Performance Management: Changing Behavior That Drives Organizational Effectiveness (part 3)

Separating Behavior from Non-Behavior

by

Charles Lamson

What Behavior Is Not

If you will remember that behavior is an observable action, you will avoid most of the egregious errors in managing behavior. The following is a list of the four most common assumptions that cause out-of-control variability in management systems. If you can control these management inputs, you will go a long way toward creating the behaviors you want.

Generalities are not behavior.

Unfortunately, many people who talk about behavior have a very imprecise definition of the term. Performance appraisal forms often ask the manager to discuss the employee's behavior and then give them key words such as professionalism, creativity, teamwork, enthusiasm, or quality of communications. Some managers talk about having a commitment to safety as if it were a behavior. Additionally, terms such as selling, monitoring, checking, delegating, supervising, managing, taking ownership, and being proactive fail the test for behaviors. They do not describe what you can observe someone doing.

When we use imprecise terms to tell people what to do, we have to expect a great deal of variability in how they interpret our directives. Many managers think that they are being clear when they tell their direct reports things like, "I don't care how you do it. Just get it done!" They assume that the person understands (from policy, procedures and precedents) their meaning. We have even heard managers say things like, "If I have to tell them how to do their job, I don't need them." The literature on failed companies is filled with cases where the senior manager gave direction only in general terms. Enron senior management wanted entrepreneurs, resulting in managers who started unfunded and unscrutinized ventures that robbed funds from the revenue producing units of the company as well as from the honest majority of the company's employees. One of the worst forms of management is when the boss asks for something and gives as his/her criterion for success, "I'll know it when I see it."

Attitudes are not behavior.

Business seems to have a considerable interest in areas such as safety awareness, quality consciousness, and cost consciousness. These general descriptions are often referred to as attitudes. Such descriptions are particularly difficult to work with because they are assumed to come from a state of mind. They are not behaviors but refer to a vast collection of tasks and behaviors. Additionally, different people using these terms are usually referring to different tasks and behaviors. When we refer to safety consciousness, we may want people to duck as they walk under overhead pipes, clean up spills, put on safety glasses, and warn others of safety hazards. Quality conscious may mean doing extra engineering tests on materials and designs, inspecting incoming raw materials for defects, cleaning the assembly area and frequently checking machine settings. Cost conscious may mean turning off equipment when finished, cleaning and lubricating equipment daily, and checking settings at the beginning of a job. For an engineer, cost consciousness may mean documenting engineering change orders, calculating loads on schedule, and recording time charged to the job. Terms and phrases denoting attitudes always fail the measurability and activity criteria for behavior.

States are not behavior.

It is also important to differentiate between states and behaviors. A state is a static condition that exists as a result of behavior. Wearing safety glasses is a state; putting on safety glasses is a behavior. Sleeping is a state; getting in bed is a behavior. Sitting in a chair is a state; sitting down is a behavior, getting up is a behavior. States do not require action. Action is usually required to get to a state but, once there, no action is required. Once you fall asleep, no action is required to remain asleep. Once you sit in a chair, no action is required to stay there. The problem is that the action (behavior) that created the state may not be one of which you would approve. Behavioral consultant Courtney Mills recounts the following:

A distribution manager I was working with wanted his crew to put their safety glasses on as soon as they walked through the warehouse door. He explained that he never reinforced someone for wearing safety glasses (a state) unless he knew they put the glasses on at the warehouse door. He insisted on the standard for recognition because one day when he went into the warehouse, he saw an employee hurriedly putting his glasses on when he saw the manager coming. The manager said later that he almost reinforced the employee for wearing the glasses, but thought better of it because he did not reinforce the behavior of putting on his safety glasses only when he sees a manager coming.

Values are not behaviors.

Defining mission, vision, and values has long been a leadership function. Mission, vision, and values are activities that help companies articulate their chief functions or activities (mission), their direction, focus or impact anticipated for the future (vision) and what is acceptable in terms of how they treat one another and go after business success (values). Articulating mission, vision, and values, however, has had little impact on behavior in most organizations as they still have articulated and communicated these things very well only to end up in trouble with both the law and/or stockholders. Executives have completed mergers only to realize later that they had no expertise in the acquired business or that the acquired business was not a strategic fit. Employees have been caught lying, cheating, and stealing to get customers, reduce costs, or increase profit or stock price. It is no longer sufficient to post mission, vision, and values on walls. Unless the leadership actively manages the behaviors they describe in these documents, they could be permitting internal counterproductive competition and other destructive actions. Activities such as creating behavior-based mission and values statements can produce worthwhile guidelines for business; but, without an assessment of the true behavioral impact, those documents can also breed employee cynicism and deceit.

A value like honesty is not a behavior; it is a group of behaviors defined by their impact on the observer. You may consider yourself as honest but others may see you as being dishonest because of what they know, or believe, that you said or did not say, or by the way you talk about what you do. Many organizations have failed to change values because they think that values are behaviors. Teamwork, for example, is a value that most organizations have. It is certainly not a behavior, but many behaviors. The criticism "We don't work as a team" could mean many things. Until teamwork is broken down into behaviors and/or tasks that describe it in measurable and observable terms, you may be very frustrated in your efforts to increase teamwork. Your organization may list speaking up when there is a problem as a value, but employees find that those who do speak up are told to "Get on board" or "Stop criticizing" or in other ways given the message that the value of open communication and the action that should go along with it are two very different things. Stated values are not behavior, and values that cannot be described in specific behavioral terms are almost impossible to instill in an organization. If you know the behaviors that are necessary to produce valuable results in your organization, you know more than most managers and are much closer to improving organizational efficiency and effectiveness.

*SOURCE: PERFORMANCE MANAGEMENT: CHANGING BEHAVIOR THAT DRIVES ORGANIZATIONAL EFFECTIVENESS, 4TH ED., 2004, AUBREY C. DANIELS & JAMES E. DANIELS, PGS. 35-37*

end

Conclusion of Strategic Organizational Communication in a Global Economy 02/18 by CharlesXLamson | Current Events

Conclusion of Strategic Organizational Communication in a Global Economy 02/18 by CharlesXLamson | Current Events: 'Trust is the glue of life. It's the most essential ingredient in effective communication. It's the foundational principle that holds all relationships.' -Stephen Covey

Performance Management: Changing Behavior That Drives Organizational Effectiveness (part 2)

Web results

The Value of Performance Management to Organizations

by

Charles Lamson

Organizations use Performance Management for many reasons. However, the seven reasons that follow highlight the value of PM to business, industry, and government.

1. PM works.

PM is practical. It is not generalized abstract theory that suggests ways to think about problems; it is a set of specific actions for increasing desired performance and decreasing undesired performance. The PM procedures have been validated against measurable results in a wide variety of applications.

The writers of Performance Management contend that firms using performance management have reported returns on investment ranging from 4:1 to 60:1 in the first year. Successful applications have occurred in a wide range of organizations, from manufacturing and service to software development and research. Job-specific applications range from sales and safety to customer service and vendor performance. In a survey of the research literature, Duncan (1989) reports the average improvement in PM applications is 69 percent.

2. PM produces short-term as well as long-term results.

Mitchell Fein (1981), the creator of a gain-sharing system called Improshare, says that if you go onto the production floor, into the office, or into the lab and do the right things, you will see a performance change in 15 minutes. He is not entirely correct. If you do the right things, you will, in many cases, see the effect immediately! In fact, laboratory research (Foster & Taylor, 1962; Mal, McCall, Newland and Cummins, 1993; Stoddard, Serma & McIlvane, 1994) has shown that animals and humans can learn or change after receiving only one reinforcer!

Most initiatives introduced into organizations make no claim that results can be expected quickly. In fact, their advocates warn that changes should not be expected for a year or more. Few managers can stick to any motivational program or system that takes several years to show results.

The writers of Performance Management go on to say on page 12 that results are produced quickly using the principles of Performance Management. Once mastered, the applications of PM to accelerating organizational performance are so useful that they become habitual and the only way to manage performance. An increasing number of companies using PM are still getting consistent improvement after more than 20 years.

If you try to solve a problem using the procedures and techniques described in this book and do not see changes in performance within the first 10 to 15 data points, you can bet you are doing something wrong, the writers contend. The good thing about this approach is you will know the steps to take to correct the problem. To sustain commitment and enthusiasm, people must see short- and long-term results.

3. PM requires no formal psychological training.

Performance management is supported by thousands of experimental and applied research studies in laboratories, universities, schools, clinics, hospitals, and homes since the early 1950s. This research is based on the pioneering work of the American psychologist, B. F. Skinner.

Dr. Skinner rejected the belief that in order to work effectively with people you must first understand their deep-seated anxieties, feelings, and motives. He took the position that the only way you can know people is by observing how they behave (what they do or say). In his book About Behaviorism, he states, "No matter how defective a behavioral account may be, we must remember that mentalistic explanations explain nothing" (Skinner, 1974, p. 224). It explains nothing to say that a person is lazy or unmotivated or passive-aggressive. These explanations require interpretation of the actions of performers (as though any of us can read the minds of others). Labels such as lazy make the work of improving performance much more complex than many managers see themselves as capable of handling. Applying labels to actions, rather than just describing what is seen or heard, removes objectivity and lessens or destroys the possibility for rapid performance improvement.

Because the PM approach focuses on behavior rather than mental activity, some critics have said it denies thoughts and feelings. Performance Management and the science from which it is derived do not deny thoughts and feelings but consider them just more behavior to be explained. Thoughts and feelings are private behaviors. The methods used to study and understand overt behavior applies to private behavior as well. The difference is that the only person who can use those methods on internal thoughts and feelings is the individual who has them. Until private thoughts are shared through spoken words, they are not available to others. Once any private event is made public, then others can study the overt expression just as with any other behavior.

Performance Management accepts people as they are, not as they were. Because it deals with the here and now, managers do not need to pry into people's private lives or their histories in order to manage them effectively. Managers do not need to know how people were potty trained, that they hate their fathers, or that they are middle children.

Because PM deals with the present, everybody can learn its techniques. In other words, you do not need to be a psychologist, psychiatrist, or a mind reader. As a matter of fact everyone, even if unaware of doing so, makes use of and is influenced by the laws of behavior. Unfortunately, in many cases, people use these laws haphazardly and ineffectively.

The principles of behavior are so simple that infants learn to use them to gain control over their parents in a very short period of time. Notice how quickly people respond when a baby cries or smiles. However, the paradox is that even though the basics are simple, they are not obvious. As a result, we often inadvertently teach people to do what we do not want them to. Consider an example from home. A child asks for candy an hour before dinner and you say no because it will spoil his appetite. He cries loudly for 10 minutes and you give the candy to him to stop the crying. In the short-term, you have stopped the crying (may be seen as a good thing), but in reality, you have increased the likelihood that the child will cry again in the future when he wants something, especially candy. Not only that, but you might have punished his asking for something rather than crying for it. This applies to our own behavior as well. We learn and do things that are sometimes, in the larger picture, not good for us even though we find them rewarding. For example, eating fast food that is high in fat, cholesterol, carbohydrates, salt or sugar is more pleasurable immediately, but eating fast food has long-term detrimental effects on our health. We are all subject to the laws of learning. You can avoid this mistake by learning how such situations occur and how to change them in a productive way.

4. PM is a system for maximizing all kinds of performance.

Because PM is based on knowledge acquired through a scientific study of behavior, the principles are applicable to behavior wherever it occurs. This means that PM applies to people, wherever they work and no matter what they do. The applicability of PM to routine and easily measured jobs is apparent with a basic understanding of the principles. However, it may be easier to see how PM applies to production jobs than to jobs where the main outcome is creativity such as in research or engineering, or to complex organizational problems such as bringing about a cultural change or creating autonomous work groups.

Be assured that if one or more people are involved in any activity, PM can enable them to work consistently at their full potential. These principles work whether the performer is the president of the company or the custodian, whether the target is an R&D group working on telecommunications systems for future generations or a group of textile employees producing a product that the company has been making for 50 years. PM principles have been shown effective in companies as small as 5 employees and as large as 50,000 or more employees.

5. PM creates an enjoyable place in which to work.

Most people agree that if you are doing something you enjoy, you are more likely to perform better than if you do not like what you are doing. Unfortunately some managers have the notion that fun and work do not mix. Indeed in many cases the way people have fun at work is at the expense of the work rather than through it. Everyone knows of employees who engage in off-task behavior such as horseplay, practical jokes, playing computer games, surfing the Internet, or other forms of goofing off.

If, however, the fun comes from doing the work, then management should be preoccupied with how to increase fun rather than how to eliminate it. A manufacturing executive recently said, "Sales and marketing folks know how to have fun at work. In manufacturing, we haven't had much fun; no, we haven't had any fun. We've got to change that." 

Fun and work are so antithetical to some managers that this subject may turn them off. But, as you will see, when you have fun that is directly related to your primary job tasks, you will find that quality, productivity, cost and customer service can all be dramatically improved.

6. PM can be used to enhance relationships at work, at home, and in the community.

While this book focuses on the workplace, the writers use many examples from everyday life because they are easy to relate to, and they highlight the universality of the approach. Indeed, many managers have been convinced of the power of the approach by applying PM to a difficult problem at home. Imagine using PM to increase your child's completion of chores at home or to increase the volunteers' participation at your school fundraiser, all by making the activities more enjoyable for everyone involved!

7. PM is an open system.

PM includes no motivational tricks. You will learn nothing in this book that you would not want everybody in your organization to know. You will learn nothing that is illegal, immoral, or unethical. Because of the stable number of positive reinforcers needed to sustain high levels of performance, high performance organizations teach these principles to everyone so that employees at all levels can facilitate the performance of others as well as their own. Just as managers influence the performance of the people they supervise, employees influence the performance of managers by the same process. Nothing about the principles states that reinforcement only works down the organizational hierarchy. Reinforcement works on behavior. It does not matter who performs the behavior. Therefore, PM works equally well up and across the organization. Performance Management suggests only methods for changing another person's performance that you would enjoy having done for you in the same circumstance. Therefore, there is no need for secret plans to improve performance. On the contrary, every reason exists to be open and honest in all relationships at work. In the final analysis, changing performance with PM will result in everybody getting more of what they want from work.

To be continued...

*SOURCE: PERFORMANCE MANAGEMENT: CHANGING BEHAVIOR THAT DRIVES ORGANIZATIONAL EFFECTIVENESS, 4TH ED., 2004, AUBREY C. DANIELS & JAMES E. DANIELS, PGS. 10-17*

end

Performance Management: Changing Behavior That Drives Organizational Effectiveness (part 1)

Introduction to Performance Management
by
Charles Lamson

In Wealth and Poverty, author George Gilder (1981) states:

...productivity differences between workers doing the same job in a particular plant are likely to vary as much as four to one and differences as high as 50 percent can arise between plants commanding identical equipment and the same size labor force that is paid identically. Matters of management, motivation, and spirit - and their effects on willingness to innovate and seek new knowledge - dwarf all measurable inputs in accounting for productive efficiency, both for individuals and groups and for management and labor (p. 40).

The organization that can isolate effective people management practices, processes, and procedures and implement them efficiently will have a significant competitive advantage over those that cannot. Performance Management (PM)  gives you a precise system for managing performance at work, and is based on scientific knowledge of human behavior.

Performance Management: Science and Values

As you read this analysis, you will see many instances of the science of behavior analysis applied with precision and effectiveness. Once you master the technology, you will have choices about how you achieve your performance objectives. What you work to achieve, how you set up conditions for success, what you reinforce, and what you punish - all such actions contain ethical elements.

None of us are free from the moral and legal implications of what we do. The business of managing people is very serious indeed but it can and should be fun more often than not. When done well, nothing managers do is of greater importance than helping employees become and remain successful while having a good time doing it.

What is Performance Management?

Performance Management is a technology for creating a workplace that brings out the best in people while generating the highest value for the organization. The techniques and practices of PM are derived from the field called behavior analysis, the term describing the scientific study of behavior analysis that seeks to extend the findings of laboratory research to everyday problems.

The field of Applied Behavior Analysis was clearly defined by Baer, Wolf, and Risley (1968). Its subject matter is human behavior: why we act as we do, how we acquire habits, and how we lose them; in other words, why we do the things we do and how we can change them, if change is needed. Performance Management, as defined in this book which is the subject of this analysis (Performance Management by Aubrey C. Daniels and James E. Daniels), is a branch of Applied Behavior Analysis that focuses on the workplace.

To understand behavior, behavior analysts use the same scientific methods that the physical sciences employ: precise definition of the behavior under study, experimentation, and consistent replication of the experimental findings. Basic research in this area has been conducted for over a century (e.g., Thorndike, 1898; Watson, 1913; Skinner, 1936). However, applied research has been conducted only since the 1950s. Business, industrial, and government applications began in the late 1960s.

Compared with most of the established sciences, behavior analysis is very young, but much has been learned in a short period of time. Many of the principles of learning are relatively well understood at this point. Although much remains to be learned, current knowledge has been used to solve thousands of business problems in the last four decades. Many of these problems plagued organizations for a long time and in some cases were thought to be unsolvable. For example, in a television tube manufacturing plant two quality problems that had troubled the plant for over a year were solved in one day! Also, many businesses such as restaurants, hotels, call centers, and other minimum wage occupations accept high turnover rates as a necessary cost of doing business. Yet, the use of PM methods has cut turnover in just 90 days, or so the writers of this book contend.

To be continued...

*SOURCE: PERFORMANCE MANAGEMENT: CHANGING BEHAVIOR THAT DRIVES ORGANIZATIONAL EFFECTIVENESS, 4TH ED., 2004, AUBREY C. DANIELS, JAMES E. DANIELS, PGS. 4-7*

end

Daily Catholic Mass - 2019-02-13 - Dcn Gerald

Strategic Organizational Communication in a Global Economy (part 3) 02/11 by CharlesXLamson | Management Podcasts

Strategic Organizational Communication in a Global Economy (part 3) 02/11 by CharlesXLamson | Management Podcasts: 'I think for any relationship to be successful, there needs to be loving communication, appreciation, and understanding.' -Miranda Kerr

Personal Financial Planning: An "How-To" Guide (part 54)

Retirement Planning: Estimating Income Needs
by
Charles Lamson

The combined impact of when you start your program, how much you contribute each year, and the rate of return you earn on your investments is seen in Exhibit 1 (below). Note that it is really the combination of these three factors that determines the amount you will have at retirement. Thus, you can offset the effects of earning a lower rate of return on your money by increasing the amount you put in each year or by lengthening the period over which you build up your retirement account---meaning that you start your program earlier in life (or work longer and retire later in life). The table shows that there are several different ways of getting to roughly the same result; that is, knowing the kind of nest egg you would like to end up with, you can pick the combination of variables (period of accumulation, annual contribution, and rate of return) that you are most comfortable with.

Retirement planning would be much simpler if we lived in a static economy. Unfortunately (or perhaps fortunately), we do not, and as a result, both your personal budget and the general economy are subject to considerable change over time. All of which make accurate forecasting of retirement needs difficult at best. Even so, it is a necessary task, and one you can handle in one of two ways. One strategy is to plan for retirement over a series of short-run time frames. A good way to do this is to state your retirement income objectives as a percentage of your present earnings. For example, if you desire a retirement income equal to 80 percent of your final take-home pay, you can determine the amount necessary to fund this need. Then, every 3 to 5 years, you can revise and update your plan.

Alternately, you can follow a long-term approach in which you actually formulate the level of income you would like to receive in retirement, along with the amount of funds you must amass to achieve that desired standard of living. Rather than addressing the problem in a series of short-run plans, this approach goes 20 or 30 years into the future---to the time when you will retire---to determine how much saving and investing you must do today to achieve your long-run retirement goals. Of course, if conditions or expectations should happen to change dramatically in the future (as they very well could), it may be necessary to make corresponding alterations to your long-run retirement goals and strategies.


Determining Future Retirement Needs

To illustrate how future retirement needs and income requirements can be formulated, let's consider the case of Jack and Lois Spellman. In their mid-thirties, they have two children and an annual income of about $60,000 before taxes. Up to now, Jack and Lois have given only passing thought to their retirement. But even though it is still some 30 years away, they recognize it is now time to give some serious consideration to their situation to see if they will be able to pursue a retirement lifestyle that appeals to them. Worksheet 1 provides the basic steps to follow in determining retirement needs. This worksheet shows how the Spellmans have estimated their retirement income and determined the amount of investment assets they must accumulate to meet their retirement objectives.

Jack and Lois began their calculation by determining what their household expenditures will likely be in retirement. Their estimate is based on maintaining a "comfortable" standard of living---one that will not be extravagant yet will allow them to do the things they would like in retirement. A simple yet highly effective way to derive an estimate of expected household expenditures is to base it on the current level of such expenses. Assume that the Spellmans' annual household expenditures (excluding savings) currently run about $42,000 a year---this information can be readily obtained by referring to their most recent income and expenditures statement. Making some obvious adjustments for the different lifestyle they will have in retirement---their children will no longer be living at home, their home will be paid for, and so on---the Spellmans estimate that they will be able to achieve the standard of living they would like in retirement at an annual level of household expenses equal to about 70 percent of the current amount. Thus, in terms of today's dollars, their estimated household expenditures in retirement will be $42,000 x .70 = $29,400. (This process is summarized in steps A through D in Worksheet 1.)



Estimating Retirement Income

The next question is: Where will they get the money to meet their projected household expenses of $29,400 a year? They have addressed this problem by estimating what their income will be in retirement---again in terms of today's dollars. Their two basic sources of retirement income are Social Security and employer-sponsored pension plans. Based on today's retirement tables they estimate that they will receive about $13,000 a year from Social Security (you can receive an estimate directly from the Social Security Administration of what your future Social Security benefits are likely to be when you retire) and another $9,000 from their employer pension plans, for a total projected annual income of $22,000.                     When this is compared to their projected household expenditures, it is clear the Spellmans will be facing an annual shortfall of $7,400 (see steps E through I in Worksheet 1). This is the amount of retirement income they must come up with; otherwise, they will have to reduce the standard of living they hope to enjoy in retirement.

At this point we need to introduce the inflation factor to our projections in order to put the annual shortfall of $7,400 in terms of retirement dollars. Here we make the assumption that both income and expenditures will undergo approximately the same average rate of inflation, causing the shortfall to grow by that rate over time. In essence, 30 years from now, the annual shortfall is going to amount to a lot more than $7,400. How large it will grow to will, of course, be a function of what happens to inflation. Assume that the Spellmans think inflation, on average, over the next 30 years will amount to 5 percent---while that is a bit on the high side by today's standards, the Spellmans decide to use it anyway as they would rather overestimae the effects of inflation than underestimate them.


Funding the Shortfall

The final two steps in this estimation process are to determine (1) how big the retirement nest egg must be to cover the projected annual income shortfall, and (2) how much to save each year to accumulate the required amount by the time the Spellmans retire. To find out how much money they need to accumulate by retirement, they must estimate the rate of return they think they will be able to earn on their investments after they retire. This will tell them how big their nest egg will have to be by retirement in order to eliminate the expected annual shortfall of $32,000. Let's assume that this rate of return is estimated at 10 percent, in which case, the Spellmans must accumulate $320,000 by retirement. This figure is found by capitizing the estimated shortfall of $32,000 at a 10 percent rate of return: $32,000 / .10 = $320,000 (see steps M and N). Given a 10 percent rate of return, such a nest egg will yield $32,000 a year: $320,000 x .10 = $32,000. And so long as the capital ($320,000) remains untouched, it will generate the same amount of annual income for as long as the Spellmans live and can eventually become a part of their estate.

Now that the Spellmans know how big their nest egg has to be, the final question is: How are they going to accumulate such an amount by the time they retire? For most people that means setting up a systematic savings plan and putting away a certain amount each year. The appropriate interest factor is a function of the rate of return one can (or expects to) generate and the length of the investment period. In the Spellmans case, there are 30 years to go until retirement, meaning that the length of their investment period is 30 years. Because the Spellmans must accumulate $320,000 by the time they retire, the amount they will have to save each year (over the next 30 years) can be found by dividing the amount they need to accumulate by the appropriate interest factor; that is $320,000 / 113.3 = $2,824 (see steps O to Q in Worksheet 1).

The Spellmans now know what they must do to achieve the kind of retirement they want: Put away $2,824 a year and invest it at an average annual rate of 8 percent over the next 30 years. If they can do that, they will have their $320,000 retirement nest egg in 30 years. Of course, they could have been more aggressive in their investing and assumed an average annual rate of 10 percent, in which case, either they would end up with a bigger nest egg at retirement, or they could get away with saving less than $2,284 a year. Now, how they actually invest their money so as to actually achieve the desired 8 (or 10) percent rate of return will, of course, be a function of the investment vehicles and strategies they use. All the worksheet tells them is how much money they will need, not how they will get there; it is at this point that investment management enters the picture.

The procedure outlined here admittedly is a bit simplified and does take a few shortcuts, but considering the amount of uncertainty imbedded in the long-range projections being made, it does provide a viable estimate of retirement income and investment needs. The procedure certainly is far superior to the alternative of doing nothing. One important simplifying assumption in the procedure, though, is that it ignores the income that can be derived from the sale of a house. The sale of a house not only offers some special tax features but can generate a substantial amount of cash flow as well. Certainly, if inflation does occur in the future (and it will), it will very likely drive up home prices right along with the cost of everything else. A lot of people sell their homes around the time they retire and either move into smaller houses (often in Sun Belt retirement communities) or decide to rent in order to avoid all the problems of homeownership. Of course, the cash flow from the sale of a house can have a substantial effect on the size of the retirement nest egg. However, rather than trying to factor it into the forecast of retirement income and needs, we suggest that you recognize the existence of this cash flow source in your retirement planning, and consider it as a cushion against all the uncertainty inherent in retirement planning projections.

*SOURCE: PERSONAL FINANCIAL PLANNING, 10TH ED., 2005, LAWRENCE J. GITMAN, MICHAEL D. JOEHNK, PGS. 598-603*

end

Personal Financial Planning: An "How-To" Guide (part 53)

MUTUAL FUNDS: SOME BASICS
by
Charles Lamson

For individual investors today, mutual funds are, without a doubt, the investment vehicle of choice. The fact is, more people invest in mutual funds than any other type of investment product. The reason they are so popular is that they offer not only a variety of interesting investment opportunities, but also a wide array of services that many investors find appealing. They provide an easy and convenient way to invest, and are especially suited to beginning investors and those with limited investment capital. A mutual fund is basically a financial services organization that receives money from its shareholders and invests those funds on their behalf in a diversified portfolio of securities. Thus, when investors buy shares in a mutual fund, they actually become part owners of a widely diversified portfolio of securities. In an abstract sense a mutual fund can be thought of as the financial product that is sold to the public by an investment company. That is, the investment company builds and manages a portfolio of securities and sells ownership interests---shares of stock---in that portfolio through a vehicle known as a mutual fund. This concept underlies the whole mutual fund structure and is depicted in Exhibit 1.

The Mutual Fund Concept

The first mutual fund in this country was started in Boston in 1924; by 1940, there were 68 mutual funds in operation, and by 1980, there were 564. There are now well over 15,000 funds available. To put this number in perspective, there are more mutual funds in existence today than there are stocks listed on the New York and American exchanges combined! The fund industry has grown so much, in fact, that it is now the largest financial intermediary in this country---ahead of even banks.

In mid-2017, an estimated 56.2 million households, or 44.5 percent of all US households, owned mutual funds. The current estimate of the number of individual investors owning mutual funds is 100.0 million (https://www.ici.org/faqs/faq/mfs/faqs_mf_shareholders). Clearly, mutual funds appeal to a lot of investors---investors who come from all walks of life and all income levels. And they all share one common view: They have decided for one reason or another, to turn the problem of security selection and portfolio management over to professional money managers. Questions of which stock or bond to select, when to buy, and when to sell have plagued investors for about as long as there have been organized securities markets. Such concerns lie at the very heart of the mutual fund concept and, in large part, are behind the growth in funds. The fact is, a lot of people simply lack the time, the know-how, or the commitment to manage their own securities. As a result, they turn to others. And more often than not, that means mutual funds.

US Household Ownership of Mutual Funds
Millions, selected years

*Sources: Investment Company Institute and US Census Bureau*

smart.sites Want to know more about the fund industry, from the funds themselves to fund investors and legislation affecting funds? The Investment Company Institute Web site (www.ici.org) has all the answers.

Pooled Diversification

The mutual fund concept is based on the simple idea of turning the problems of security selection and portfolio management over to professional money managers. In essence, a mutual fund combines the investment capital of many people with similar investment goals, and invests the funds in a wide variety of securities. Investors receive shares of stock in the mutual fund and, through the fund, are able to enjoy much wider investment diversification than they could otherwise achieve. 

No matter what the size of the fund, as the securities held by it move up and down in price, the market value of the mutual fund shares moves accordingly. And when dividend and interest payment are received by the fund, they too are passed on to the mutual fund shareholders and distributed on the basis of prorated ownership. For example, if you own 1,000 shares of stock in mutual fund and that represents, say, 1 percent of all shares outstanding, you would receive 1 percent of the dividends paid by the fund. When a security held by the fund is sold for a profit, the capital gain is also passed on to fund shareholders. The whole mutual fund idea, in fact, rests on the oncept of pooled diversification, and works very much like insurance, whereby individuals pool their resources for the collective benefit of all the contributors.

*SOURCE: PERSONAL FINANCIAL PLANNING, 10TH ED., 2005, LAWRENCE J. GITMAN, MICHAEL D. JOEHNK, PGS. 550-552*

end

Personal Financial Planning: An "How-To" Guide (part 52)

The Bond Market
by
Charles Lamson
                                                                           

According to The Motley Fool, the global bond market has more than tripled in size in the past 15 years and now exceeds $100 trillion. By contrast, S&P Dow Jones Indices put the value of the global stockmarket at around $64 trillion (https://www.fool.com/knowledge-center/5-bond-market-facts-you-need-to-know.aspx). Given such size, it is not surprising that today's bond market offers securities to meet just about any type of investment objective and suit virtually any type of investor, no matter how conservative or aggressive. As a matter of convenience, the bond market is usually divided into four segments, according to type of issuer. Treasury, agency, municipal, and corporate.

Treasury Bonds
Treasury bonds (sometimes called Treasuries or government) are a dominant force in the bond market, and if not the most popular, certainly are the best known. The U.S, Treasury issues bonds, notes, and other types of debt securities as a means of meeting the ever increasing needs of the federal government. All Treasury obligations are of the highest quality (backed by the full faith and credit of the U.S. government), a feature that, along with their liquidity, makes them extremely popular with individual and international investors, both here and abroad. U.S. Treasury securities are traded in all the major markets of the world, from New York to London to Tokyo.

Treasury notes are issued with maturities of 2, 3, 5, and 10 years, whereas Treasury bonds carry 20- and 30-year maturities (Note that while the treasury is authorized to issue these securities, the last time they issued 20-year bonds was in January 1986 and the last 30-year bond was issued in August 2001. Even so, many of these bonds are still outstanding and actively traded in the secondary market.) All treasury notes and bonds are sold in minimum denominations of $1,000, and although interest income is subject to normal federal income tax, it is exempt from state and local taxes. Also, the Treasury today issues only noncallable securities---the last time the U.S, Treasury issued callable debt was in 1984.



In 1997, the Treasury began issuing its newest security, the Treasury inflation-indexed bond---or TIPs as they are also known, which stands for "Treasury Inflation-Protection Securities." Basically, these securities---which are issued as notes with 10-year maturities, and until 2001, as bonds with 30-year maturities---provide investors with the opportunity to stay ahead of inflation by periodically adjusting their returns for any inflation that has occurred. That is, if inflation is running at an annual rate of, say, 3 percent, then at the end of the year the par (or maturity) value of your bond will increase by 3 percent (actually, the adjustments to par value are done every six months). Thus, the $1,000 par value will grow to $1,030 at the end of the first year and if the 3 percent inflation rate continues for the second year, the par value will once again move up, this time from $1,030 to $1,061 (or $1,030 x 1.03). Unfortunately, the coupons on these securities are set very low, as they are meant to provide investors with so-called real (inflation-adjusted) returns. Thus, one of these bonds might carry a coupon of only 3.5 percent (at a time when regular T-bonds are paying, say, 6.5 or 7 percent). But there is an upside even to this: The actual size of the coupon payment will increase over time as the par value on the bond goes up. For investors who are concerned about inflation protection, these securities may be just the ticket. These securities are a lot more complex than your normal Treasury bonds.


Agency Bonds

Agency Bonds are an important segment of the U.S. bond market. Though issued by political subdivisions of the U.S. government, these securities are not obligations of the U.S. Treasury. An important feature of these securities is that they customarily provide yields comfortably above the market rates for treasuries, and, therefore, offer investors a way to increase returns with little or no real difference in risk. Some of the more actively traded and widely quoted agency issues include those sold by the Federal Farm Credit Bank, the Federal National Mortgage Association (or "Fannie Maes," as they are more commonly known), the Federal Land Bank, the Student Loan Marketing Association, and the Federal Home Loan Bank. Although these issues are not the direct obligation of the U.S. government, a number of them actually do carry government guarantees and thus effectively represent the full faith and credit of the U.S. Treasury. Moreover, some have unusual interest-payment provisions (interest is paid monthly in a few instances and yearly in one case), and, in some cases, the interest is exempt from state and local taxes.

smart.sites If bonds are still a mystery to you, the Bond Market Association’s “Investing in Bonds” site (www.investinginbonds.com) has a wealth of practical and educational tools and useful links.

Municipal Bonds

Municipal bonds are often the issues of states, countries, cities, and other political subdivisions, such as school districts and water and sewer districts. They are unlike other bonds in that their interest income is unusually free from federal income tax (which is why these issues are known as tax-free bonds). Note, however, that the same tax-free status does not apply to any capital gains that may be earned on these securities---that is, such gains are subject to the usual federal taxes. A tax-free yield is probably the most important feature of municipal bonds and is certainly a major reason why individuals invest in them. The higher the individual's tax bracket, the more attractive municipal bonds become.

As a rule, the yields on municipal bonds are (almost always) lower than the returns available from fully taxable issues. Thus, unless the tax effect is sufficient to raise the yield on a municipal to a yield that equals or exceeds the yields on taxable issues it obviously does not make sense to buy municipal bonds. You can determine the return a fully taxable bond would have to provide in order to match the after-tax return on a lower-yielding tax-free issue by computing what is known as a municipal's fully taxable equivalent yield:

Municipal bonds are generally issued as serial obligations meaning that the issue is broken into a series of smaller bonds, each with its own maturity date and coupon rate. Thus, instead of the bond having just one maturity date 20 years from now, it will have a series of, say, 20 maturity dates over the 20-year time frame. Although it may not seem that municipal issuers would default on either interest or principal payments, it does occur. Investors should be especially cautious when investing in revenue bonds, which are municipal bonds serviced from the income generated from specific income-producing products, such as toll roads. Unlike issuers of so-called general obligation bonds---which are backed by the full faith and credit of the municipality---the issuer of a revenue bond is obligated to pay principal and interest only if a sufficient level of revenue is generated. General obligation municipal bonds, in contrast, are required to be serviced in a prompt and timely fashion regardless of the level of tax income generated by the municipality.

Caution should be used when buying municipal bonds because some of these issues are tax-exempt and others are not. One effect of the far-reaching Tax Reform Act of 1986 was to change the status of municipal bonds used to finance nonessential projects so their interest income is no longer exempt from federal taxes. Such bonds are known as taxable munies, and they offer yields considerably higher than normal tax-exempt securities. Buy one of these issues and you will end up holding a bond whose interest income is fully taxable by the IRS.

Corporate Bonds

The major nongovernmental issuers of bonds are corporations. The market for corporate bonds is customarily subdivided into several segments, which include industrials (the most diverse of the group), public utilities (the dominant groups in terms of volume of new issues), rail and transportation bonds, and financial issues (banks, financial companies, and so forth). The corporate bond market offers the widest range of issue types. There are first mortgage bonds, convertible bonds, debentures, subordinated debentures, and income bonds, to mention just a few. Interest on corporate bonds is paid semiannually, and sinking funds are common. The bonds usually come in $1,000 denominations and are issued on a term basis with a single maturity date. Maturities usually range from 5 to 10 years, to 30 years or more. Many of the issues---particularly the longer-term bonds---carry call provisions that prohibit prepayment of the issue during the first 5 to 10 years. Corporate issues are popular with individuals because of their relatively high yields.

*SOURCE: PERSONAL FINANCIAL PLANNING, 10TH ED., 2005, LAWRENCE J. GITMAN, MICHAEL D. JOEHNK, PGS. 526-530*

end

smart.sites

If bonds are still a mystery to you, the Bond Market
Association’s “Investing in Bonds” site
(www.investinginbonds.com) has a wealth of
practical and educational tools and useful links.