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Cypen & Cypen
OCTOBER 21, 2004

Stephen H. Cypen, Esq., Editor

Never Forget - September 11, 2001


Following up our recent piece on Fannie Mae (see C&C Newsletter for October 14, 2004, Item 3), Bloomberg News reports that federal prosecutors have opened a criminal investigation into accounting errors at Fannie Mae outlined by the Office of Federal Housing Enterprise Oversight. Last month, that federal regulator said Fannie Mae used improper “cookie jar” reserves in the 1998 deferred expenses to smooth earnings and meet executive bonus targets. Fannie Mae (together with Freddie Mac) owns or guarantees about half of the $7.3 Trillion mortgage market. Curiously, until 2002 those two government-chartered entities were exempt from filing financial statements with the Securities and Exchange Commission. (Can you imagine what went on before then?)


New York local governments now face questions raised over the state’s decision allowing them to delay almost $1 Billion this year in pension costs. The state recently approved the plan to delay until next year a sharp hike in payments that cash-strained local governments must make to the state pension system. But the Governmental Accounting Standards Board, in a draft “technical bulletin,” says that the pension costs accrued this year must be counted as 2004 expenses and not pushed off into 2005. The issue has sent shockwaves among local government finance officials, who are counting on the state’s fix to balance their books this year. GASB supporters say it is trying to uphold an honest and consistent accounting system and not weaken standards by approving fiscal gimmicks. While the New York State Comptroller has informed localities that they can rely on the law, others say local governments should be extremely cautious about not following GASB’s edicts. Ignoring GASB could draw the attention of Wall Street rating agencies -- and that could cost taxpayers dearly when their local governments borrow. For example, one recognized credit rating agency has already sent warnings about the pension law, which, it says, prolongs the problem by merely delaying the pension tab’s payment date. We will report further developments here as we learn of them.


As previously reported, the Securities and Exchange Commission has prohibited directed brokerage -- the practice in which mutual fund managers route trades through broker/dealers’ trading desks as a back-door reward for the broker/dealers’ advisers selling their mutual funds to retail clients (see C&C Newsletter for August 26, 2004, Item 3). As of December 13, the effective date of the ban, the estimated directed brokerage industry that generates $475 Million in revenue a year for domestic brokerage firms will be cut roughly in half. (In the absence of directed brokerage, asset managers will be forced to make direct, hard-dollar payments to broker/dealers -- and disclose them.) The loss of funds is likely to force firms (particularly smaller regionals) to cut back-office services, such as product development and technical support, that they now provide to their affiliated representatives. As a result, representatives will end up taking on more operational burden, which will cut into the time they can devote to sales and other profit-generating activities. For independent broker/dealers, the ban will likely result in modified compensation grids. At these firms, where payouts average 82% and operating margins are 4%, revenue from directed brokerage was not a bonus but an essential component of revenue stream. Because independents do not share with representatives, directed brokerage revenue goes right to the bottom line. This report was originated by Primedia.


A Standard & Poor’s announcement reported in indicates that performance of domestic equity funds in the third quarter of 2004 is consistent with the latter stages of a bull market. With large-cap value funds holding up despite an overall decline in domestic equity funds, S&P believes the U.S. economy may be in a secular bear market combined with a cyclical bull market. S&P defines a cyclical bull market as one with a 20% or higher bounce from a prior bear market’s closing low. A secular bull market is one that sets record highs. And a bear market is one that declines 20% or more from recent highs. Commenting on the latest figures, S&P believes that the cyclical bull market will remain in place in the coming year.


In an article entitled as above, a paper issued by the Center for Retirement Research at Boston College says that retirement security depends on both the income of the aged and their consumption needs. Recent studies project that Baby Boomers (born between 1946 and 1964) will on average receive more income in later life than earlier generations of older Americans. But increases over time in consumption needs might offset these income gains. In particular, rising health care costs may threaten the Baby Boomers’ retirement security. If current policies continue, income after taxes and health care spending for the typical older married couple will be no higher in 2030 than it was in 2000 -- despite 30 years of productivity growth. The increased health care burden will be particularly painful for those at the lower end of the income distribution who do not qualify for Medicaid.


The U.S. Securities and Exchange Commission has requested documents from six companies to determine how they made assumptions about their pension plans and how that affected their bottom lines, according to Investor’s Business Daily. The SEC’s enforcement division is looking to see whether managers are adjusting their assumptions to enhance the earnings and balance-sheet numbers investors consider important. The SEC has identified some companies whose assumptions seem aggressive and whose pension plans are big enough that changes in the estimates could have a significant impact on the bottom line. By the way, hundreds of companies updated key assumptions in their accounting for post-retirement benefits last year to come more into line with real-world trends. (Rumor has it that GM, Ford and Delphi are on the list.)


Investment managers are traditionally evaluated on quantitative measures of performance, including performance relative to a benchmark, portfolio attribution analysis and statistical measures such as information ratios. But this method of evaluation can potentially lead to a misalignment of goals and objectives between portfolio managers and those charged with evaluating their performance. An analysis from The Vanguard Group reviews some common flaws in the current manager-assessment process: lack of awareness of client biases, misuse of good tools, overreliance on bad tools and a short-term focus. After reviewing the flaws, the paper outlines a framework for manager evaluation that: (1) addresses shortcomings that keep investors from sending the right message, (2) communicates the right message and (3) continually reemphasizes the right message. When investment committees and managers establish a common understanding of their goal, one much broader than the short-term index-based definitions used today, managers will be able to invest based on their convictions, rather than on a composition of an index or the holdings of their peers. They will not be distracted by benchmarks that have little to do with their investment process. And at the end of the day, they will be able to tell their clients that a portfolio is structured in a particular way because it is the right way to manage these assets. When a talented manager can operate with this kind of conviction, clients are the winners.


Nearly 50 million Americans receiving Social Security will get a 2.7% boost (an average $25.00 extra) in their monthly checks next year. Unfortunately, much of that increase will be eaten up by higher Medicare premiums. The latest increase is the largest since benefits rose by 3.5% in 2001. This year, the increase was 2.1%. The annual cost of living adjustment is based on an increase in the Consumer Price Index from the July-September quarter of last year through the same period this year. The average monthly check will rise from $930.00 now to $955.00 in January. However, about half the increase will go toward monthly Medicare premiums for doctor visits, which are going up by $11.60 a month next year (see C&C Newsletter for September 9, 2004, Item 3). And because the maximum amount of earnings subject to the Social Security tax will rise from $87,900.00 to $90,000.00, about 9 million workers will pay more in 2005.


Wilshire Associates has released its 2004 Wilshire Report on City & County Retirement Systems: Funding Levels and Asset Allocation. Of the 63 city and county retirement systems that provided actuarial data for 2003, pension assets and liability were, respectively, $149 Billion and $179 Billion. The ratio of pension assets-to-liabilities, or funding ratio, for all 63 was 83% in 2003, down slightly from 84% for the same 63 in 2002. For those 63 plans, pension assets grew 6%, or $8.4 Billion, from $140 Billion 2002 to $149 Billion in 2003, while liabilities grew 7%, or $11.8 Billion from $167 Billion to $179 Billion. Falling asset values combined with continued growth and liabilities caused the 63 to go from a $27.3 Billion shortfall in 2002 to a $30.6 Billion one in 2003. For the 99 city and county retirement systems that provided actuarial data for 2002, pension assets and liabilities were, respectively, $256 Billion and $319 Billion. The funding ratio for all 99 was 80% in 2002. (Wilshire estimates that the asset shortfall for local pension plans is similar to state retirement systems: state pension assets totaled $1,720 Billion, $366 Billion less than pension liabilities of $2,086 Billion, yielding an aggregate funding ratio of 82%.) City and county pension portfolios have an average allocation of 65% to equities (including real estate and private equity) and 35% to fixed income. The 65% equity allocation is slightly higher than the 63% in the prior year. Nine retirement systems have allocations to equity that equal or exceed 75%, and 3 systems are below 50%. The 25th and 75th percentile for equity allocation is 62% to 70% (quite a surprise to us). Finally, Wilshire forecasts a long-term return on local pension assets equal to 7% per annum, which is almost a full percentage point below the average actuarial interest rate assumption of 7.9%. If accurate, this asset performance shortfall will increase the total unfunded liabilities for the 63 systems that reported actuarial data for 2003 by an additional $3 Billion per year. A billion here, a billion there, pretty soon, you’re talking real money.


The Employee Benefit Research Institute’s October 2004 Issue Brief examines the level of participation by workers in public and private-sector employment-based pension or retirement plans, using the most recent Census Bureau data. In 2003, after two years of declining overall levels of worker participation in employment-based retirement plans, the percentage of workers participating in such plans has either leveled off or slightly increased. Specifically, the percentage of all workers participating in an employment-based retirement plan crept up nominally, from 41.8% in 2002 to 42% in 2003. The percentage of full-time, full-year wage and salary workers age 21-64 (those most likely to be offered a retirement plan at work) increased form 56.7% in 2002 to 57.1% in 2003. Most of the increased participation was among workers who had experienced participation declines in the prior two years, in some cases to their lowest levels since 1987. Workers showing a higher likelihood of retirement plan participation in 2003 include those who work full time, full year, for large employers or public-sector employers, or were high earners. Workers at smaller firms, private-sector firms or firms in the personal service industry were less likely to participate in a retirement plan. Geographic location of workers is also a factor, with those in the South and West less likely to participate in a plan than workers in other regions of the country. While the overall percentage of females participating in a retirement plan was lower than of males, when controlling for work status or earnings, the female participation levels surpassed that of males. Furthermore, black and native-born Hispanic workers had participation levels much closer to those of white workers within each age group. Nonnative-born Hispanics had substantially lower participation levels than native-born Hispanics, even when controlling for age and earnings.

Copyright, 1996-2004, all rights reserved.

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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