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Employment Statistics, Fiduciary Duty and 401k Investor Angst

Employment Statistics, Fiduciary Duty and 401k Investor Angst
April 08
00:02 2014

There’s something about “Fiduciary Duty” that often goes misunderstood, even among professional fiduciaries. With all the talk of the SEC and its proposed Uniform Fiduciary Standard and all the articles on the DOL and its much anticipated 1432606_78655440_waves_stock_xchng_royalty_free_300new Fiduciary Rule, most folks think Fiduciary Duty – acting in the clients’ best interest – is a dry regulatory-laden act. Nothing can be further from the truth. It is vibrant. It is rigorous. It is all-encompassing.

If we go back to the original definition of fiduciary, a definition that derives from centuries of trust law and practice, we find a fiduciary tends to play the role of the enlightened parent to the beneficiary’s child. That’s because, more often than not, the trustee replaced the deceased or displaced parents of a child. The trustee managed the trust fund on behalf of the child until the child came of age. Given securities information wasn’t as widely available in the late 1800’s and early 1900’s as it is today, the trustee of that era would need to demonstrate a renaissance man’s ability to quickly make decisions from one varied topic to another. In other words, the trustee’s fiduciary duty required him to study the real world and pay attention to which data was relevant and which data wasn’t.

Today, thanks to an overabundance of attention paid to fees and, specifically, fees associated with what was typically once referred to (in a connotatively derogative manner) as “prohibited transactions” but today are considered mere “conflicts-of-interest” to be brushed away with the flippant hand of disclosure, the natural inclination is to think of monitoring fees as the sole purpose of a fiduciary. That much of the fiduciary discussion has centered on 401k plans – where the safe harbor pushes the investment liability on to the participants – has also contributed to this naïvely narrow understanding of fiduciary duty.

In fact, one’s fiduciary duty extends to all matters pertaining to the assets of the beneficiary – from the safe and timely transport of funds to the undertaking the appropriate due diligence into the viability of any potential investment. This puts a lot on the shoulders of the one with the fiduciary duty. Let’s look at a hypothetical example from the late nineteenth century. By translating some modern era fiduciary issues into that time period, we’ll begin to appreciate the full breadth of fiduciary duty.

Let’s start with the trustee. We’ll call him “Mr. Thatcher.” Next we have “Endora,” an otherwise unsophisticated boarding house owner who falls into possession of some “worthless” mining stocks that turn out not to be worthless after all. She wants the best for her young son, whom we’ll call “Charlie,” so she hires Mr. Thatcher to become his legal guardian. Now, Mr. Thatcher has a number tasks to perform under his fiduciary duty to Charlie. Not only does he have to pick out the most appropriate schools for the lad, who invariably flunks out of them, but he also needs to determine an appropriate spending budget for the little devil.

But let’s keep things simple. Let’s just look at the investment management of Charlie’s trust fund. In the time before the horseless carriage, a trustee would populate such a fund primarily with bonds. When determining the proper candidates for Charlie’s portfolio, Mr. Thatcher was prohibited from buying certain securities, specifically those in which he or his bank stood to gain from such a transaction, but otherwise he had free reign. Yes, he needed to concern himself with fees, but he was more concerned with questions like these. Will the buggy whip company offering a great rate for a 30 year bond actually survive those thirty years? Are these attractive railroad (probably Erie) bonds collateralized so when the eventual bankruptcy occurs, Charlie’s principle will remain safe? And, finally, will the overall economy support corporate earnings so companies can continue to pay interest on their bonds, or should Mr. Thatcher reduce Charlie’s risk (and Charlie’s income) and buy government bonds instead?

Forget 12b-1 fees, revenue sharing and fees in general. If you, as a fiduciary, are responsible in any way for investments – and this includes portfolio managers of those many mutual funds that populate our nation’s 401k plans – then you need to have a sound grasp of the current economic climate. Fortunately, unlike in Mr. Thatcher’s time, our world provides a cornucopia of financial data. Some of it is good. Some of it isn’t. And it’s your fiduciary duty to know the difference.

Which brings us to a forthcoming white paper titled “What Employment Data Tells Us About the Economy.” Authored by Joseph J. LoMando, a graduate student at the Hajim School of Engineering Institute of Optics at the University of Rochester, this short paper reveals a truth all fiduciaries must know. Along the way, it reveals one of the media’s most cited “headline” numbers is a sham.

“As you know,” says LoMando, “the news reports the unemployment rate monthly and annually to catalog and analyze the job market, economy, and general market environment for Americans looking for work. My original intent was to test whether this unemployment rate was related to the general ups and downs of the U.S. economy as measured by GDP.”

LoMando took readily available government data, and ran several regression and correlation analyses. He told, “I decided to also look at total US employment to see whether this alternate measure of the amount of people in the country working had a similar or different correlation to the national GDP. My original hypothesis was that there was most likely a correlation between Total Employment and GDP but that the correlation wouldn’t be too high, and that over time it would decrease due to the growth of the interconnected global economy. This was based on the assumption that the percentage of US workers, employed for organizations not based in the US or in the import business has increased in the last 20 years or so.”

It turned out that, not only was his original hypothesis wrong, but “within minutes” he exposed the bogus assumption implied by most, if not all, financial and political media outlets. “What I discovered,” says LoMando, “was that looking at annual figures (and the GDP in 1990 US Dollars), there was an extremely high correlation between total employment and GDP (0.98). The correlation between GDP and the unemployment rate was much lower (0.31). This would seem to dispel the notion that the percentage of US workers not contributing to GDP was significant and/or growing.”

More important, and relevant to every fiduciary whose duty it is to monitor the economy, LoMando says, “The results also shed light on the general unreliability of the unemployment rate to signify the state of the economy (especially compared to the total employment data).”

Why is this important for a 401k plan sponsor or fiduciary service provider to know? It’s critical because one of the most important things that they need to manage is 401k investor angst. We all know the only 401k investors who lost following the 2008/2009 market collapse were those who panicked and sold.

Many investment professionals, while not complaining about last year’s high market gains, have expressed concerns about the market outpacing the fundamental data. LoMando’s white paper suggests this disconnect may exist. Since 1950, there have been eight times when the GDP has dropped for the year. In all but two of those times, GDP had increased by more than 10% by the fourth year following the negative GDP number. Those two times are the two most recent negative GDP years, 2008 and 2009.

Even the other back-to-back consecutive year drops in 1974 and 1975 saw GDP rebounds of 16% and 20% respectively. The 2008/2009 GDP rebound has been a meager 4% and 9% respectively.

Now, knowing what we now know about the high degree of correlation between total employment and GDP, the numbers look even worse. In three of the eight four-year periods following a negative annual GDP, total employment rebounded by roughly 10% or more (1974, 1975 and 1982). Two of the other periods saw rebounds of about 6% (1958 and 1991). Prior to the 2008/2009 declines the worst 4-year rebound was 3.6% (in 1954), but bear in mind that 4-year period ended with the 1958 decline in GDP. The 2008/2009 statistics are just plain bad. In the four years following the 2009 negative GDP year, the total employment is up less than 3%. But the 4-year period following the 2008 negative GDP year was an all-time worst net loss of 2%. That’s the only 4-year period with no recovery.

Here’s where the investor angst comes in. Despite having one of the worst employment recoveries and the most anemic GDP recoveries, even worse than 1954’s gain (again, this is the period that ended with another decline in GDP), since the 2009 negative GDP, the 4-year recovery in the market has been the second highest. Only the market recovery during the Reagan Revolution following the 1982 negative GDP was greater. Ironically, the third highest market recovery was in the four years following the 1954 negative GDP year.

We’ll leave to others to explain the reasons for this disconnect between the market and the fundamental economic data. There are two significant takeaways from this white paper. First, the unemployment rate number means nothing. Total employment is the number that media should report. It is also the number fiduciaries should be paying attention to. Second, and this becomes more relevant each day the market falls, it’s important to prepare 401k investors for, what some believe, will be the inevitable correction. Markets go up and down, albeit irregularly, but they never continue in one direction forever. Hopefully, 401k plan sponsors have a tiered option menu that focuses employees on savings rather than worrying about investing. Even with this useful tool, the temptation to jump ship in the face of a falling market is something experience shows us will happen.

Now, more than ever, it’s incumbent upon 401k plan sponsors and service providers to lead 401k investors through what might become unsteady waters.

It is your fiduciary duty.

Mr. Carosa is available for keynote speaking engagements and will be available for groups in St. Louis on Thursday and Friday April 24th and 25th, as well as for groups in Los Angeles from Tuesday April 29th through Sunday May 4th. You may contact him through this site.

About Author

Christopher Carosa, CTFA

Christopher Carosa, CTFA


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