Wednesday, November 27, 2013

Company Stock as a 401(K) Option

Company Stock as a 401(K) Option

The Solicitor General of the United States has petitioned the Supreme Court to hear a case involving the ability of employees to bring a class action suit against their employer’s inclusion of the company stock in a 401(K) plan.  This type of litigation is known as stock-drop class action and seems to be initiated whenever a company’s equity plunges in value.  Many courts have been reluctant to allow these types of suits to proceed when the situation involves a 401(K) with an option to purchase company stock.  The courts have ruled that there’s a presumption that the decision to create such an option is reasonable given Congress’s intention to encourage employee ownership.   The suits have been dismissed at a preliminary stage..

The Sixth Circuit Court of Ap   The bank maintained a stock option in its 401(K) despite its ongoing mortgage problems.  The bank’s stock plummeted, the value of 401(K) balances fell, and a class action lawsuit ensued.  The Sixth Circuit ruled that the presumption of reasonableness did not apply at the preliminary stage of the case and allowed the plaintiffs to at least initiate their case.   The Supreme Court is being asked to determine if the Sixth Circuit or other circuit courts have the correct interpretation of the law.
Fund of Funds (2003)
peals broke away from the rulings of other circuits and allowed a class action to proceed against Fifth Third Bancorp.

Aside from the legal debate, corporations argue that if the Supreme Court sides with the Sixth Circuit, it will bring on a flood of stock-drop lawsuits by the class action bar.  The US Department of Labor counters the standard of winning one of these cases would remain high given the that a stock ownership option in a 401(K) plan is presumed to be reasonable.

I’m not in any position to handicap the outcome of this case.  However, I strongly believe that including a company’s stock in a 401(K) plan is a very bad idea.  By working at the company, employees are already taking on a great deal of risk.  Their salaries and career are tied to the wellbeing of the company.  When employees also buy the company’s stock in their 401(K)s, they are also betting their retirement on company’s future.  In addition, they may also be participating in a stock option or stock purchase plans using after-tax dollars.  In short, employees are taking an enormous amount of company-specific risk and shouldn’t risk their retirement as well.  While Congress has blessed the inclusion of company stock in a 401(K) plan, it completely violates the notion of prudent and diversified investing.

Tuesday, November 26, 2013

Bitcoins Have Company

Bitcoins Have Company

The early success of Bitcoins has spawned imitators, according an article in The New York Times by Nathaniel Popper[1].  They go by names such as PeerCoin, Litcoin, and Ripple.  They use different algorithms and have yet to outpace Bitcoins, but they all have the same purpose.  They intend to supplant, or at least supplement, government issued currency. 
Asian Efforts (1999)
Digital money is based on the premise that a well-constructed and secure algorithm can’t succumb to the inflationary practices of deeply indebted governments.  While this premise is true, I believe it is probably an insufficient basis for establishing a viable digital currency.  There are a virtually infinite number of algorithms that can produce a slowly growing supply of alternative currency.  Thus there’s no limit to the number of these forms of money.  While widespread acceptance may give one type of digital money a form of first mover advantage, my guess is that it will be hard to maintain.  Instead of government firing up the printing press, I suspect that computer programmers will fire up their laptops and create a form of inflation by flooding the market with competing digital specie.

Although lax monetary policies are a risk to conventional currencies, traditional money maintains one advantage that digital currency cannot match.  Currency is not only a means of exchange, but also a rough measure of the wealth of a country.  In my view, the status of the dollar as the world’s default currency stems from America’s inherent wealth.  Investors not only want to hold US dollars, they also want to invest a portion of their wealth in American assets.  Our political system may be dysfunctional, and our economy may be operating at less than peak capacity, but the United States is still the richest and most diverse economy on the planet.  Digital currency can never make that claim.

Someday America’s wealth may be sapped and our politicians and central bankers may succumb to the printing press in order to pay off the country’s IOUs.  However, we’re a long way from this situation. Digital currencies will develop as a form of accepted payment.    It’s hard to say which algorithms will win.  However, if I had to bet, I’d wager that the winning digital currencies will be pegged to or backed by the US dollar.


Monday, November 25, 2013

Money Management Bonanza

Money Management Bonanza

Most public employee pension plans end their fiscal years on June 30, and it takes about four or five months to issue the annual report.  The first reports are being published, and they have a story to tell.  On Friday, I discussed the continuing disputes in South Carolina (“South Carolina Retirement System: At It Again [November 21, 2013]”), which are being driven by their retirement system’s high level of management fees.  Rapidly rising fees aren’t just a story in the Palmetto State.  They are a national story.

College Savings (1999)

I’ve looked at the annual reports for six public pension plans (see below) that have released data for FY 2013, and there is a clear picture.  Assets have risen by 7%, while fees have soared by 33%.  The modest rise in assets isn’t just due to market appreciation, although it played a role.  Assets have also risen because employer and employee contributions have outpaced benefit payouts and costs.  The sharp rise in fees is the result of a bit of appreciation and the growing commitment to alternative investment.  For example, the Texas Teachers had a 65% increase in fees because they’ve been active in hiring all sorts of private equity, real estate, and hedge funds. Meanwhile their assets only rose by 6%.  Their fees, at 67 basis points, are still a fraction of those incurred by South Carolina.

I’d like to tell you just how much it’s costing these plans to move into alternatives, but the data isn’t uniformly available because disclosure practices vary from plan to plan.  For example, Pennsylvania State Employees uses one set of definitions for its asset allocation and another set for breaking out fees, so it’s hard to show exactly how much of Pennsylvania’s fees are being absorbed by alternative managers.  In New York, the Comptroller doesn’t break out the fees by asset class, although it is clear that NYC has been enamored of alternative managers.  The Comptroller-elect, Scott Stringer, says he’s going to clamp down on fees.  It is a promise he won’t be able to keep.  Most of City’s fees are imbedded in long-term management contracts.  

Washington State’s annual report provides some idea of just how much in fees private equity commands.  The State has $16 billion in PE assets, or 30% of its portfolio.  The State’s PE fees are $196 million, or 60% of its fees.  I’m sure this pattern is being repeated for the other categories of alternative investment in most states. 

Meanwhile, conventional managers of stocks and bonds are under fee pressure and of course are losing assets as public plans continue their infatuation with alternatives.  I don’t think we should have much sympathy for equity and fixed income managers as they’ve had a long run and failed to add value.  I’m very confident that the alternative managers won’t add value either.  However, it will take many years before it is clear that they failed to produce, and in the meanwhile, alternative managers are going to  enjoy a financial bonanza.

As we enter the holiday season, the beneficiaries of public pension plans are hurting and worried.  Public employees face stagnant wages and declining benefits.  Retirees are wondering whether their pensions will survive.  In the mean time alternative managers are going to enjoy a massive windfall thanks to a 30% increase in public pension management fees.  They’ll face the tough decision of whether to buy another vacation home or put an addition on the existing one.

Friday, November 22, 2013

South Carolina Retirement System: At It Again

South Carolina Retirement System: At It Again

Let’s begin with the old news. South Carolina’s various public pensions have very high fees, and those fees continue to grow.  For the year ended June 30, 2013, SC incurred fees of $419 million with $233 million contained in an amorphous category called strategic partnerships.[1] A year ago the fees were $304 million.[2]  They are paying management fees of about 1.61% of investment assets due in large measure to their 44% commitment to alternative investments.  Most pension plans have fees that are 65% to 70% lower.  The plan returned 9.99% for the fiscal year, which isn’t likely to compare favorably with other public pension plans that have more conventional asset allocations.  These results will allow State Treasurer Curtis Loftis and the other members of the Investment Commission to continue their political battles.  Of course, there’s not much that South Carolina can do about these fees as they’ve made long-term commitments to private equity, real estate, and hedge fund managers.  The Treasurer has made his point and should probably move on to other issues.

Restatement (1999)
However, the Treasurer’s battles aren’t confined to the pension assets.  A few months ago he entered into a legal settlement with Mellon/BNY over losses in the securities lending program.  The financial recovery under the settlement was relatively small and was accompanied by a new contract giving SC a bigger share of the securities lending revenue (90%), as well as an explicit fee for custody.   I think the settlement is a better deal for Mellon/BNY than South Carolina because it offers the bank a ten-year contract on very favorable terms.

It turns out the State Treasurer hasn’t signed the contract yet because he needs concurrence from the Investment Commission and other agencies.  As you’d expect they aren’t acceding.  The Commission’s new COO has rejected the contract.  There is no surprise in his reaction. The COO is former State Senator Greg Ryberg, who as a Senator tried to remove the Treasurer from the Commission.

From what I can tell, the Treasurer probably had authority to enter into the contract for custodial services.  He is custodian of the pension assets, and historically his office has made these arrangements for the retirement system.  Former Senator Ryberg and the Commission are paying the Treasurer back for dragging his feet on funding an investment mandate earlier this year.  See, “Skirmish Avoided: The SC Investment Commission versus Treasurer Loftis (April 15, 2013).”

According to newspaper reports[3], the Treasurer’s critics seem to think that the contract should either be subject to a legislative appropriation or be paid by the Treasurer’s office.  Both these arguments are wrong.  Custodial expenses are a legitimate requirement of the pension plan and should be netted from pension assets.  If the custodial contract were to be subject to an appropriation, then the $419 million of management fees should also flow through the legislature.  I doubt South Carolina’s laws have any such requirement, and I doubt the Investment Commission could function if money management fees had to run the legislative gauntlet.

The Treasurer’s critics are also asserting that South Carolina has never paid custody fees in the past.  This is a ridiculous assertion.  Before Treasurer Loftis was elected, the fees were hidden inside securities lending income.  In other words, the securities lending program generated income for the pension plan but the custody fees were netted out before the income figures were reported to the pension.  My former boss, Treasurer Richard Moore of North Carolina, walked into the same situation and renegotiated the custody and securities lending relationships so that fees and income were transparent.  Critics claimed that we were now paying for a service that had been free.  The critics were wrong.

The war between the Investment Commission and the State Treasurer has just extended to 115 iPads.[4]  The Treasurer has been handing out the iPads to schools in order to promote financial literacy.  The Commission chairman heard that the iPads were funded by a money manager, raising the juicy prospect that the Treasurer had some type of untoward deal with one of the pension plan’s advisors.  It turns out the iPads were supplied under SC’s college savings plan, which is overseen by Treasurer Loftis and administered by Columbia Management.  The computers are part of a financial literacy program. 

Once again the retirees, public employees, and taxpayers of South Carolina are seeing their public officials feud instead of managing the pension plan.  The Investment Commission needs to talk about investments instead of iPads.