Hot Off the Web- January 11, 2009

John Bogle’s “Six lessons for investors” in the WSJ are: (1) beware of market forecasts (unreliable even from experts), (2) never underrate importance of asset allocation (“a good place to start is a bond percentage equals your age”), (3) mutual funds with superior performance often falter, (4) owning the market remains the strategy of choice (costs of active management exceed benefits), (5) look before you leap into alternative asset classes (don’t performance chase-e.g. recently emerging markets, commodities), and (6) beware of financial innovations (they are “designed to enrich the innovators, not investors”).

Grim pension results are reported in Globe and Mail’s “Canadian Pension plans’ solvency at record lows” and Financial Post’s “Canadian pensions pummelled in 2008” . Watson Wyatt’s pension plans solvency calculations indicate that end of 2008 Canadian pension plan solvency is at historic lows after having dropped 27 percentage points to 59%. (This is a result of not only the impact of severe stock market losses for the equity portion of plan assets, but also likely due to the drop in prescribed discount rate, related to government bond rates, for solvency calculation. Distressed companies may have even lower funded levels than the average Canadian plan. If a company declares bankruptcy in these challenging economic times, pension underfunding is an unsecured liability, meaning that pensioners may end up with only 59% of their pensions. Many feel that the government must pass legislation to raise DB pension underfunding to a level equivalent to wages- which they in fact are as deferred wages.) Despite the market carnage many companies’ 2008 financial reports will show improvement in their pension plan ‘going concern based’ funding ratio because liabilities are typically (but having lots of discretion) discounted using AA-corporate bond rates, which have spiked over the past year. (For those looking to compare balance sheet of different companies, they have to be extra vigilant in assessing impact of pension.)

For those wondering if they escaped a close call should the bankruptcy court provide some level of protection for existing (unsecured) pension obligations and the company survives reorganization, unfortunately there is still no guarantee in long-term success. Jeff McCracken’s “Study suggests hope for some ailing firms” in the WSJ reports on a recent study of corporate bankruptcies that “bankruptcy reorganization can rehabilitate companies with good operations and bad balance sheets, but offer little salvation to those with broken business models.” “The study differentiated between companies that were “financially distressed,” or whose main problem was an inability to pay off debts, versus those that were “economically distressed,” meaning they had negative operating performance and fundamental business-model problems.” “The economically distressed firms were three times as likely to re-file within three years for bankruptcy”.

WSJ’s Tom Lauricella in “Bear mauls ‘safe’ target funds, too”  reports that target date funds did not protect people who just retired or were within a couple years of retirement from the market hit as much as one might have expected. (I had written earlier blogs Target Date Funds  and Target Date Funds II  on the subject.) The reasons are many: (1) not all target date funds have the same asset mix for a target-date, (2) most funds have relatively high equity allocations even at the point of retirement because retirement is expected to last 20-30 years, (3) the bond portion of the portfolio also lost value because rates on non-government issue bonds increased significantly, (4) most funds have foreign equity content and foreign markets were even worse than American markets. (Target-Date Funds may be a place to start looking but are not the complete answer; one must also factor in an individual’s risk tolerance. In a follow-up blog on target-date funds Are ‘target-date’ funds or age-independent ‘fixed-asset allocation’ funds right for you? I try to add additional perspectives to determining appropriate asset allocation in retirement.)

More lessons on asset allocation can be found when NYT’s Ron Lieber looks at the trials and tribulations of saving for college in “Saving for college amid financial turmoil” . People save for college for 10+ years. If they put the money in fixed income investments, for a given savings rate, they know won’t achieve the target. Many of the state-based 529 (RESP-like) plans have heavy equity components, gradually becoming more conservative as college start approaches; but ‘conservative’ is relative and many plans were hit hard in 2008. This education application is actually (surprisingly to many) less forgiving than retirement to a significant market drop near or just after start of college, since the total expenditures occur over 4-5 years, whereas in retirement the expenditures occur over 20-30 years. (Of course for college you could borrow more easily than for retirement!)

Also in the WSJ Ruth Mantell’s “Tool up for midcareer job hunt” looks at steps that are likely applicable for those recently retired and are looking to re-enter the workforce to protect their remaining assets that have been significantly depleted with the market drop. Here are some tips: (1) update resume (and look for ways to update skills if necessary), (2) look for hybrid jobs (having had varied experience like finance and project management), (3) network (use your contacts and their contacts and tell people that you are looking for work), (4) use on-line tools (build your own website, online search, job boards) and (5) be flexible (on pay, hours, location, etc if necessary)

WSJ’s Eleanor Laise reports that “Big slide in 401(k)s spurs calls for change” . Some think that 401(k) (defined contribution) plans have failed not just because of the market impact, but also because this system turns “countless amateurs…into pension-fund managers” (not that pension fund managers have demonstrated much competence lately). The market losses are aggravated by the drop in real estate values. Defined contribution plans are gradually replacing defined benefit plans as more and more companies transitioned to them. “Plan participants typically are presented with a complex investment menu that includes some risky and expensive options.” The recent addition of target-date funds to the menu has not protected individuals. “Boston College’s retirement-research center recently ran scenarios that assumed workers had contributed 6% of pay to a plan for 40 years, had invested in a target-date fund, had never touched their savings until retiring and had annuitized the assets at retirement. The chunk of preretirement income these savers could replace in retirement varied dramatically depending on when they retired. Those retiring in 1948 could replace just 19%; those retiring in 1999, 51%; and 2008 retirees, 28%.” (This also shows you that 6% of pay won’t put you on the path to success even after 40 years of saving, even if you end with an 18 year bull market! The numbers that you need to be looking for are annual savings closer to 15% for those starting early.)

And finally, Terence Corcoran in the National Post’s “The real Mado game”  questions whether individual investors and professional investors managing portfolios (like pension plans) have been fooled into expecting long-term equity risk premiums of 6-9%; individuals base their (low) saving rates on that, just as many companies make their (low) pension plan contributions on the same assumption. (The pain in both instances is usually and ultimately borne by the individual.) The victims of the need for the downward revision of equity risk premiums to a more reasonable level will be just as if not more damaged than Madoff’s victims. “What Madoff did is promise +10% and appear to deliver on the promise by producing fake statements. What the pension and money manager industry does is promise high returns but fail to deliver on the promise. It’s more honest, but it still points to the fact that the long-run returns on equities, while unattainable, are still the shaky foundation for all of our investment assumptions. We’re all, in some way, victims of a Madoffian con.”