The Risks of Investing Like the Big Pension Funds

19-Sep-2011

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Mr. Gao co-found and became the CFO at Oxstones Capital Management. Mr. Gao currently serves as a director of Livedeal (Nasdaq: LIVE) and has served as a member of the Audit Committee of Livedeal since January 2012. Prior to establishing Oxstones Capital Management, from June 2008 until July 2010, Mr. Gao was a product owner at Procter and Gamble for its consolidation system and was responsible for the Procter and Gamble’s financial report consolidation process. From May 2007 to May 2008, Mr. Gao was a financial analyst at the Internal Revenue Service’s CFO division. Mr. Gao has a dual major Bachelor of Science degree in Computer Science and Economics from University of Maryland, and an M.B.A. specializing in finance and accounting from Georgetown University’s McDonough School of Business.







Over the last several years, the managers of many big, traditional pension plans have become increasingly cautious. Instead of viewing high returns as their top priority, these managers have focused on avoiding risk. Some have shifted assets from stocks to bonds, while others have changed the way they analyze their investments or hired special risk officers. An old investment strategy called liability-driven investing has been revived, in which pension plans buy a series of bonds with maturity dates timed to match the years when cohorts of employees are expected to retire.

A 401(k) investor might well look at such developments at places like the Boeing Company and the California Public Employees’ Retirement System and say: “These are trained professionals with business degrees and years of experience. They must know what they’re doing. Shouldn’t I do the same?”

The comparison is not that simple, however. Certainly, 401(k)s and traditional defined-benefit plans have much in common because both are long-range investments. Yet the two pools of money are significantly different in size, in the diversity of recipients, in payment schedules and in legal requirements. To make matters even more confusing, experts disagree about whether individuals should be more aggressive than big plans, or less.

“What people can take from defined-benefit plans is how important it is to have a good understanding of your financial risks,” said Michael Archer, a senior consultant at the benefits consulting firm Towers Watson, which is based in New York and advises large plans.

The caution among pension managers began about five years ago, and some of the driving forces clearly do not apply to individuals. These include a new accounting rule that requires pension liabilities to be listed on the corporate balance sheet and a new federal pension law that gives companies only seven years, rather than the previous 30, to make sure their plans are fully funded. Those institutional changes discourage pension managers from choosing risky investments, because any losses will be more obvious to stockholders and will have to be replaced more quickly.

However, other cautionary pressures — severe market swings, recession, more complex investment choices and increased longevity — might seem familiar to anyone with a 401(k).

To a novice 401(k) investor, the most obvious solution might be to switch money out of volatile stocks and into more stable bonds, and in fact, many traditional plans are doing just that.

But unlike a 401(k) investor, a giant fund like the California Public Employees’ Retirement System, known as Calpers, cannot easily move its $237.5 billion around without causing financial tidal waves. Instead, the fund last December adopted what it called a “risk-focused asset allocation strategy.” The staff now looks at the investments in terms of how they perform in different market conditions.

In another example, officials from a dozen large plans, including Boeing, meet regularly to demand more data on risk from their outside managers.

“The desire is to have a system that tells them where they are exposed across the market,” said Karyn Williams, a managing director specializing in risk management at the Los Angeles consulting firm Wilshire Associates.

Pensions are a delicate topic, as companies increasingly shift new employees to 401(k)s. In addition, “It’s not a fun thing to talk about, when the funded status is low and equity values are low,” said the Vanguard Group’s chief actuary, R. Evan Inglis.

In the broadest sense, defined-benefit and 401(k) retirement portfolios are similar because they must try to anticipate developments decades in advance and then find investments that match those projections.

Still, size matters, and there are strong arguments against copying the big plans too closely.

Because their losses are spread around a wider base, defined-benefit plans enjoy more flexibility, which allows them to take more investment risk. “An individual in a 401(k) has a set time frame,” said Alison Borland, the retirement manager for Aon Hewitt’s outsourcing arm. The individual must make sure there is enough money to stretch from Year 1 of retirement all the way through the actuarially expected lifespan. A pension plan, by contrast, can juggle the estimates for thousands of different retirement schedules. “You can be pretty sure the entire population is not going to live to 90,” Ms. Borland said.

“Individual investing tends to be more complex,” said Stephen M. Horan, head of private wealth management for the CFA Institute, a trade group for financial advisers. “I need to think about that individual’s past profile, estate planning, life situation and any family dynamics that might have wealth implications.” Again, a defined-benefit manager can disregard the personal details and “aggregate the employees altogether,” Mr. Horan said.

Another important distinction is that 401(k) holders must worry about inflation eating away at their savings. Traditional pension plans can ignore the topic, because most do not offer cost-of-living adjustments.

All those differences might seem to imply that 401(k) holders should be even more cautious than the newly cautious defined-benefit plans. They cannot afford losses jeopardizing their ability to retire on their hoped-for date.

But experts also cite some intriguing reasons why 401(k)s could actually be a bit more daring than their larger cousins.

For one thing, a 401(k) holder can delay retirement if the portfolio gets depleted. The pension manager cannot change the decisions of the work force. “An individual is aiming for a target, but it’s not so precisely nailed down,” said Stephen P. Utkus, director of Vanguard’s Center for Retirement Research.

The new pension funding law also constrains traditional plans, because they have only seven years to get their assets and liabilities back in balance after a market crash. Individuals face no such limits. “If I’m an individual, 30 years old, I’ve got a lot more than seven years,” Mr. Archer of Towers Watson said. In theory, that 30-year-old has until age 65 to make up the losses. “Even if I’m 60 years old,” Mr. Archer continued, “I still have more than seven years, because I’m not planning to use up all my money the day I retire.” He said “this gives you as an individual an ability to take on more risk.”

True, defined-benefit managers have access to professional advice and complex investment choices that allow them to hedge against risk. But simplified versions of those investment options are becoming increasingly available to the retail and 401(k) markets. Michael Kresh, president of M. D. Kresh Financial Services in Islandia, N.Y., advocates using Treasury inflation-protected securities, international bonds and mutual funds that specialize in commodities, even if it must be done outside the 401(k), via an individual retirement account.

Whether 401(k) investors decide to be more cautious, less so or stay the course depends on their attitudes toward risk. And that is something that has always been true, regardless of what the big players are doing.


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