Pension Plan Investing

[justin]

I am asking the board for a little help because of all the smart people here. I have recently been asked to sit on a pension advisory committee for the company I work for. About 25 employees. The committee's role is to advise our pension plan trustee on what investments to make with the employees' money. It isn't exactly a pension plan, but has similar characteristics to a defined contribution pension plan. In other words, the payout upon retirement/termination will vary based on market returns (how lucky we are). The trustee picks the investments though.

Here is what the trustee wants: 8 to 12 percent returns year after year. He never wants a year with returns less than zero. Almost any equity/bond investment is allowable (something that is traded in the markets). Each investment must produce the 8% returns each year.

Some ideas being floated by the trustee: utilities stocks/funds; mutual funds displaying the 8-12% returns every year for the last 5 years; 15% allocation to short term bonds.

Is this goal feasible? Any ideas on what would produce these returns? It seems like he is looking for an investment with limited downside potential, and steady returns. In other words, high returns with limited risk?

Please help. I'm stumped.

I did pull together a model portfolio of vanguard total stock market, total international stock market, short term corp bonds and intermediate term corporate bonds. This portfolio allocation was analyzed from Jan 1, 2000 till present, and managed to return a total of 20% for this period (total, not annual gains). At the worst point, the portfolio was down 16%. In my mind, this portfolio held up very well, given the little crash of 2000-02. This simple, balanced portfolio failed to impress however.

Also, are CFP's frequently hired by the hour to consult on matters like this? Or who would we hire to do this type of planning?

[grumpy]

If you can come up with investments that meet all of those criteria, then quit your job and become an investment adviser. I'm afraid you've been asked to do the impossible. Good luck.

Grumpy

[justin]

Quote:

Originally Posted by grumpy If you can come up with investments that meet all of those criteria, then quit your job and become an investment adviser. I'm afraid you've been asked to do the impossible. Good luck. Grumpy

I'm thinking the exact same thoughts. I guess my job as a member of the advisory committee is to present the best alternative that comes closest to the guidelines we've been given. I don't think they are realistic goals, but I thought some might have advice as to how to get close to these goals.

[Martha]

Gee, it feels to me like your trustee is trying to pass the fiduciary duty he has to your plan on to you guys.

[Brat]

First I think your trustee is setting assumptions too high and I think taking on too much responsibility for financial decisions.* Consider shifting responsibility for financial decisions to each individual participant.* Fidelity, I know, will handle self-directed 401k plans.* If Vanguard does, that is where I would set up an account.* ALWAYS EXAMINE THE FEE STRUCTURE!!!* A number of firms will perform this service but their "carry" would make venture capital firms look bargain basement.

Otherwise I recommend the fund invest in a couple low-cost balanced mutual funds and let their experts choose the stocks and bonds.* There is no way you, or the trustee ,have the expertise to do this.* Look at FundAlarm's list of no-alarm funds.* You can examine the historical performance of these funds and their managers.* Pick managers with sustained superior performance and if they leave watch the fund performance like an eagle checking out salmon at a fish farm.

[Patrick]

Justin,

Here are some excerpts from my plan's newsletters:

Investments - The System has a funding objective to provide a total rate of return which exceeds the
Consumer Price Index (CPI) by 4.5% each year over the long-term future. Our investment objective to achieve
that funding is to capture market returns for each asset class. For example, regarding domestic common
stocks, it is the return of the S & P 500; for U.S. bonds, the Lehman Aggregate Index; and for real estate, the
National Council of Real Estate Investment Fiduciaries (NCREIF) index. International stocks are measured
against the Morgan Stanley Capital International Europe, Australia, Far East Index, and International Bonds
against the Citigroup Non-Dollar Government Bond Index. Total return for the year was 12.1%.

For the first six months of our fiscal year (July - December 2004), the investment markets generated
positive returns, driven by international stocks and bonds. During this period, PERS’ portfolio generated
a return of 8.6%. Since inception (20 ½ years), the fund’s average annual return has been 11%.

The Retirement Board annually reviews PERS’ asset allocation strategy (the mix
of stocks, bonds and alternative investments) to ensure the investment program continues
to support the long-term goal of safely funding the system’s financial
obligations.
This review begins with an analysis of long-term capital market risk and
return expectations. We then use these assumptions to determine the return expectation for
the total fund.
Over the last few years, we have acknowledged lower return expectations and
lower inflation in the markets in which we invest. The trend continued following this
year’s review, as the Board modestly reduced PERS’ assumptions for long-term returns
from each asset class, as detailed in the chart below.

Asset Class * New Expected Return * Prior Expected Return
U.S. Stocks * * * * * * * * * * * 9.25% * * * * * * * * * * * * 9.50%
International Stocks * * * * 9.50% * * * * * * * * * * * * 9.75%
U.S. Bonds * * * * * * * * * * * *5.75% * * * * * * * * * * * * 6.00%
International Bonds * * * * *6.00% * * * * * * * * * * * * 6.25%
Alternative Investments* 9.00% * * * * * * * * * * * * *9.10%

* Includes allocation to Private Real Estate, REITs, and Private Equity


To improve the probability of meeting our funding objectives, the Board shifted
5% of assets from U.S. Bonds to U.S. Stocks. The asset allocation change enhances the
opportunity to generate our actuarial goal over the long term by shifting assets from a
lower returning asset class (U.S. bonds), to a higher returning asset class (U.S. stock).

U.S. Bonds * 25%
Intl. Stocks *10%
U.S. Stocks *45%
Intl. Bonds * 10%
Alternative Investments 10%

The new asset mix is statistically efficient, meaning it maximizes return given its level of risk. The new strategy was implemented in October, and we believe, with these
changes, PERS’ investment program continues to be well-positioned to meet its long-term financial objectives.

I hope this helps.* Good luck!

Patrick

[justin]

Brat,

We already have a self-directed 401k plan. The plan that I'm involved in advising is an ESOP, half or less of which will be invested in stocks or bonds. Each employee has a partial interest in the ESOP's entire value. We don't have to pay a certain amount to each retiree/terminee, rather whatever their share is worth on their termination date.

Patrick,

Thanks for the info. My gut instinct had me put together a model portfolio that is close to your plan's allocation:
vanguard total stock market - 45%
total international stock market - 25%
short term corp bonds - 15%
intermediate term corporate bonds - 15%

It is good to see that the pros are investing along similar lines as what I would like to. It looks like your plan is attempting to obtain market returns for sp500, Lehman Aggregate index, and MSCI EAFE. I'm guessing through index funds.

[unclemick]

PER's investment plan is totally full of it - apparently they can't read history - coming off one of history's best 20 years for stocks and bonds - they are commiting the sin of recency and:

Join the club - pension funds will join 'why didn't we see this coming' *club of the 70's after the 'go-go 60's. Congress stepped in on that one - after the bust of many a pension plan.

I won't repeat Bogle's admonitions among others - but forward expectations for bonds and stocks are way too high - based on history - for way to many pension funds.

Stay tuned - Heh, heh, heh, heh - sigh! - here we go again.

[unclemick]

BTY - That does NOT mean that the asset allocation selection is too far off the mark - JUST the expected return values.

[justin]

Patrick,

Would you mind disclosing what company/organization this pension is for? I'd like to look into it more. I'm thinking of preparing a few case studies of some pension plans for the Advisory committee. I think it is good to see their asset allocations, and their expected long term returns by asset class (however accurate they may be).

Unclemick,

You might be right about the expected value returns. They might be lower for the next 10 years, but looking 20-30 years out, they should be close to the historical norms? This brings me to another question. Any one have any idea the time horizon for pension investing? 10, 20, 30 years? Does it depend on the average age of our employees/plan participants?

[Patrick]

Quote:

Originally Posted by justin Any one have any idea the time horizon for pension investing?* 10, 20, 30 years?* Does it depend on the average age of our employees/plan participants?

I'm not sure exactly what you're asking, but our system plans on being in existence forever.* There are always new employees coming in that need to be covered.

Are you asking about holding periods for various investments?*

[justin]

Quote:

Originally Posted by Patrick I'm not sure exactly what you're asking, but our system plans on being in existence forever. There are always new employees coming in that need to be covered. Are you asking about holding periods for various investments?

I trying to think about a pension fund's investment strategy in terms of personal investment strategy - ie - a person 5 years from retirement would be more risk averse and have more conservative investments in their portfolio than a person 25 years from retirement. After reading some pension plan documents, I realized pension plans don't look at this time horizon at all. They make actuarial assumptions about tons of different things and invest to meet their future liabilities (making pension payments for the rest of their participants' lives upon retirement).

Our ESOP plan doesn't have to make lifetime payments, but rather a lump sum payment of whatever a participant's share is worth on their termination/retirement date. We don't really have "liabilities" to meet like your typical pension plan. It looks like we'll have to make our risk/asset allocation decisions based on what is the best balance for all plan participants, realizing that our asset allocation might be too risky for the participant that is about to retire, and that it might be too conservative for someone just entering the workforce with 20-30 years to retirement.

[Patrick]

Quote:

Originally Posted by justin Our ESOP plan doesn't have to make lifetime payments, but rather a lump sum payment of whatever a participant's share is worth on their termination/retirement date.* We don't really have "liabilities" to meet like your typical pension plan.* It looks like we'll have to make our risk/asset allocation decisions based on what is the best balance for all plan participants, realizing that our asset allocation might be too risky for the participant that is about to retire, and that it might be too conservative for someone just entering the workforce with 20-30 years to retirement.*

It seems a middle-of-the-road strategy might be best.* But that may not provide the returns your trustee is looking for.* Quite the dilemma.*

[justin]

Quote:

Originally Posted by Patrick It seems a middle-of-the-road strategy might be best. But that may not provide the returns your trustee is looking for. Quite the dilemma.

Dilemma it is. I'm not aware of any fund or funds that will provide the returns that the trustee is looking for. Unless I discover something new in the next few weeks, I'm planning on recommending a mix of index stock and bond funds. So far, all of the pension plans I've looked at around the US have a major portion (or all) of their assets in index funds. Those that don't still have an expense ratio of 0.1% or so. They focus on meeting a long-term return goal of 7.25-8% returns, with 35-60% fixed income investments. Over the last five years, most of the pensions have lagged this 7.25-8% goal. It doesn't really matter though, since their goal is "long-term", not "5 year".

I'm convinced that shooting for a one-year return of 8% every year will doom our plan to low long term returns.

[greg]

Justin-I don't have any slice and dice suggestions but . . . . You might, if you haven't already, think about suggesting a "prudent man" approach to your trustee. Most people here, I believe, follow that type of financial plan. Too much risk could seriously jeopardize the pile. Expecting 8%-12% returns nowdays means going way out on the limb. Lots of data could be found to support this view. But, working on changing the trustee's mind, I believe, would be worth the effort.

You might also suggest to him that other employee input might be helpful. You mentioned 25 current participants. They could be polled (stay out of this Dan! ) to find out what their risk tolerance level might be. Of course, this could backfire, but it would improve the work environment--until the bad returns started. Here too, education would be the key component. Good luck.

--Greg

[Nords]

Quote:

Originally Posted by Apocalypse . . .um . . .SOON Justin-I don't have any slice and dice suggestions but . . . .* You might, if you haven't already, think about suggesting a "prudent man" approach to your trustee.* Most people here, I believe, follow that type of financial plan.* *Too much risk could seriously jeopardize the pile.* *Expecting 8%-12% returns nowdays means going way out on the limb.* Lots of data could be found to support this view.* But, working on changing the trustee's mind, I believe, would be worth the effort. You might also suggest to him that other employee input might be helpful.* You mentioned 25 current participants.* They could be polled (stay out of this Dan! ) to find out what their risk tolerance level might be.* Of course,* this could backfire, but it would improve the work environment--until the bad returns started.* Here too, education would be the key component.* Good luck. --Greg

If I remember the vocabulary correctly, "prudent man" implies a fiduciary duty to avoid losses. That's the standard used by a lot of trust companies (although their fees aren't regarded as "losses"!) which has led several trustees to be savaged by long-term inflation losses in all-bond fixed-income portfolios.

"Prudent investor" acknowledges a "modern" imperative to seek higher returns through higher volatility. The implication is that beneficiaries will stay ahead of inflation even though they'll have occasional short-term losses.

8-12%/year is at the bleeding edge of the risk/reward curve. Doing so without a losing year is not considered possible, although I'm sure there are a lot of plans which advertise that claim!

I think that trustee is more interested in evading responsibility than in creating an effective asset allocation.

[justin]

The polling idea to get a consensus of risk aversion is something I thought of too that would help guide us. I'm thinking that a reasonable person/reasonable investor standard should guide our behavior too.

Shooting for 8 percent average returns over a long term period is probably doable. Shooting for 8 percent returns every year will likely result in a poor long-term performance.

[SteveL]

Your company needs another trustee/ drug testing policy, as the current trustee is clearly smoking dope. What else could account for such a detachment from financial reality? As for your own participation, with this kind of ground rules, one should decline to serve on the committee. When the investments chosen fail to produce the desired result as will certainly happen, someone will be at fault, and chances are not the trustee.....

[justin]

Quote:

Originally Posted by SteveL Your company needs another trustee/ drug testing policy, as the current trustee is clearly smoking dope. What else could account for such a detachment from financial reality? As for your own participation, with this kind of ground rules, one should decline to serve on the committee. When the investments chosen fail to produce the desired result as will certainly happen, someone will be at fault, and chances are not the trustee.....

"What else could account for such a detachment from financial reality?" - I think a lot of investors are like the trustee. He's a stockpicker, a returns-chaser, an admirer of the "hot" sector. It is in his blood. Not necessarily the best traits for our retirement plan though.

"As for your own participation, with this kind of ground rules, one should decline to serve on the committee." - I concur. If our objectives don't change, I won't be able to serve on the committee for liability reasons. I'm hoping we can change the trustee's mind at our next meeting. One main reason I want to stay on the committee - Greed. I want to ensure that my share of the retirement money has good, stable long-term growth (to assist with ER!!!).

[ats5g]

Hi Justin,

Here a link to the UNIFORM PRUDENT INVESTOR ACT.

I'm a little confused about who exactly are the fiduciaries here. Is it your group, is it the trustee?

I used these little lines of argument when a broker was trying to convince some friends of ours to picks stocks and chase sectors:

Is this person legally bound to reimburse you when their strategy of non-diversification breaks down or falls apart? If no, they don't have a stake in their strategy and don't get hurt if it doesn't work.

Does this person make more money if you use their strategy? If yes, how can you take this person's "advice" seriously and not treat it as a sales pitch.

Does this person invest all of his/her own money the same way [and make them prove it]? If no, they don't have a stake in their strategy and don't get hurt if it doesn't work.

Does this person have the necessary education and understanding of investments and portfolio theory? If no, why should you listen to him/her at all.

One of the downsides of being diversified is that you're always going to hold something that is getting killed, and you'll likely get ridiculed for it. But that's exactly what you're holding it for, isn't it? In the 90's it was tech, then it was REITS, or gold, or energy, etc.

Also, if you're going to "backtest" any portfolio or set of investments, you really need to go further back than 5-10 years. 30,40, 50 years is a much better test of a strategy.

- Alec