This article is meant to serve as a caution flag arising from a somewhat alarming trend that the financial advisors of our firm have noticed over the last several months. It relates specifically to the Florida Retirement System Investment Plan.
First, I will start with some history. The last time that we noticed the trend that I’m referring to was in late 2006 through 2007. Those familiar with the FRS Investment Plan might already know where I’m going with this.
A little more than ten years ago, we began to notice that more and more of the vested FRS Pension Plan employees that we spoke with had recently made the election to switch from the FRS Pension Plan to the FRS Investment Plan. We also noticed that many of those in the FRS Investment Plan maintained surprisingly aggressive investment allocations, within the context of other elements of their investor profile.
When these participants were asked why they had decided to make the change from the Pension Plan to the Investment Plan, there were usually three answers we heard in response – often in some combination:
I’ll dive deeper into these responses later, but let me get to the point. Just like so many other investors that were swept up in the whirlwind of the last financial crises, some of these FRS Investment Plan participants realized the true implications of their decision a little too late.
What struck us as the most unfortunate factor of all was that some participants just happen to make the switch at the worst possible time. That is, within a few years of their expected retirement date, and while the assets they were investing in were just peaking out in valuation.
Fast forward ten years, and the question “Should I switch to the FRS Investment Plan?” seems to be coming up more frequently in conversations. Not only that, but it also seems that many participants in the Investment Plan – at least those that we have spoken with – are once again experiencing risk tolerance creep to the more aggressive end of the spectrum.
Let me preface what comes next with the statement that the FRS Investment Plan is not intrinsically right or wrong. In fact, for some people, especially those that know they will not be around long enough to vest in the Pension Plan, it is a real treasure. It is also true that, even when someone is already vested in the Pension Plan, it can sometimes make sense to switch to the Investment Plan.
Just like so many other matters of personal finance, the right or wrong choice is based on a multitude of factors specific to the individual making the choice. That being said, one person’s choice – especially a choice of this magnitude – should not be based solely on the actions of some other person. Perhaps making the switch really does make sense for someone, but that person’s objectives and circumstances could be totally different than someone else’s, even if they seem similar enough on the surface.
The Florida Retirement System Pension Plan is a defined benefit plan. That means that, at some point after vesting, a benefit will be provided to a participant according to a set of factors like years of service, earnings history, and participant class applied to a common formula. Because the benefit is defined in advance by the employer, the risk of not being able to fulfill this defined obligation falls on the employer. In other words, under the FRS Pension Plan, investment risk is maintained by the State of Florida.
The Florida Retirement System Investment Plan is a defined contribution plan. In this case the formula no longer applies to the eventual benefit, but, rather, to the ongoing contributions into the plan. Under a defined contribution plan, the employer has no obligation to produce a defined (or undefined, for that matter) benefit. Instead, the employer’s obligations end once contributions as defined by the plan are made to a participant’s account. Whatever happens to the assets after the contributions are made is up to the participant. In other words, under the FRS Investment Plan, investment risk is transferred from the State of Florida to each individual participant.
Right, everybody knows that. So what?
Many, if not most, of the Investment Plan participants that we encounter still intend to utilize the funds available to them in their Investment Plan account to create a stream of retirement income. Some expect that they will be able to utilize the funds in their Investment Plan to distribute a greater amount of recurring income to themselves than they would have otherwise received had they stayed in the Pension Plan and chosen Option 1 (the highest payout option available).
It seems reasonable to believe that some participants have been able to accomplish this task of having their cake and eating it too. However, it is our opinion that this is one of the most important factors to critically consider prior to taking action.
Maybe. But some due diligence, math, and good old-fashioned horse sense should be applied before any knee-jerk reactions are acted upon.
Let’s start with some context. The State is refreshingly transparent about the operation of both the FRS Pension Plan and FRS Investment Plan. That being the case, every participant should take advantage of the State’s most recent Annual Investment Report.
This document – in combination with some other publicly available information – reveals that the FRS Pension Plan is a behemoth, even among other pension plans. It is quickly approaching $200 billion in assets. Managing it cost over a half-billion dollars a year. The document also reveals, in general, the types of investments utilized to try to reach its objectives.
The contents of these documents are significant because, after reading them, it is not difficult to determine that the FRS Pension Plan is not an ordinary investor. Because of its size, the plan has access to investments not always available to rank-and-file investors. Of special note is the Pension Plan’s investment policy target allocation weight to Real Estate, Private Equity, and Strategic Investments, which equal almost 30% of the overall investment allocation. To investors on the street, these asset classes would typically be considered “alternative,” and would likely come with an elevated cost of management, if accessible at all.
Conversely, unless the self-directed brokerage option is selected, investors in the FRS Investment Plan have access to a handful of rather run-of-the-mill investment options.
If earning the returns required to produce the benefit promised by the Pension Plan was possible using traditional bond and equity allocations, why wouldn’t the State invest in the same securities offered to Investment Plan participants? Well, some might say that, because the State is retaining the investment risk, and they know exactly what their objectives are, they have selected the most appropriate investment allocation to meet those objectives that 500 million dollars a year can buy. Oh, and, as mentioned previously, their size provides them with special access to types of investments that the ordinary investor often misses out on…so, the State does it because it can.
Another consideration is that the State – being on the hook for huge future obligations – is very sensitive to risk, and has, therefore, clearly defined its risk tolerances. Some of these alternative investments are presumably included to allow the State to achieve actual diversification – hopefully mitigating certain risks – while remaining invested. This is something that has become increasingly hard for the ordinary investor to accomplish.
If these points are considered, it should be somewhat apparent that the average investor utilizing the FRS Investment Plan to try to keep up with the benefit promised by their Pension Plan might be at an investing disadvantage.
The State is doing everything it can to keep the Pension Plan fully funded. Even with the advantages of elite professional investment managers and access to less-than-ordinary investments, the State hasn’t yet been able to fully recover from the last big economic downturn in terms of its funded status. Does it not seem, then, that producing a reliable stream of income from the assets available might be a little more difficult than it might look on the surface?
At the very least, those Pension Plan participants that intend to make the switch to the Investment Plan, but still hope to receive a Pension Plan like stream of income, should have a qualified professional walk them through the math. If one were to only perform a cursory evaluation online, for example, one might believe that everyone should assume an 8% compounding rate of return on their investments every year for the rest of their lives. In reality, seemingly ubiquitous return assumptions are much harder to achieve in the context of risk mitigation and continuous distributions. Just ask any pension plan manager!
It is human nature to want to take part in what we perceive to be a good thing. Especially when it appears to require little effort.
As we saw in 2006 and 2007, more people became interested in switching to the Investment Plan from the Pension Plan as rumors began to swell about colleagues who took advantage of a rising stock market to ride their Investment Plans to a healthy profit and early retirement. Combine this with constant media exposure of how well the economy is humming along, and how spectacularly everyone expects the market to perform, and the desire to participate in apparently easy money has the potential to override other functions of judgement.
History tells us that excitement and confidence in the future performance of investments tends to build into a crescendo just prior to a period of relatively poor performance. Unfortunately, we, as humans, are generally most likely to give in to our fear of missing out as this peak is forming, as opposed to when it might have been more advantageous to participate in risk, much earlier in an economic cycle.
In 2008-2009 we witnessed lives adversely affected by the decision to risk a career’s worth of accrued pension benefit for an opportunity to chase investment performance.
I am in the camp that believes we may be in for rough economic times in the near future. Although others may disagree, it is for this reason that I write about this topic now. It may make sense for someone to switch to the Investment Plan today, but if the switch is motivated by the prospect of quick riches, I encourage those considering the choice to seek professional council.
…which brings me to my next point…
I mentioned earlier that one of the most common responses we heard back in 2006-07 – and are starting to hear again now – about why the switch was made was that “A representative from an investment company came to my place of employment and essentially told me that I would be a fool not to make the switch and ride the wave of recent market performance.”
Consider how a representative from an investment company is compensated. Typically, this person is compensated according to the amount of money that someone invests with them or their company. If someone chooses the Pension Plan, they might have access to DROP, but their investable assets might not be anywhere close to what they would have available to invest if they switched to the Investment Plan.
It is possible that it might be in the financial representative’s best interest to encourage someone to switch to the Investment Plan even if they only have a sliver of a hope of one day getting that person to invest those assets with them. From their perspective, they have no shot of accessing those assets if someone stays in the Pension Plan, but convincing a number of people to switch to the Investment Plan is like sowing seeds for future potential harvest.
I know that this happens at least occasionally because I have heard people that call themselves financial professionals say that this is their intent. To be safe, evaluate the bias of the advice provider. Especially if the provider of advice is not particularly well known to you.
Yes! Of course!
The trick here and now, though, is to evaluate one’s own motives: Why now? What is so different about the conditions of my life and financial circumstances that I am willing to assume the investment risk associated with my retirement benefit?
Some might find that something really has changed, and the switch is totally warranted. Others might realize that nothing has changed other than the application of social pressure, and a general desire to not be left in the dust as others strike it rich.
This is a huge decision that should not be taken lightly, and certainly not decided upon a whim. It is absolutely inadvisable to make this decision without performing some serious due diligence. Under scrutiny, some will determine that switching to the Investment Plan is in their best interest; and those that scrutinize that decision might be more likely to be making it for the right reasons.
Of the three typical responses we hear about why a switch was made, the one that I haven’t covered yet applies here. That is, the FRS Investment Plan does provide flexibility. Not only in terms of control over investment decisions while working and in retirement, but also for estate planning purposes. Again, though, there are many factors that go in to figuring out what is sacrificed for the sake of flexibility and control, and it is a decision that should not be made lightly.
Again, the FRS Investment Plan is not intrinsically bad or scary. But the reality remains that, unlike participation in the FRS Pension Plan, all of the investment risk is squarely on the shoulders of the FRS Investment Plan participant. This means that the investing responsibility should be taken as seriously as one’s desire to eventually retire.
This doesn’t necessarily mean that an Investment Plan participant should be continuously tinkering in their account. What it does mean is that actual effort should be made, at least periodically, by a participant to understand the current state of their investment situation. Participants should hope to grasp the risk and reward potential of any allocation selected.
In other words, look under the hood. If you don’t understand what you see, seek help.
One particular pain point that might arise for those currently participating in the FRS Investment Plan are the underlying exposures of the target date funds available within the plan. We have come across several near retirees that were very surprised to learn of the behind the scenes asset allocation of what they thought sounded like a conservative investment.
As for those that have very recently made the switch, and feel that they may have made an error, there is a chance that they might be able to undo their election; but they’ll have to act fast. Some additional information is provided by the State here.
I want to be clear that the point of this article is not necessarily to talk anyone out of switching to the FRS Investment Plan. My point, I hope, is to make it clear that the temptation to make this very important decision for the wrong reasons might be increasing at the present. I also fear that the present might be precisely the wrong time to make this decision for the wrong reasons.
Unfortunately, most people only have the opportunity to observe this choice from the front end until the decision has already been made. Because of the nature of our work, I have had the ability to see what this decision looks like from a variety of angles and across time. Based on what I’ve seen, I can assure you that you do not want to make this decision for the wrong reasons.
My parting advice is to examine yourself and the factors of your decision. If you decide that making the switch to the Investment Plan is in your best interest, recognize the responsibility that comes with it, and do your best to understand the nature of your investments.