Why Defined Contribution Translates to Defined Loss.
Nearly all workers of today know the term 401k. 401k is a retirement plan. It is structured under what some know as defined contribution. What defined contribution means is that the employee and enrollee in this plan contributes an agreed upon dollar amount or percentage, normally a set percentage of the income or paid salary. The allocation of this contribution can be distributed in many different ways. Depending on the investor preference it can go to treasuries and relatively secured bonds with low yields. The bond market is better known as fixed income in the financial markets.
Fixed can denote a set percentage of income, or there can be an assigned dollar amount regardless of the size of the investment. For equities the return is much more variable (and volatile). This means that returns change much more quickly and frequently. The more typically speculative and volatile investment comes from equities more commonly referred to as stocks. Stocks are open to any range of gain or loss; some stocks may outperform the overall stock market or underperform where they grow less than the rate of return on the stock market. Conversely some stocks may lose less nominal value simply known as the stock market in a down day or stock market that has lost more point value than some individual stocks. The overall level of volatility surrounding one particular stock is defined as a beta factor.
The stock market is up by a full per cent in one day where the market has increased by one percentage point in measured point value. Some stocks have jumped more than 10% during this very same day. This is a beta factor of roughly 10 or 10% return on one single equity (stock) divided by the 1% return on the stock market. The next day nearly the opposite happens. The stock market slides (or some will say plunge) more than the same one percent. Some stocks are slammed and pounded; they tumble by double digit percentages. This means that they consists of a beta factor higher than 10 on the downside. It is clear that some stocks can be very reactive based on the overall performance of the equity market. Some stocks outpace the rest of the equities market by such large multiples that who can say no to investing in these particular securities (also equities and another term is financial instruments)?
What faster way to get a quick buck and grow your wealth? This is such a lucrative return that every investor will be guaranteed success in obtaining the dollar amount and rate of return that they thought they can only dream of, except that not so fast. I just noted that some stocks behave much more erratically than the stock market as a whole and can also slide faster. The reality is that there is only limited potential for upward ascention in the price of a stock, and there is also plenty of room for the downward diminution. It is always illegal to guarantee to an investor a preset rate of return in percentage value or specified dollar amount. That does not lessen the legitimacy of being realistic about how these returns occur.
The best performing of companies will inevitably plateau, and the stock will hit its ceiling (the highest pinnacle that the stock price is able to climb to). It is indicative of the adage “What Goes up Must Come Down”. This will occur in varying degrees. Companies with more stable personnel practices and management structures will be able to limit downside risk better than those companies with more frequent turnover and unreliable job training practices. This still does not mean the upside potential is limitless or forever. That will never be the case. Therefore in the most profitable and optimistic of circumstances losses can occur. Without question a company where the job training is deficient, a high turnover rate, and morale is strained here the downside risk can be a plunge almost straight to the bottom. Continually elevated and/ or climbing stock prices present another set of concerns worth thinking about.
While I just addressed the life lesson of “What Comes up Must Come Down”, another question to ask is simply why does the stock keep going up when this is not the case for competing firms or other industries altogether? An upward trajectory in the stock price can be subverting managerial and in some cases accounting problems. If an equity price is exceedingly high and it remains that way continuously this at the very least obviates a high rate of return. High rates of return at least could mean that there is a lot of risk and hence a lack of stability. This begs the question how much higher will the stock price go and for how long? Often times these are the equities where the prices tumble the fastest and with the greatest percentage in lost market value.
This may mean any number of things. Some of the possibilities include an erratic management, e.g. high turnover, mismanagement of funds, poor accounting, chronic personal difficulties such as tardiness, calling in sick, missed project deadlines, and lack of quality control among others. A high stock price and rate of return are only beneficial when the company structure is in place to support it. Otherwise when the situation unravels it unwinds very quickly with hardly any warning. This has the investor ‘holding the bag”. As discussed here stock prices can rise and fall for countless reasons, some impossible to explain and also to greatly varying degrees. Previously I talked about bonds as the fixed income side of the market and investing.
Although bonds are stated to have a fixed income stream or flow of funds (also known as liquidity), bonds have their own risk. There can be issues with individual creditors. Their funding might be unreliable and unstable. Just as liquidity has to do with the flow of funds, the other component is whether or not funds are fungible. Fungible refers to the ability to transfer the funds. If funds are problematic for transfer and they are difficult to access in terms of liquidity this means that the bonds will be more risky and hence susceptible to default. Therefore as with stocks there is a higher rate of return because investment is more speculative. Additionally bonds have 2 major categories.
One is GO (general obligation/ municipal), and the other is revenue bonds. General obligation bonds are backed by the full faith and credit of the tax payer. They fund municipal structures such as public libraries, public schools, police stations, and the county court houses. Revenue bonds are funded by what are known as covenants. Covenants have to do with the reputation of the borrower or company. Unlike general obligation bonds revenue bonds are about the underwriting and capital funding of a new structure. Broadly speaking this has to do with office space, but it also includes an extensive gamete of businesses. There are multiple examples of structures that are funded in this manner including malls, corporate centers, doctor’s offices, warehouses, factories, incinerators, car manufacturing plants, bridges, tunnels, and much more.
The funding streams are very complex regarding the above entities I have mentioned. There is the question of how reputable the individual funder is. It is widely known about some of our cities having filed for bankruptcy. Detroit has been in the news throughout this past month about that. Harrisburg, the Capital of PA, is another city that has faced this. Many of these cities have had decades of mismanagement. It is often contended that the pension liabilities are driving this. That argument is only true insofar as those who are on the top of the management ladder getting in extreme multi-million pension payouts each year. For everyone else the overwhelming majority of retirees are living very modestly or are in poverty altogether. The cost of doing business, both in the public and private sectors, is blamed largely on retirement pensions because pensions have what are known as legacy costs.
Legacy namely means that the costs are ongoing and permanent. The longer a retiree lives the longer the pension payout. While it is true that pensions can last decades depending on the individual pension holder, there are many other examples of legacy costs that also must be examined. Social Security, Medicare, Medicaid constitute this cost structure. There is the expression that these entitlements are on ‘autopilot.” They happen automatically, and they can’t be controlled. Much of the reasoning behind that argument is false. They are paid into through income, payroll, and other taxes. These expenditures recur each year because they are paid into, not because they exist on their own. Legacy costs pertain to our infrastructure including roads, bridges, and tunnels, but also transportation including bus, rail, and the airports. Businesses and real estate have legacy costs due to the property value of corporations and private residences alike. Wars have these permanent cost structures because of indebtedness to other countries. The expense structure related to our pension is only one element.
As reflected above legacy costs come in many forms, and occur for a wide range of reasons. Regardless of how large the dollar amount maybe, pensions and also medical benefits, only make up so much of the equation. What has occurred in the 2 cities I have mentioned, Detroit most recently and Harrisburg, PA, is poor planning and management. This has come from a culmination of unsecured business deals with private contractors, tax abatements which put pressure on property taxes, and lack of coordinated planning with developers regarding traffic flow and its impact of commerce. These reasons would not be the only explanations for the need to obtain bankruptcy protection. Lack of building maintenance leading to non-compliance with fire codes, weak emergency management, and poor plumbing leading to frequent flooding shutting down entire roadways eventually shuttering some local businesses entirely have caused the costs of running these cities to simply become insurmountable. Funding pensions through 401k rather than 403b only adds these costs.
Because 401k’s are based on defined contributions they are also based on speculative funding and the rate of return. The financing comes from corporations with funding streams that are tied to rate covenants. The relationship with respective contractors and developer is often unclear and not established. While feasibility studies are designed to address this they never can and never will eliminate the cost of unsecured contracts and irresponsible underwriting. 403b pensions are based on and funded by entities funded through the full faith and backing of the taxpayer including libraries, the police precincts, fire houses, publics schools, the post office, and other public facilities. This is why we need the old retirement and pension restored.
I noted at the opening of this piece that a 401k is a defined contribution plan because the employee contributes to it. 403b is a defined benefit, which means that it is fixed in dollar amount or rate of return. Therefore 403b pensions have a guaranteed payout whereas that’s not the case for a 401k plan under a defined contribution system. 403b pensions are funded through public facilities that build reliability and trust in communities, not private contractors and corporations within unknown reputations that are often negative as with the 401k pension system we now have.