Value is Elusive

In The Value Project (see the links below), I set out to try to ascertain where and how value in the markets may be found. I argued that establishing a well-diversified asset allocation plan consistent with one’s goals, investment horizon, and risk tolerance should be the first priority. The key advantages of broad and deep diversification are the capture of a healthy share of available returns, smoother portfolio performance and lower volatility.  Especially in a secular bear market like the one we have been suffering through since 2000, those are worthy goals.

Once an asset allocation decision is made, one can move on to investment choices to “populate” the plan.  On account of the relative success of passive management strategies and the relative failure of active ones, I noted that any recommendation containing active management must be carefully considered and supported, especially when the advisor is a fiduciary. I generally suggest using active investment vehicles within portfolios for momentum strategies, focused (concentrated) investments, in the value and small cap sectors (domestic and international), for low volatility/low beta stocks,  and for certain alternative investments.  Passive strategies can be used to fill out the portfolio to provide broad and deep diversification.

I carefully emphasized, however, that success in this arena is extremely hard to achieve and success achieved through good asset allocation can be given back quickly via poor active management.  Moreover, one cannot count on the suggested active strategies in the short-term, and perhaps not even in the long run (remember, investment success draws a crowd and dilutes future success), but they are excellent potential sources of value (apologies for the pun) today. I focus much of my portfolio attention there. 

However, finding investment skill is at least as difficult as finding value, particularly since investing is a probabilistic exercise and, as a consequence, very skilled investors can underperform for significant periods of time.  The key then is to choose money managers with more than just a good track record of results.  We must choose money managers with an excellent investment process too.

Finally, costs, taxes and fund size matter — a lot.  Accordingly, all else being equal, I will generally favor smaller money managers and those who charge lower fees.  I will also favor strategies with a higher likelihood of tax efficiency (in taxable accounts), for the same general reasons.

That this framework makes sense has been highlighted in the news recently.  The 2012 Quantitative Analysis of Investor Behavior from DALBAR has recently been released and, as always, it reflects comprehensive investor irrationality.  In general, investors do not remain invested for sufficiently long periods to derive real benefit from the investment markets and investors make such investment moves at particularly inopportune times. Not surprisingly, investors are particularly bad at market timing — they buy when the market is high and sell when it is low. 

For 2011, the QAIB showed that equity investors lost 5.73 percent as compared to the S&P 500’s gain (with dividends) of 2.12 percent.  Over 20 years, the average equity investor earned 3.49 percent per year compared to the S&P’s 7.81 percent — an annual underperformance of a whopping 4.32 percent. It seems clear that investors are not finding value and need help.  What is less clear is how they can get it. Professional managers (more here) and even hedge funds do not have great track records either.

As The Capital Speculator pointed out yesterday (consistent with my findings in The Value Project), the evidence in favor of passive management (most typically indexing) is surprisingly compelling. TCS correctly concludes that chasing alpha demands a lot of extra time and effort for an uncertain payoff. It’s easy to claim that “market returns” are inadequate (for example, The Reformed Broker does so here), but astonishingly few (including even the always entertaining and frequently insightful Josh) provide reason to think that they can do any better.  Again — investors need help but it remains uncertain if and how they can get it.

I offer some suggestions about finding such elusive value in the links below.  Happy hunting.

Will You Live to 100?

If you want to see how long — on average — you can expect to live you need only to consult standard actuarial tables.  But if you undertake your retirement planning based upon an average lifespan, you have a 50 percent chance of outliving your planning. Moreover, we all generally underestimate how long we will live by a lot (more here). Indeed, this year’s Risks and Process of Retirement Survey from the Society of Actuaries again shows that many people have a much shorter planning horizon than their future expected lifespan.

According to the Society of Actuaries, 30 percent of all American women and almost 20 percent of American men age 65 can expect to reach 90 years old. In Britain, the Department for Work and Pensions has released a report detailing life expectancy and comparing the generations at 20, 50 and 80 years old. The data sees 20-year-olds as being three times more likely to reach 100 than their grandparents, and twice as likely as their parents. Even so, a girl born in 2011 has a one-in-three chance of living to her 100th birthday while a boy has “only” a one-in-four chance.  Compared to a baby born in 1931, today’s children are almost eight times more likely to become centenarians. An easy tool to see your own likelihood of reaching 100 using this data is available here; it says that I have a 10.5 percent chance of reaching 100.  I’m not sure if that’s good news or not.

Actuaries in the United Kingdom are now pricing longevity risk in insurance contracts using age 125, and those in the U.S. are using age 120. Thus for anyone thinking s/he might not need to plan beyond age 90 or even 100, the key take-away is that “tail risk” is substantial – that is, the risk of living well beyond one’s life expectancy, into old old age.

According to Danish researchers, if the pace of increase in life expectancy in developed countries over the past two centuries continues through the 21st century, most babies born since 2000 in France, Germany, Italy, the UK, the USA, Canada, Japan, and other countries with long life expectancies will celebrate their 100th birthdays. Although trends differ between countries, populations of nearly all such countries are aging as a result of low fertility, low immigration, and long lives. A key question is: are increases in life expectancy accompanied by a concurrent postponement of functional limitations and disability? The answer is still open, but research suggests that aging processes are modifiable and that people are living longer without severe disability. This finding, together with technological and medical development and redistribution of work, will be important for our chances to meet the challenges of aging populations.

The analysis of data by these same Danes from more than 30 developed countries reveals that death rates among people older than 80 are still falling. In 1950, the likelihood of survival from age 80-90 was 15-16% for women and 12% for men, compared with 37% and 25%, respectively, in 2002. “The linear increase in record life expectancy for more than 165 years does not suggest a looming limit to human lifespan. If life expectancy were approaching a limit, some deceleration of progress would probably occur. Continued progress in the longest living populations suggests that we are not close to a limit, and further rise in life expectancy seems likely,” Kaare Christensen, of the Danish Aging Research Center at the University of Southern Denmark, and colleagues wrote.

If you want to look at your own life expectancy using more variables than just age and sex, a number of tools exist for doing so.  Examples follow.

Northwestern Mutual Life’s Lifespan Calculator
Northwestern Mutual Longevity Game
Vanguard Longevity Calculator
Wharton Life Calculator

So how many of us will actually live to age 100? Whatever the number, it’s almost surely higher than we think and, obviously, that has serious implications for retirement planning.

“Except for health coverage, insurance products such as annuities and long-term care insurance are not seen as major components of retirement planning,” said actuary and retirement expert Anna Rappaport just last week.  Rappaport serves as chair of the Society of Actuaries’ Committee on Post-Retirement Needs and Risks. “As a result, many retirees continue to be at risk of running out of assets and having to rely solely on Social Security,” she said

As Seneca pointed out over two centuries ago, “Our minds should be sent forward in advance to meet all the problems, and we should consider not what is wont to happen, but what can happen.”

How prepared are you for what can happen?

Asset Allocation and Retirement Planning

The Center for Retirement Research at Boston College has an important new paper out entitled How Important is Asset Allocation to Financial Security in Retirement?  I encourage you to read it carefully. 

The motivation for this paper is the concern that financial advice tends to focus too much on financial assets, which gives too much emphasis and prominence to asset allocation decisions. Most people have too little financial wealth and typical financial tools are silent on the levers that will have a much larger effect on retirement security for most Americans. As the article points out, these levers include delaying retirement, tapping home equity through a reverse mortgage, and controlling spending.  Accordingly, the paper concludes that given the relative unimportance of asset allocation, financial advisers would be of greater help to their clients if they focused more on a broad array of tools – including working longer, controlling spending, and taking out a reverse mortgage.

I agree with this argument, but would add an additional point along with a caveat.

The additional point is a crucial one:  everyone needs to save more.  It is the single most important thing one can do to enhance his or her retirement prospects.  The ideas that the article focuses on — working longer, controlling spending, and taking out a reverse mortgage — are good ones.  Saving more is even better.

My proposed caveat relates to the (good) idea that people would be well served by working longer.  As the article points out, retiring later is an extremely powerful lever.  Because Social Security benefits are actuarially adjusted, they are over 75 percent higher at age 70 than at age 62. As a result, they replace a much larger share of pre-retirement earnings at later ages – 28.6 percent at 62 and 51.5 percent at 70 in an example offered by the article — reducing the amount required from savings. By postponing retirement people also have additional years to save and allow their balances to grow. Finally, a later retirement age means that people have fewer years to support themselves on their accumulated retirement assets.

But the caveat is an important one. Working longer is an excellent idea, but it is not always viable.  Health can deteriorate.  Jobs can disappear.  Opportunities can vanish. Indeed, a recent Society of Actuaries survey found that half of retirees had retired from their primary occupation before age 60. And, though other studies show an increase in the percentage of people over age 65 who are employed, many who lose jobs in their 50s and early 60s experience more difficulty finding new employment than younger people. As a consequence, a commitment to work longer is a good thing, but it is no substitute for planning and saving so as to be able to retire sooner, because you may not have a choice.

Advisor Value

Among the benefits that a good financial advisor can offer is some protection from ourselves.  We all suffer from a variety of inherent weaknesses and behavioral biases that conflict with our best financial interests.  This is an underappreciated and vital role.  Unfortunately, it is often better accomplished in theory than in execution.

A recent paper entitled The Market for Financial Advice: An Audit Study, by Sendhil Mullainathan of Harvard, Markus Nöth of the University of Hamburg and Antoinette Schoar of MIT, is as distressing as it is expected. The authors sent trained auditors to meet with financial advisers and presented them with different types of portfolios. These portfolios reflected either biases that were in line with the financial interests of the advisors (e.g., returns-chasing portfolio) or which ran counter to advisor interests (e.g., a portfolio with company stock or very low-fee index funds). They concluded that advisors fail to de-bias their clients and often reinforce biases that are in the interests of the advisor. Advisors encourage returns-chasing behavior and push for actively managed funds that have higher fees, even if the client starts with a well-diversified, low-fee portfolio.

There is an implicit bias in these results of the active management bad, index funds good variety, but even so, the results should give every financial advisor pause. We like to think that advisors act in their clients’ best interests.  But, whatever their motives, they clearly do not in far too many cases. Sadly, financial incentives tend to distort advice.  Moreover, the quality of advice is necessarily constrained by the quality of advisors.  Since the barriers to entry in this industry are low and the educational requirements minimal, it should not be surprising that advisors are not be as knowledgeable in finance as necessary or even as expected. The bottom line is clear:  The advice given to the auditors by and large failed to deal with bias and, if anything, may have exaggerated existing biases.

Fee-only of fee-based advisors argue that the nature of their businesses means that they are immune to the lure of incentives. I’m less sanguine on that even though the lesser incentives in such cases ought to help generally.   

In What is the Impact of Financial Advisors on Retirement Portfolio Choices and Outcomes?, John Chalmers of the University of Oregon and Jonathan Reuter of Boston College and NBER examined choices and outcomes in the Oregon University System’s Optional Retirement Plan by looking at participants who used an advisor and those who self-directed their choices.  Overall, advisor clients earned net returns that were approximately one percentage point lower per year with much higher volatility. On a risk-adjusted basis, therefore, self-directed investors outperformed their counterparts who used advisors by more than 2 percentage points per year— a difference that is obviously both economically and statistically significant.

Thus there is good evidence to doubt the value of advisors both with respect to what we traditionally think as being at the heart of the profession – money management – as well as with respect to the behavioral aspects thereof.  Some will conclude from this sort of research that advisors are not necessary.  I, on the other hand, conclude that choosing the right advisor is more important than ever.  It’s not easy, but it can make all the difference.

Of Data and Certainty

We crave certainty. 

As reported by Harvard’s Daniel Gilbert on the Happy Days blog at, Maastricht University researchers gave (volunteer) subjects a series of 20 electric shocks. Some subjects were told that they would receive an intense shock every time while others were told that they would receive 17 mild shocks and 3 intense ones, but that they wouldn’t know on which of the 20 the intense shocks would come. The study showed that subjects who thought there was a small chance of receiving an intense shock were more afraid — they sweated more profusely, their hearts beat faster — than those who knew for sure that they’d receive an intense shock. Interestingly, that’s because people feel worse when something bad might occur than when something bad will occur — they find uncertainty more painful than the things they’re uncertain about.

Why do people seem to prefer to know the worst rather than merely to suspect it? According to Gilbert, that’s probably because when most of us get bad news we cry for a bit and then get busy making the best of things. We change our behaviors and we change our attitudes. We raise our attentiveness and lower our expectations. We find our bootstraps and pull (pretty hard if necessary). But we can’t come to terms with circumstances whose terms we don’t yet know. An uncertain future leaves us stranded in an unhappy present with nothing to do but wait. 

We all respond positively to increased certainty in our lives (including in financial outcomes) — even after a major shock and when that certainty limits our prospective gain. In these highly uncertain times, increased certainty can be a highly valuable commodity.  Unfortunately, our level of certainty – desired though it is – is not well correlated to the facts.

The day after the space shuttle Challenger exploded in 1986, Cornell psychology professor Ulric Neisser (who died last month at 83) had his students write precisely where they’d been when they heard about the disaster. Nearly three years later, he asked them to recount it again. A quarter of the accounts were strikingly different, half were somewhat different, and less than a tenth had all the details correct. Yet all were confident that their most recent accounts were completely accurate. Indeed, many couldn’t be dissuaded even after seeing their original notes.  One of them even asserted, “That’s my handwriting, but that’s not what happened.”

For neurologist Robert Burton, the Neisser study is emblematic of an essential quality of who we are. In his brilliant book, On Being Certain, Burton systematically and convincingly shows that certainty is a mental state, a feeling like anger or pride that can help guide us, but that doesn’t dependably reflect anything like objective truth. One disconcerting finding he describes is that, from a neurocognitive point of view, our feelings of certainty about things we’re right about is largely indistinguishable from our feelings of certainty about things we’re wrong about.

Such unwarranted certainty is consistent with our tendency (discussed earlier this week here and here) to build our ideologies first and then to construct narratives to support those ideologies, with facts and data only sought out to undergird our pre-conceived notions after the fact and subjectively “analyzed” only in that light.  It also suggests why we can be so uncomfortable with the necessarily inductive process of scientific inquiry.  We’d much prefer the certainty of deductive logic.  Sadly, much that claims to be “research” in the financial world is nothing of the sort – it is ideology (or sales literature) in disguise (and not very well disguised at that).  Even so, perceived certainty gives us the confidence we need to make decisions and to establish trust and credibility with others.  It’s an ironic feedback loop of sorts. 

Good science requires the careful and objective collection of data with any interpretations and conclusions drawn therefrom being tentative and provisional, and of course subject to any subsequent findings.  But that’s not what often happens, especially in the financial world.  As Columbia’s Rama Cont points out, “[w]hen I first became interested in economics, I was surprised by the deductive, rather than inductive, approach of many economists.” In the hard sciences, researchers tend to observe empirical data and then build a theory to explain their observations, while “many economic studies typically start with a theory and eventually attempt to fit the data to their model.”  As noted by Emanuel Derman:

In physics it’s fairly easy to tell the crackpots from the experts by the content of their writings, without having to know their academic pedigrees. In finance it’s not easy at all. Sometimes it looks as though anything goes.

I suspect that these leaps of ideological fancy are a natural result of our constant search for meaning in an environment where noise is everywhere and signal vanishingly difficult to detect.  We are meaning-makers at every level and in nearly every situation.  Yet, as I have noted before, information is cheap and meaning is expensive.  Therefore, we tend to short-circuit good process to get to the end result – typically and not so coincidentally the result we wanted all along.

Science progresses not via verification (which can only be inferred) but by falsification (which, if established and itself verified, provides certainty as to what is not true).  Thank you, Karl Popper. In our business, as in science generally, we need to build our investment processes from the ground up, with hypotheses offered only after a careful analysis of all relevant facts and tentatively held only to the extent the facts and data allow. Yet the markets demand action.  There is nothing tentative about them. That’s the conundrum we face.

The scientific process cannot offer meaning and can only suggest interpretation.  Near the end of her wonderful novel, Housekeeping, Pulitzer Prize winner (for the equally wonderful Gilead) Marilynne Robinson notes that ”[f]act explains nothing. On the contrary, it is fact that requires explanation.” This is a telling observation and one those who are overly enamored with the scientific process are prone to ignore or forget. Science is a fabulous tool – the best we have – but also merely a tool. It is not a be-all nor is it an end-all. Derman again:  “[d]ata alone doesn’t tell you anything, it carries no message.” Brute fact requires both meaning and context in order to approach anything like truth or understanding. But meaning is increasingly difficult to find in a world and with respect to markets that demand definitive answers (or at least definitive decisions) immediately.

I’m certain of it.

Retirement Withdrawal Rates and Portfolio Success Rates

Regular readers of this site (thank you!) will know that I cite my friend Wade Pfau’s research on retirement planning — especially his work on safe withdrawal and savings rates — approvingly and often.  His work is terrific and important.  Morningstar has now made an article of Wade’s available which had been locked behind a paywall at the Retirement Management Journal and which summarizes his research about safe withdrawal rates.  It’s an outstanding summary piece.  Here’s a taste:

“High earnings multiples, low dividend yields and low nominal interest rates indicate that conservative retirees should adjust their forecasts for future asset returns downward, which further implies lower sustainable withdrawal rates. For prospective retirees, the real lesson provided by the historical data is not past portfolio success rates, but rather to see how maximum sustainable withdrawal rates have related to the underlying sources of asset returns.”

I also recommend Wade’s blog (note my Links Plus page).

How Not to Be Data-Driven

Earlier today I wrote about the nature of scientific progress — how it isn’t always linear and incremental.  Sometimes it moves in drastic and revolutionary ways, dramatically shifting the fundamental working paradigm of the subject. I then related this idea (from Thomas Kuhn’s seminal work, The Structure of Scientific Revolutions) to economics and markets, recognizing that this is not “hard” science, making the application of the idea at least a bit problematic.

That post got me to wondering how fact-based (or as I say with respect to this blog’s aspirations, how data-driven) economists are when developing their ideas and hypotheses.  At first brush, my question seemed too cynical by half.  But a bit of research suggests that I may not be nearly cynical enough.

Nobel Prize winning economist Gary Becker of the University of Chicago is famous for seeking to apply the economic concept of utility maximization essentially everywhere, so as (or so the claim goes) to understand virtually all human behavior.  Despite the gains of behavioral economics and just plain common sense, Becker and his ilk see inherent rationality behind essentially every damaging and ridiculous human endeavor. 

In that context, Ole Rogeberg and Hans Melberg surveyed a group of economists in a particular area of study to examine the extent to which they looked to actual empirical tests of a theory’s predictions to evaluate the success of that theory. It sounds like the answer ought to be right out of The Scientific Method for Dummies, right? Of course the data controls. Unfortunately, the answer was that actual data didn’t matter all that much to the economists surveyed — internal consistency (elegance?) seems to have been much more important.

Rogeberg and Melberg looked specifically at the literature of “rational addiction,” which postulates that those who suffer life-destroying addictions (such as an addiction to heroin) are actually acting in what they perceive to be their own best interest. Intuitively, I would expect the evidence needed to support this idea would be pretty high.  But my intuition seems to be clearly in error.  Ironically, the facts simply don’t support it. 

Instead, the surveyed economists’ ignoring actual evidence to adhere to elegant theories (dare I say preconceived notions) led to what Rogeberg and Melberg concluded were “absurd and unjustified claims being made and accepted in even highly ranked journals.”  As their abstract states:  “A majority of the respondents believe the literature is a success story that demonstrates the power of economic reasoning. At the same time, they also believe the empirical evidence to be weak, and they disagree both on the type of evidence that would validate the theory and the policy implications.”

Significantly, this isn’t a matter of people interpreting the evidence differently.  Indeed, in many cases evidence isn’t even gathered:

“The core of the causal insight claims from rational addiction research is that people behave in a certain way (i.e. exhibit addictive behavior) because they face and solve a specific type of choice problem. Yet rational addiction researchers show no interest in empirically examining the actual choice problem – the preferences, beliefs, and choice processes – of the people whose behavior they claim to be explaining.”

In fact, supporting evidence was deemed unnecessary (in that it likely doesn’t exist):  “Becker has even suggested that the rational choice process occurs at some subconscious level that the acting subject is unaware of, making human introspection irrelevant and leaving us no known way to gather relevant data….”  In other words, “a choice problem people neither face nor would be able to solve prescribes an optimal consumption plan no one is aware of having.  The gradual implementation of this unknown plan is then claimed to be the actual explanation for why people over time smoke more than they should according to the plans they actually thought they had.” 

Unless I’m making some glaring error or omission here, I can only conclude that the entire “rational addiction” enterprise is simply nuts.  It should be a good reminder for us always to check and re-check both our assumptions and our data, perhaps especially when it comes from economists.  Theories can be helpful, surely.  But unless and until they are actually supported by evidence, they must remain irrelevancies — elegant irrelevancies perhaps, but irrelevancies nonetheless.

Otherwise Occupied

A new study conducted by Stanford University used census data to examine family income at the neighborhood level in the 117 biggest metropolitan areas in the U.S.  The study — part of US2010, a research project financed by Russell Sage and Brown University — found that the portion of American families living in middle-income neighborhoods has declined significantly since 1970, as rising income inequality left a growing share of families in neighborhoods that are mostly low-income or mostly affluent. Today, there are thus larger patches of affluence and poverty and an ever-shrinking middle.

According to the most recent data, 44 percent of families live in neighborhoods the study defined as middle-income, down from 65 percent of families in 1970. At the same time, a third of American families live in areas of either affluence or poverty, up from just 15 percent of families in each of those categories in 1970. The study also found that upper income people are congregating in new exurbs and in gentrifying city areas that lower and middle-income families cannot afford.  The study identified these patterns in about 90 percent of large and medium-size metropolitan areas. 

Harvard economist Lawrence Katz says that the evidence for the presumed adverse effects of economic segregation is inconclusive. In a recent study of low-income families randomly assigned the opportunity to move out of concentrated poverty into mixed-income neighborhoods, Katz and his collaborators found large improvements in physical and mental health, but little change in the families’ economic and educational fortunes. However, an author of the Stanford study notes a growing gap in standardized test scores between rich and poor children, now 40 percent bigger than it was in 1970 and double the testing gap between black and white children.

The gap between rich and poor in college completion — one of the single most important predictors of economic success — has grown by more than 50 percent since the 1990s, says Martha J. Bailey, an economist at the University of Michigan. More than half of children from high-income families finish college, up from about a third 20 years ago while fewer than 10 percent of low-income children finish, although that is up from 5 percent. 

Harvard sociologist William Julius Wilson argues that “rising inequality is beginning to produce a two-tiered society in America in which the more affluent citizens live lives fundamentally different from the middle and lower-income groups. This divide decreases a sense of community.”

This data has obvious implications for the Occupy Wall Street and related protests.

Truly organic protests (as opposed to those that are carefully orchestrated) are, by their nature, typically messy, noisy and confused.  The fact that the Occupy Wall Street protestors still have no clear solutions to offer nor even a coherent vision of what exactly is wrong does not, in my view, damage their credibility nor mitigate the emotional clarity with which they have conveyed (and will likely continue to convey) that something really is wrong.  The general sense that we have serious problems and that things don’t seem fair or right has a striking ring of truth. 

Unfortunately, it is unlikely that we as a society will reach anything like consensus on issues like employment, taxation and equality.  That said, all of us — whatever our views of politics, business and economics — ought to agree on the centrality of opportunity.  The assumption that anyone can get ahead based on capability and effort is central to the idea of the American Dream.  Equality of opportunity is crucial to the success of our society.

As stated by Nobel laureate Joseph Stiglitz, “growing inequality is the flip side of something else: shrinking opportunity. Whenever we diminish equality of opportunity, it means that we are not using some of our most valuable assets—our people—in the most productive way possible.”

One crucial way — perhaps the most important one — to spur upward mobility (and protect against downward mobility) is education.  In today’s economy, a child’s educational attainment strongly influences his or her future earnings and is a strong determinant of economic mobility.Women with a high school diploma or less who are raised in middle-class homes are between 14 and 16 percentage points more likely to be downwardly mobile than women who get a college degree.  Men with no more than a high school diploma are 7 to 15 percentage points more likely to be downwardly mobile than men with just some postsecondary education but no bachelor’s degree.  College graduates have a much lower risk of experiencing a serious long-term income drop and are much more likely than others to recover therefrom.

As the father of a three California public school graduates, one of whom also graduated from the University of California (Berkeley) and another of whom is a Teach For America alum who worked in the Richmond, California school district, as well as the husband of a California public school teacher, I think I am pretty well positioned to offer some thoughts on ways we can improve the current system, at least in the Golden State.  Indeed, let me suggest that all of the focus on ideology related to the protests misses some important points. Are we allocating the public resources we have wisely? Are we looking for creative solutions to difficult problems? Are we rewarding the behavior we want to see? I suspect not, pretty much across the board.

We must begin by getting more kids — and especially disadvantaged kids — to aspire to college.  Obviously, that should start with parents and teachers.  My wife is reinforcing the benefits (as well as the demands and the requirements) of the “next levels” — middle school, high school and college — with her 5th grade students every single day.  We talked with our kids about college constantly.  Here in California, the Pathways to College Network is an alliance of national organizations that provides leadership to advance college opportunity for underserved students and research into how best to accomplish that task. Reality Changers, a non-profit here in San Diego designed to build first generation college students, and groups like it are imperative in a process that can be alienating for students and parents who don’t understand and are afraid of it.

Once students aspire to college, that aspiration has be particularized so that the students prepare and then apply to college and apply wisely. A prominent University of Chicago study reported that “[a]cceptance is less of a barrier than might be expected,” noting that only 8% of lower-income students with four-year college aspirations applied and were not accepted. But many more students missed benchmarks in the application and enrollment process.  Only 41% of these students who said they wanted four-year degrees even completed the senior year steps needed to apply and enroll.

Students often need help learning and managing the process, especially if their parents did not attend college. Economically disadvantaged students are also the most likely to “mismatch” their college choice, enrolling in colleges with selectivity levels well below those of colleges they probably could get into based on their academic qualifications. The College Board (among others) has some great free resources to help all students manage the college application and selection process. These students also tend to lack support during the planning process and even while in school.

We must do better.

Once students have aspired and applied to college and been admitted, we need to be sure that they can pay for college.  A major piece of that puzzle is simply letting them know how much aid is available.  Many students limit their college searches to schools they assume they can afford and thus neglect great (usually private) colleges that might be less expensive for them to attend on account of financial aid.

Private schools typically have more financial aid to offer and some even guaranty to meet all or more of a student’s determined need pursuant to the applicable formulae.  Other schools are particularly generous with non-need based aid.  These issues often have a very significant impact on a college’s actual cost and should be considered carefully by every aspiring freshman. Underserved students and communities will often need help in this regard.

Berkeley now costs $32,635 per year for in-state students, still well less than its rival Stanford’s $56,906.  However, while Stanford meets 100% of each student’s financial need (as determined by FAFSA) and provides average financial aid packages of $40,298, Berkeley (on average) only meets 76% and provides average financial aid packages of $20,619.

According to the U.S. Department of Education, between 1.5 and 2 million low and moderate income students fail to apply for federal financial aid each year.  Moreover, a majority of those who file a FAFSA only do so after important deadlines have passed, decreasing their likelihood of receiving state and institutional aid.

Yet financial aid isn’t the only necessary response to the need to make it possible for students to pay for college.  I am absolutely in favor of providing “first chances” for those who have been disadvantaged and “second chances” for those who need them. I absolutely support the ideal of providing a place where high school graduates who may not be ready for a place like UC-Berkeley can get prepared to enroll there. Therefore, in my judgment, the mission of the California community college system is a noble one and one that ought to be continued.  But any fair assessment of that system must also conclude that it’s a mess.

According to research performed under the auspices of the Institute for Higher Education Leadership and Policy at CSU Sacramento (link), only 24% of students entering a JC to seek a certificate, get a degree or transfer to a four-year school accomplish their goal within a six-year period (and it’s only 14.5% of total students). Thus California ranks near the top in terms of getting students in the door of higher education, but in terms of actual achievement -– either via a degree or by transferring to a four-year school -– California ranks near the bottom. That said, a community college education remains remarkably inexpensive — costs are the lowest in the nation and a small fraction of the average cost nationally. Thus we’re paying a very high price for surprisingly little return.

Moreover, and more importantly, many community colleges are replete with students of means who have always had tremendous opportunities available to them who are wasting their time (and taxpayer dollars) there. Roughly 50% of California community college students have annual family incomes in excess of $50,000 and roughly 25% have annual family incomes in excess of $80,000 (link). Why should taxpayers provide — essentially for free — second, third and more chances to students with means and opportunity galore who have consistently refused to make good academic and educational choices while, at the same time, charging students who have made the best choices higher and higher prices and prices that are, by far, the highest in the system? Is it too radical to suggest the our UCs (Berkeley, UCLA, UCSD, etc.) charge prices more like what community colleges charge (to reward student achievement, to keep more of our best students “home” and to ease the financial burden on these students and their families) and that community colleges charge prices more like what the UCs charge for those that can afford them? It seems to me that the same amount of money could be put to much better use.

We also need to encourage more foreign students who come to the U.S. to school to stay here when they graduate.  What is intriguing is not just that the U.S. has won so many prizes, but that the a third of American Nobels have gone to immigrants to the U.S.:

“The United States has won more Nobel prizes for physics, chemistry, physiology or medicine, and economics since World War II than any other country, by a wide margin (it has been less dominant in literature and peace, two awards that are much more broadly distributed among nations). At least one American has won a prize each year since 1935 (excluding the years 1940 through 1942, when no prizes were given out). And the United States became dominant after a very slow start: no American won a science prize in the first six years of the prize’s existence.”

Sadly, it is now very difficult for foreign graduates to stay in this country when their educations are complete.  It doesn’t make sense to me for the U.S. to train them and then send them back overseas to compete with us when they want to stay.  Their skills and training could help the U.S. compete internationally and keep more high-tech jobs here. 

The Occupy Wall Street movement has struck a nerve.  I realize I am probably delusional in this regard, but we ought to at least be able to come together and provide better educational opportunities for everyone even though we are unlikely to find much in the way of consensus elsewhere with respect to the OWS agenda (such as it is).

More Nonsense from the Financial Press

P.T. Barnum is famously said to have opined that nobody ever went broke underestimating the intelligence of the American public.  In a similar way, it’s hard to overstate how poor the financial press in this country — and most especially the monthly consumer magazines — is (despite some notable exceptions to the rule).  It’s enough to make me want to scream for mercy.

In another tired re-cycling of the anti-fixed index annuity meme, Marla Brill offers the same ‘ol, same ‘ol criticisms and bromides (you can read about some of the issues at a higher level here and here).  My thoughts on that topic will appear in the next issue of Research magazine and are outside the scope of my missive today, even though it seems to me that Brill ought to offer the other side of the story.

My comments today (and the object of my ire) relate to the closing lines of Brill’s piece, which are apparently offered as the last word in doing the right thing.  Brill quotes Jerry Miccolis, chief investment officer at Brinton Eaton Wealth Advisors, apparently with respect to retirement income.

“For most people, even those who are already retired, a diversified portfolio is still the best way to stay ahead of inflation and generate income,” he says. “And if market volatility is a concern you can smooth the ride out by tilting your portfolio more toward bonds.”

I’m hopeful that Miccolis is merely stating his preference for such a portfolio to the deferred annuities Brill is criticizing and not ignoring the obvious benefits of immediate (income) annuities for retirement income.  If so, Brill is placing his remarks out of context. At a minimum, Brill had a duty to provide the majority view of unbiased academic experts along with her view — especially in what purports to be a news story rather than an opinion piece.  Kevin McCormally of Kiplinger’s Personal Finance makes a similarly silly mistake here.

Either way, had Brill done even a little bit of research, she would have recognized that portfolio approaches to retirement income do not deal with longevity risk and do not deal with sequence risk.  Moreover, at current market levels, failure risk is extremely high.  More importantly, by touting a portfolio approach to the exclusion of income annuities, Brill (and perhaps Miccolis too, even though I hope not) contradicts the full weight of academic authority (a  presentation I recreated on this subject is available here).  Unfortunately, such ignorance is common

Representative examples of the best answers for retirement income — from prominent academics who are hardly unscrupulous insurance agents seeking commissions — follow.

  • “Lifetime income [products] may not be the perfect financial instrument for retirement, but… they dominate anything else for most situations.”  Babbel, “Lifetime Income for Women: A Financial Economist’s Perspective,” Wharton Financial Institutions Center (August 2008).
  • “To achieve a similar riskless guarantee of income throughout one’s uncertain lifetime without life annuities would cost between 25% and 40% more.”  Babbel & Merrill, “Rational Decumulation,” Wharton Financial Institutions Center (May 2007).
  • “[T]he market for privately purchased individual [income] annuities in the United States is very small,” which represents a “remarkable disconnect between theory and practice” because income “annuities ought to play an important role in the portfolios of elderly households.”  Brown, “Life Annuities and Uncertain Lifetimes” National Bureau of Economic Research, NBER Reporter (Spring 2004).
  • “Lifetime income annuities may not be the perfect financial instrument for retirement, but when compared under the rigorous analytical apparatus of economic science to other available choices for retirement income, where risks and returns are carefully balanced, they dominate anything else for most situations. When supplemented with fixed income investments and equities, it is the best way we have now to provide for retirement. There is no other way to do this without spending much more money, or incurring a whole lot more risk coupled with some very good luck.”  Babbel, “Lifetime Income for Women: A Financial Economist’s Perspective,” Wharton Financial Institutions Center (August 12, 2008).
  • “For all time periods and for all portfolios, the addition of the annuity leads to a decline in the portfolio failure rates.”  Ameriks, Veres & Warshawsky, “Making Retirement Income Last a Lifetime,” Journal of Financial Planning (December 2001).
  • “If…the Social Security program will not generate sufficient income to satisfy minimal consumption needs, then it should be supplemented with the purchase of high-grade private annuities.”  Babbel & Merrill, “Rational Decumulation,” Wharton Financial Institutions Center (May 2007).
  • “Without additional guaranteed lifetime income streams…, middle-income Americans are at high risk of outliving their financial assets and living their final years in poverty.”  Ernst & Young, “Retirement Vulnerability of New Retirees,” Americans for Secure Retirement (June 2009).
  • “I have reviewed over 70 academic studies that have appeared since 1999, analyzing lifetime income annuities vs. other alternatives, and coauthored another major study. …The consensus of the literature from professional economists is that lifetime income annuities should definitely play a substantial role in the retirement arrangements of most people. How great a role depends on a number of factors, but it is fair to say that for most people, lifetime income annuities should comprise from 40% to 80% of their retirement assets under current pricing. Generally speaking, if a person has no bequest motive, or is averse to high risk, the portion of wealth allocated to annuities should be at the higher end of this range.” Babbel, “Lifetime Income for Women: A Financial Economist’s Perspective,” Wharton Financial Institutions Center (August 12, 2008).

If quoted accurately, what Miccolis said is common.  If a retiree annuitizes, the advisor doesn’t get paid much and loses control of the money.  And Miccolis isn’t obligated to provide alternative approaches, no matter how misguided his may be.  Brill, on the other hand, surely does.

This isn’t rocket science.  Really, we all deserve better from the financial press.