love them to death.? By the way, if I may say so publicly, the editors at RealMoney (particularly Gretchen) are some of their hidden treasures.? They really made my writing sing.? I like to think that I can write, but I am much better when I am edited.
Okay, before I start this piece, I have to deal with the issue of why equity market tops and bottoms are different.? Tops and bottoms are different primarily because of debt and options investors.? At market tops, typically credit spreads are tight, but they have been tight for several years, while seemingly cheap leverage builds up.? Option investors get greedy on calls near tops, and give up on or short puts.? Implied volatility is low and stays low.? There is a sense of invincibility for the equity market, and the bond and option markets reflect that.
Bottoms are more jagged, the way corporate bond spreads are near equity market bottoms.? They spike multiple times before the bottom arrives.? Investors similarly grab for puts multiple times before the bottom arrives.? Implied volatility is high and jumpy.
As a friend of mine once said, ?To make a stock go to zero, it has to have a significant slug of debt.?? That is what differentiates tops from bottoms.? At tops, no one cares about debt or balance sheets.? The only insolvencies that happen then are due to fraud.? But at bottoms, the only thing that investors care about is debt or balance sheets.? In many cases, the corporate debt behaves like equity, and the equity is as jumpy as an at-the-money warrant.
I equate bond spreads and option volatility because contingent claims theory views corporate bondholders as having sold a put option to the equityholders.? In other words, the bondholders receive a company when in default, but the equityholders hang onto it in good times.? I described this in greater measure in Changes in Corporate Bonds, Part 1, and Changes in Corporate Bonds, Part 2.
Though this piece is about bottoms, not tops, I am going to use an old CC post of mine on tops to illustrate a point.
Bubbles are primarily a financing phenomenon. Bubbles pop when financing proves insufficient to finance the assets in question. Or, as I said in another forum: a Ponzi scheme needs an ever-increasing flow of money to survive. The same is true for a market bubble. When the flow?s growth begins to slow, the bubble will wobble. When it stops, it will pop. When it goes negative, it is too late.
As I wrote in the column on market tops: Valuation is rarely a sufficient reason to be long or short a market. Absurdity is like infinity. Twice infinity is still infinity. Twice absurd is still absurd. Absurd valuations, whether high or low, can become even more absurd if the expectations of market participants become momentum-based. Momentum investors do not care about valuation; they buy what is going up, and sell what is going down.
I?m not pounding the table for anyone to short anything here, but I want to point out that the argument for a bubble does not rely on the amount of the price rise, but on the amount and nature of the financing involved. That financing is more extreme today on a balance sheet basis than at any point in modern times. The average maturity of that debt to repricing date is shorter than at any point in modern times.
That?s why I think the hot coastal markets are bubblettes. My position hasn?t changed since I wrote my original piece.
Position: none
I had a shorter way of saying it: Bubbles pop when cash flow is insufficient to finance them.? But what of market bottoms?? What is financing like at market bottoms?
The Investor Base Becomes Fundamentally-Driven
1) Now, by fundamentally-driven, I don?t mean that you are just going to read lots of articles telling how cheap certain companies are. There will be a lot of articles telling you to stay away from all stocks because of the negative macroeconomic environment, and, they will be shrill.
2) Fundamental investors are quiet, and valuation-oriented.? They start quietly buying shares when prices fall beneath their threshold levels, coming up to full positions at prices that they think are bargains for any environment.
3) But at the bottom, even long-term fundamental investors are questioning their sanity.? Investors with short time horizons have long since left the scene, and investor with intermediate time horizons are selling.? In one sense investors with short time horizons tend to predominate at tops, and investors with long time horizons dominate at bottoms.
4) The market pays a lot of attention to shorts, attributing to them powers far beyond the capital that they control.
5) Managers that ignored credit quality have gotten killed, or at least, their asset under management are much reduced.
6) At bottoms, you can take a lot of well financed companies private, and make a lot of money in the process, but no one will offer financing then.? M&A volumes are small.
7) Long-term fundamental investors who have the freedom to go to cash begin deploying cash into equities, at least, those few that haven?t morphed into permabears.
8 ) Value managers tend to outperform growth managers at bottoms, though in today?s context, where financials are doing so badly, I would expect growth managers to do better than value managers.
9) On CNBC, and other media outlets, you tend to hear from the ?adults? more often.? By adults, I mean those who say ?You should have seen this coming.? Our nation has been irresponsible, yada, yada, yada.?? When you get used to seeing the faces of David Tice and James Grant, we are likely near a bottom.? The ?chrome dome count? shows more older investors on the tube is another sign of a bottom.
10) Defined benefit plans are net buyers of stock, as they rebalance to their target weights for equities.
11) Value investors find no lack of promising ideas, only a lack of capital.
12) Well-capitalized investors that rarely borrow, do so to take advantage of bargains.? They also buy sectors that rarely attractive to them, but figure that if they buy and hold for ten years, they will end up with something better.
13) Neophyte investors leave the game, alleging the the stock market is rigged, and put their money in something that they understand that is presently hot ? e.g. money market funds, collectibles, gold, real estate ? they chase the next trend in search of easy money.
14) Short interest reaches high levels; interest in hedged strategies reaches manic levels.
Changes in Corporate Behavior
1) Primary IPOs don?t get done, and what few that get done are only the highest quality. Secondary IPOs get done to reflate damaged balance sheets, but the degree of dilution is poisonous to the stock prices.
2) Private equity holds onto their deals longer, because the IPO exit door is shut.? Raising new money is hard; returns are low.
3) There are more earnings disappointments, and guidance goes lower for the future.? The bottom is close when disappointments hit, and the stock barely reacts, as if the market were saying ?So what else is new??
4) Leverage reduces, and companies begin talking about how strong their balance sheets are.? Weaker companies talk about how they will make it, and that their banks are on board, committing credit, waiving covenants, etc.? The weakest die.? Default rates spike during a market bottom, and only when prescient investors note that the amount of companies with questionable credit has declined to an amount that no longer poses systemic risk, does the market as a whole start to rally.
5) Accounting tends to get cleaned up, and operating earnings become closer to net earnings.? As business ramps down, free cash flow begins to rise, and becomes a larger proportion of earnings.
6) Cash flow at stronger firms enables them to begin buying bargain assets of weaker and bankrupt firms.
7) Dividends stop getting cut on net, and begin to rise, and the same for buybacks.
8 ) High quality companies keep buying back stock, not aggresssively, but persistently.
Other Indicators
1) Implied volatility is high, as is actual volatility. Investors are pulling their hair, biting their tongues, and retreating from the market. The market gets scared easily, and it is not hard to make the market go up or down a lot.
2)The Fed adds liquidity to the system, and the response is sluggish at best.? By the time the bottom comes, the yield curve has a strong positive slope.
No Bottom Yet
There are some reasons for optimism in the present environment.? Shorts are feared.? Value investors are seeing more and more ideas that are intriguing.? Credit-sensitive names have been hurt.? The yield curve has a positive slope.? Short interest is pretty high.? But a bottom is not with us yet, for the following reasons:
Implied volatility is low.
Corporate defaults are not at crisis levels yet.
Housing prices still have further to fall.
Bear markets have duration, and this one has been pretty short so far.
Leverage hasn?t decreased much.? In particular, the investment banks need to de-lever, including the synthetic leverage in their swap books.
The Fed is not adding liquidity to the system.
I don?t sense true panic among investors yet.? Not enough neophytes have left the game.
Not all of the indicators that I put forth have to appear for there to be a market bottom. A preponderance of them appearing would make me consider the possibility, and that is not the case now.
Some of my indicators are vague and require subjective judgment. But they?re better than nothing, and kept me in the game in 2001-2002. I hope that I ? and you ? can achieve the same with them as we near the next bottom.
For the shorts, you have more time to play, but time is running out till we get back to more ordinary markets, where the shorts have it tough.? Exacerbating that will be all of the neophyte shorts that have piled on in this bear market.? This includes retail, but also institutional (130/30 strategies, market neutral hedge and mutual funds, credit hedge funds, and more).? There is a limit to how much shorting can go on before it becomes crowded, and technicals start dominating market fundamentals.? In most cases, (i.e. companies with moderately strong balance sheets) shorting has no impact on the ultimate outcome for the company ? it is just a side bet that will eventually wash out, following the fundamental prospects of the firm.
As for asset allocators, time to begin edging back into equities, but I would still be below target weight.
The current market environment is not as overvalued as it was a year ago, and there are some reasonably valued companies with seemingly clean accounting to buy at present.? That said, long investors must be willing to endure pain for a while longer, and take defensive measures in terms of the quality of companies that they buy, as well as the industries in question.? Long only investors must play defense here, and there will be a reward when the bottom comes.
Now, I’ve never been a great fan of the financial guarantee insurers, or the rating agencies.? Consider my post dealing with then over at RealMoney, Snarls in Insurance Investigation, Part 2.? In it, three-plus years ago, I suggested that Eliot Spitzer should investigate the relations between the rating agencies and the financial guarantors.
Now the City of Los Angeles is bringing a suit against the financial guarantors for forcing them to buy unnecessary municipal bond insurance.? Oh, please.? Did the armies of MBIA and Ambac surround LA City Hall, threatening violence if you didn’t give in to their protection racket?? This suit almost makes the failed efforts of regulators to split the guarantors into separate municipal and non-municipal insurers seem intelligent.
First, the real value of the municipal bond insurance was not for credit enhancement.? Municipal bonds rarely default, and when they do, they often become current again.? It was liquidity insurance.? Now, for a city like Los Angeles, maybe that’s not needed, but most municipalities are small issuers, and there is not enough manpower at bond managers to analyze them all.? The rating agencies fill part of the gap with their ratings.? For most municpalities, they are the only analytical coverage at all.
Now, the municipalities had the choice of issuing insured or uninsured bonds.? Insured bonds could be sold at AAA rates, and bond managers would buy them more easily because they were more liquid.? The question to an issuer boiled down to which is cheaper?? Pay AAA rates plus the guarantee fees and have an easy sale, or, pay at the rates that managers demand for lower-rated municipal bond?? For many munipalities they chose an insured sale because it was cheaper, or not much more expensive.
Any yield premium paid could possibly be attributed to their investment bankers, who did not want the extra work of having to actually sell the bonds.? With the AAA, they would fly out the door with no questions.? A lower-rated bond would cause some bond managers to sit on their hands; even though they could look at the rating from the agencies, they would not trust the rating without further analysis, and that takes time and effort.? (I know from my time as a bond manager, you can’t push your credit staff too hard, or they start making mistakes, because they can’t do quality work.)
The municipalities had another choice as well.? They could have borrowed less money, and raised more taxes, bringning their credit profiles up to AAA.? I know, the rating agencies should have rated municipalities higher, but that’s not who they are suing.? (That said, credit ratings are only moderately related to the yield spreads paid.)
A suit like this would have a better chance if it alleged implicit collusion between the rating agencies and the financial guarantors, and sued them both.? I still don’t think the City of Los Angeles would win such a suit, but the real flaw was not the insurers, but the ratings, including the ratings the financial guarantors themselves, which in my opinion, were always somewhat liberal.? (Hint: with financials, don’t just look at the rating, but look at the implied rating from the spreads on their debt.? The rating agencies holding company debt always traded at wider yields than their stated ratings would imply.)
Now, with the added fun in the space since Moody’s moved Assured Guaranty and FSA to negative watch, something I did not expect, this leaves Berky as the last man standing in the space.? But one seller does not a market make.? What this means, if Moody’s follows through, and S&P follows suit, is that muni bond insurance is likely dead for some time.? Who loses?? Small municipalities primarily.? They will face higher debt issuance costs.? Even large issuers have found the new issue market less than inviting recently.
In closing, could this come at a worse time for municipalities?? Revenue bases are eroding even as demands for services rise.? (Housing price will be a drag here for a few more years.)? They can’t print money or issue debt at whim to solve the problem, so they have to make painful cuts.? I will add this, even more painful cuts will come over the next 10-20 years as the pensions/ retiree healthcare crisis descends on the municipalities.? Not a fun time for anyone… and I’m sure there will be more lawsuits over the whole shebang, most of them bogus.
Where were you while America aged? 😉 I’ve been following the issues in this book written by Roger Lowenstein for over 20 years. As an actuary (but not a pension actuary) and a financial analyst, I have written about the issues involved since 1992.
Roger Lowenstein motivates the issues surrounding pensions by telling three stories, those of General Motors, the New York City Subway, and the City of San Diego. He captures the essence of why we have pension problems in a way that anyone can appreciate. I sum it up this way: promises today, payments far in the future. Get through the present difficulty, at the price of mortgaging the future.
If you repeat that recipe often enough, you get into a tough spot, as GM is in today. Give GM credit though, a lesser firm would have declared bankruptcy long before now, and shed its pension liabilities to the Pension Benefit Guaranty Corporation [PBGC].
Given the softness of funding requirements for pension liabilities, the easy road for corporations and municipalities has been to skimp on funding pensions, leaving a bigger problem for others to solve 10+ years later. As for municipalities, review my recent post here.
Now, why didn’t the US Government insist on stricter funding standards for pension plans? Because of pushback from corporations and municipalities. The US Government hoped that their funding methods for corporations would encourage the creation of pension plans, and that corporations would be good corporate citizens, and not play it to the edge.
As for municipalities, which are not subject to ERISA, as corporations are, the government assumed that they would act in their best long-term interests. Alas, but governments are run by men, not angels.
I found each of the three stories in the book to be interesting and instructive. They are tales of people aiming at short-term results, while letting the future suffer. In the case of the NYC Subways, the plan sponsors finally fought back. With GM, they accomodated until they were nearly dead. With San Diego, they compromised until it cost them their bond rating, and many people involved got sent to jail.
As any good author would, the book offers a few solutions at the end, but it recognizes as I do, that we are pretty late in this game — there are no “good” solutions. There are solutions that may aid future generations. An example is making municipalities subject to the funding requirements of ERISA. I agree, and add that we should apply that to Federal DB [defined benefit] plans, and Social Security too. This could be our own Sovereign wealth fund, investing overseas for the good of US retirees. (What, there is no money available to do that? What a shock.)
I would also add that the funding requirements specified in ERISA are weak. The standards for life insurance reserving are stronger. The weak standards were there to encourage the creation of DB plans. Well, you can encourage creation, but maintenance is another thing.
A certain level of overfunding is need in good times, hopefully, with discipline not to increase benefits. That overfunding is hard to achieve, because the IRS discouraged overfunding above a certain level, because it did not want companies to shelter income from taxation by contributing to the DB pension plans.
Now, I have also reviewed the book Pension Dumping. Which one is better? For the average reader, While America Aged motivates the topic better, but if you want to dig into some of the deeper issues, Pension Dumping does more.
Full disclosure: If you enter Amazon through a link on my site and buy something, I get a small commission. This is my version of the “tip jar.” Thanks to all who support me.
PS — In some ways, the actuarial profession comes out with a black eye in books like this, and I would say that it is deserved. I don’t believe in professions, per se. Self-regulating guilds/industries are a fool’s bargain. There are no guilds/industries where if you can’t explain it to a bunch of average folks, there should be no cause for discipline from society at large. What stinks to me, is that there is no hint of discipline to any of the actuaries, and other third party consultants from the actions that they took to support the actions of politicians and corporations where they bent and broke pension funding rules. The ABCD? What a joke.
In my blogging, in my other research and in investing, I gain some degree of comfort from being criticized by both bulls and bears. Worst of all would be no criticism; it would mean that I am not saying much. Criticism from both sides means that I am probably not blindly taking a partisan view, or talking my own book.
Briefly this evening, I want to point out some of the costs of our current monetary policies. Now, some things are going well, and the Fed might want to take some credit.? But the costs are soft costs, ones that are preferable to systemic financial collapse. That said, there are smarter and dumber ways to do bailouts. When I criticized the Bear Stearns bailout, I tried to point out how there have been better ways of doing bailouts from history, and that the Fed should have known this. I understand that the Fed may have felt rushed at the time, leading to a suboptimal decision, but they should be better read on economic history. Bailouts should be very painful for those bailed out, or else others line up for them.
Well, now that there has been one bailout, why not more? Other shaky areas of the economy could use a bailout… student lenders, homedebtors, home lenders, etc. Are they less worthy than Bear Stearns? Ignore the student lenders, because they pose little systemic risk. If housing prices fall another 20%, the systemic risk issues could be severe. Consider there two quotes from the article:
“There is no way to put the genie back in the bottle,” Minneapolis Fed President Gary Stern said in an interview with Fox Business Network on April 18. “What worries me most about where we wind up is that we will have an expansion of the safety net without adequate incentives to contain it.”
and
Richmond Fed chief Jeffrey Lacker and policy adviser Marvin Goodfriend wrote in a 1999 paper that central bank lending creates ever-expanding expectations. “The rate of incidence of financial distress that calls for central bank lending should tend to increase over time,” they wrote. That “creates a potentially severe moral-hazard problem.”
We’re on that slippery slope now. Should the Fed bend monetary policy even more to compensate for areas of lending where they have inadequate control? To the extent that you believe in central banking, central banks should deal with the big issues, and leave the little ones alone. Lend at a penalty rate during a crisis; don’t try to make things normal. Where there is systemic risk, stand behind the core but not the fringe; defend debt claims, and wipe out equity claims.
Or, consider the second order effects that our monetary policy creates: the weak dollar and the responses that foreign governments must follow: let their export sector wither, or follow US policy down, and accept more inflation. It will take a long time for the US to lose its reserve currency status, but we are on that path. Here’s to the day when we have to borrow in the currencies of oil exporters, or China. (Please no. 🙁 )
Or, consider the troubles that the states are in, since they have to run balanced budgets, unlike the Federal government, which can borrow in dollars, and inflate the currency as needed. I follow state tax revenues; it is an excellent coincident read on the economy. Well, sales tax revenues are falling. Also, some states are considering one of the “dumbest ideas ever” — pension bonds (borrowing to fund pension plans, relying on clever investing to beat the rate paid on the bonds). New Jersey lost big on their last attempt at pension bonds. Far better to consistently fund municipal pensions through general revenues. For those that have read me before on municipal pensions, their claim to fame is that they make private sector funding look good.
Finally, to end on a less sad note, is Iceland looking better, or , is it just part of an overall bear market rally?? (What of Argentina?) ? My guess is the latter, but maybe they have successfully defended their currency. Then again, we can look at Brazil, which is now investment grade on one side (from S&P). Good news follow good policies, and Brazil has been on the right track — they have become a net creditor, unlike the US. Hey, maybe the Real should be a reserve currency.
I?m an actuary, but not a Pension Actuary.I don?t understand the minutiae of pension law; I only know the basics.Where I have more punch than most pension actuaries is that I understand the investing side of pensions, whereas for most of them, they depend on others to give them assumptions for investment earnings.I?ve written on pension issues off and on for 15 years or so.I remember my first article in 1992, where I suggested that the graying of the Baby Boomers would lead to the termination of most DB plans.
I am here to recommend to you the book Pension Dumping.It is a very good summary of how we got into the mess we in today with respect to Defined Benefit [DB] pension plans.Now, much of the rest of this review will quibble with some aspects of the book, but that does not change my view that for those interested in the topic, and aren?t experts now, they will learn a lot from the book.The author, Fran Hawthorne, has crammed a lot of useful information into 210 pages.
The Balancing Act
One of the things that the book gets right is the difficulty in setting pension regulations and laws.In hindsight, it might have been a good idea to give pensioners a higher priority claim in the bankruptcy pecking order.But if that had been done, many companies might have terminated their plans then and there, because of the higher yields demanded from lenders who would have been subordinated.
She also covers the debate on the ?equity premium? versus immunization well.Yes, it is less risky to immunize ? i.e., buy bonds to match the payout stream.Trouble is, it costs a lot more in the short run.With equities, you can assume that you will earn a lot more.
She also notes how many companies were deliberately too generous with pension benefits, because they did not have to pay for them all at once.Instead, they could put up a little today, and try to catch up tomorrow.
Things Missed
?Individuals aren?t good at managing their own money.Even if a participant-directed 401(k) plan is cheaper than a DB plan in terms of plan sponsor outlay, the average person tends to panic at market bottoms and get greedy at market tops.DB plans and trustee-directed DC plans are a much better option for most people.That said, most people prize the illusion of control, and will not choose what is best for them.
?Technological progress was probably a bigger factor in doing in the steel industry, and other unionized industries, than foreign competition.Nucor and its imitators did more damage to the traditional steel industry than did foreign competition.With commodity products, low price wins, and Nucor lowered the costs of creating steel significantly.
?In the analysis of what industries could face pension problems next, she did not consider banks and other financial institutions.Most of those DB plans are very well-funded.Why?They understand the compound interest math, and the variability of the markets.But what if the current market stress led to financial firms cutting back on their plan contributions?
?She gets to municipal pensions at the end, and spends a little time there, but those face bigger funding gaps than most private plans.Also, she could have spent more time on Multiple Employer Trusts, where funding issues are also tough, and plan sponsor failures leave the surviving plan sponsors worse off.
?She also thinks that if you stretch out the period of time that companies can contribute in order to fund deficits, it will make things better.In the short run, that might be true, but in the intermediate term, companies that are given more flexibility tend to get further behind in funding DB pensions.
The book could have spent more time on changes in investing within DB pension plans, which are drifting away from equities slowly but surely, in favor of less liquid investments in private equity and hedge funds. How that bet will end is anyone’s guess, but pension investors at least have a long time horizon, and can afford the illiquidity. My question would be whether they can fairly evaluate the skill of the managers.
Summary
This book describes the motives of all of the parties in DB pension issues very well, and why they tend to lead to DB plan terminations.There are possible solutions recommended at the end, but in my judgment they might save some plans that are marginal, but not those that are sick.If you are interested in the topic of pensions, buy the book, and if you buy it through the links above, I get a small commission.(If you buy anything through Amazon after entering from a link on my site, I get a small commission.That?s my tip jar, and it doesn?t raise your costs at all.)
1) A lament for Bill Miller.? Owning Bear Stearns on top of it all is adding insult to injury.? Now, living in Baltimore, I get little bits of gossip, but I won’t go there this evening.? I think Bill Miller’s problems boil down to lack of focus on a margin of safety, which is the main key to being a good value manager.? During the boom periods, he could ignore that and get away with it, but when we are in a bust phase, particularly one that hurts financials.? When financials get hit, all forms of accounting laxity tend to get hit, making the margin of safety more precious.
2) Now perhaps one bright spot here is rising short interest. Short interest is a negative while it is going up, but a positive once it has risen to unsustainable levels.? What is unsustainable is difficult to define, but remember Ben Graham’s dictum, that the market is a voting machine in the short run, and a weighing machine in the long run.? The value of stocks in the long run will reflect the net present value of their free cash flows, not short interest or leverage.
3)? Now, if you want the opposite of Bill Miller in the value space, consider Bob Rodriguez of FPA Capital.? Along with a cadre of other misfit value managers that are willing to invest in unusual long-only portfolios aiming for absolute returns while not falling victim to the long/short hedge fund illusion, he happily soldiers on with a boatload of cash, waiting for attractive opportunities to deploy cash.
4) Retirement.? What a concept amid falling housing and equity prices.? Though we have difficulties at present from the housing overhang, and the unwind of financial leverage, there will be continuing difficulties over the next two decades as assets must be liquidated and taxes raised to support the promises of Medicare, and to a lesser extent, Social Security.? My guess: Medicare gets massively scaled back.
5) I get criticism from both bulls and bears.? I try to be unbiased in my observations, because amid the difficulties, which I have have been writing about for years, there is the possibility that it gets worked out.? When there are problems, major economic actors are not passive; they look for solutions.? That doesn’t mean that they always succeed, but they often do, so it rarely pays to be too bearish.? It also rarely pays to be too bullish, but given the Triumph of the Optimists, that is a harder case to make.
6) Bill Rempel took me to task about a post of mine, and I have a small defense there, and perhaps a larger point.? Almost none of my close friends invest in the market. It doesn’t matter whether we are in boom or bust periods, they just don’t.? These people are by nature highly conservative, and/or, they are not well enough off to be considering investments in equities.? They are not relevant to a post on investing contrarianism, because they are outside the scope of most equity investing.? They are relevant to a discussion of the real economy, and where your wage income might be impacted.
7) To close for the night, then, a note on contrarianism.? When I read journalists, they are typically (but not always) lagging indicators, because they aren’t focused on the topics at hand. They get to the problems late.? But when I think of contrarianism, I don’t look for opinions as much as financial reliance on an idea.? Many opinions are irrelevant, because they don’t reflect positions that have been taken in the markets, the success of which is now being relied upon.? Once there is money on the line, euphoria and regret can do their work in shaping the attitudes of investors, allowing for contrary opinions to be successful against fully invested conventional wisdom.? But without fully invested conventional wisdom, contrarianism has little to fight.
I’ve written about “the lost decade” before at RealMoney.? A lost decade is where? the stock market goes nowhere, or loses money for ten years.? My purpose in doing so was to point out:
That it is normal for lost decades to occur.? Stock returns are weakly autocorrelated.? Good years tend to be followed by good years, and bad years by bad years.
Once a generation, you have to get a severe boom and a severe bust.? It is partly driven by monetary policy/financial regulation laxity, followed by tightness.? It is partly driven by the fear/greed cycle, because most people, even professional investors, chase performance.
This has a chilling effect on retirement planning.? Recall my recent article on longevity risk.? In that article, I tried to point out the similarities for retirement investment planning between Defined Benefit plans, and an individual with his own unique retirement circumstances, typically with defined contribution plans.
I’ll amplify the last point, because the WSJ doesn’t do much with it.? Nothing kills a DB plan’s funding level worse then a protracted flat/falling equity market, and low bond yields (showing not much alternative for reinvestment).? Same for an individual financial plan.? If a DB plan has an assumed earnings yield of 8%, and the stock market earns zero, and bonds earn 5%, with 60/40 stocks/bonds, than plan earns 2% when it needs 8%.? The funding deficits grow rapidly, and corporations finally bite the bullet, and begin making contributions to their DB plan, cutting earnings in the process.
As for individuals, they should start to save more for their retirements after such a long bad market, in order to get their retirement funding back on track.? Oops, wait.? This is America.? We don’t save personally (particularly Baby Boomers), and our governments run deficits (even more on an accrual basis when we look at Medicare, Social Security, and other long-term inadequately funded programs.? Only our corporations save on net.
So, what to do?
Save more.
?Don’t materially increase or decrease allocations to stocks.? Things may be rough for a while longer, until excesses in the US financial system and in China are worked out, but positive returns will recur.
Avoid investing in companies with large pension funding deficits.
Avoid investments with high embedded leverage, whether individual companies, or ETFs.
Be wary of investing in esoteric asset classes this late in the performance cycle.? They may do well for a while longer, but their time is running out.? (It could be one year or another decade.)
Be ready for increasing inflation.? Even with the income giveup, it is probably wise to have bond durations shorter than the benchmark.
To the extent you can, push back retirement, or plan that you will do it in phases, where you slowly leave the formal labor force.
Of course, you could be a good stock picker, but that’s not a common gift.? The choices are hard when we have a “lost decade.”? There’s no silver bullet; only ways to mitigate the pain.
.) When I wrote the piece, some people who were friends complained, because they thought that I was too bullish.? I don?t know, liking the market from 2004-2006 was a pretty good idea in hindsight.
Where were you while America aged? 😉 I’ve been following the issues in this book written by Roger Lowenstein for over 20 years. As an actuary (but not a pension actuary) and a financial analyst, I have written about the issues involved since 1992.