New 401(k) Limit is $17,000 in 2012

The IRS announced several inflation adjustments for retirement plans in 2012. Here are some highlights:

• The elective deferral (contribution) limit for employees who participate in 401(k), 403(b), most 457 plans, and the federal government’s Thrift Savings Plan is increased from $16,500 to $17,000.
• The catch-up contribution limit for those aged 50 and over remains unchanged at $5,500.
• The AGI phase-out range for taxpayers making contributions to a Roth IRA is $173,000 to $183,000 for married couples filing jointly, up from $169,000 to $179,000 in 2011.  For singles and heads of household, the income phase-out range is $110,000 to $125,000, up from $107,000 to $122,000. 

The IRS also announced several other items to be adjusted for inflation in 2012.

MUTUAL FUNDS WITHOUT MORALS

The Financial Times article, “Fund mergers obscure performance” highlights a real problem in the investment industry. Many mutual fund companies close poor performing funds or merge them into better performing funds.  This may not sound like a huge problem, but it enables fund companies to appear more successful than they really are. 

A quick search shows that one large fund family has 204 mutual funds.  Even if only 5% of these funds outperform their relevant benchmark index, they would still have over 10 funds they could tout in investment magazines.  The strategy of having many, many, many funds, allows large fund families to always have plenty of funds with good track records.  When you open Money magazine, or SmartMoney, or Kiplinger’s you will see dozens of ads for mutual funds with fantastic track records.  The problem is the outperforming funds were probably only lucky and quite likely won’t be as lucky in the future.

As I pointed out in previous posts, the majority of mutual funds underperform index funds.  A quick search on Morningstar’s mutual fund database shows only 25% of large cap blend mutual funds that have a 10-year return higher than their benchmark index and only 13% of mid cap blend funds beat their benchmarks.  However, your odds for picking one of those outperforming funds 10 years ago was much smaller than 25% for large cap funds and much smaller than 13% for mid cap funds.  Why?

Many, many funds that were around 10 years ago have disappeared by now.  Hundreds of funds are closed each year and hundreds more are opened.  This is how the mutual fund industry dupes folks into believing they can beat passive index funds.  Just think about it, if you personally could run 10 different stock portfolios, you could probably produce 4 or 5 that would beat passive index funds even if you just randomly picked your stocks.  After a few years, you would just close the funds with poor performance and open new funds with no track record.  Again, after a few years close the funds with poor performance and start new funds.  Do this over and over until you have a dozen funds with great track records.  This is exactly what many fund families do!

So, instead of having a 25% chance of picking a Large Cap fund that will outperform an index fund, your odds are probably more like 10% or even less.  In the Mid Cap space your odds are likely less than 5% of picking a fund that will outperform a good low cost Mid Cap index fund.  And, if you own any of these funds in a taxable account, your odds of outperforming simple index funds on an after-tax basis is very close to ZERO due to the increased capital gains active funds pass on to their investors who have to pay taxes on those gains.  


Rick Ferri has written a great article on this topic titled: Fund Investors Should Lead "Occupy Boston". Every mutual fund investor should read it.

ACTUALLY, IT GETS WORSE

But wait, it actually is worse than that!  First, I need to give you a little primer on equity mutual fund “style boxes.”

Mutual fund databases like Morningstar and Lipper segregate domestic stock mutual funds into 9 categories based on the type of stocks the funds focus on.  Funds are segregated by the size of the firms whose stocks they buy: Large Capitalization companies (referred to as Large Caps), Mid Caps, and Small Caps.  Then, each of these three tiers are further segregated into funds that focus on high growth companies (Growth Funds) or on stocks that are “cheap” referred to as Value Funds.  The third category is for funds that buy both “Growth” stocks and “Value” stocks.  This category is usually called “Core” or “Blend.”  So, we end up with 9 investment “style” boxes.

       

     

Value fund managers want to be measured against Value indexes and Growth fund managers want to be measured against Growth indexes.  We’ve seen 25-year periods where Value and Growth was a dead heat tie.  (This is why I don’t recommend messing with Value or Growth and just buy Core or Blend funds, preferably index funds).  But, sometimes Value stocks perform better than Growth stocks over shorter periods of time like 5 years. Sometimes Growth beats Value.  One really never knows when or why one will outperform the other.  But, it is important for investors to know which index should be used to measure their funds performance.

THE ANATOMY OF WHAT SHOULD BE A MUTUAL FUND CRIME

The 5 years leading up to 2006 was a period where Large Value stocks had dramatically outperformed Large Growth stocks.  One particular fund family had two Large Cap funds – one was a Large Cap Value Fund (ticker: BBTGX) and the other a Large Cap Growth Fund (ticker: BLGAX) as follows:

                                                            Value               Core                Growth

5-year Large Cap Index Returns        5.3%               0.5%                -3.6%

BB&T Large Cap Funds                     4.0                                          -4.9

Underperformance                -1.3%                                       -1.3%

Both the Large Cap Value Fund and the Large Cap Growth Fund had performed poorly during the 5-year period. Each fund had failed to beat their passive index by approximately -1.3% per year for 5 years.

If a fund family had no morals, they might think to merge the two funds, bury the track record of the worst of the two bad funds, keep the “least bad” track record, and move the “new” fund to a category where the poor track record “appears” to be better.  So, BB&T did just that!

On March 14, 2006 they announced a change in the name of the Large Cap Value Fund

Despite the change in the name and the focus, the fund actually kept its performance track record!  Really, I’m not kidding!  The 4.0% 5-year return looked bad in the Large Cap Value category where the benchmark index was 5.3%, but suddenly looked great in the Large Cap Core category where the benchmark index return was just 0.5%!

But they didn’t stop there.  Once BB&T had successfully “moved” the Large Cap Value performance track record into the Large Cap Core category, on January 29, 2007 BB&T merged the lousy Large Cap Growth Fund into the new fund named Large Cap Fund. 

This is how the owners of the Large Cap Growth Fund came to own a Large Cap Core Fund with a Large Cap Value track record!  Seriously, I’m not making this up!  This should be illegal, but if it is, they got away with it. 

Just to obscure the issue as much as possible, in 2010 BB&T renamed “The BB&T Large Cap Fund” to “The Select Equity Fund.”  Lastly, just in case someone was still able to connect the dots, recently they changed the name yet again to the “Sterling Capital Select Equity Fund” but kept the original ticker symbol of BBTGX. 

However, with all this changing of the name, and the focus of the fund, and jumping of style boxes, what was not changed is the poor performance.  Five years later, the Sterling Capital Select Equity Fund now ranks in the bottom 5% of all Large Cap Blend Funds in the Morningstar mutual fund database.  With a 5-year annualized return (loss) of -6.4%, the Sterling Capital Select Equity Fund once again trails its benchmark – underperforming the S&P 500 Index by a whopping -5.2%.

In my opinion it should be illegal for a mutual fund to officially change its investment strategy and performance benchmark and keep its old performance track record.  I believe, in a situation like this, the old fund with the old strategy should be deemed to have been closed and a new fund with NO PERFORMANCE track record has been created.  


In short, STYLE BOX JUMPING SHOULD BE OUTLAWED.  Mutual funds without morals need to be eradicated from the investment industry.  The investment managers and the mutual fund boards of directors that allow this to happen should be banned from the industry.

The lesson here: Actively managed mutual fund performance is even worse than you think. So, just buy low cost index funds.

Getting Out of a Bad Annuity: 1035 Exchange

The Oblivious Investor blog has a good post about how to get out of a bad annuity.  If you own any annuity, it is worth a look.

Not all annuities are bad - just 95% or more.  For this reason, I typically tell folks to completely avoid all annuities. The odds are the annuity your salesman is pushing is one of the bad ones.  He/she would not be pushing it if it didn't provide big fees for him/her.  While it might not make tax sense to sell out of an annuity, it might make sense to "exchange" a bad annuity for a less bad annuity.  I would hazard a guess that if you have an annuity, and it is NOT a Vanguard annuity, you should look into exchanging into a low cost Vanguard annuity.

Most annuities will charge a "surrender fee" when you leave, but this fee gets smaller over time and quite often goes to zero after 7 years. You've got to do the exchange right to avoid a tax headache - so read the blog at the link above, and call Vanguard at 1-800-357-4720 if you are not comfortable doing this yourself online.

As I always say, I don't work for Vanguard, but they are the lowest cost investment manager in the world and most of my money is invested in their mutual funds and ETFs. That is why I always recommend them to family and friends and use their funds and their ETFs in my investment recipes in my books.

Capitalism Without Capital: Why Executive Stock Options Should Be Outlawed

Lehman Brothers and Bear Sterns survived World War I, World War II, and The Great Depression. Why then did the mortgage crisis of 2008 cause these firms to fail? What was different with this economic crisis?  The answer: employee stock options.

In the past 20-30 years, income disparity from the CEO and other executives down to the rank and file employees has dramatically diverged with C-level executives (CEO, CFO, COO) now making 300-400 times the average worker up from 30-40 times just 20-30 years ago.  What changed?  The answer: the invention of employee stock options.

Actually, I am talking about “executive” stock options. Rank and file employees rarely receive stock options as compensation, and when they do, it is a trifling amount.  Typically stock options are awarded from the very top CEO level down to mid-level managers.  But, the allocation of stock options is greatly skewed with the largest grants made to the highest level executives.

In the past, investment banks were partnerships.  Every decision within these firms was a really big deal since the vast majority of every partner’s net worth was at risk.  Becoming a partner was a huge decision and NOT a no-brainer.  Becoming a partner meant the individual would share in the profits of the firm – generally a lucrative option.  However, becoming a partner quite often required the employee to buy into the partnership.  Thus, the employee actually had to save their own money and then put it all into the firm.  While the new partner shared in the profits of the firm, those profits largely stayed in the firm until retirement.  Most of these partners became quite wealthy on paper, but the vast majority of their wealth was tied up in the working capital of the firm until they retired.  Having everyone’s wealth at risk made these folks fairly balanced in their decision making.  Sure, they knew if they bet big they could win big.  But, since their personal wealth was at stake, they also were somewhat cautious.  In addition, every partner was VERY interested in what was going on in EVERY division of the firm.  Just because a partner worked in the equity division, he was not immune to a blunder in the fixed income division of the firm.  Thus, everyone monitored everyone, and that form of checks and balances worked pretty well for more than 100 years through thick and thin.

Then, over the last 20 years or so, investment banks “went public” by issuing stock to the public.  Suddenly, anyone could own a piece of Wall Street and share in their profits.  However, more importantly, investment bankers could now gamble with other people’s money instead of just their own. 

This switch from partnership to a stock form of company structure resulted in two significant changes in compensation.  Investment bankers have always had a large portion of their compensation tied to profits of the firm.  Wall Street bonuses have always made up the majority of employee compensation.  However, in the partnership form, a large portion of this bonus would stay within the capital account of the firm.  With the new stock form, cash bonuses were taken home free and clear by the employee. 

In addition to the new portability in bonus payments, executives were given stock options in what has been falsely sold as an effort to “align employees’ incentives with stockholder interests.”  But, this is not a perfect alignment.  For example, imagine you own one share of stock in XYZ Corporation that is currently worth $60.  Also imagine a company executive has been given one stock option.  Typically, an executive stock option has a life of 10 years and gives the executive the “option” to buy the stock at some point in the next 10 years at the current price of $60.  Thus, the executive wants the stock to increase in value.  If, in 7 years the stock trades at $100, the employee has the ability to convert the stock option into stock.  The executive pays just $60 and receives a share of stock now worth $100.  However, the executive rarely keeps the stock.  Most executives don’t have to put up any money at all.  Usually, an executive in this circumstance will exercise the option and immediately sell the stock.  So, the executive buys the stock for $60 and immediately sells the stock for $100 and pockets the $40 difference.  In fact, companies facilitate this process and the executive usually does not have to put any money up at all – they just pocket the $40 gain.

We have been sold a false bill of goods in the thought that this executive’s incentives have been perfectly aligned with actual owners of the stock.  Let me now point out another scenario that shows how wrong this thought is.  Let’s take the same example as above.  Let’s say you own a $60 stock and the executive has a stock option with a $60 exercise or strike price.  But now imagine the employee makes a very bad bet with the firm’s capital.  Perhaps the executive buys a complicated collateralized debt obligation that falls dramatically in value.  Further assume that this large loss causes the stock to fall to $20.  As a shareholder, you just lost $40.  However, the company executive has lost nothing.  The executive still collects his salary and probably a much smaller bonus, but the executive never actually owned the stock.  The stock option expires worthless.  So, the executive did not get the added kicker of cashing in his stock option, but he also did not incur any loss whatsoever.  I suggest that executive stock options do not align company executives’ incentives with shareholder’s best interest.  Sure, stock investors and stock option holders both want the stock to go up, but actual shareholders are much more concerned about the possibility of the stock going down than someone who merely has the “option” to buy the stock in the future.

In addition, stock options encourage company management to stop paying dividends. Stocks with large dividends tend to be much less volatile than stocks that pay no dividends.  This lowers the value of executive stock options.  Plus, the value of the stock goes down by the exact amount of the dividend every time.  Thus, an executive who owns a stock option has two reasons to not want the firm to ever pay a dividend.  Executive stock options encourage company managers to take undue risks as there is no downside for the employee. 

Executive stock options also encourage managers to over leverage the firms that they run. Imagine an employee conceives of a project that costs $100 and believes it will result in earning either $15 or a loss of $5. The owner of a stock option will likely make that bet while a stock holder might not be thrilled with those odds.  In addition, the executive knows that this project could increase the stock price by 15%.  This same executive knows that if he can borrow another $100 in the bond market that he can magnify the impact of this project and its impact on the stock price by a factor of two.  With no downside, the owner of an option to buy a stock would likely make this gamble.  Why not really roll the dice and borrow $1,000 or $10,000 or $10 billion?  The executive might hit it big and be able to retire early.  And, if it blows up, so what?  It’s not like he had anything personally at risk.  He’ll still get his salary and bonus, but just won’t cash in on the stock option.

The incentive to over leverage the firm is further encouraged by the U.S. tax code since interest on debt payments is tax deductible while dividend payments are not tax deductible. 

So here is a recipe to take advantage of the current state of capitalism without capital.  Start a company with other people’s money by selling stock in your firm.  Use that money to borrow 20 times the amount from the bond market.  Invite all your friends to sit on your board of directors and issue yourself a whole slew of stock options.  Then take all the money everyone has given you and go make a huge bet on something.  Repeat as necessary until you win and cash in.  (This recipe works anywhere, not just Wall Street).

Directors at US corporations have no idea what they are paying their executives.  Let me repeat that. Boards of directors at companies that issue executive stock options won’t know what they really paid their executives until the options are cashed in or expired.  That means many firms won’t know the true compensation of their executives for another 10 years!  How is an investor supposed to forecast the financial statements of a firm for the next 10 years when we don’t really know the true profitability of any firm for the last 10 years? 

Executive stock options have led capitalism down a path where capital is misallocated.  Boards of directors have no idea if they are over paying their executives, and investors have no idea if companies are profitable or not.  Thus, managers within companies are possibly misallocating company funds and investors may be allocating funds to companies whose financial statements are not known with any certainty.  With executive stock options, company executives actually have no capital at risk.  A stock option allows the executive to win or break even, but there is no risk of loss.  Isn’t the reason capitalism succeeded for as long as it has is that it properly allocates capital to those people and those projects and those firms that deserve it?  Capitalism does not work without proper allocation based on specific measurable profits. 

Executive stock options should be against the law as there is no downside for the company executive. Instead, executives should be compensated with actual shares of stock – not options on stock. And, executives awarded stock should not be allowed to sell until they leave the firm.

Capitalism without capital is just gambling, with other people's money, and destined to fail.  We need to outlaw executive stock options, now.

CEO Pay is Crazy!

The AFL-CIO has a database for CEO pay.
 
You can:

 search CEO pay by state, or
company name, or
get a list of the 100 highest paid.

Vanguard Finds Picking Active Managers is Hard – Duh?!

Vanguard fired Mellon Capital Management.  Vanguard had previously hired Mellon to manage the Vanguard Growth and Income Fund(VQNPX).  VQNPX is a large cap blend mutual fund whose stated goal is to beat the S&P 500 Index.  Mellon didn’t get the job done so Vanguard has hired two new managers to try to beat the S&P 500 Index. 

The fact that Vanguard even attempts to have actively managed funds perplexes me since the Vanguard Group was built on the theory that active managers won’t beat index funds over the long-term.  The performance of VQNPX below once again proves this:

VQNPX                      S&P 500

3-year             -0.6%                          +1.2%

5-year             -2.6%                          -1.2%

10-year           +2.2%                         +2.8%

I love Vanguard, but this makes no sense to me. Personally, I think the VQNPX investors would have been better served if Vanguard had merged the fund into the Vanguard 500 Index Fund (VFINX) – but time will tell.

Vanguard Discovers Market Timing is Hard - Duh!?

Vanguard Mutual Funds is merging its Vanguard Asset Allocation Fund (VAAPX) with its Vanguard Balanced Index Fund (VBINX).  The Asset Allocation Fund (VAAPX) utilized "tactical" asset allocation moves which is Wall Street code for "trying to time the market." The Vanguard Asset Allocation fund tried to increase its allocation to stocks when the manager thought stocks would go up, and increase its allocation to bonds when it thought stocks would do poorly.  The VAAPX fund is currently allocated 90% stocks and just 10% bonds.

  

Conversely, the Vanguard Balanced Index Fund (VBINX) simply uses a static allocation of 60% stocks and 40% bonds and periodically re-balances the portfolio to keep this static 60/40 mix.  Below are the performance results of the two funds at the end of last month.  You can easily see why Vanguard is merging the Asset Allocation Fund into the Balanced Index Fund.  Simply put, Vanguard has discovered that they are no good at getting in and out of the stock market in an attempt to "time the market." Duh!  No one can do this.  Not even Vanguard.

  

VAAPX                      VBINX

3-year             -1.6%                          +4.1%

5-year             -0.4%                          +3.9%

10-year           +2.9%                         +4.8%

I think the VAAPX investors ($8 billion) will be better served in the VBINX fund going forward. Here is the link to the Vanguard announcement.