1. WILL YOU OUTLIVE YOUR INCOME? HOW TO BE CERTAIN YOU WILL NOT: While our extended longevity should be greeted with gratitude for the possibility of enjoying a longer life with our grandchildren, many retirees are approaching it with trepidation, wondering if their hard earned assets will be sufficient to fulfill their vision of a good life for the rest of their life -- however long it should last, according to Asset Strategy Advisors. At the critical point when assets are to be converted to income and a spend-down plan is launched, retirees need the assurance that they will not outlive their income. Unfortunately, the traditional and outdated retirement planning models espoused by the media and the general financial services population only serve to generate more angst among retirees. Not only do many of them still adhere to the old “allocate for your age” asset allocation strategy, they continue to base their spend-down plans on the traditional life expectancy model that requires us to die on time in order for the plan to work. In today’s near-zero-interest rate environment and in the face of life spans that can expand to age 100, these planning assumptions dangerously defy current realities. There was a time, a few decades ago, when stock market returns and bond yields worked effectively in combination to generate stable and relatively good returns for retirement portfolios. It was then when the “allocate for your age” strategy provided retirement savers with a reasonably sound formula of asset allocation that, when adjusted for your age, would automatically moderate the portfolio’s volatility, reduce risk while still producing targeted returns. For instance, a 40 year old would be advised to allocate his age in bonds and the balance in equities -- 40% bonds, and 60% stocks. At age 50, with 15 years left before retirement, he would adjust his allocation to 50/50. By age 60 -- 40/60, and then by age 65 his allocation should be 35% bonds and 65% equities. This allocation strategy would continue throughout his life -- 20/80, 10/90, etc. With stocks and bonds generating steady returns throughout the 1990 and 2000s, this strategy would allow most retiree to draw down 4% of their assets to produce sufficient income for the rest of their lives which, by the way, were shorter than today’s retirees. But during the next two decades, as bond yields decreased, and stock market volatility generated flat to low returns, financial advisors were forced to make some “adjustments” to their strategies in order to prevent an income shortfall before life expectancy. But, instead of changing the asset allocation, they experimented with decreasing the spend-down rate. So, instead of drawing down 4% of assets, retirees were advised to draw down 3% with some going even lower. In today’s environment, the biggest mistake pre-retirees and retirees can make is to invest too conservatively. An extensive study offers clear evidence that portfolios overly weighted in “safe” investments are likely to exhaust their assets well before today’s life expectancy. It showed that a portfolio invested in 100% fixed or short term vehicles would be exhausted within 25 years base on a 5% draw down rate; whereas a portfolio with just 20% allocated in stocks would last another five years. A properly diversified portfolio of 50% stocks, 40% bonds and 10% in short term vehicles, would last indefinitely. Increasing your exposure to equities, especially as part of your retirement income plan, may seem like a scary proposition. While there is risk, you are far more likely to lose asset value and purchasing power to inflations and longevity when investing to conservatively. Research has shown that the deliberate assumption of risk, when applied to a properly diversified portfolio of stocks, bonds and cash will consistently generate above-average returns while reducing overall portfolio volatility. It is through the management of risk, not the management of investments that the optimum level of stability and returns are achieved, and that must be the critical objective for any retiree. [The only way we know to be certain you will not outlive your income is to retire with a defined retirement benefit. See item 14 below.]
2. SSA ISSUES FINAL RULE EXPLAINING 60-MONTH PERIOD OF EMPLOYMENT TO RECEIVE GPO EXEMPTION FOR SPOUSE’S BENEFITS: The Social Security Administration has issued a final rule that adopts, with clarifying changes, the proposed rule the agency previously published in the Federal Register on August 3, 2007 (72 Fed. Reg. 43202). The final rule revises the SSA’s Government Pension Offset regulations to reflect changes to the Social Security Act made by Section 9007 of the Omnibus Budget Reconciliation Act of 1987 and Section 418 of the Social Security Protection Act of 2004. The regulations explain how and when the SSA will reduce the Social Security spouse's benefit for some people who receive federal, state, or local government pensions if Social Security did not cover their government work. The final rule becomes effective on July 15, 2015. (June 15, 2015).
3. ASSUMPTIONS DO NOT DRIVE PENSION COSTS: Pensions & Investments says there is a lot of talk these days about public pension plans, the size of their unfunded liabilities and the level of their costs. It is appropriate that policymakers and policy influencers focus their attention on, what to do. But when these conversations turn to actuarial assumptions, you can bet there is something amiss. The woefully misguided -- and dangerous -- idea that assumptions drive costs leads decision makers down a perilous path. Cost management is not achieved by managing actuarial assumptions. Costs are determined by what actually happens, not by what we assume or predict will happen. That assumptions do not drive pension costs goes against everything you have always thought, right? Well, here is the truth. The cost of a pension plan, paid by making contributions over time, is a function of the pensions paid out and of the investment earnings of the fund. Period. Costs are not a function of assumptions. Real management of a pension plan involves setting the level of pensions and deciding how to invest the assets. The cost of the plan -- again, paid by making contributions over time -- is unaffected by assumptions. It is simply the sum total of the pension payments to plan members, offset by the pension fund’s investment earnings. So, what does drive pension costs? Raising or lowering the formula used to determine employees' pensions does drive costs. And, how long those pensions are paid also drives costs -- so actual longevity matters. But, here is the trap. The recent mortality tables from the Society of Actuaries, reflecting significantly improved life expectancy, provoked this typical response: “the new tables will increase plan costs -- as much as 8%.” Of course, that statement is not true, because people in real life are living longer, pension costs already have increased. The new tables simply recognize that fact. How can pension costs be reduced? How should pension costs be managed? The only ways to cure an underfunded situation is to contribute more, earn more or reduce pension payouts. And, we all know that earning your way out of an underfunded situation involves risk. It is a crapshoot. And you certainly cannot earn your way out merely by managing the actuarial assumptions. That is a failed strategy. Over attention to assumptions can lead, and has led, to bad decision making. We pay too much attention to assumptions, we will overlook what is really driving costs and what can put a troubled pension plan back onto a path toward sustainability. Be clear on what we are talking about in order to move forward toward responsible management of public pensions. It is important to use good actuarial assumptions, but managing assumptions as a means of managing true pension costs just does not work. Let us make sure we listen with a discerning ear and we do not confuse the two.
4. NEW MORNINGSTAR TOOL SEEKS TO SETTLE ACTIVE-PASSIVE DEBATE: There is a new tool to see how actively managed funds compare to passive ones, according to onwallstreet.com. Morningstar, the financial research behemoth, has launched a new "barometer" of active funds' performance, net of fees, as measured against the collective performance of a composite of passively managed funds. The Active/Passive Barometer report will appear every six months and compare the performance of the two fund types over the trailing six months, one-year, three-year, five-year and 10-year periods within their respective Morningstar categories. The inaugural report, released this month, shows passive management beating active almost down the line. The report's release is timely in that the active-passive debate is sort of freshly stoked coming out of 2014, which was one of the worst years for active managers in terms of how they fared compared to their relative benchmarks. With the recurring report, Morningstar seeks to fill a gap, given that much of the research on the subject comes from academic sources that are relatively unintelligible to average investors or from industry players with skin in the game. Key findings from the first report include:
- Actively managed funds underperformed their passive counterparts across nearly all asset classes and Morningstar categories examined in the report, especially in the 10-year period. They also experienced higher mortality rates, where funds merged or closed. The U.S. mid-cap value category was the only one where actively managed funds had a 10-year success rate above 50%.
- Low-cost active funds were more likely to survive and outperform than higher-cost active funds over the long term. But low-cost active funds had lower average annualized returns compared with the average passive fund in nine of the 12 Morningstar categories examined in the report.
- Over the trailing three-year and five-year periods, 72.9% and 69.7% of active intermediate-term bond funds, respectively, beat their average passive peer, which surpassed the performance of active U.S. equity funds. No U.S. equity category notched a success rate higher than 50%in the same time periods.
- Actively managed U.S. value funds had higher long-term success rates than U.S. blend and growth funds. Active large-cap value, mid-cap value and small-cap value funds had success rates of 38.2%, 54.4 percent and 48.4%, respectively, for the 10-year period.
- Low-cost active U.S. mid-cap value funds had the highest success rate, at 68.2% for the 10-year period, while high-cost, active mid-cap blend funds had the lowest success rate, at nearly 5%.
- Over the past 10 years, 40.2% of actively managed foreign large blend funds survived and beat the average passive fund, nearly double the success rate of active U.S. large-cap blend funds.
5. FEDERAL, STATE & LOCAL GOVERNMENTS -- A CLOSER LOOK: Federal, State and Local Government is responsible for ensuring federal tax compliance by federal, quasi-governmental and state agencies; city, county, and other units of local government; and governmental entities in American Samoa, Guam, Puerto Rico and the U.S. Virgin Islands. The office coordinates activities with other IRS offices such as Customer Account Services, Counsel, Government Liaison & Disclosure, Employee Plans and Excise Tax. Additionally, Federal, State and Local Governments works with the Taxpayer Advocate Service to resolve tax problems. FSLG delivers various services through partnership with government associations, practitioner associations, IRS Counsel, and other IRS offices. Individualized service is available on a voluntary basis. Specially trained IRS staff can address tax topics - unique to government entities - that may relate to, for example, governments as employers, and issues of payments to outside contractors. FSLG offices located throughout the country currently provide:
- Assistance through individualized instruction focused on employment tax withholding, reporting and filing requirements.
- Assistance for information return reporting for payments to vendors.
- Guidance on any other federal tax-related issues.
- Participation in educational seminars and workshops at national and local levels.
FSLG works with the Social Security Administration to educate government entities about Section 218 Social Security Agreements. These voluntary agreements provide social security and/or Medicare coverage for state and local employees. While IRS is responsible for administering and enforcing the tax laws, SSA processes and interprets these agreements and related coverage issues.
6. CalPERS’S DISCLOSURE ON FEES BRINGS SURPRISE, AND SCRUTINY: According to a piece in the International New York Times, earlier this year, a senior executive of the California Public Employees' Retirement System, the United States' biggest state pension fund, made a surprising statement: the fund did not know what it was paying some of its Wall Street managers. The chief operating investment officer, told an investment committee in April that the fees that the pension fund, paid to private equity firms were not explicitly disclosed or accounted for, we cannot track it today. It was an unusual disclosure. In the world of public pension funds, CalPERS is a big fish. It manages $300 billion in retirement funds for 1.6 million teachers, firefighters, police officers and other state employees and is generally credited with being the most sophisticated investor in the pension world. For a member of the CalPERS board, the disclosure raised a red flag. Private equity firms typically charge investors a management fee of 1% to 2% of assets and about 20% of any gains each year. But fees for transactions, costs for monitoring investments and legal fees are not readily disclosed. Faced with ballooning deficits and lackluster performance, state pension funds are beginning to examine more closely how much they are paying Wall Street to manage their investments. CalPERS for the first time this year will begin to make more payments to retirees than it receives from contributions and its investments. Pennsylvania is facing a $50 billion shortfall in its pension fund. In New York City, the comptroller, commissioned a study that showed that the city's five pension funds paid more than $2 billion in fees over the last decade, outpacing the returns those funds made in the period. The public scrutiny comes as CalPERS seeks to simplify what it has called a complex and expensive portfolio. The chief investment officer, said that over the next five years, CalPERS would cut by more than half the 212 external money managers it invests with for private equity, real estate and global equity funds. It will reduce the number of private equity firms to 30 from 98, giving those firms $30 billion to manage. CalPERS has put its money with some of the biggest private equity firms in the world, including TPG, Blackstone, Carlyle and Kohlberg Kravis Roberts. Last year, as part of its move to slim down its external investments, CalPERS decided to liquidate $4 billion of hedge fund investments. The Securities and Exchange Commission has started to look more closely at private equity firms to understand how they value their assets and charge fees. The agency, which has conducted examinations of private equity firms, found that more than 50% of the time there were violations of law or weaknesses in a firm's controls.
7. NASRA ISSUE BRIEF: PUBLIC PENSION PLAN INVESTMENT RETURN ASSUMPTIONS: National Association of State Retirement Administrators has released an updated issue brief on public pension plan investment returns assumptions. As of December 31, 2014, state and local government retirement systems held assets of $3.78 trillion. These assets are held in trust and invested to pre-fund the cost of pension benefits. The investment return on these assets matters, as investment earnings account for a majority of public pension financing. A shortfall in long-term expected investment earnings must be made up by higher contributions or reduced benefits. Funding a pension benefit requires the use of projections, known as actuarial assumptions, about future events. Actuarial assumptions fall into one of two broad categories: demographic and economic. Demographic assumptions are those pertaining to a pension plan’s membership, such as changes in the number of working and retired plan participants; when participants will retire, and how long they will live after they retire. Economic assumptions pertain to such factors as the rate of wage growth and the future expected investment return on the fund’s assets. As with other actuarial assumptions, projecting public pension fund investment returns requires a focus on the long-term. The brief discusses how investment return assumptions are established and evaluated, and compares these assumptions with public funds’ actual investment experience. Some critics of current public pension investment return assumption levels say that current low interest rates and volatile investment markets require public pension funds to take on excessive investment risk to achieve their assumption. Because investment earnings account for a majority of revenue for a typical public pension fund, the accuracy of the assumption has a major effect on the plan’s finances and actuarial funding level. An investment return assumption that is set too low will overstate liabilities and costs, causing current taxpayers to be overcharged and future taxpayers to be undercharged. A rate set too high will understate liabilities, undercharging current taxpayers, at the expense of future taxpayers. An assumption that is significantly wrong in either direction will cause a misallocation of resources and unfairly distribute costs among generations of taxpayers. Although public pension funds, like other investors, experienced sub-par returns in the wake of the 2008-09 decline in global equity values, median public pension fund returns over longer periods meet or exceed the assumed rates used by most plans. The median annualized investment return for the 3-, 5-, 20- and 25-year periods ended December 31, 2014, exceeds the average assumption of 7.68%, while the 10-year return is below this level. Public retirement systems typically follow guidelines set forth by the Actuarial Standards Board to set and review their actuarial assumptions, including the expected rate of investment return. Most systems review their actuarial assumptions regularly, pursuant to state or local statute or system policy. Actuarial Standards of Practice No. 27 (Selection of Economic Assumptions for Measuring Pension Obligations) (ASOP 27) prescribes the considerations actuaries should make in setting an investment return assumption. As described in ASOP 27, the process for establishing and reviewing the investment return assumption involves consideration of various financial, economic, and market factors, and is based on a very long-term view, typically 30 to 50 years. A primary objective for using a long-term approach in setting public pensions’ return assumption is to promote stability and predictability of cost to ensure intergenerational equity among taxpayers. Unlike public pension plans, corporate plans are required by federal regulations to make contributions on the basis of current interest rates. This method results in plan costs that are volatile and uncertain, often changing dramatically from one year to the next. This volatility is due in part to fluctuations in interest rates and has been identified as a leading factor in the decision among corporations to abandon their pension plans. By focusing on the long-term and relying on a stable investment return assumption, public plans experience less volatility of costs. Since 1984, public pension funds have accrued an estimated $5.9 trillion in revenue, of which $3.7 trillion, or 62%, is estimated to have come from investment earnings. Employer contributions account for $1.5 trillion, or 26% of the total, and employee contributions total $730 billion, or 12% Public retirement systems operate over long timeframes and manage assets for participants whose involvement with the plan can last more than half a century. Consider the case of a newly-hired public school teacher who is 25 years old. If this pension plan participant elects to make a career out of teaching school, he may work for 35 years, to age 60, and live another 25 years, to age 85. This teacher’s pension plan will receive contributions for the first 35 years and then pay out benefits for another 25 years. During the entire 60-year period, the plan is investing assets on behalf of this participant. To emphasize the long-term nature of the investment return assumption, for a typical career employee, more than one-half of the investment income earned on assets accumulated to pay benefits is received after the employee retires. The investment return assumption is established through a process that considers factors such as economic and financial criteria; the plan’s liabilities; and the plan’s asset allocation, which reflects the plan’s capital market assumptions, risk tolerance, and projected cash flows. Standards for setting an investment return assumption, established and maintained by professional actuaries, recommend that actuaries consider a range of specified factors, including current and projected interest rates and rates of inflation; historic and projected returns for individual asset classes; and historic returns of the fund itself. The investment return assumption reflects a value within the projected range. Many public pension plans have reduced their return assumption in recent years. Among the 126 plans measured in the Public Fund Survey, more than one-half have reduced their investment return assumption since fiscal year 2008. The average return assumption is 7.68%. Over the last 25 years, a period that has included three economic recessions and four years when median public pension fund investment returns were negative, public pension funds have exceeded their assumed rates of investment return. Changes in economic and financial conditions are causing many public plans to reconsider their investment return assumption. Such a consideration must include a range of financial and economic factors while remaining consistent with the long timeframe under which plans operate. The Florida Retirement System’s plan assumption return is 7.65%.
8. PRESIDENT SIGNS LEGISLATION EXCLUDING CERTAIN PUBLIC SAFETY OFFICER BENEFITS FROM INCOME TAX: On May 22, 2015, the “Don’t Tax Our Fallen Public Safety Heroes Act” (H.R. 606) was signed into law. As reported by GRS, the Act amends § 104(a) of the Internal Revenue Code to exclude certain types of compensation received by public safety officers and their dependents from gross income. Under current law, amounts received under a workmen’s compensation act as compensation for personal injuries are excluded from gross income. This applies to amounts received under a workmen’s compensation act (or under a statute that is in the nature of a workmen’s compensation act) that provides: 1) compensation to employees for personal injuries or sickness incurred in the course of employment; or 2) compensation paid under a workmen’s compensation act to the survivor or survivors of a deceased employee. In addition, if the Justice Department’s Bureau of Justice Assistance determines that a public safety officer has died as the direct and proximate result of a personal injury sustained in the line of duty, the BJA will pay a monetary benefit to surviving family members or other beneficiary. Also, if the BJA determines that a public safety officer has become permanently and totally disabled as the direct and proximate cause of a personal injury sustained in the line of duty, the BJA will pay a monetary benefit to the public safety officer. The new law, as explained in U.S. Senate Report 114-26, clarifies that “benefits paid solely as a result of a public safety officer’s death or disability in the line of duty are excluded from income.” Consequently, H.R. 606 “amends the Code to provide a specific exclusion from gross income for amounts paid (1) by the BJA as a public safety officer survivor’s benefit or public safety officer disability benefit; or (2) under a state program that provides monetary compensation for surviving dependents of a public safety officer who has died as a direct and proximate result of a personal injury sustained in the line of duty...” However, the exclusion does not apply if the death of the public safety officer had occurred other than as the direct and proximate result of a personal injury sustained in the line of duty. While the Act does not define “public safety officer,” the term is defined in IRC § 101(h) (which, in turn refers to § 1204 of the Public Safety Officers’ Benefits Act of 1976). Generally, the term refers to an individual serving a public agency in an official capacity, with or without compensation, as a law enforcement officer, firefighter, chaplain, member of a rescue squad or ambulance crew, or as an employee of a state or local emergency management or civil defense agency performing official duties in connection with a Federal Emergency Management Agency related to major disasters or emergencies or duties that are hazardous.
H.R. 606 is available at: http://www.gpo.gov/fdsys/pkg/BILLS-114hr606enr/pdf/BILLS-114hr606enr.pdf and Senate Report 114-26 is available at: http://www.gpo.gov/fdsys/pkg/CRPT-114srpt26/html/CRPT-114srpt26.htm.
In addition, on June 10, 2015, Ice Miller published a summary of H.R. 606 which is available at: http://www.icemiller.com/ice-on-fire-insights/publications/new-law-eases-tax-burden-for-fallen-public-safety/
9. SUPREME COURT COULD DETERMINE FUTURE OF PUBLIC-SECTOR UNIONS: The Supreme Court of the United States said it would consider whether the U.S. Constitution bars states from requiring government employees to contribute to collective bargaining costs, casting a doubt over the strength of public sector unions. The lawsuit, brought by the Christian Educators Association International and 10 California public school teachers who object to paying union fees, seeks to overrule a 1977 precedent that allows government entities to require public employees to shoulder their fair share of the costs for unions negotiating in their behalf. The challengers contend public sector unions are effectively engaging in political lobbying when they negotiate contract terms with school boards and other government agencies. The plaintiffs say forced union contributions compel public employees to subsidize speech with which they disagree, in violation of their First Amendment rights. According to theWall Street Journal lower courts have rejected the suit, citing the 1977 high court ruling.
10. APHORISMS: The trouble with bucket seats is that not everybody has the same size bucket.
11. TODAY IN HISTORY: In 1956, Elvis Presley records “Hound Dog” and “Don’t Be Cruel.”