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7 Deadly Sins Every ERISA Fiduciary Must Avoid: The 3rd Deadly Sin – “Bond Insecurity”

October 06
00:05 2010

(The following is one of a special five part series meant to be shared by professionals and non-professionals alike. This particular series covers only one of the 7 Deadly Sins Every ERISA Fiduciary Must Avoid.)

1147161_70362873_sloth_stock_xchng_royalty_free_300Sloth (in the ecclesiastical world) – All work and no play makes Jack a dull boy. Even God didn’t work all week. So, while rest is commendable, laziness – the fanatic indulgence of rest at the expense of productive behavior – rises to the level of a Cardinal Sin.

Sloth (in the investment world) – bonds (The easy way out of making a tough decision by succumbing to what has been considered “the safest path.”)

Who else can plan sponsors turn to for investment advice beside the financial services sector and the finance professors? The investment industry and academic theory have long held that bonds reduce the volatility of a portfolio. Evidence dating from the 1970’s now suggests the “safe” bond market has been just as volatile as the stock market. At the same time, the long term returns on equities have continued to outpace those of bonds. Dubbed the “Equity Premium Puzzle” in 1985, some traditionalists, using data from the depths of the current stock market cycle, deny its existence. Yet others, particularly behavioral economists, have studied this particular anomaly with deep interest. While there remains no consensus regarding the theoretical approach to the Equity Premium Puzzle (nor whether it really even exists), the practical use of bonds within investment portfolios has changed since the days of Ben Graham, when he looked at these as safe “risk-free” investments. Indeed, the behavior of bonds themselves have changed since the advent of Modern Portfolio Theory, perhaps calling into question some of the assumptions long held regarding this “unique” asset class. To avoid this sin, an ERISA plan fiduciary must correctly understand the current characteristics of the wide varieties of securities calling themselves “bonds” and insure those characteristics properly align with the investment objective. It might help if the fiduciary first review the practical dissimilarity between equities and fixed income.

Need help explaining the theoretical difference between a stock and a bond? This little parable should work.

The Short Happy Story of the Employee, the Entrepreneur and Each of Their Ideas on How to Seek Financial Comfort.

Farm families live and die upon the vagaries of weather, insects and blight. A young America found itself populated with subsistence farmers – farmers who grow just enough to feed their own families and livestock. Imagine living like that today. Your family’s health and livelihood would depend solely on the annual harvest from your vegetable garden. Pretty scary, huh?

Now place yourself at the dawn of the industrial age more than one hundred years ago. After years of random acts of meteorology, uncontrollable pests and crop destroying diseases, you’ve had enough. You’ve heard of this new economy. It’s an economy that guarantees a living wage in return for your muscle. It’s a lot different from the agricultural economy. In that economy, there are no guarantees, other than breaking your back every year. Sure, every five years you might have a bumper crop, but usually so will everyone else, so it’s not like you can sell it or anything. The bottom-line: you still have to pay the rent and feed your family even when a bunch of mindless grasshoppers gorge themselves on your fields.

This new economy, on the other hand, seems to offer certain advantages. You go to work everyday – except now you get Sunday off. You don’t have to worry about ordering supplies or selling the product, you just push or dig or assemble or whatever the boss tells you. Finally, come Friday, you get a wage you can count on. You know in advance how much you’ll earn, so you know you can feed your family, afford your rent and, just maybe, buy that nice hat for your wife’s Sunday dress. Sounds like a no-brainer.

Though this example reaches back more than a century, we make the same sort of decisions today. Think about it. As an employee, we find ourselves each facing a certain reality. We have living expenses, so we must earn a minimum amount of money each year to pay for such boorish luxuries as food, clothing and shelter. Let’s say our employer, an internet start-up headed by a 21 year-old college drop-out, comes to us with an incredible offer. It seems investment bankers wish to take this company public. Investor demand is sky rocketing, despite the company having no revenues to hang its hat on. Your young boss gives you the following choice: you can either keep your current salary or forgo it for a share of the company’s profits.

Your first thought: “Holy American Dream, Batman!” While the traditional annual salary does just cover your current annual expenses, it offers limited earnings growth in future years. A share of the firm’s profits, on the other hand, has the potential for unlimited growth in earnings for who knows how many years. Oh sure, the profit sharing arrangement does have the downside of not covering your expenses every year, especially in the short-term. How do you decide which offer to take?

Ultimately, you must assess your needs and priorities. What’s more important: Putting bread on your family’s table today or having a big bank account tomorrow? In the end, you must first address meeting the basic needs of existence. For that reason, most people choose to live on a fixed salary for the silly reason that they do not want to see their kids starve.

An entrepreneur confronts a similar reality. He has a business idea that can make loads of money after some lean years of start-up. To act on this idea, he needs resources (i.e., man-power and materials) and he understands he will have to give something up to pay for these resources. He has two choices on how to raise the capital necessary to acquire the resources: He can borrow money or seek out investment partners.

Borrowing money has a negative impact on the cash flow of the business. The entrepreneur must pay back interest and principal on a regular basis. On the plus side, the entrepreneur gets to keep all the profits and doesn’t have to share control with anyone. Though taking on debt increases the chance of bankruptcy, it will allow the employer to recoup a greater share of profits in the long-term. Moreover, the entrepreneur can shift the liability of bankruptcy away from his personal finances by isolating it within a corporation. Despite this shift, his personal finances can still benefit from taking in a greater share of profits.

In seeking out investment partners, the entrepreneur can reduce or even eliminate any negative impact on the annual cash flow of the business. The entrepreneur, however, must now share the profits and control with the other partners. Finding venture capital partners might help stave off bankruptcy in the early years, but at the expense of a reduced share of profits. Given these options, how does the entrepreneur make his decision?

Again, it comes down to a question of needs, costs and personal preferences. What’s more important: Avoiding bankruptcy and sharing control or increasing long-term profits and retaining control? The analysis must consider how much value any specific deal offers versus how much it will cost in terms of dollars, control and equity.

It’s the same sort of decision one makes when deciding whether to buy a risk-free bond or buy a stock. By definition, a risk-free bond (a subset of the entire bond species) offers safety in principal and some modest return. The value of stocks, on the other hand, can fluctuate wildly, proving riskier in the short-term but, on average better in the long term. Which investment you choose depends on a variety of personal factors. There is no secret formula. But, you might ask, what exactly is a “risk-free” bond?

Part I: How the Fiduciary can Explain the Practical Differences Between Stocks and Bonds
Part II: Defining the Perfect Bond: What Every Plan Sponsor Must Know About Bonds – Before They Crash!
Part III: 401k Plan Sponsors Beware: Are You Lighting a Match in the Powder Room Despite 1995 Study?
Part IV: Will Plan Sponsors Believe Their Lying Eyes or Will They Still Believe Bonds are “Safe”?
Part V: How the ERISA Fiduciary Can Avoid the 3rd Deadly Sin – Bond Insecurity

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Christopher Carosa, CTFA

Christopher Carosa, CTFA

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