Sunday, February 19, 2012

401(k), Pension, Social Security, Annuity and Private Equity Funding and Investing ... A KISS Approach


Americans are owners. Through our retirement plans, we own shares of American companies and worldwide firms as well. Some of us also own mutual funds and shares of individual companies directly. As Americans we all have a big stake in our nation's general prosperity.

In fact, Americans directly and indirectly own far more stock than do citizens of any other country. It's a vital part of the fabric of our private sector oriented, freedom based system of free market capitalism and property ownership.

That said, my view is that Americans should own much more stock than we do. Even more important, we should better understand why private sector ownership is an essential ingredient of American prosperity. Unfortunately, too many of our fellow citizens still fail to make the connection between private sector wealth creation and broad based American prosperity.

Our fellow Americans, individually and collectively, need to know how a successful private sector leads to a prosperous society for one and all. That private sector ownership, directly as well as indirectly, is good for both individual and all Americans.

If only it were properly understood, our free enterprise system would be by far our biggest comparative advantage as a nation. Accordingly, and since knowledge is a fundamental prerequisite of any self governing society, let's now engage the KISS method of investing to further enhance our understanding of the private sector wealth creating American way.

We'll begin with a brief discussion of the various funding methodologies available for meeting our future financial needs. We'll focus on retirement funding, but the same rules apply across the board. There are lots of ways these old age benefits can be funded, or not funded, as the case may be. Let's look closer.

To repeat, let's acknowledge that the basic funding and investing methodology for our country's private and public pension systems is not well understood. Nor is the zero funding manner by which Social Security benefits are provided. Also lacking is an understanding of how 401k, IRA and insurance annuities work. And last but not least, private equity investments (think Mitt Romney and Bain Capital) are at best a mystery to most people. For others they seem to believe that they're something "bad."

So let's now take a few KISS swings of the retirement funding and investing bat and try to make all this stuff much easier to understand. We'll begin with an explanation of the mysterious or "bad"-- who invests in private equity funds and why.


Private Equity Keeps Public Pensions Sound is written by a public sector investment manager who often invests the retirement monies under his direction in private equity funds. He offers the KISS rationale underlying private equity investing:

"Private-equity firms raise money from many pension funds, as well as from charitable foundations and college and university endowments. They pool the money and buy companies to improve their performance, add jobs, and increase their value. When the firms succeed in this, the beneficiaries we serve—including public-sector and union employees across the country—reap the rewards.

In my capacity as the head of the private-market team for the Teacher Retirement System of Texas (TRS), I've invested tens of billions of dollars in private equity for a very simple reason: The investment returns they generate are critical to TRS's ability to provide the retirement benefits we have promised to the 1.3 million teachers, bus drivers, custodians and cafeteria workers we serve. . . .

So for TRS, it's a simple proposition. Private-equity firms deliver stellar investment returns to the beneficiaries we serve—or we wouldn't invest more money in their funds. To do this, they must increase the value of the companies they own. In my experience, the result is added jobs over the long term.

The main point, though, is that the retirements of millions of teachers in Texas, cops in Florida, fire fighters in California and public employees in New York are more financially secure because of private-equity and real-estate investments. It's been a critical part of TRS's success and it should be part of the equation for others as well. The fact that many U.S. companies are prospering and creating jobs because of the capital and expertise invested by private equity just makes it all the better."

Simply put, successful private equity firms make money for their investors by investing in successful companies. And those investors use the proceeds to fund retirement benefits for their plan participants, often public sector workers.

Private equity's KISS investment objective is to realize investment returns which will enable the public sector pension funds to meet their obligations to provide promised retirement benefits to teachers, fire fighters, cops, custodians and other public employees, as well as generate successful returns for private sector individual and institutional fund investors.


But first there has to be money set aside for investment. That leaves the Social Security system out of the discussion, since there are no Social Security investment funds. Because Social Security payments are made to beneficiaries by the government directly from employer and employee current payroll deductions (and if necessary, by using government general funds, however borrowed) and not from a funded investment portfolio, there's no money to invest. Hence, there are no investments.


On the other hand, a pension plan is funded in order to meet its future obligations. This it does in large part by successfully investing its participants' contributions. To the extent the pension fund's investment returns match or exceed its assumptions, there will be sufficient money on hand to meet the promised payments to beneficiaries. To the extent investment returns fall short of the assumed rate of return, the employer or taxpayer is required to make up the shortfall.

In any event, the future payment obligations are expressed in the form of promised fixed retiree benefits. That word "fixed" represents a critical difference between a pension and 401k type plan. In the pension, the benefit is guaranteed or fixed. The fund's investment risk and reward, if any, lies with the plan sponsor.

401(k) and IRA

On the other hand, a 401k plan or similar vehicle has no such "fixed" payment obligation with respect to retiree benefits. When the employer's 401k contributions are made as promised, the employer's obligation has been satisfied. Thereafter any investment returns, high, low or even negative, are the sole responsibility of the employee. The employee takes both the risk and the reward, if any, of investing his 401k money. Thus, high returns mean higher benefits than projected or assumed, while lower than expected returns equal lower benefits than projected or assumed.

Thus, the employer doesn't share in either the risk or reward with respect to how well the employee invests his 401k money, including employer contributions. This, of course, is unlike the pension plan. Neither does the company directly benefit nor suffer when general market conditions cause the share price of companies in which the 401k invests to go up or down.

Unlike a 401k, employers have an ongoing direct interest in what happens to fund investments when pension plans are involved.The more money the pension plan earns on funds invested, the less money it will cost the employer to fund the pension plan's retirement benefits. Of course, the worse the fund's investment results, for whatever reason, the greater will be the required future employer payments.


Companies, fund managers, individual employees and U.S. citizens all have a common interest in retirement fund investments achieving solid investment results. And our various governmental bodies share that interest as well. Why's that, you may wonder?

If a company and the overall market do well in financial terms, everybody connected with that company and marketplace, directly or indirectly, will tend to benefit. If a company prospers, the government will receive higher tax revenues and be required to pay fewer unemployment and related benefits, as examples.

Of course, as the share price of a company increases, its shareholders will benefit as well. So will those pension funds that have invested on behalf of their plan participants in shares of those companies. And employees and the government will benefit, too. In other words, when one of us wins, we're all likely to win. It's not a zero sum game.

But it's the same with losing. So our private sector companies deserve our government's strong support by staying out of the way, along with the active support of employee plan participants and citizens alike.


Now let's return to why I believe we should own more stocks as individuals, members of retirement plans and taxpaying citizens.

We'll use a common KISS example to make the point. We'll assume that the company's pension plan predicts that its investments will earn an average annual rate of return of 8% over a long period of time. Using the rule of 72, that money will double every 9 years. If it actually earns 2%, it will take 36 years to double in amount.

Let's further assume that a pension plan has to pay out $16 in 36 years. At an average annual 8% investment return, it needs to contribute $1 in year one. At 8% compounded over 36 years, that initial $1 will grow to $16. Total cost=$1.

But what if the plan actually earns 2% on average each year in the next 36 years instead of its assumed 8% rate of return? In that case, it has to come up with another $14 in year 36, because its initial investment of $1 only grew to $2. Since it owes $16, its total cost is $15.

So in our example, it cost us either $1 or $15 to provide the "fixed" pension benefit due in 36 years. {For simplicity's sake, we're ignoring the time value of money. We'll try that one another time, but it's all KISS today.}

Thus, investors clearly want to achieve high returns over time on the money they invest. With patience and enough time, the rule of 72 will enable them to do just that. And that's true, of course, for all investors, and whether the funds invested are 401k money, pension money, insurance annuity money or just plain old MOM.

The salient point regarding pension investing is that fixed pension beneficiaries aren't investors, unlike 401k participants. And as a rule, annuity purchasers aren't investors either. With pensions the investment risk and reward belong to the party obligated to fulfill the promise, aka the employer, government, taxpayer or insurance company. All that said, even if not investors directly, we're all very interested parties and "invested" in the bigger sense. Here's why.

Looking at the broader picture, without a stable economy in which to invest, lots of bad things can and will happen. With a stable economy, however, lots of good things can and will happen.

Even if we're not directly on the hook as the promisor, for us to pretend that a poorly performing economy over an extended period of time won't affect our promised "fixed" pension or social security benefit is just plain nonsense. And for us to ignore that a strong and vibrant economy will likely result in investment returns equal to or greater than 8% is just plain nonsense as well.

Over time the health of the economy is the biggest single contributing factor to a successful company's economic health and that of its employees, investors and fellow citizens alike. Hence, its government heavily depends on the private sector for its economic health, too.

Somebody needs to tell the politicians what "we're all in this together" really means.


Here's how pension plans get to an assumed 8% average annual rate of return over a long period of time. They very well may assume a blend of a 10% return for stocks and 5% for bonds, and plan to invest in a 60%/40% mix of stocks to bonds. {The calculation: 60% at 10%=6% and 40% at 5%=2%. 6%+2%=8%.}

Accordingly, an individual choosing to invest in stocks exclusively over a long period of time should earn a 10% rate of return. That gets my vote.


So why don't we all understand the simple fact that wealth created by free market capitalism pays all the bills? And that America is unique among nations in having an ownership society where individual citizens are allowed and encouraged to invest in 401k plans and reap the rewards that come with that? And that their pension fund monies are best invested in stocks as well?

Maybe because not enough of us understand this funding and investing stuff well enough yet. And because that which we don't comprehend often makes us fearful. Since fear is a very bad thing in investing, it's hard to stay the course when things are tough out there, especially when we're hearing that owning stocks is too risky.

Regarding fulfilling our retirement promises, either to ourselves in a 401k or to others, including pensioners, Social Security recipients and annuitants, we individually and collectively could be writing much smaller checks when the bills come due down the road.

And just how would we be able to do that? Simply by properly funding and investing an appropriate amount of money over the long term in stable and profitable private sector companies.

Oh, and we'll need one more thing. A supportive out-of-the-way government sector so the private sector can get the job done.

Thanks. Bob.

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