As we wrap up the first quarter of 2013, we are receiving several inquiries from plan sponsors regarding InvestMap^TM, Milliman’s retirement glide path technology.

Let me start with some background. Model portfolios offer risk-based options to participants consisting of asset allocations comprising many of the core funds already in the plan. Target date funds are portfolios designed to achieve returns based on a participant’s target retirement date; those closer to retirement will typically have less exposure to equities and commensurate expectations of lower investment returns, while those further from retirement will be exposed to more risk and a higher potential investment return.

InvestMap is a great solution for participants and employers alike because it brings together the benefits of both target date funds and model portfolios. Conceptually, target date funds are a good idea, but product orientation and lack of customization have underscored their limitations. Specifically, target date funds take somewhat of a “catch all” approach at the plan level.

InvestMap is designed to work at the participant level, incorporating the best aspect of target date funds (the automated glide path for which equity exposure is reduced over a period of several years). However, personal risk attributes of individual participants are incorporated as well. This sophisticated “marriage” between risk-based models and an age-based target date glide path, coupled with an open architecture investment platform, provides the best of both worlds for plan sponsors and participants.

The core funds are still available for participants to select their own asset allocations if they choose not to participate in InvestMap.
Advantages to the plan sponsor:

• InvestMap offers fiduciary protection for the construction of the models
• Can be used as the plan’s qualified default investment alternative (QDIA)
• Investment management fee transparency and no additional costs

Advantages for participants:

• Investment education that is easily understood
• Personalized strategies for each participant’s individual risk tolerance
• Hands-off management from initial enrollment to retirement

Please contact your Milliman representative for more information on how InvestMap could benefit your plan.

The U.S. Federal Reserve recently announced changes that will have major implications for investors and plan fiduciaries. The Fed’s decision to move to economic targets rather than date-based indications will result in a higher-rate environment. Plan sponsors and trustees would be wise to examine their plans and make adjustments now to prepare for the coming rate increases, as well as plan what actions to take when rates stabilize.

This paper offers several considerations for investors pertaining to the Fed’s policy shift from calendar to economic targets.

When discussing indirect compensation in relation to defined contribution plans, “float income” typically receives minimal coverage. However, litigation risk persists in a post-408(b)(2) world with regards to float. Diligent plan fiduciaries should be aware of this trickle of income and its implications.

“Float” or “Float income” represents interest that may be earned on cash held for investment or distribution. For most institutional trustees, the omnibus nature of these cash accounts makes it difficult to track and allocate the appropriate amounts at the participant level; thus the float is typically absorbed by the trustee or custodial firm.

While these earnings constitute eligible indirect compensation for Schedule C purposes, they could potentially be considered a prohibited transaction under ERISA if not properly disclosed. For that reason plan fiduciaries should make sure that float income is addressed within the service agreement between the plan and the applicable service provider and that it is properly disclosed on the form 5500 Schedule C. In order to avoid a prohibited transaction of fiduciary self-dealing, the service agreement must clearly state that the trustee may retain float income as additional compensation and provide a formula to estimate the dollar amount of compensation. Float income must be included in a discussion of the reasonableness of the service provider’s fees. It would be wise of plan fiduciaries to review the possibility of float income with their service providers, make sure it is reasonable, and, if possible, request certain fee offsets if the accumulation of float is significant enough.

With interest rates currently low, it would seem reasonable that most service providers are not earning a significant amount of float income; however, as interest rates increase, this could become a large source of income for a service provider. Plan fiduciaries may be able to manage float by:

• Having clear policies in place for timing of contributions being invested (i.e., a limit of how many days after funding until contributions are invested)
• Reviewing outstanding checks that have not been cashed in a timely fashion and the procedures in place to locate and have participants cash stale-dated checks.

When a plan fiduciary does their annual plan “checkup”—normally around 5500 time—it would be a good time to discuss float with the service provider and make sure all the necessary disclosures are being done, including Schedule C of the 5500 and service agreements.

In public, and particularly in the news media, the word “derivatives” always seems to be spoken with ire or disgust. Stories involving derivatives are usually aimed at shaming greedy “Wall Street types” or describing the calamitous damage inflicted by an ill-conceived derivatives position. Wherever derivatives are mentioned there is likely a picture or graphic containing either handcuffs or a face-palming trader. Even Warren Buffett called derivatives “financial weapons of mass destruction.” But is there really cause to be terrified of derivatives as a whole? Part of the problem is that “derivatives” is a very large asset class, describing all assets whose values are derived from a notional amount and an observable event (e.g., default of a particular company) or underlying value (e.g., an interest rate or stock price). Thus “derivatives” have the potential to be very complicated. But because it is such a large asset class, maybe some derivatives are very simple. Maybe some derivatives are liquid and accurately priced. Maybe some derivatives are regulated. Maybe some derivatives allow for very cost-effective risk management. Exchange-traded equity index futures are that type of derivative. They are boring derivatives.

When investors execute equity index futures contracts they are agreeing to either buy (long) or sell (short) the value of the underlying index at contract expiration for the price as stipulated in the contract. For instance, if an investor were to take the long position in an S&P 500 futures contract, when the S&P 500 futures price was 1400, at contract expiration they would be required to pay:

(1400 – S&P 500 value at contract expiration) * contract multiple, where “contract multiple” is a standard contract term essentially defining the notional of the contract

Should the S&P 500 be higher (or lower) than 1400 at contract expiration, this value would be negative (or positive), indicating a negative (or positive) payment be made by the investor. Another way of saying this is that the investor would realize a gain (or loss). The reason for this is that the investor previously agreed to pay 1400 for something that is now worth more (or less) than 1400.

The potential gain or loss from a contract of this sort could grow quite large. It is because of this potentially large loss that margin is required to engage in futures trading. The amount of margin required is set by the futures exchange. As markets fluctuate and unrealized losses (or gains) become large, additional margin deposits may be required (or excess margin may be withdrawn). Open contracts can be, and in practice usually are, settled prior to expiration by entering into exactly offsetting positions, thereby realizing any previously unrealized gain or loss.

From a risk management point of view, the potential benefit of utilizing equity index futures contracts comes from the fact that large exposures can be acquired for minimal cash outlays. Margin requirements are roughly reflective of the exchange’s view of volatility and the investor’s open positions. In this way, an investor’s required margin is the amount roughly equal to that necessary to cover a large, unlikely, one-day loss on open contracts. For instance, in order to get an exposure the equivalent of $100,000 to the S&P 500, the required margin might be $10,000. By engaging in net short positions in equity index futures, investors can greatly reduce their broad market equity exposures without having to liquidate their equity holdings.

Equity index futures contracts are exchange-traded, meaning an exchange facilitates all trading. Margin is required of net long traders and net short traders. As markets move, gains accrue on one side, washing out losses on the other. The margin requirements protect the exchange and virtually guarantee each investor’s ability to settle their potential liability. As such, it’s very likely that equity index futures will remain boring derivatives. That’s exciting.

Traditionally, hedge funds have sought to achieve outsized returns relative to the level of market risk in their portfolios while simultaneously maintaining a low correlation with the market at large. In other words, they seek high alpha and low beta. Proprietary investment strategies and relaxed reporting requirements have helped to make these goals possible, but also aiding the endeavor was a lack of appropriate investable benchmarks against which hedge funds might be measured. However, the emergence of hedge fund replication strategies (subscription required) might help institutional investors to more accurately assess the performance of hedge funds and correctly identify and quantify the components of their returns. Furthermore, hedge fund investors suspicious of the relative value of investing in single funds or funds-of-funds (“I can’t believe it’s not beta”) may now have a lower-cost avenue for accessing hedge fund beta.

Hedge fund replication is the general name for strategies attempting to replicate, or beat, the returns of hedge fund indices using assets that are potentially more liquid and transparent. For instance, a replication strategy might attempt to achieve returns similar to a particular hedge fund index while only investing in equities. Successful strategies would achieve returns very similar to their target indices, creating lower-cost, investable hedge fund beta.

Potential investors should consider carefully before allocating assets to hedge fund replication strategies as there are potential downfalls. First, the replication strategy may or may not perform as expected, meaning that an investor may or may not be able to access hedge fund beta. Second, although fees associated with replication strategies are generally lower than direct investment in hedge funds or hedge funds-of-funds, they are still rather high, typically comprising either a 1% to 2% management fee or a 15% performance fee, according to a recent Pension and Investments article. And finally, investors should consider their goals in making any asset allocation. Hedge funds, or hedge fund replication strategies, may provide diversification, but at a significant cost. Further, if risk management is the end goal, and diversification simply a means for achieving that goal, it is important to remember that diversification relies on correlation and, as correlations vary over time, diversification alone may not prove an effective risk management tool. Focused risk management strategies may be more effective in meeting those goals at a much lower overall cost.

The Society of Actuaries (SOA) recently came out with the 2011 Risks and Process of Retirement Survey (see the full report). It is the sixth biennial study on post-retirement risks and how they are managed.  The next few weeks’ polls are part of our series highlighting some of the same concerns brought up in the SOA survey results. Afterwards, we’ll compare your answers, to those of the general public. To start things off we’re wondering how our readers foresee inflation affecting their retirement plans.

In 2010, 60% of large pension plans invested in hedge funds (up from 11% in 2001) and 92% of large plans invested in private equity. Hedge funds and private equity can be very profitable investments but they come with risks beyond those posed by traditional investments. These investments are often difficult to value and can be highly leveraged, which can lead to large rewards, but plenty of risk.

As noted on this blog: Investment professionals overseeing pension assets today are not just managing money. They are also acting to prudently fund the earned pension obligations. So we want to know how you feel about these types of investments.

The S&P downgrade is no doubt one of the most historic valuations in recent memory. What should a plan sponsor or investor do in light of the recent downgrade?

• U.S. debt: In light of the S&P downgrade, both Fitch and Moody’s have noted that they will keep the AAA and Aaa ratings for the time being.  On August 9, the Federal Reserve auctioned around $32 billion in debt to the public without a blink. Seems the rating downgrade has not led to investors shying away from U.S. debt.
• Interest rates: With the downgrade, the rates may go up in light of the presumed risk related to the rating. Adjustments in rates will affect bonds, as well as pension plans. Moving interest rates will have more of an effect on longer durations. Review the duration of bond holdings and consider diversification across short, intermediate, and long durations to lessen the impact of changing rates.
• Investment policy: With the S&P downgrade, investors should review their investment policy statements (IPS) to see if there are terms that require bond holdings to maintain AAA or Aaa ratings. If this is the case, the IPS may need to be adjusted; alternatively, liquidations of bond investments not meeting this requirement may be necessary.
• Diversification: We have already seen a great deal of volatility since the downgrade, and going forward we may see continued discomfort in the markets, both bond and stocks. As has always been the case, diversification is key. A mixed portfolio of U.S. stocks, bonds, and international stocks and bonds are key in managing some of the volatility we’re seeing in the U.S. markets.
• Stay the course: Invest for the long term. Don’t make rash decisions, in particular after dramatic stock market fluctuations. Set a policy, adjust it as necessary, and think before making knee-jerk reactions to market declines.

One thing is certain: There will be many debates over the right course of action, as much will unfold over the coming months.

The U.S. Department of Labor (DOL) issued this announcement today:

The Department published in the Federal Register of October 24, 2007 a final regulation (the qualified default investment alternative regulation) providing relief from certain fiduciary responsibilities for fiduciaries of participant-directed individual account plans who, in the absence of directions from a participant, invest the participant’s account in a qualified default investment alternative. On October 20, 2010, the Department published a final regulation that requires the disclosure of certain plan and investment-related information, including fee and expense information, to participants and beneficiaries in participant-directed individual account plans (the participant-level disclosure regulation).

This proposed regulation contains proposed amendments to the qualified default investment alternative regulation to provide more specificity as to the information that must be disclosed in the required notice to participants and beneficiaries concerning investments in qualified default investment alternatives, including target date or similar investments. This document also contains a proposed amendment to the participant-level disclosure regulation that would require the disclosure of the same information concerning target date or similar investments to all participants and beneficiaries in participant-directed individual account plans.

Written comments on the proposed regulation should be received by the Department of Labor no later than 45 days after publication of the regulation in the Federal Register. The proposed regulation is scheduled to be published on November 29, 2010.

CFO picks up on the theme of corporate pensions investing in alternative asset vehicles. Here is an excerpt:

Alternative investments are especially attractive to pension plans as the traditional categories of equity and fixed income present investing dilemmas. On one hand, plan sponsors are trying to get away from the volatility associated with equities, in order to remain in compliance with the funding requirements set forth in the Pension Protection Act of 2006 (PPA). Equity investments have declined from 46% to 42% of pension portfolios, according to J.P. Morgan, down from about 60% several years ago.

On the other hand, fixed income doesn’t offer enough return to help companies make up for the investment losses of the past few years, particularly with bond rates dropping. “In my conversations with clients, they usually say they cannot afford to reduce equity allocations any further — they need the return to reduce their deficits,” says Franceries. Hedge funds, in particular, can help companies achieve equity-like returns but with dampened volatility.

Other experts, however, point out that the categorizations of various assets can be fuzzy. A survey of the U.S.’s 100 largest pension plans by Milliman found they had stepped up their allocations to alternative investment categories by an average of 17% at the end of last year, compared with 12% at the end of 2007. However, Paul Morgan, co-author of that report and director of capital markets at Evaluation Associates, a Milliman company, says he believes much of the increase was due to revised FAS 157 guidance that could have led some companies to relabel existing investments, rather than to a true increase in exposure.

The full article is available here.