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Cypen & Cypen
NEWSLETTER
for
July 18, 2013

Stephen H. Cypen, Esq., Editor

1.  PENSION AND RETIREMENT SECURITY:  National Institute on Retirement Security has issued a study entitled “Pensions & Retirement Security 2013: A Roadmap for Policy Makers.”  The key research findings are as follows:
•         Americans remain highly anxious about their retirement outlook despite stabilization of the financial markets, declining unemployment and increased consumer confidence. An overwhelming majority of Americans (85%) continues to report concern about their retirement prospects, with more than half (55%) very concerned.
•         Americans are highly supportive of pensions and see these plans as a way to improve retirement readiness. Some 83% of Americans report favorable views of pensions, and 82% say those with pensions are more likely to have a secure retirement. Moreover, 84% indicate that all Americans should have access to a pension to be self-sufficient in retirement.
•         Americans feel that leaders in Washington do not understand their struggles to save for retirement. Americans overwhelmingly would support Congressional action to provide all Americans with access to a new type of privately run pension plan. More than 90% would favor a new pension plan that is available to all Americans, is portable from job to job and provides a monthly check throughout retirement for those who contribute.
•         When looking across generations, Millennials are highly cognizant of the broken retirement infrastructure and are highly dissatisfied with the state of retirement and policymakers. Even though retirement is in the distant future, virtually all Millennials agree that the retirement system is under stress and needs repair (95%), and that lawmakers need to make retirement a higher priority (90%). Millennials are especially supportive of a new pension system (84%), with 88% saying they would consider participating. 
•         Protecting Social Security benefits remains important. Some 67% of Americans say it is a mistake to cut government spending in such a way as to reduce Social Security benefits for current retirees.
•         Americans support pension benefits for public employees because these workers contribute to the costs, and because some segments of the public workforce have high-risk jobs and lower pay. Nearly three quarters of Americans (73%) support these pensions because public employees contribute from every paycheck to their pension. For police and firefighters, 86% of Americans say these employees deserve pensions given their job risks. And for teachers, 72% of Americans indicate pensions are deserved to compensate for low pay. 
•         Americans seem to understand there is an economic imperative for ensuring Americans have pensions and sufficient income to retire. An overwhelming majority of Americans, 87%, say that the increasing number of Baby Boomers retiring without pensions or inadequate savings is straining families and the economy.
 
2.  BIG CALIFORNIA FUNDS PERFORM BIG:  California Public Employees' Retirement System reported a 12.5% return on investments for the 12 months ended June 30, 2013.  The gain was led by strong performances by global public equity and real estate investments, according to a plansponsor.com report.  Investments in domestic and international stocks returned 19%, outperforming CalPERS’ equity benchmark by nearly 1 percentage point. Investments in income-generating real properties like office, industrial and retail assets returned 11.2%, outperforming the pension fund's real estate benchmark by 1.4%.  CalPERS' 12.5% return is well above the fund's discount rate of 7.5%, the long-term return required to meet current and future obligations. CalPERS' 20-year investment return is 7.6%, while its return since 1988 is 8.5%.  Meanwhile, steady growth in the global equity market fueled a 13.8% fiscal year investment return at for California State Teachers' Retirement System (CalSTRS’ actuarial assumed rate of return is 7.5%, and its 20-return is 7.5%).  At $258 Billion and $166 Billion, respectively, CalPERS and CalSTRS are the largest public pension funds in the nation.  
 
3.  PENSION SMOOTHING PLAN GOES NOWHERE: A pension smoothing option that is supposed to help New York local governments cope with rising employee retirement costs is proving to be a flop with school districts. Timesunion.com reports that a recent survey found that less than 10% of school business officials planned to use the option, which allows for slightly lower payments in the short term but could cost more in the long run.  Reasons for not participating range from “postponing the inevitable” and “shifts burden onto the backs of future taxpayers” to “not a very fiscally sound way to operate” and “district does not want to push current costs onto future years.”  In essence, the smoothing option allows school districts to borrow against the future in order to even out periodic spikes in retirement costs. In wake of the 2008 financial crash and facing a steady stream of baby boom retirements, schools, as well as municipalities, face enormous increases in their pension costs. 

4.  CROSS- COLLATERALIZATION AGREEMENT BY ITSELF DOES NOT DISQUALIFY IRA FROM EXEMPT STATUS: Generally speaking, assets in an individual retirement account are off limit to tax collectors and creditors of bankruptcy.  Yet, if the owner of the retirement account uses in a prohibited way, taxation and bankruptcy protection disappears.  After saving money in an IRA with Merrill Lynch, Daley filed a Chapter 7 bankruptcy petition. The bankruptcy court and the district court thought that Daley had impermissibly used the IRA to extend himself credit by granting Merrill Lynch a lien on the retirement funds to cover any potential future debts to the firm. On appeal, the Sixth Circuit reversed.  When Daley signed a boilerplate client relationship agreement with Merrill Lynch, he pledged his IRA as security for any future debts to Merrill Lynch.  No debts ever arose, whether at the time Daley opened the account or later.  When Daley filed a Chapter 7 bankruptcy petition, he sought to protect his retirement savings from creditors, invoking the IRA exception. The bankruptcy trustee objected, contending the IRA lost its exempt status when Daley signed the client relationship agreement and granted the lien to Merrill Lynch.  There is a statutory presumption that his account is exempt. If a retirement fund has received a favorable determination from IRS, those funds shall be presumed to be exempt from the bankruptcy estate. A letter from the IRS stated that Merrill Lynch’s IRAs satisfied the requirements of retirement-account exemption. In 2011, IRS announced that lien provisions like this one would not destroy an IRA’s tax exempt status. The mere existence of a cross-collateralization agreement, by itself does not disqualify an IRA from exempt status. At most, it is actual use of such an agreement, and the prohibited extension of credit through it in a later transaction, that might disqualify a retirement account.  On this record, Daley did not use his retirement account to extend himself credit. Daley v. Mostoller, Case No. 12-6130 (U.S. 6 Cir. June 17, 2013).  (Note that this case was argued on Thursday, June 13, 2013 and was decided on Monday, June 17, 2013.  Talk about speedy justice.)

5.  WHAT A SUSTAINED LOW-YIELD RATE ENVIRONMENT MEANS FOR RETIREMENT INCOME ADEQUACY: Using results from the 2013 Employee Benefit Research Institute Retirement Security Projection Model, the institute’s Dr. Jack VanDerhei found the following:
•         Overall, 25%–27% of Baby Boomers and Gen Xers who would have had adequate retirement income under return assumptions based on historical averages are simulated to end up running short of money in retirement if today’s historically low interest rates are assumed to be a permanent condition, assuming retirement income/wealth covers 100% of simulated retirement expense. 
•         A low-yield-rate environment may have an extremely large impact on retirement income failure rates when viewed in isolation. However, the impact is muted somewhat when included as part of the entire retirement portfolio (for example, Social Security benefits, possible defined benefit accruals and net housing equity).
•         There appears to be a very limited impact of a low-yield-rate   environment on retirement income adequacy for those in the lowest-(pre-retirement) income quartile, given the relatively small level of defined contribution and IRA assets and the relatively large contribution of Social Security benefits for this group. However, there is a very significant impact for the top three income quartiles.
In other words, those of you who advocate a switch from defined benefit to defined contribution better be careful what you wish for -- you just might get it.

6.   AS FUNDED STATUS RISES, MULLING A GRACEFUL GLIDE:The funded status of corporate defined benefit pension plans in the U.S. year-to-date has notably improved in wake of a rise in bond yields and equity markets, according to Goldman Sachs Asset Management.  Based on GSAM’s analysis, the aggregate funded status of the plans of S&P 500 companies has risen to more than 85%, significantly higher than levels from the end of 2012, says the white paper “Rising Funded Status: Time for Glide Path Implementation?,” reviewed by planadvisor.com. A key question for plan sponsors is what to do now.  A glide path strategy would call for asset allocation and investment strategy to change, as certain factors, such as pension plan funded status, change. Several plans have adopted glide path or dynamic asset-allocation strategies that call for adjustments to their portfolios as funded levels or bond yields rise. These adjustments could entail adding to or extending duration of their fixed-income holdings, as well as reducing exposure to equities or other return-seeking assets.  Bond yields and equity prices can rise at the same time when the risk-free rate is at a low level. This scenario has played out over the past few months, and if it were to continue, could result in even further improvements to corporate funded levels.  A plan sponsor may determine, for example, that at an 80% funded level the appropriate asset allocation is 60% equities/other return-generating assets, and 40% liability hedging assets.  The liability hedging assets would be predominately long-duration, fixed-income since those items provide the best match for the pension liabilities.  As funded status changes, the glide path strategy would call for that strategic asset allocation to change. For example, if due to a rise in bond yields and equity markets, funding status for a plan has increased to 90%, the higher-funded plan would be more focused on preserving that funded status than seeking higher returns. Consequently, the glide path may call for an asset allocation of 50% equities/other return-generating assets and 50% liability hedging assets. The point is that as funded status improves, the plan sponsor should make changes in the asset allocation that reduce risk. Since pension liabilities are bond-like in nature, the best way to reduce risk is to have assets that match characteristics of the liabilities. 

7. SEC ADOPTS RULE CHANGES ALLOWING GENERAL SOLICITATION IN PRIVATE PLACEMENTS: On July 10, 2013, the U.S. Securities and Exchange Commission approved a final rule making changes to Rule 506 of the Securities Act of 1933 (the most widely used and important exemption from federal and state registration of offerings) to permit issuers, including funds, to use general solicitation and general advertising to offer their securities, provided that:
          (a) All purchasers of the securities are accredited investors or the issuer reasonably believes that the investors so qualify; and
          (b) The issuer takes reasonable steps to verify that the investors are accredited investors.
SEC requires an issuer relying on this new exemption in Rule 506(c) to consider the facts and circumstances of each purchaser and the transaction. Nevertheless, in response to commenters' requests, the final rule provides a non-exclusive list of methods that issuers may use to satisfy the verification requirement for individual investors.  The methods described in the final rule include the following:
•         Reviewing copies of any IRS form that reports the income of the purchaser and obtaining a written representation that the purchaser will likely continue to earn the necessary income in the current year.
•         Receiving a written confirmation from a registered broker-dealer, SEC-registered investment adviser, licensed attorney or certified public accountant that such entity or person has taken reasonable steps to verify the purchaser's accredited status.
These verification methods represent an enormous operational change for funds, and require new procedures and due diligence for funds that choose to advertise. In general, mere self-verification by a prospective investor (such as checking a box on a subscription agreement to represent that the investor is accredited) will not be sufficient. It is likely that third-party service providers will offer verification services. Issuers conducting Rule 506 offerings without the use of general solicitation or general advertising (now called Rule 506(b) offerings) can continue to conduct securities offerings in the same manner, and are not subject to the new verification rule.  The final rule amends Form D, which is the notice that issuers must file with SEC and state regulators when they sell securities under Regulation D. The revised form adds a separate box for issuers to check if they intend to engage in general solicitation or advertising under this new rule exemption.  Many private fund managers rely upon exemptions from regulation by the Commodities Futures Trading Commission (such as the de minimis exemptions available to fund managers with limited trading in commodity interests). These exemptions currently prohibit general solicitation or advertising. Absent further guidance from the CFTC, you should assume such important exemptions are not available to fund managers who conduct general solicitations. Further, sponsors of private funds should be aware that if they broadly advertise as they are now allowed, they may not be allowed to fall back on the exemption from registration under Section 4(a)(2) of the Securities Act of 1933 if they fail to satisfy the exemption under Rule 506(c). Moreover, alternative state blue sky exemptions for private offerings that avoid federal Form D filings and state investment adviser exemptions based on “not holding out” may be unavailable for offerings that engage in general solicitation.  Finally, issues of integration may remain if an issuer conducts multiple offerings. Antifraud rules and specific advertisement content rules, especially for registered advisers, may be a trap for the unwary advertiser. These rule amendments become effective in 60 days after publication in the Federal Register, which should mean they are effective by the end of September, 2013.  Our thanks to Holland & Knight for the summary.

8.  PENSION ADVISERS TALK LIKE CFOS: CFOs have an edge if they can talk about finance in a way that’s meaningful to key stakeholders who are not finance people, like some board members and investors. And when they are on the receiving end of communications they are like anyone else: they are more responsive when the communicators speak a language they understand.  That is what is behind a push by institutional investment managers to address CFOs of their client pension plan sponsors in the language of corporate finance rather than overuse investment-industry jargon, according to cfo.com.  Investment folks like to talk about things like surplus VAR, referring “to value at risk,” a statistical technique for quantifying the level of financial risk within a company or investment portfolio over a specific time frame. Corporate risk managers and CFOs are generally familiar with VAR, but surplus VAR is particular to defined-benefit pension plans. It requires a shift from thinking about the volatility of assets to the volatility of the difference between assets and liabilities.  For example, where a VAR analysis might show that a plan risks losing $1 million, given its current investment allocations and economic conditions, surplus VAR might show that a $1 million loss may be fine because plan liabilities also could go down by that amount. Boards and pension committees, even CFOs, do not always know what investment managers are talking about.  The investment industry is in the midst of changing its ways. One firm is presenting client CFOs with a one-page analysis of risks related to pension assets and liabilities, expressed in terms of the potential impact from pension-fund performance on common financial metrics like free cash flow and earnings per share. The shift is not actually a response to specific requests from finance chiefs.  Rather, it is a recognition of what firms were talking about before was not resonating as it should have.  A better feel for the true implications of pension risk could help pension committees, which are frequently chaired by CFOs, avoid excessive focus on evaluating the plan’s return on assets and the performance of asset managers at the expense of prudent attention to some other, more important items. Historically, fund managers have typically been selected and measured based on their investment performance relative to benchmarks for equities and benchmarks for bonds.  Often, discussions about manager selection and asset returns have dominated committee meetings.  But the global financial crisis exposed the inadequacy of that focus. If a plan’s entire pool of assets went down by 25%, why would you be talking about an asset manager outperforming or underperforming the market by 100 basis points, so that instead of 25% you were down 24% or 26%? What really happened was that your funded status fell through the floor. You need to be more aware of what is happening in absolute terms than relative terms. While monitoring asset managers is not unimportant, you have a limited amount of time for the meeting, so focus first on overall asset allocation and overall risk exposure.

9. THE SECURE ANNUITIES FOR EMPLOYEE (SAFE) RETIREMENT ACT OF 2013:  Senator Orrin Hatch (R – Utah) has introduced the Secure Annuities for Employee (SAFE) Retirement Act of 2013.  Among other things, the bill would provide for public pension “reform” in the form of a “SAFE Retirement Plan” for state and local governments.  A new type of pension plan, which is optional for state and local governments, would deliver lifetime, defined benefit retirement income for employees with stable, predictable costs for employers and taxpayers. Key features include:
•         Employees receive secure monthly income at retirement for life.
•         Employer pension costs are stable, predictable and affordable.
•         Pension plan underfunding is not possible.
•         The life insurance industry invests the assets, pays the retirement benefits and bears the risks.
•         Retirement benefits are protected by a robust state regulatory system and financial backstop.
The new pension structure for state and local governments will solve the pension underfunding problem prospectively, while delivering retirement income security, in the form of a deferred, fixed income life annuity, to public employees. Involvement by the federal government will be limited to certifying the tax qualified status of the plan.  Memo to Senator Hatch: somebody better pay attention to pension plans in the private sector.  Public plans are doing quite well, thank you very much.

10. BUSINESSWEEK SAYS HEDGE FUNDS ARE FOR SUCKERS:  According to a report by Goldman Sachs reviewed by BloombergBusinessweek, hedge fund performance lagged the Standard & Poor’s 500-stock index by approximately 10 percentage points this year, although most fund managers still charged enormous fees in exchange for access to their brilliance. As of the end of June, hedge funds had gained just 1.4% for 2013, and have fallen behind the MSCI All Country World Index for five of the past seven years.  These figures come as the SEC passed a rule that will allow hedge funds to advertise to the public for the first time in 80 years (see Item 7   above).  Hedge funds are built on the idea that a smarter guy (and they are almost all guys; only 16.8 percent of managers are women) with a better computer can make miracles possible by uncovering inefficiencies in the market or predicting the future. In pure dollar terms, there are more resources, advanced degrees, and computing firepower devoted to chasing this elusive goal than almost any other endeavor, and that may include fighting wars. Yet traders face the immutable fact that every second, each megabyte of information, blog post, one-line rumor, revenue estimate, or new product order from China has already been taken into account by the efficient market and reflected in a security’s price. So, trying to gain what traders call an edge, at least legitimately, is almost impossible. As the financial incentives on Wall Street have become enormous, so have the competition and pressure to gain an advantage at any cost. The age of the multi-billionaire celebrity hedge fund manager may be drawing to a close, but the funds themselves can still serve a useful purpose for prudent investors looking to manage risk. Let the industry’s recent underperformance serve as a reality check: no matter how many $100 million Picasso paintings they purchase, hedge fund moguls are not magicians. The sooner investors realize that, the better off they will be. (To those of you who did not catch the cover of the July 15-July 21, 2013 issue, go back and take a look. Where is Jimmy Kimmel when we need him?)

11.  ARE HEDGE FUNDS REALLY FOR SUCKERS? YEAH, KINDA:  Kinda in response to the Bloomberg Businessweek piece (see Item 10, above), that question was posed by washingtonpost.com. The first four paragraphs will give you the flavor: 
I am starting a hedge fund. Here’s the plan.
You give me your money.  Every year I will take this money to Las Vegas at the beginning of football season and bet that some pretty good team will NOT win the Super Bowl. The Seattle Seahawks currently face 7-1 odds, and I don’t really like the color of their jerseys, so I’ll bet against them this year. Assuming Seattle does not win the Super Bowl, I should turn every $7 of my investors’ money into $8, a whopping 14% return!  
Even better, my ability to achieve that return is not affected a whit by whether the stock market rose or fell that year. In the world of investing, a “non-correlating” asset like my hedge fund is particularly desirable. You want things that zig when the rest of the markets zag, or at least where the zigs and zags happen randomly.
Now, of course, I require adequate compensation for my hard labor. Suppose you and my other investors gave me $1 billion to “invest.” I think I’ll take 2% of that off the top, you know, $20 million in walking around money. Then I’ll take 20 percent of the profits I generate, another $28 million in this case. So I’m paying myself a handy $48 million a year before expenses for “managing” my investors’ money. And suddenly your 14% return is actually more like 9%.  Sorry! Gotta pay the bills. Do you know what a Gulfstream jet and a house in the Hamptons cost these days?

12. WHEN INSULTS HAD CLASS: He uses statistics as a drunken man uses lamp-posts... for support rather than illumination.  Andrew Lang

13. PHILOSOPHY OF AMBIGUITY: Atheism is a non-prophet organization.
 
14.  TODAY IN HISTORY: In 1967, silver hits record $1.87 an ounce in New York. 
 
15. KEEP THOSE CARDS AND LETTERS COMING: Several readers regularly supply us with suggestions or tips for newsletter items. Please feel free to send us or point us to matters you think would be of interest to our readers.  Subject to editorial discretion, we may print them.  Rest assured that we will not publish any names as referring sources. 
 
16. PLEASE SHARE OUR NEWSLETTER: Our newsletter readership is not limited to the number of people who choose to enter a free subscription.  Many pension board administrators provide hard copies in their meeting agenda. Other administrators forward the newsletter electronically to trustees. In any event, please tell those you feel may be interested that they can subscribe to their own free copy of the newsletter at http://www.cypen.com/subscribe.htm.

 

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Items in this Newsletter may be excerpts or summaries of original or secondary source material, and may have been reorganized for clarity and brevity. This Newsletter is general in nature and is not intended to provide specific legal or other advice.


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