Pensions – Page 15 – The Aleph Blog

One Dozen Notes on Our Crazy Credit Markets

Posted on 13 March 200813 March 2008 by David Merkel

1) I typically don’t comment on whether we are in a recession or not, because I don’t think that it is relevant. I would rather look at industry performance separate from the performance of the US economy, because the world is more integrated than it used to be. Energy, Basic Materials, and Industrials are hot. Financials are in trouble, excluding life and P&C insurers. Retail and Consumer Discretionary are soft. What is levered to US demand is not doing so well, but what is demanded globally is doing well. Much of the developed world has over-leverage problems. Isn’t that a richer view than trying to analyze whether the US will have two consecutive quarters of negative real GDP growth?

2) So Moody’s is moving Munis to the same scale as corporates? Well, good, but don’t expect yields to change much. The muni market is dominated by buyers that knew that the muni ratings were overly tough, and they priced for it accordingly. The same is true of the structured product markets, where the ratings were too liberal… sophisticated investors knew about the liberality, which is why spreads were wider there than for corporates.

3) Back to the voting machine versus the weighing machine a la Ben Graham. It is much easier to short credit via CDS, than to borrow bonds and sell them. There is a cost, though. The CDS often trade at considerably wider spreads than the cash bonds. It’s not as if the cash bond owners are dumb; they are probably a better reflection of the true expectation of default losses, because they cannot be traded as easily. Once the notional amount of CDS trading versus cash bonds gets up to a certain multiple, the technicals of the CDS trading decouple from the underlying economics of the bond, whether the bond stays current or defaults. In a default, often the need to buy a bond to deliver pushes the price of a defaulted bond above its intrinsic value. Since so many purchased insurance versus the true need for insurance, this is no surprise.. it’s not much different than overcapacity in the insurance industry.

4) If you want a quick summary of the troubles in the residential mortgage market, look no further than the The Lehman Brothers Short Swaption Volatility Index. The panic level for short term options on swaps is above where it was for LTCM, and the credit troubles of 2002. What a take-off in seven months, huh?

5) Found a bunch of neat charts on the mortgage mess over at the WSJ website.

6) I have always disliked the concept of core inflation. Now that food and fuel are the main drivers of inflation, can we quietly bury the concept? As I have pointed out before, it doesn’t do well at predicting the unadjusted CPI. Oh, and here’s a fresh post from Naked Capitalism on the topic of understating inflation. Makes my article at RealMoney on understating inflation look positively tame.

7) The rating agencies play games, but so do the companies that are rated. MBIA doesn’t want to be downgraded by Fitch, so they ask that their rating be withdrawn. Well, tough. Fitch won’t give up that easily. Personally, I like it when the rating agencies fight back.

8 ) Jim Cramer asks if Bank of America will abandon Countrywide, and concludes that they will abandon the bid. Personally, I think it would be wise to abandon the bid, but large companies like Bank of America sometimes don’t move rapidly enough. At this point, it would be cheaper to buy another smaller mortgage company, and then grow it rapidly when the housing market bounces back in 2010.

9) Writing for RealMoney 2004-2006, I wasted a certain amount of space talking about home equity loans, and how they would be another big problem for the banking system. Well, we are there now. No surprise; shouldn’t we have expected second liens to have come under stress, when first liens are so stressed?

10) In crises, hedge funds and mortgage REITs financed by short-term repo financing are unstable. No surprise that we are seeing an uptick in failures.

11) As I have stated before, I am not surprised that there is more talk of abandoning currency pegs to the US dollar. That said, it is a getting dragged kicking and screaming type of phenomenon. Countries get used to pegs, because it makes life easy for policymakers. But when inflation or deflation gets to be odious, eventually they make the move. Much of the world pegged to the US dollar is importing our inflationary monetary policy.

12) Finally, something that leaves me a little sad, people using their 401(k)s to stay current on their mortgages. You can see that they love their homes, as they are giving up an asset that is protected in bankruptcy, to fund an asset that is not protected (in most states). Personally, I would give up the home, and go rent, and save my pension money, but to each his own here.

The Value of a Balance Sheet

Posted on 11 March 2008 by David Merkel

Monday, at about 10AM, I sold my holdings in Deerfield, Deutsche Bank, and Royal Bank of Scotland.? I did it bloodlessly, realizing that Deerfield is the largest loss I have ever taken.? With the proceeds, I bought two placeholder assets that I will hold until the next reshaping (coming in a month), the Industrial (XLI) and Technology (XLK) Spiders.? By doing that, I cut the majority of the links that I had to the leveraged lending economy, which is collapsing at present.? When I saw that haircuts on repo for prime agency collateral had been raised for the second time, I threw in the towel, because too many things have broken that even I did not expect would break. (Even the haircuts on Treasuries have risen.)

With Deerfield, I made the error that if the collateral was very high quality, it could survive, even at high levels of leverage.? In a true panic, that does not matter.? All that matters is whether your leverage is low enough to allow you to survive the credit bust, and that you can do that over your financing horizon.

Financing horizon?? By that I mean how often your solvency gets measured.? For many mortgage REITs, that is a daily, weekly, or monthly phenomenon.? The longer the period, the better the odds of survival.? Short repo financing is by its nature is a weak financing method in a crisis.? The day you cross the line (margin inadequate) the brokers move to liquidate.? Given that some other managers may have been more aggressive, your excess capital can disappear, as more aggressive mangers miss margin calls, and the pressure of their liquidations, forces your more conservative positions down, and you have to liquidate also.

Now, think of a life insurance company, a long-tailed casualty insurer or a defined benefit pension plan.? If they buy AAA whole loans, or prime mortgage collateral, they can hold that position for 3+ years without worry.? Their liabilities aren’t going anywhere.? They know what they will be able to hold the investment through the panic period.? There are still questions over what the best time to buy is, but with many large companies or plans, the optimal thing to do is to suck in a little bit each day, quietly, when the bonds are cheap.? You won’t get the exact bottom; no one does, but you will do well.? My own example is buying floating rate trust preferreds back in late 2002.? Bought a 2% position over two months for my life insurance client without disturbing the markets.? My client cleared a minimum of 10% on those investment grade bonds within a year as the panic lifted.

Accounting vs. Financing

Now, there’s a lot of talk about fair value accounting standards, and how they are adding to the volatility at present.? They are adding to the volatility, but they have less effect than the way things get financed.? Unless the fair value accounting leads a company to violate a debt covenant, typically it does not have that much effect, because it does not change the pattern of cash flows that the company will generate.? Short term financing, where the portfolio’s “market value” gets measured on a daily basis has a much bigger impact, because as prices fall, liquidation of assets can feed a collapse of prices.? Or consider this article from Going Private, which cites an article from Financial Crookery, which highlights an attempt by Merrill Lynch to avoid having to pay out cash on a putable bond.? In order to do that, they make the bond more valuable, so that it won’t be put.? But this isn’t an accounting issue.? It is a financing issue.? Merrill doesn’t want to part with cash now, so it makes its future financing schedule more difficult.? It is a complex way of selling off a bit of the future in order to bail out the present.

Now, I disagree with The Economist article that spawned those posts as well.? There is a better way.? In place of the four common financial statements (Income Statement, Balance Sheet, Cash Flow Statement, and Shareholders Equity), have six.? The two additional statements would come from having a amortized cost income statement, and a fair value statement, and then, the same for the balance sheet.? It would not be a lot of extra work, because all of that data has to be gathered now already.? It would just create two different ways of looking at a financial entity.? One views it as a buy-and-hold investor (amortized cost), and the other as a trader (fair value).? The interpreter of those statements could decide which is more relevant.

I proposed this to an IASB commissioner 2-3 years ago, and she was horrified at the idea.? Two income statements?? Two balance sheets?? What confusion.? I pointed out to her that every financial statement is designed to answer one question.? Bond investors have to rearrange the data to do their analyses; we could create an EBITDA statement to make life easier for them, but we don’t.? The two statements types define two different ways of looking at a firm.? Each is more valid in different situations.

Now, for utility and industrial firms, these distinctions usually don’t matter much, but they do matter for financial firms.? There could be a seventh statement added there, which life insurance companies calculate for their regulators.? All financial companies should have cash flow testing done over the greater of the life of their assets and liabilities, over a wide number of interest rate and credit scenarios, calculating the present value of distributable earnings, to show where they are vulnerable.? They should publish the assumptions and results, and then let the market stew over them.

Now, for my actuarial friends, this would be the “Actuarial Full Employment Act.” Life Insurers control risk not by looking at short term movements in market prices, but through long-term stress testing.? It is no surprise that the insurers are doing much better than the banks in this environment.

Can You Carry The Position?

Posted on 6 March 2008 by David Merkel

My post yesterday on corporate bond spreads was received well.? I want to amplify one point that I did not make strongly enough.? During market crises, asset values cheapen not only in response to likely losses over the long run, but the possibility that there might be forced sellers due to:

Reduction of leverage because of asset values declining
Reduction of leverage because of brokers lending money get skittish
Reduction of leverage because of rating agency downgrades
Reduction of leverage because of client withdrawals
Reduction of leverage because of an increased need for capital from the regulators
Arbitrage from falling prices in related markets

This can temporarily self-reinforce falling asset prices, until unlevered (or lightly levered) buyers find the returns from the assets to be compelling.? Though my piece yesterday was more fun to write, this makes the argument plain.? Can you carry the asset through hard times?? What about the rest of the asset holders?

The concept of weak hands versus strong hands is a very real issue, and for those with a subscription to RealMoney, I recommend these four classic (Labor of love) articles of mine:

Managing Liability Affects Stocks, Pt. 1
Separating Weak Holders From the Strong
Get to Know the Holders? Hands, Part 1
Get to Know the Holders? Hands, Part 2

These articles are core to my thinking, and I spent a lot of time on them.

Ten More Odds & Ends

Posted on 9 February 200810 February 2008 by David Merkel

I’m just trying to clean up old topics, so bear with me:

1) This blog is not ending because of my new job. Finacorp wants me to keep it going, and they may use the posts in PDF form for clients. Also, unlike my prior employer, Finacorp wants me to have a high degree of exposure, because it aids them. You may see me in more venues, which could include TV and radio.

2) In one sense, I had an unusually productive Saturday. I built two models — one for a critique of the PEG ratio, and one for a model of the Treasury yield curve. You will see articles on both of these, and I am really jazzed on both of them. It is not often that I get one impressive result in a day. Today I got two. I’ll give you one practical upshot for now, if you are an institutional bond investor: go long 10-year Treasuries and short 7-year. We are very near the historical wides. If you are like me, and can live with negative carry, dollar duration-weight the trade, so that you are immune to parallel yield curve shifts.

3) I didn’t read Barron’s, Forbes, or The Economist today, but I did read the Financial Analysts Journal. In it there were three articles that are worth a comment. There was an interesting article on fundamental indexation that comes close to my view on the topic. Fundamental indexation, when properly done, is nothing more than enhanced indexing with a value tilt. Will it make you more money than an ordinary index fund? Yes, it will, over a long enough period of time. Will it work every year? No. Is there one optimal way to fundamentally index? No. There is no one cofactor, or set of cofactors that optimally define value, if for no other reason than the accounting rules keep changing.

4) The second article went over the value of immediate annuities as risk reducers to retirees, something I commented on recently. The tweak here is buying annuities that start paying later in retirement, for example at 80 or 85, with the risk that if you die before then, you get nothing. Longevity insurance; a very good concept, but the execution is tough.

5) The third article was on Risk Management for Event-Driven Funds. Here’s my take: risk arb is like being a high yield bond manager. Anytime a deal is announced, you have to do a credit risk analysis:

How likely is it that this deal will go through?
How badly could I be hurt if it does not go through?
Am I getting paid more than a junk bond with equivalent risk?

But the portfolio manager must ask some more questions:

Are there any common factors in my risk arb book that could bite me? Sectors? Need for debt finance?
What if deal financing terms go awry all at the same time? How will that affect the worst risks in my book?
Am I getting paid more than a junk bond with equivalent risk? (Okay, it’s a repeat, but it deserves it.)

Risk arbs have been burned lately, with all of the deals that have been busted because financing is not available on easy terms. It’s tough but this happens. Most easy arbs tend to get overplayed before blowups happen. The lure of easy money brings out the worst in people, even institutional investors.

6) Naked Capitalism had an interesting post on GM. I made the following comment:

I took some criticism at RealMoney.com for writing things like this about GM, though the author here was a much better writer.

The thing is, there are enough levers here that GM can keep the debt ball in the air for some time, as can many of the financial guarantors, so long as they can make their interest payments.

The “Big 3” lose vitality vs. Toyota and Honda each year — in the long run GM and Ford don’t make it. Perhaps after they go through bankruptcy, and shed liabilities to the PBGC, and issue new equity to the current unsecured bondholders, they can exist as smaller companies that have focus. Maybe Ford could be a division of Magna, and GM a division of Johnson Controls. At least then there would be competent management.

7) Barry Ritholtz had a good post called, 5 Historical Economic Crises and the U.S. The paper he cited went into five recent crises in the developed world, and how the current US situation stacks up against that.? Here was my comment on one of the areas where the US situation did not seem so dire, that of the run-up in government debt:

On the last point about the increase in the debt, what is missed is that a lot of the government debt increase is hidden by the non-marketable Treasury bonds held by the entitlement programs. Add that in, and consider the unfunded promises made at the Federal, State, and municipal levels, and the debt increase on an accrual basis is staggering.

We do face real risks here.? The rest of the world will not finance us in our own currency forever.? Oh, one critical difference between the US and the 5 crises — we are the worlds reserve currency, for now.

8 )? I like Egan-Jones on corporate debt.? They have quantitative models that follow contingent claims theory, and use market based factors to estimate likelihood and severity of default.? They are now trying to do models for asset backed securities.? Very different from what they are currently doing, and their corporate models will be no help.? They will also find difficulties in getting the data, and few market-based signals that inform their corporate models.? I wish them well, but they are entering a new line of business for which they have no existing tools to help them.

9) This article from Naked Capitalism pokes at the rating agencies, and the proposed reforms from the SEC.? My view is this: the financial regulators need a model on credit risk.? They need a common platform for all credit risks.? They need one set of ratings that allow them to set capital levels for the institutions that they regulate, or they need to bar investments that cannot be rated adequately.? The problem is not the rating agencies but the regulators.? How do they properly set capital levels.? They either have to use the rating agencies, or build internal ratings themselves.? Given my experiences with the NAIC SVO, it is much better to use the rating agencies.? They are more competent.

10)? Finally, on Friday, a UBS report stirred the pot regarding non-borrowed reserves.? You can see the H.3 report here. Both Caroline Baum of Bloomberg and Real Time Economics debunked the UBS piece.? But it was simpler than that.? The Fed published its own explanation at the time they put out the H.3 report.? UBS did not include the effect of the new TAF.? Whoops.? Oh well, I make mistakes also.? It’s just better to make mistakes when one doesn’t sound so certain.
Full disclosure: long MGA, HMC

The Fiscal Elephant in the Room

Posted on 2 February 20083 February 2008 by David Merkel

Those that know me well know that I have been following the entitlements issue for over 15 years. I feel that the leadership of the American Academy of Actuaries has blown it royally over this whole period, and before, through and before the Greenspan commission (his worst legacy). We had a chance to warn the nation, and did not do it. We allowed actuaries who could do the math, but didn’t understand the politics, to write in our journals, and talk to Congress, and suggest that everything would be fine.

Well, things are fine now, and they might be fine for the next president, but they won’t be fine by the 2020 election.

I am talking about Medicare/Medicaid. Unless there are significant changes made, there is no way that we can afford the promises that have been made.? The graph from the Wall Street Journal (from this fine article), on the right, depicts spending excluding interest.? Including interest payments makes the graph worse, and more so as time goes on.? In general, Americans don’t like sending more than 20% of GDP to the Federal Government.? By 2020, that will no longer be possible to avoid, unless significant changes are made.

This is the same issue that faces every state in the nation (except Wisconsin) and the Federal Government over their retiree health care programs; they didn’t set aside money for the future payments, but decided to pay-as-it-goes.? Now, what choices are there to remedy the situation?? Not many good ones:

Raise taxes significantly.
Raise the age for Medicare eligibility to 75 or so (don’t phase it in).
Means-test eligibility (lousy incentives there, as it is for Medicaid)
Eliminate part D now, while there is no imperative to keep it.
Create a reimbursement system that forces the creation of a two-tier medical system.? For the elderly, it will mean limited help in their waning years.? Treatments for expensive prolonging of life will have to come out of private sources.? Call it the Federal Elderly HMO.

The likely solution will involve all five policy options in some form.? How it works out depends on how much political resistance the elderly Baby Boomers will put up.? Another political hurdle: much as I dislike National Health Care, that is a wild card in this mix.? That could be the de facto way that limits the benefit payments that seniors receive.

I’m not into doom and gloom.? I manage money that is invested in stocks, and I have to look for advantage every day.? But we have put off real reform of entitlements for over 25 years, and we continue to do so.? Which of our six remaining presidential candidates is willing to talk about reforming Medicare?? I haven’t heard any of them go that way; it just loses votes.? But when it is hitting us between the eyes twelve years from now, younger people will be incented to vote in politicians that will curb benefits.

My investment implication is this: don’t rely on Medicare existing in its current form past 2020.? Plan today for the medical care you will need then.? Unless you have a funded private plan behind you, that means saving for the future costs.

With 401(k)s and Other Defined Contribution Plans, Watch Your Wallet

Posted on 30 January 2008 by David Merkel

When financial matters are opaque, there must be a large discount to prices representing clarity to interest people to buy.? Unfortunately, with 401(k)s and other defined contribution plans, it is sometimes akin to being limited to the “company store.”? I’ve written about these issues before, both here and at RealMoney.? Here’s a good example of one of them:

		David Merkel
		Pension Consultants: Watch Your 401(k) Expense Levels
		9/27/2006 5:36 AM EDT

I want to point you to an article of John Wasik’s of Bloomberg. Having worked in the pension business while an actuary at a mutual life insurer, I had the experience of reviewing the pension services proposals of a number of competitors, and of complementary service providers. Most players were honest, but there were a number of players, while technically not breaking the law, would stretch ethics by finding ways to disguise fees by wending them into the change in unit value of the funds inside a deferred compensation plan. Why embed them in the unit value change? Slice up a fee over hundreds or thousands of participants, and over 365 days a year, and it is remarkable how little people notice it, because most people don’t bother to go and look at plan expenses as disclosed in the Form 5500. Even if everything were disclosed in detail there (some charges don’t get unbundled), an individual doesn’t see that the pro-rata expenses are coming out of his hide. Unless the plan sponsor goes the extra mile to try to minimize costs to participants, there is little that an individual can do.

We had a rule at our firm. We only take fees from one source, and we disclose them. We had a second rule: we only pay commissions once, and they can be disclosed to the ultimate client, or nondisclosed, but not both, but if nondisclosed, the ultimate client must know that.

Oe reason why we did not hire certain investment consultants was the potential for conflict of interest. We eventually hired a consultant to aid us in manager selection that took no fees from the managers, so we could get unbiased advice. There were other consultants that were less than scrupulous in that matter. Without naming names, we terminated our first investment manager consultant because we learned they would not recommend managers to us, unless they were receiving a fee from the manager. That fee would get built into the expenses would into the unit value, or, come out of my firms profit margins, which were for the good of the participating policyholders.

Now that was just my experience, so take that for what it’s worth, perhaps I’m just an investment actuary with a axe to grind. If you want a more general view of the problem, you can review this 2005 study of conflicts of interest done by the SEC. Now, as John Wasik notes, “The commission didn’t take any enforcement action after the report was issued, nor did it name any of the firms surveyed.” The problem is still there, and I’m afraid your only advocate is for you to appeal to your plan sponsor to watch out for the best interests of all participants, which is the duty of trustees under ERISA.

Position: none, but at the mutual life insurer, we had a saying, “We’re out to save the world for 25 basis points on assets, plus shipping and handling.” Beats a lot of other deals out there…

Now, here is another piece from Bloomberg: Fees on 401(k)s Rock Boomers Facing Flawed Disclosure.

The difficulty here is that fees on small plans are sometimes high, and defined contribution plans don’t allow for easy examination of the total fee structures.? How much are the investment managers taking?? The recordkeeper? The custodian/trustee?? The marketer?? It is not always clear.? What can be worse is the manager selection, which are usually random on average (before fees) in terms of any outperformance versus indexes.

Now, in fairness, anytime you have a large number of small accounts, the costs will be high as a percentage of assets.? But there are limits.? Disclosure needs to be improved, but until then, ask your plan sponsor for all of the Form 5500 documents.? There are two classes of expenses.? Explicit: what the fund pays for directly.? Implicit: what gets deducted from investment returns.? Add the two together, because that is the total load.? Insist on as full of an accounting as the plan sponsor will give you.

If you are paying more than 1% of assets per year, then something is wrong, unless the asset classes are esoteric, which should not be the case for DC plans.? Remember, you have to be your own guardian with defined contribution plans.? No one will do it for you.? And, if a few of your colleagues complain at the same time, you will be amazed at how quickly it will be taken seriously, because the administrative staff of the plan sponsor usually doesn’t get that much feedback.

Personal Finance, Part 12 ? Longevity Risk

Posted on 29 January 2008 by David Merkel

When I started this irregular series on personal finance, I didn’t think it would live this long. Maybe it’s appropriate then that this piece deals with longevity risk. After all, my prior piece dealt the the concept of the PRIER [Personal Required Investment Earnings Rate].

One of the main ideas there is that you have to take enough risk so that you earn enough money to meet all of your goals. One of those goals would likely be having enough to live off of if you live to a ripe old age, like 100. 100 sounds old; after all, it serves our fascination with watching the odometer roll over. Old age mortality has been improving, though and the number of centenarians is growing rapidly. The same is true of those living into their 90s. Yet many people plan retirement as if they were only going to live to 85.

The destitute elderly definitely have it worse than those with resources. What if you could eliminate some of the risk of outliving your income? I have a product that could help you — the life-contingent immediate annuity. Life-contingent immediate annuities pay a stream of income for the life of the annuitant (or joint lives of two annuitants). They give an income that cannot be outlived. Today, a number of insurance companies do that one better, and offer inflation adjustments on the payments, with the trade-off being accepting a lower initial payment than the unadjusted annuity. The only remaining risk is insurance company solvency, but only buy from reputable firms. That said, remember that the state guarantee funds stand behind the companies, and the benefit payments they are least likely to cut off in an insolvency are death benefits, disability payments, and immediate annuity payments.

Immediate annuities are bought, not sold, unlike other life insurance products. Why? Because once they are bought, there are usually no ways to surrender the policy. You can only take payments over time. Agents don’t like selling immediate annuities, because they will never derive another commission from that money. They would rather sell a variable annuity with a living benefit rider, because it will be possible to roll the policy at a later date to a “better” policy (surrender charges are low), and earn another commission.

Though I am not crazy about variable annuities with living benefit riders, if you own one, be careful before you surrender it. You may have a valuable option to have the company pay a fixed amount for a long time that is worth more than your surrender value rolling into a new policy. In general, be careful in buying any deferred annuities, because the fees are stiff. Be most careful if the agent comes to you when the surrender charge is gone, and encourages you to “roll” to a new product. His interests are different than your interests. You are likely better off staying in your existing deferred annuity.

Are there any other solutions to longevity risk? There are a few. First, cultivate younger friends and family who will be advocates for you in your dotage. They are necessary for kind treatment on the part of the staff of any old age home that you might enter. Those that have no advocates don’t fare well. (For those who are really young, marry, and have more than two kids! Love them, and they will love you.) Second, have an investment policy that reflects the longer-term, realizing you might live longer than average for those that have attained your age. This means more risk assets (stocks) on average than what is commonly recommended, but I would temper this with two caveats:

1) Remember that the Baby Boomers are graying, and will need to liquidate assets to support their old age.

2) Sometimes the markets are overvalued, and it is time to preserve capital, not go for capital gains. Tweak you asset allocation to reflect asset valuations.

A long life is a blessing, and even more so when you have friends, family, good health, and peace with God. Plan now to live longer than you expect. Save more, invest wisely, and buy some longevity insurance.

PS — Don’t go “hog wild” with any single pecuniary strategy for your old age. This is another area where diversification pays, so don’t put all of your eggs in one basket.

PPS — Some of the larger insurers (Pru, Met, Hartford) allow you to buy future income streams should you be alive to receive them. They are an inexpensive way for younger people to put money away for retirement, though there are risks of early death, company insolvency and inflation.

Full disclosure: long HIG

Personal Finance, Part 11 ? Your Personal Required Investment Earnings Rate

Posted on 26 January 200827 January 2008 by David Merkel

Everybody has a series of longer-term goals that they want to achieve financially, whether it is putting the kids through college, buying a home, retirement, etc.? Those priorities compete with short run needs, which helps to determine how much gets spent versus saved.

To the extent that one can estimate what one can reasonably save (hard, but worth doing), and what the needs of the future will cost, and when they will come due (harder, but worth doing), one can estimate personal contribution and required investment earnings rates.? Set up a spreadsheet with current assets and the likely savings as positive figures, and the future needs as negative figures, with the likely dates next to them.? Then use the XIRR function in Excel to estimate the personal required investment earnings rate [PRIER].

I’m treating financial planning in the same way that a Defined Benefit pension plan analyzes its risks.? There’s a reason for this, and I’ll get to that later.? Just as we know that a high assumed investment earnings rate at a defined benefit pension plan is a red flag, it is the same to an individual with a high PRIER.

Now, suppose at the end of the exercise one finds that the PRIER is greater than the yield on 10-year BBB bonds by more than 3%.? (Today that would be higher than 9%.)? That means you are not likely to make your goals.?? You can either:

Save more, or,
Reduce future expectations,whether that comes from doing the same things cheaper, or deferring when you do them.

Those are hard choices, but most people don’t make those choices because they never sit down and run the numbers.? Now, I left out a common choice that is more commonly chosen: invest more aggressively.? This is more commonly done because it is “free.”? In order to get more return, one must take more risk, so take more risk and you will get more return, right?? Right?!

Sadly, no.? Go back to Defined Benefit programs for a moment.? Think of the last eight years, where the average DB plan has been chasing a 8-9%/yr required yield.? What have they earned?? On a 60/40 equity/debt mandate, using the S&P 500 and the Lehman Aggregate as proxies, the return would be 3.5%/year, with the lion’s share coming from the less risky investment grade bonds.? The overshoot of the ’90s has been replaced by the undershoot of the 2000s.? Now, missing your funding target for eight years at 5%/yr or so is serious stuff, and this is a problem being faced by DB pension plans and individuals today.

While the ’80s and ’90s were roaring, DB plan sponsors made minimal contributions, and did not build up a buffer for the soggy 2000s.? Part of that was due to stupid tax law that the government put in because they didn’t want pension plans to shelter income from taxes for plan sponsors.? (As an aside, public plans did less than corporations, even though they did not face any tax consequences.)

But the same thing was true of individuals.? When the markets were good, they did not save.? Now when the markets are not good, the habit of not saving is entrenched, and now being older, saving might be more difficult because of kids in college, interest on a mortgage for a house larger than was needed, etc.

Now, absent additional saving, when investment earnings lag behind the PRIER, that makes the future PRIER rise, to try to make up for lost time.? Perhaps I need to apply the five stages of grieving here as well… trying to earn more to make up for lost time is a form of bargaining.? It rarely works, and sometimes blows up, leaving a person worse off than before.? Most aggressive asset allocation strategies only work over a long period of time, and only if a player is willing to buy-rebalance-hold, which only a few people are constitutionally capable of doing.? Most people get scared at the bottoms, and get euphoric near tops.? Few follow Buffett’s dictum, “Be greedy when others are fearful, and fearful when others are greedy.”? Personally, I expect the willingness to take investment risk over the next five years to rise, but over the next ten years, I don’t think it will be rewarded.

Now, as time progresses, and the Baby Boomers gray, unless the equity markets are returning the low teens in terms of returns, there will be a tendency for the average PRIER to rise, absent people realizing that they have to save more than planned, or reduce their goals.? This problem will be faced in the ’10s, bigtime.? The pensions crisis will be front page news, and I’m not talking about Social Security and Medicare, though those will be there also.? The demographics will be playing out.? After all, what drives the funding of retirement at a DB plan, but aging, where the promised expected payments get closer each day.

Well, same thing for individuals.? Every day that passes brings a slow weakening of our bodies and minds.? Dollars not saved today, or bad investment returns mean the PRIER rises, making the probability of attaining goals less achievable.

Now, is there nothing that can be done aside from increasing savings and reducing future plans?? In aggregate, no.? You will have to be someone special to beat the pack, because few do that.? Better you should take the simple solution, which is a humble one: save more, expect less.? For those that do have the talent, you will have to take the risks that few do, and be unconventional.? Note: for every four persons that think they can do this, at best one will succeed.? My own methods are always leaning against what is popular in the markets, and I think that I am one of those few, but it takes work and emotional discipline to do it.

Then again, I have done it, as far as my PRIER is concerned — it is below the rate on 10-year Treasuries.? Most of that is that my goals are modest, aside from putting my eight kids through college, and I am not planning on retiring.

With that, I leave to consider a post I wrote at RealMoney two years ago.? It’s kind of a classic, and Barry Ritholtz e-mailed me to say that he loved it.? Given what we are experiencing lately, it seems prescient.? Here it is:

		David Merkel
		Make the Money Sweat, Man! We Got Retirements to Fund, and Little Time to do it!
		3/28/2006 10:23 AM EST

What prompts this post was a bit of research from the estimable Richard Bernstein of Merrill Lynch, where he showed how correlations of returns in risky asset classes have risen over the past six years. (Get your hands on this one if you can.) Commodities, International Stocks, Hedge Funds, and Small Cap Stocks have become more correlated with US Large Cap Stocks over the past five years. With the exception of commodities, the 5-year correlations are over 90%. I would add in other asset classes as well: credit default, emerging markets, junk bonds, low-quality stocks, the toxic waste of Asset- and Mortgage-backed securities, and private equity. Also, all sectors inside the S&P 500 have become more correlated to the S&P 500, with the exception of consumer staples. In my opinion, this is due to the flood of liquidity seeking high stable returns, which is in turn driven partially by the need to fund the retirements of the baby boomers, and by modern portfolio theory with its mistaken view of risk as variability, rather than probability of loss, and the likely severity thereof. Also, the asset allocators use “brain dead” models that for the most part view the past as prologue, and for the most part project future returns as “the present, but not so much.” Works fine in the middle of a liquidity wave, but lousy at the turning points.

Taking risk to get stable returns is a crowded trade. Asset-specific risk may be lower today in a Modern Portfolio Theory sense. Return variability is low; implied volatilities are for the most part low. But in my opinion, the lack of volatility is hiding an increase in systemic risk. When risky assets have a bad time, they may behave badly as a group.

The only uncorrelated classes at present are cash and bonds (the higher quality the better). If you want diversification in this market, remember fixed income and cash. Oh, and as an aside, think of Municipal bonds, because they are the only fixed income asset class that the flood of foreign liquidity hasn’t touched.

Don’t make aggressive moves rapidly, but my advice is to position your portfolios more conservatively within your risk tolerance.

Position: none

Municipal Tensions

Posted on 21 December 2007 by David Merkel

Tonight I want to point you to something that might make you uncomfortable.? Don’t worry, it is for a good purpose.

Depending on where you live in the US, various states and municipalities are more or less prepare for the onslaught of cash flow that they will have to pay baby boomer employees after they retire.? Here’s a very good summary of which states are prepared, and which are not, from the Pew Charitable Trusts.? As for pension benefits, they are relatively well funded, with 85% of the accrued benefits funded.? Other Retiree benefits (mainly health care) are only 3% funded.

Only ten states are more than 96% funded on pensions: Oregon, Utah, South Dakota, Wisconsin, Tennessee, Georgia, Florida, North Carolina, Delaware and New York.? Ten states are less than 70% funded on pensions: Hawaii, Kansas, Oklahoma, Louisiana, Illinois, Indiana, West Virginia, Connecticut, Rhode Island, and New Hampshire.

But as for other retiree benefits, 32 states have funded nothing at all (0%).? See the graph on page 42.? They will either pay it out of cash flow (from increased taxes), or decrease the benefits, because they are not guaranteed as pension benefits are. ? Only one state is in good shape, Wisconsin (my home state), which has its other retiree benefits 99% funded.? Next best are Arizona (72%), Alaska (65%), and North Dakota (41%).?? In a word — ugly.? Either promises will have to be rescinded, or taxes raised.

It’s worth looking at this report because these matters will be upward drivers of taxes starting about five years from now, and lasting for two decades beyond that.? It will be a big political fight.? Taxpayers will do their best to reduce benefits to state and local government workers who worked at lower salaried jobs, knowing that they would make it up on better benefits.? Alas, but the benefits may be less than expected.

Now as far as the US goes, Federal DB plans are unfunded, including Federal Employees, Social Security and Medicare.? Holding US Government bonds doesn’t count, those are just indicators of future taxation.? Higher future taxation from the US government will be a fact of life.? I don’t argue with it.? They’re bigger than me.

States and municipalities may be another matter, though.? Many municipalities are even worse funded than the states, and their taxation capabilities are more limited.? People can leave to go to other places in the US.

My advice: review the pension and other benefit funding levels of your state, and any other places that you get taxed (county, city, assessment district).? Figure out now whether your taxes are likely to rise or not, and ask yourself whether you can live with it or not.? This is somewhat cold-blooded, but you need to act on this in the next 2-3 years.? Five years out, and this will factor into land values and a wide number of other economic variables, making any move less economic.

Ten Chosen Items from the Current Market Troubles

Posted on 27 November 2007 by David Merkel

Superstition is alive and well.? Google at $666?? Personally, I think it is all hooey.? There has always been a morbid fascination about the Antichrist in Western Culture.? Would that they had more concern about Christ.
Longtime readers know I am no fan of FAS 157 or FAS 159.? From the Accounting Onion, here is a good demonstration of what could go wrong as FAS 157 is implemented.? In my opinion, the concept of fair market value allows managements too much flexibility.? For assets that have a liquid market bigger than the holdings of the company in question, fair market value is not a problem.? It is a misleading concept otherwise, because the ability to realize that asset value in a sale is questionable.
This is an “uh-oh” moment on two levels.? Level one is defined benefit pension plans exiting US equities.? They are big holders, and a reallocation could hurt US stock prices.? Level two is that foreign markets have outperformed the US by a great deal over the last few years.? Perhaps the DB pension plans are late to the party?
There are no “almosts” in investing.? I have owned Genlyte twice in my life.? Great company.? I had it on my candidate list in my last reshaping.? I didn’t buy it then.? Now it is being bought out by Philips Electronics.? Good move for Philips; the only way they could make it better would be to take the management team of Genlyte, and have it run Philips.? That won’t happen; it is more likely that Philips will ruin Genlyte.
Activist hedge funds don’t always know best.? Smart managements and boards don’t get scared.? They calculate.? What’s the best thing for shareholders in the long run?? Do the hedge funds really have the willingness to fight?? Personally, I think it is usually best for managements to “call their bluff” and make the hedge funds work for control, rather than wave the white flag early.
Higher US dollar oil prices are only partly a dollar phenomenon.? Oil prices are rising in almost every currency; there is a relative shortage of crude oil globally.
Want an antidote to pessimism?? Read this post from VOX.? Personally, I think the lending issues are bigger than they think, but it is true that corporate balance sheets are in good shape.? Would that we could say the same for the consumer or the government.
Appreciation of the Chinese Yuan versus the Dollar may be accelerating.? Alongside that, many of the Gulf States are re-evaluating their peg to the US Dollar.? Given the inflation, who can blame them?
$300 Billion in losses from US residential mortgages?? That’s a believable figure to me.? Underwriting got progressively worse from 2003 to the first quarter of 2007.? Needless to say, that would kill a lot of non-bank mortgage lenders, and a few banks as well.
Could Japan be the great countercyclical asset in this market phase?? There is more speculative fervor in Japan at present, and many Japanese investors are buying stocks and selling bonds, partly due to relative yield measures.

That’s all for now.? More to come.