Seeing Your Company as a System

Much-needed guidance on making companies more employee-centered, adaptive, and capable.

strategy+business magazine

by Andrea Gabor

Photograph by Hideki Kuwajima

… No matter how disparate the causes of failure, there is always a common thread: somewhere, somehow, management has let its attention slip. …[Now] is an opportune time to reflect on the leading ideas that have shaped what we know about the management of social systems, particularly corporations, and how to stabilize and improve them.

The recognition that a company is a complex social system and a living community has been an underlying theme of leading management thinkers as far back as the early 20th century. Nevertheless, the machine continues to be the dominant metaphor for business leaders, …

The speed and complexity of the global business environment calls for a new appreciation of a systems-focused view of the world, one that recognizes the interrelationships of people, processes, and decisions — and designs organizational actions accordingly. The intellectual roots of systems understanding … converge around three interrelated assumptions. First, … static solutions that try to lock in any ongoing management solution are likely to become new sources of destabilization themselves. … Second, organizations must have a capacity for widespread experimentation and trial-and-error learning if they are to be self-correcting. Finally, although a systems view requires an understanding of how all the parts fit together as a whole, it also depends on an intimate understanding of the parts themselves. This is because change in any part of the system or in its outside environment — including the other systems to which it is connected — can produce profound ripple effects.

Significantly, these assumptions all recognize the importance of human participation in decision making. … Everyone who works within a system — including suppliers and line workers, designers, and marketers — should learn how the system works, develop their creativity, and apply that creativity to improve the system. …

… The most valuable expertise is understood to be held by those who are closest to any given part of the system. Management’s chief jobs are, first, to facilitate learning, adaptation, and improvement by creating a culture that is free of fear, and, second, to provide the tools and training that employees need to identify problems and opportunities for improvement. And the leaders throughout these companies also practice “mindfulness.” They establish and revise routines that constantly test current assumptions and seek to anticipate future needs, they pay attention to process, and they see continuous improvement as the best way to achieve not only step change but also innovative leaps.

Whole-systems Design

Any effort to cultivate a systems orientation could profitably begin with the work of the late Russell Ackoff, …

Ackoff drew a clear distinction between the machine age, in which companies could assume relative stability and seek optimum solutions to discrete problems, and the systems age, beginning after World War II, a time of growing … complexity. Organizations would henceforth have to deal with “sets of interacting problems” and give up the quixotic search for simple solutions that could be applied consistently. The key challenge, Ackoff said, would be designing systems that would learn and adapt. … [He] said, “Experience is not the best teacher; it is not even a good teacher. It is too slow, too imprecise, and too ambiguous.” Organizations would have to learn and adapt through experimentation, which he said “is faster, more precise, and less ambiguous. We have to design systems which are managed experimentally, as opposed to experientially.” To accomplish this, he laid out a method of interactive planning, … that reflected how key stakeholders would redesign and rebuild a system if it were suddenly destroyed.

[Re-creating the Corporation: A Design of Organizations for the 21st Century] is full of both conceptual tools for organizational redesign and specific practices for developing adaptive and resilient learning environments. … Ackoff describes the use of elected internal boards to give people more control over their decision making, and shows how to set up an internal market for shared services that reflects their real value (or, as he calls it, an “internal market economy”). The overriding theme is the need to avoid any particular management panacea, and instead institute an adaptive, continually evolving design process that (as Ackoff puts it) manipulates the parts of a company “with a primary focus on the performance of the whole.”

Better Thinking and Interacting

Ackoff’s focus on learning is picked up by Peter Senge, … the author of The Fifth Discipline: The Art and Practice of the Learning Organization, which focuses on the need for blending the “behavioral” and “technical” elements of organizations. One underlying premise of the book is that a systems orientation requires individual employees to be open to new ideas and points of view and free of conscious and subconscious prejudices.

“Organizations work the way they do because of how we work, how we think and interact,” writes Senge, … The “best systemic insights don’t get translated into action when people don’t trust one another and cannot build genuinely shared aspirations and mental models.”

Senge identified five disciplines — … as necessary for organizational learning.

1. Systems thinking, which in this case means learning to recognize the forces of acceleration and equilibrium at work in complex systems, how they interact over time, and how to use them to gain leverage.

2. Personal mastery, … tapping immense creative potential by aligning the personal aspirations of individuals with the goals of the organization and a clear view of current reality.

3. Mental models, which are the prevailing attitudes, beliefs, and cognitive habits held within a group that shape its perceptions of the world and how it takes action.

4. Shared vision, which is the collective voiced aspiration that supports the collective pursuit of worthwhile goals.

5. Team learning, which embodies open dialogue with no preconceptions, and other forms of candid, in-depth group activity.

… Senge’s disciplines are fundamentally personal, and require a shift in perspective among individual members of an organization, as well as a collective transformation. …[The] first chapter of The Fifth Discipline offers an excellent overview of the disciplines and how they fit together. Senge’s subsequent book, the collaboratively written The Fifth Discipline Fieldbook: Strategies and Tools for Building a Learning Organization (Doubleday/Currency, 1994), offers a step-by-step guide to tackling the five disciplines. (Disclosure: Art Kleiner, the editor-in-chief of strategy+business, was a Fieldbook coauthor and its editorial director.)

Everyone’s a Knowledge Worker

Widespread employee participation is essential for creating and maintaining learning and adaptive capabilities, but that goal has long been elusive for many companies. …

…“[Knowledge] workers,” whom Peter Drucker first described in 1959 and broadly defined in Management Challenges for the 21st Century (Harper Business, 1999) as people who “know more about their job than anybody else in the organization,” that a widespread recognition of the role of ordinary employees in improving systems began to take hold. …

A narrow definition of knowledge workers, … is articulated by Thomas Davenport. Davenport … wrote, in “Why Don’t We Know More about Knowledge?” a 2004 article in the MIT Sloan Management Review (coauthored with Michael Hammer and Dorothy Leonard), that although “every job requires some knowledge, most would agree that knowledge workers are people with high levels of education and expertise whose primary task is the creation, distribution or application of knowledge.” In contrast, a systems view demands the broadest possible definition of knowledge workers because, at the most elemental level, any employee who connects to a process must have the knowledge to recognize when something is wrong and to sound an alarm.

Employee participation plays an integral role in companies seeking a systems orientation. … [It] lies at the core of one type of company that Karl Weick and Kathleen Sutcliffe, … have studied in depth: high reliability organizations (HROs). These are nuclear power plants, aircraft carriers, and other enterprises that must foster constant mindfulness as a way to avert catastrophic system failures.

In Managing the Unexpected: Resilient Performance in an Age of Uncertainty, … Weick and Sutcliffe describe a culture in which employees engage in the continuous updating and deepening of their understanding of the context of organizational systems, the problems that define them, and what remedies they contain. Mindful organizations, … are characterized by a broadly defined “deference to expertise,” in a setting where “expertise is not necessarily matched with hierarchical position.” … HROs are also capable of seeing weak signals of systemic failure and responding with vigor. To support this capability, such organizations strive for open communication, recognizing that if people refuse to speak up out of fear, this capability will be undermined.

Managing the Unexpected is replete with examples of the importance of mindfulness and imagination at all levels of the hierarchy. … They note the precision and on-the-ground decision making that are necessary to prevent accidents on aircraft carriers operating on the high seas, explaining that because of the sensitivity of operations, junior officers are expected to disregard a captain’s orders when following those orders could jeopardize the crew’s safety. “Rigid hierarchies have their own special vulnerability to error,” write Weick and Sutcliffe. “Errors at higher levels tend to pick up and combine with errors at lower levels, thereby making the resulting problem bigger, harder to comprehend and more prone to escalation.”

Training and Tools

Systems thinkers embrace Louis Pasteur’s dictum that “fortune favors the prepared mind.” …

…Toyota Motor Corporation’s … kaizen philosophy, long associated with the Toyota production system, remains one of the most critically important facets of a systems approach to management. Over a period of decades, it enabled Toyota to achieve its current position as the automaker with the most to lose, in terms of both market share and reputation.

Learning is such an integral part of kaizen — the continuous improvement of every process, every day, at every level of a company —that for many practitioners, training is considered the most important responsibility for any manager. For years, Toyota’s competitive advantage rested on the institutionalization of two interlinked routines, or kata: continuous improvement and coaching. The coaching kata, explains Mike Rother, … author of Toyota Kata: Managing People for Improvement, Adaptiveness, and Superior Results, “is the repeating routine by which Toyota leaders and managers teach the improvement kata to everyone in the organization.”

Rother offers a detailed look at the intertwined layers of routines, processes, and training that define the kaizen approach. …

Achieving kaizen depends on the knowledge and skill of every employee. Thus, writes Rother, “the primary task of...managers and leaders does not revolve around improvement per se, but around increasing the improvement capability of people.”

For decades, Toyota employees, … were engaged in a constant cycle of finding and solving problems, developing and testing new ideas, implementing and codifying new solutions and routines, then starting all over again. … Every Toyota employee was engaged in a constant quest for what Matthew E. May dubbed “the elegant solution” in his book of the same name (The Elegant Solution: Toyota’s Formula for Mastering Innovation [Free Press, 2007]). May defines this solution as “one in which the optimal or desired effect is achieved with the least amount of effort.”

… To explain how managers can apply them more effectively, John Shook, … has written Managing to Learn: Using the A3 Management Process to Solve Problems, Gain Agreement, Mentor, and Lead. This slim, illustrated guidebook offers a worm’s-eye view of A3 diagrams. (An A3 diagram is a single-page document, roughly 11 by 17 inches, that aims to capture a snapshot of an individual process problem and its recommended solution.) “Every issue an organization faces can and should be captured on a single sheet of paper,” writes Shook. “This enables everyone touching the issue to see through the same lens.”

Shook explains the centrality of employee development by following the story of a single employee and his supervisor — with the perspective of each following two parallel columns on every page — as they map out the solution to a single problem, translating production documents from Japanese to English to support the expansion of Acme Manufacturing, … By focusing in minute detail on the mapping of a single problem, he shows how a seemingly mundane process can be fraught with errors, delays, and cost overruns that have system-wide implications, and how a deep understanding of the problem and its causes eventually leads to resolution. He also shows how patient coaching by the supervisor not only helps resolve the problem, but teaches his charge to be a better analyst.

The Deming Connection

The kaizen philosophy, Toyota production system, and similar methods are all closely linked to the work of W. Edwards Deming, the statistician who came to be known as a leading management guru and paved the way for the ascendancy of quality as a management priority. … Deming’s key insight — a deceptively simple yet profound statistical observation about how processes work — offers one of the most practical and important insights into the role that employees play in improving processes and developing a systems approach to organizations.

Deming, … argued that the predictability and quality of all processes are subject to two distinct causes of variation: special causes, which are generally due to a glitch in the system that can be fairly easily fixed, …; and common causes, which are more complex and difficult to isolate because they are systemic. …Treating a systemic problem as though it is a one-time glitch not only makes it less likely that the root cause will be found and fixed, but can cause even bigger problems going forward.

Deming recognized that when it comes to the myriad processes that make up a large system, ordinary employees — including line and maintenance workers, salespeople, and technicians — know the system best. They possess the crucial knowledge that is needed to distinguish between mere glitches and systemic failures and to ensure the predictability of any given process. He argued that a predictable, stable system offers unexpectedly valuable opportunities for improvement and innovation. Companies that rely on outside “experts” to monitor their processes, in lieu of employees with day-to-day experience, lose these opportunities for gain.

In his book Out of the Crisis (MIT Press, 1986), Deming codified his management philosophy in 14 points, which emphasized the importance of a change-friendly culture and participative management, including a work environment free of fear in which employees get the training needed to analyze and improve the system.

Deming’s writing tends to be dense and difficult to read, …The most accessible source for Deming in his own words is his last book, The New Economics for Industry, Government, Education. The first chapter touches on the role of management and the customer, as well as the connection between continuous improvement and innovation. The third and fourth chapters illuminate Deming’s view of systems and the context for thinking about systems within a human organization. “If Japan Can...Why Can’t We?” the 1980 NBC television documentary produced by Clare Crawford-Mason, which is credited with rediscovering Deming’s work and helping to launch the quality revolution in the United States, is a very accessible video introduction to Deming’s ideas — and surprisingly relevant to today’s businesses.

Quantitative Distractions

Any discussion of systemic visions or ideals confronts one final — and profound — hurdle: what H. Thomas Johnson, …refers to as the “quantitative abstractions” that control most companies. “When businesses regard economic activity as if it involves only the manipulation of abstract quantitative variables,” writes Johnson, “they miss what is really happening to the people, the communities, and the natural world that surround them.”

In his books Profit beyond Measure: Extraordinary Results through Attention to Work and People (co-authored with Anders Bröms) and Relevance Regained: From Top-down Control to Bottom-up Empowerment, Johnson outlines how perverse financial incentives and the use of top-down accounting information to control operations ushered in a “dark age of American business history” between the 1950s and 1980s. …

Johnson found that financial systems aimed at achieving short-term, bottom-line results treat the organization mechanistically, as “a collection of independent parts.” … He argues that ignoring the systemic impact of financial decision making is unsustainable in the long run and will yield progressively worse results. Yet, as Johnson wrote in the March 2009 issue of The Systems Thinker, …“the thinking and behavior of almost all business managers in today’s world reflects a world view grounded in the whole-equals-sum-of-the-parts and win-lose competitive principles of 19th-century mechanics, not the systemic, cooperative, win-win symbiotic principles of 21st-century cosmology and life sciences.”

… He argues that Toyota’s performance, unrivaled for close to 50 years — up until about 2000 — could be attributed in part to accounting and financial practices that were consistent with the company’s systemic approach to management. But that changed, wrote Johnson in the February 2010 issue of The Systems Thinker, when Toyota’s top managers “turned away from the thinking that had implicitly anchored its operations to the concrete reality of natural systems in the real world.”

There’s no question that Johnson’s perspective on many issues is controversial. … But his work shows how financial practices can be profitably redesigned with an eye toward participation, increased day-by-day awareness, and shared information, rather than mechanistic control.

All the works mentioned in this guide have been linked to higher performance. Yet their focus on the expertise of ordinary employees remains a hard sell in many companies, because it requires an enormous long-term commitment to training and to local control and knowledge sharing.

Moreover, employee-centered systems organizations need to develop trust — between supervisors and employees and among employees who have to work together to understand and improve the system. Making this work takes skillful management. Indeed, many quality improvement efforts in the U.S. failed because they absorbed rigid process guidelines but failed to build in flexibility.

But it can be done; by now, thousands of managers in dozens of companies have accomplished it. These resources provide a path for others to follow.

Reprint No. 10210

Author Profile:

• Andrea Gabor is the author of several books, including The Capitalist Philosophers: The Geniuses of Modern Business — Their Lives, Times, and Ideas (Three Rivers Press, 2002). She is the Bloomberg Professor of Business Journalism at Baruch College at the City University of New York.

It Makes Sense to Adjust

Business transformation is now a continuous process that most companies haven’t mastered. Here’s a formula for managing ongoing change.

strategy+business magazine

by Vinay Couto, Frank Ribeiro, and Andrew Tipping

It used to be that a business transformation was a once-in-a-lifetime event, … But if the recent economic upheaval reveals anything, it is that companies of all sizes, in all industries, are operating in a more volatile, less predictable environment, and that change has become a way of life. …

… A review of businesses faced with “burning platforms” (which are enterprise-threatening events) would reveal that most have failed to make the transformation the situations demanded. …

The problem is that most companies don’t have an adequately proactive road map for transformation. Instead, they attempt change on the fly, reacting to business disruption with equally explosive responses that may not be useful six months down the road or even sooner. …[If] an organization prepares for transformation (perhaps when it is not occurring), steering through it is far less difficult.

Each company’s strategy for approaching transformation falls into one of three categories. These categories in turn determine the level of transformation — the timing and the magnitude — that the company can support.

1. Reactive. This is the default transformation strategy; it is minimal, and has become second nature to most seasoned executives. A change in circumstances provokes a short-term response, generally an abrupt shift that requires little cross-company coordination or follow-up. … Problems arise when executives try to apply this approach to situations that call for more sweeping and highly detailed transformation. …

2. Programmatic. This strategy is more comprehensive and is appropriate when major change is required and a company has sufficient lead time. In such circumstances, the company launches a widespread change initiative across the lines of business that are most affected. A cross-functional program office is set up, tactics are identified, milestones are established, executives are assigned to oversight, a communications program is launched, and progress is tracked.

These programs can be effective in dealing with a contained event or threat, such as a new competitor or a new product from a rival, and their potential reward is greater than that of the reactive approach because they are more forward-looking. But as the name of this category implies, the transformation is a program — a systematic, planned sequence of activities designed to achieve specific goals within a specific period of time — and, thus, the outcome takes longer than a reactive transformation.

3. Sense-and-adjust. This is the most long-term and sustainable strategy, … Unlike the first two approaches, sense-and-adjust is dynamic, constantly and consistently smoothing out volatility in areas of business subject to swift and dramatic change, such as research and development or frontline operations like manufacturing and logistics.

Sensing is an ongoing effort to gather and analyze data on current and future business conditions and, more important, translate it into likely outcomes. The sensing process should …synthesize [planning information] with key performance data to form a single “dashboard” of actionable information that can be used by business unit heads or corporate leaders in functions like IT, HR, or marketing.

A high-quality sensing dashboard offers an early organizational indicator of future business conditions. … For example, a business unit head may use a dashboard to reveal unanticipated decreases in either product unit price or volume that could translate to an overall decline in revenue. Or a logistics firm may place its sensing system on alert for changes in pricing and functionality of handheld computers, wireless communications, mapping software, and the like; the goal would be to determine how and when to start applying these technologies to its own business (and to avoid being blindsided by a competitor).

Adjusting is the process of altering business strategies on the basis of sensed outcomes. In this phase, which is done in tandem with sensing, business unit or department heads assess the data to determine possible resource and capability trade-offs. They explore the impact on people, processes, and technology, and then develop a consensus on the plan that is most appropriate for building or maintaining competitive position. In the case of an unexplained drop in unit prices, the adjustment may be an emphasis on marketing, innovation, or layoffs. And if a company has learned that it could outpace its rivals by implementing a GPS system, a slate of new training programs that teach employees how to use the technology may be just as important as purchasing the equipment itself.

As adjustments are made, the sensing capability picks up and continues the cycle, both scanning the horizon for market shifts and monitoring the execution of these strategic responses. Sensing does little good in the absence of adjusting, and vice versa.

The sense-and-adjust approach to change is not the traditional stutter-step strategic planning process in which business units are summoned every six or 12 months to present their take on the market and their performance expectations. The sense-and-adjust process is continuous, incorporating new information and forecasting outcomes and expectations constantly. Companies that have mastered the skills to handle the programmatic approach and have an organization that is reasonably resilient — … are the best candidates for this sustainable strategy….

For some companies, particularly those without the mature planning processes and deep leadership bench necessary to implement a full-fledged sense-and-adjust strategy, a programmatic transformation can offer a clear path toward that goal. …

If nothing else, all companies must recognize that the pace and magnitude of change is far faster and greater now than ever before and that transforming their business is no longer something they can avoid, defer, or out-manage. Even small moves to increase an organization’s sense-and-adjust skills will reap significant and sustainable rewards.

Author Profiles:

• Vinay Couto is a partner with Booz & Company in Chicago. He focuses on global organization restructuring and turnaround programs in the automotive, industrials, and consumer packaged goods industries.
• Frank Ribeiro is a partner with Booz & Company in New York. He focuses on overall corporate transformation and associated capability-building programs to increase an organization’s effectiveness and efficiency.
• Andrew Tipping is a partner with Booz & Company in Chicago. He focuses on large-scale organizational transformation to increase the effectiveness and efficiency with which companies meet customer needs.
• Also contributing to this article were Booz & Company Senior Associate Matthew Siegel and Principal Curt Mueller.

Cleaning the Crystal Ball

How intelligent forecasting can lead to better decision making.

strategy+business magazine

by Tim Laseter, Casey Lichtendahl, and Yael Grushka-Cockayne

Illustration by Lars Leetaru

Peter Drucker once commented that “trying to predict the future is like trying to drive down a country road at night with no lights while looking out the back window.” Though we agree with Drucker that forecasting is hard, managers are constantly asked to predict the future … Good forecasts hold the key to good plans. Simply complaining about the difficulty does not help.

Nonetheless, few forecasters receive any formal training, or even expert apprenticeship. … This lack of attention to the quality of forecasting is a shame, because an effective vehicle for looking ahead can make all the difference in the success of a long-term investment or strategic decision.

Competence in forecasting does not mean being able to predict the future with certainty. It means accepting the role that uncertainty plays in the world, engaging in a continuous improvement process of building your firm’s forecasting capability, and paving the way for corporate success. …

… By using the language of probability, a well-designed forecast helps managers understand future uncertainty so they can make better plans that inform ongoing decision making. We will explore the many approaches that forecasters can take to make their recommendations robust, even as they embrace the uncertainty of the real world.

The Flaw of Averages

In forecasting the future, most companies focus on single-point estimates: … [We] often forget that a point forecast is almost certainly wrong; an exact realization of a specific number is nearly impossible.

This problem is described at length by Sam Savage, an academic and consultant based at Stanford University, in The Flaw of Averages: Why We Underestimate Risk in the Face of Uncertainty (Wiley, 2009). He notes how focusing on an average without understanding the impact of the range can lead to flawed estimates. Better decisions result from taking the time to anticipate the likelihood of overshooting or undershooting the point, and then considering what to do today, given the range of possibilities in the future.

Savage highlights the simple example of a manager estimating the demand for 100,000 units of a product — based on a range of possible market conditions — and then extrapolating that average to produce a profit estimate. … As a result, the profits at an average demand level will be much different from an average of the profits across the range of possibilities. Rather than a simple average, a better forecast would present a wide range of scenarios coupled with a set of potential actions to influence the demand and profitability. …

Reflecting risk in forecasts is a simple concept and one that may seem easy to put into practice, but managers commonly ignore the uncertainties and simply collapse their forecasts into averages instead. … Consider a project with 10 parallel tasks. Each task should take between three and nine months, with an average completion time of six months for all of them. If the 10 tasks are independent and the durations are distributed according to a triangular distribution, chances are less than one in 1,000 that the project will be completed in six months, and the duration will be close to eight months. But using the six-month figure instead offers an almost irresistible temptation; after all, that’s the average input. …

In short, forecasting should not be treated as a game of chance, in which we win by getting closest to the eventual outcome. … Instead, it’s better to use the range of possible outcomes as a learning tool: a way to explore scenarios and to prepare for an inherently uncertain future.

Drivers of Uncertainty

The most useful forecasts do not merely document the range of uncertainties; they explain why the future may turn in different directions. … Just asking “Why might this happen?” and “What would happen as a result?” helps to uncover possible outcomes that were previously unknown. Recasting the driving forces as metrics, in turn, leads to better forecasts.

For example, the general business cycle is a driving force that determines much of the demand in the appliance industry. Key economic metrics, such as housing starts, affect the sales of new units, but a consumer’s decision to replace or repair a broken dishwasher also depends on other factors related to the business cycle, such as levels of unemployment and consumer confidence. With metrics estimating these factors in hand, companies in that industry … use sophisticated macroeconomic models to predict overall industry sales and, ultimately, their share of the sales.

… Whirlpool’s planners use their industry forecast models to focus executive attention, not replace it. The planners present the model for the upcoming year or quarter, describing the logic that has led them to choose these particular levels of demand and the reason the outcomes are meaningful. Executives can set plans that disagree with the forecasters’ predictions, but everyone has to agree on which input variables reflect an overly optimistic or pessimistic future. Even more important, managers can begin influencing some of the driving forces: For example, they can work with retail partners to encourage remodeling-driven demand to offset a drop in housing starts.

Black Boxes and Intuition

As the Whirlpool example demonstrates, mathematical models can help focus discussions and serve as a foundation for effective decision making. Thanks to the increasing power of personal computers and the Internet, we have a host of advanced mathematical tools and readily available data at our disposal for developing sophisticated models.

Unfortunately, such models can quickly prove to be a “black box,” whose core relationships and key assumptions cannot be understood by even a sophisticated user. … Without a clear understanding of the drivers of the model, executives will not be attuned to the changes in the environment that influence the actual results. …

A lack of understanding of the black boxes tempts many managers to dismiss the planners’ models and simply “go with the gut” in predicting possible challenges and opportunities. … Back in the early 1970s, Nobel laureate Daniel Kahneman and his longtime collaborator Amos Tversky began a research stream employing cognitive psychology techniques to examine individual decision making under uncertainty. Their work helped popularize the field of behavioral economics and finance. (See “Daniel Kahneman: The Thought Leader Interview,” by Michael Schrage, s+b, Winter 2003.) Work in this field has demonstrated that real-life decision makers don’t behave like the purely rational person assumed in classic decision theory and in most mathematical models.

…[Our] brains seek out patterns. … Though critical in evolutionary survival, this skill can also lead us to see patterns where they do not exist. For example, when asked to create a random sequence of heads and tails as if they were flipping a fair coin 100 times, students inevitably produce a pattern that is easily discernible. The counterintuitive reality is that a random sequence of 100 coin flips has a 97 percent chance of including one or more runs of at least five heads or five tails in a row. Virtually no one assumes that will happen in an invented “random” sequence. …

Our tendency to see patterns even in random data contributes to a key problem in forecasting: overconfidence. Intuition leads people to consistently put too much confidence in their ability to predict the future. As professors, we … challenge [our MBA students] to predict, with a 90 percent confidence level, a range of values for a set of key indicators such as the S&P 500, the box office revenues for a new movie, or the local temperature on a certain day. If the exercise is done correctly, only one out of 10 outcomes will fall outside the predicted range. Inevitably, however, the forecasts fail to capture the actual outcome much more frequently than most of the students expect. Fortunately, the bias toward overconfidence diminishes over time as students learn to control their self-assurance.

History Matters

Although Peter Drucker fretted about looking out the rear window of the car, in reality too many forecasters fail to examine history adequately. Consider the subprime mortgage crisis. In 1998, AIG began selling credit default swaps to insure counterparties against the risk of losing principal and interest on residential mortgage-backed securities. …

At the end of the fourth quarter of 1998, the delinquency rate for U.S. subprime adjustable-rate mortgages stood at just over 13 percent. By the end of the fourth quarter of 2008, this rate had almost doubled, to an astonishing 24 percent. … Although a 24 percent default rate seemed unprecedented to most bankers, a look back beyond their own lifetimes would have indicated the possibility. In 1934, at the height of the Great Depression, approximately 50 percent of all urban house mortgages were in default.

That is why looking back at past forecasts and their realizations can prove so valuable; it can help prevent overconfidence and suggest places where unexpected factors may emerge. Recently, researchers Victor Jose, Bob Nau, and Bob Winkler at Duke University proposed new rules to score and reward good forecasts. An effective “scoring rule” provides incentives to discourage the forecaster from sandbagging, a proverbial problem in corporate life. … By assessing forecasting accuracy, the rules penalize sales above the forecast number as well as sales shortfalls. …

… A recent survey by decision analysis consultant Douglas Hubbard found that only one out of 35 companies with experienced modelers had ever attempted to check actual outcomes against original forecasts — and that company could not present any evidence to back up the claim. …

Wisdom of Crowds

… Journalist James Surowiecki presented the case [for conventional wisdom] in his bestseller, The Wisdom of Crowds: Why the Many Are Smarter Than the Few and How Collective Wisdom Shapes Business, Economies, Societies, and Nations (Doubleday, 2004). Furthermore, research into forecasting in a wide range of fields by Wharton professor J. Scott Armstrong showed no important advantage for expertise. In fact, research by James Shanteau, distinguished professor of psychology at Kansas State University, has shown that expert judgments often demonstrate logically inconsistent results. For example, medical pathologists presented with the same evidence twice would reach a different conclusion 50 percent of the time.

The old game of estimating the number of jelly beans in a jar illustrates the innate wisdom of the crowd. In a class of 50 to 60 students, the average of the individual guesses will typically be better than all but one or two of the individual guesses. …[That] result raises the question of why you shouldn’t use the best single guesser as your expert forecaster. The problem is that we have no good way to identify that person in advance — and worse yet, that “expert” may not be the best individual for the next jar because the first result likely reflected a bit of random luck and not a truly superior methodology.

For this reason, teams of forecasters often generate better results (and decisions) than individuals, but the teams need to include a sufficient degree of diversity of information and perspectives. …

Group dynamics can produce a different sort of challenge in bringing together a team; … Typically, a dominant personality steps forth and drives the process toward his or her predetermined view, making little or no use of the wisdom of the crowd. In The Drunkard’s Walk: How Randomness Rules Our Lives (Pantheon, 2009), physicist and writer Leonard Mlodinow describes a number of research studies that show how most people put too much confidence in the most senior or highest-paid person. …

Culture and Capability

To become proficient at forecasting, a company must develop capabilities for both achieving insight and converting that insight into effective decision making. The firm need not seek out the star forecaster, but instead should invest in cultivating an open atmosphere … that brings to the fore a more complete picture of the expert knowledge that already resides in many of its existing employees.

The resulting culture will be one in which managers recognize and deal with uncertainty more easily; …

In the end, overcoming the problems and traps in forecasting probably requires the use of all of these approaches together, within a supportive culture. …

… Too many managers dismiss the inherent uncertainty in the world and therefore fail to consider improbable outcomes or invest sufficient effort in contingency plans. The world is full of unknowns, even rare and difficult-to-predict “black swan” events, … Overreliant on either their intuition or their mathematical models, companies can become complacent about the future.

Consider, for example, the 2002 dock strike on the West Coast of the U.S., which disrupted normal shipping in ports from San Diego to the border with Canada for a couple of weeks. A survey conducted by the Institute for Supply Management shortly afterward found that 41 percent of the respondents had experienced supply chain problems because of the strike — but only 25 percent were developing contingency plans to deal with future dock strikes.

We can train our intuition to offer a better guide in decision making. To do so, we must be aware of our biases and remember that all models start with assumptions. Engaging a diverse set of parties, … forces us to articulate and challenge those assumptions by seeking empirical data. …Rather than seeking the ultimate model or expert, managers should adopt the axiom cited by General Dwight D. Eisenhower …“plans are nothing; planning is everything.” A good forecast informs decisions today, but equally important, forces us to consider and plan for other possibilities.

Reprint No. 10202

Author Profiles:

• Tim Laseter holds teaching appointments at an evolving mix of leading business schools, currently including the Darden School at the University of Virginia and the Tuck School at Dartmouth College. He is the author of Balanced Sourcing (Jossey-Bass, 1998) and Strategic Product Creation (with Ronald Kerber; McGraw-Hill, 2007), and is an author of the newest edition of The Portable MBA (Wiley, 2010). Formerly a partner with Booz & Company, he has more than 20 years of experience in operations strategy.
• Casey Lichtendahl is an assistant professor of business administration at the University of Virginia’s Darden Graduate School of Business. His research focuses on forecasting and decision analysis.
• Yael Grushka-Cockayne is an assistant professor of business administration at the University of Virginia’s Darden Graduate School of Business. Her research focuses on project management, strategic and behavioral decision making, and new product development.

Relocation in retirement takes careful financial, logistical planning

Employee Benefit News

By Wayne Hanson, SPHR, CEPF

May 24, 2010

For employers that offer retirement planning advice, an important topic for advisers to raise with employees is the possibility of relocating after they retire.

A recent Del Webb survey shows that 42% of today's 50-year-olds plan to relocate, compared to 36% of 50-year-olds in 1996. Further, about 50% of those considering relocation plan to move to a different state, while 25% plan to move to a different city within the same state.

Employees need to concretely plan - not just carelessly ponder - for a relocation following retirement, and shouldn't pack the moving van without considering a number of key factors, including the cost of living and health care.

A 2009 Fidelity Investments survey of 502 married couples found that only 38% report making decisions about their retirement finances together. Moreover, many couples don't agree on such basics as what type of lifestyle they expect to have in retirement.

Different retirement phases

Future retirees also must understand that their retirement needs may differ from one phase of retirement to another. At first, many retirees will be eager to travel, pursue hobbies or volunteer without restriction. In a recent article at CNNMoney.com, this was called the "go-go stage," …

However, retirees inevitably move from the "go-go stage" to the "slow-go stage" - still on the go, but not as often, the site reported.

The third stage, the "no-go stage," is the point at which physical/mental limitations prevent retirees from sustaining the active pace of the previous stages.

The different stages of retirement will impact where a retiree spends their money and how much they spend. Keeping the different stages of retirement in mind will be beneficial to current employees in retirement planning, whether the focus is finances, lifestyle or where to live.

Outside of the obvious considerations such as cost of living and health care, there are many other important considerations, including family. The serious health condition of a family member may be reason not to relocate or at least to postpone a scheduled relocation.

Social supports

One of the biggest fears with relocating is not being able to develop friendships in a new place. …

Other important considerations for employees nearing retirement who are considering relocation include:

* Can you afford the occasional trip back to your old hometown for significant events such as family reunions, funerals, weddings or the birth of grandchildren?

* If you need part-time work while in retirement, what are the employment prospects in your new city?

* Does the increased probability of natural disasters, such as hurricanes or earthquakes, in the new location cause concern? Have you actually experienced the off-season weather?

* Are amenities such as grocery stores, shopping areas, airports and public transportation convenient in the new location?

* Have you looked at your tax strategy? …

* What are the crime statistics in the new location?

* Have you spent ample time in the new location to ensure it really is a good fit? …

* What is the economic, employment, social-service, and health care spending climate?

Just as marriage should not be entered into lightly, neither should relocation occur without a thorough analysis of all important factors. …

---

Contributing Editor Wayne Hanson, SPHR, CEPF, is an HR consultant with a special interest in financial literacy. He has provided support to the private sector in a number of different capacities.

The eyes have it

Employee Benefit News

By Kathleen Koster

April 5, 2010

As employers strain to emerge from the economic doldrums, vision benefits may come into focus for those who want to keep health care costs down by providing another avenue toward preventive care.

Employers that see the forest for the trees recognize the importance of providing access to routine eye check-ups, while those that don't could find themselves clouded by lost productivity and expensive health care claims. …

The Bibb County Board of Commissioners in Georgia understands first-hand the imperative of offering vision benefits.

"We didn't realize different diseases and potential health issues can be detectedduring a vision exam," says JennyBurdeshaw, Bibb County Board of Commissioners. "However, one of our employees found out he was diabetic when it was detected during hiseyeexam. He wasput on insulin within a week.That experience alone helped us change our thinking,andas a result,we now offer vision benefits to our employees.We want our employees to be healthy, and we believe getting regular eye examsis anotherway tonot only check your visual health, but to check on your overall health." …

"A vision plan tends to be a very highly regarded, yet very low-cost benefit. That's why vision insurance is one of the few products that has actually increased in popularity," says Jeff Spahr, staff vice president of vision and voluntary services at WellPoint.

For the most part, employees want vision benefits, as almost half of consumers without vision benefits are interested in obtaining them, according to Anthem's Specialty Trends Report. Yet, only half of all employers offered access to vision benefits in 2008, and employer contributions are declining, according to the report.

Perhaps if the remaining employers knew that, according to the Vision Council of America, vision disorders account for more than $8 billion in lost productivity, they would be more apt to offer vision benefits. In fact, uncorrected vision can decrease employee productivity by as much as 20%, finds the VCA Vision in Business Report.

VCA also discovered that employers stand to gain as much as $7 for each dollar spent on vision coverage. Further, a quarter of employees surveyed agree that having their vision checked and corrected would increase their productivity at work, reports a WellPoint survey.

Vision benefit plans can also serve as a gateway to employer wellness programs. VSP, for example, estimates they can funnel over 60% of people in vision plans into preventive care.

"You can't start managing people until you get them into preventive care. So, for every dollar that gets spent on eye care services, we're able to return back to an employer increased productivity and medical costs savings of about 94% through increased productivity on the job because they're healthier, lower turnover among those employees and lower overall medical costs," says Melody Healy, director of product strategy and integration at VSP.

Offering vision benefits, or at least making them available for purchase, "is an integral part of prevention," she concludes. "The vision benefit is a very good way of engaging people to start their path to wellness."

High value, high savings

Including vision care in a company's benefit package is a significant aspect in encouraging holistic health care. …

"The eyes are one of the few spots on the body where there is an unobstructed view of the circulatory system. Diseases like diabetes or arterial sclerosis can be picked up through a vision exam," he says. "The sooner that we can get folks into the system, especially with diabetes, where 20% to 30% don't know they have the condition, the greater impact we can have on reduced cost of care and improved quality of life as well." …

In fact, VSP® Vision Care helps save its customers nearly $3 billion annually on health care and human capital costs associated with the treatment of chronic diseases detectable via an eye examination, according to a study undertaken by Human Capital Management Services, Inc. on behalf of VSP.

The study showed that VSP client-companies are realizing these savings for the early detection of diabetes, hypertension and high cholesterol in the first year alone, directly related to health plan, disability and employee termination costs. …

Hear no communication, see no benefit

Andy Mechavich, senior manager of compensation and benefits for LECG/SMART, encourages employers to design their vision plans to cover preventive exams at 100% "to entice people to go and get their eyes checked."

Mechavich stresses communicating the advantages of vision care in the context of wellness. Even though 76% of employees are enrolled in their employer's vision benefit, nearly half of U.S. employees with access to a vision benefit through their employer aren't taking advantage of it, finds a recent employee survey conducted by Harris Interactive on behalf of Transitions Optical, Inc. …

Further, employees have limited knowledge of what their vision plan can do. Nearly 25% of employees who don't enroll in their plan say it's because they don't have vision or eye health problems. Only 21% of those questioned in the Transitions Optical survey select diagnosing or managing chronic disease as a reason for enrolling.

Likely contributing to the problem is lack of, or sparse, communication about vision benefits. …

Says Spahr: "Everything is in place for employees to use [vision benefits]; it's that gentle nudge from the employer that can really make a difference."

Tips for preventing, reducing computer eye strain

Encouraging vision eye check-ups is especially important in the digital age, when employees are constantly squinting at their Blackberries and working for hours in front of computer screens.

According to the American Optometric Association, nearly 90% of those who use a computer at least three hours a day suffer from vision problems associated with computer eye strain.

Symptoms of computer vision syndrome, according to VSP, include:

Blurred vision or a delay in focusing when shifting focus from the computer screen to objects farther away.

Feeling like there's something in your eyes, or burning/stinging and inflammation.

Eye discomfort.

Headaches.

VSP and AOA offer the following suggestions for mitigating the negative effects of computer eye strain:

Blink often. It washes your eyes in naturally therapeutic tears.

Follow the 20-20-20 rule: At least every 20 minutes, take a break to refocus your eyes by looking at something 20 feet away for 20 seconds, minimum.

Keep bright overhead lighting to a minimum. Use blinds and a screen instead to reduce monitor glare. Try to keep lighting off to the side.

Keep your monitor at least 20 inches from your eyes. The center should be about 4 to 6 inches below your eyes.

Enlarge the font size on your PDA or smartphone screen.

Ask your doctor to prescribe a pair of glasses that will make your eyes comfortable for viewing the computer screen.

Get an annual eye exam, letting your doctor know that you work on a computer.

Transforming 401(k) plans into DB plans

Employee Benefit News

By Lydell C. Bridgeford

April 5, 2010In the quest to make 401(k) plans look more like defined benefit plans, government officials are reaching out to employers and other stakeholders in the retirement plan industry for advice on offering annuities through defined contribution plans.

In February, the Departments of Labor and Treasury issued a request for information (RFI) to help federal regulators map out a course of action to improve Americans' retirement savings by purchasing lifetime income options, which include annuities. ...

The RFI hopes to solicit comments on topics that include:

* The advantages and disadvantages of distributing benefits as a lifetime stream of income both for workers and employers, and why lump sum distributions are chosen more often than a lifetime income option.

* Developments in the marketplace that relate to annuities and other lifetime income options.

"[The RFI] initiative is particularly important given the shift from defined benefit plans that offer employees lifetime annuities to 401(k) and other defined contribution plans that typically distribute retirement savings in a lump sum payment," says Phyllis C. Borzi, assistant secretary for the DOL's Employee Benefits Security Administration. Some retirement-income experts also contend that large swings in the stock market also have forced policymakers to rethink how the nation saves for retirement.

'Clearing the air'

The outcome of the government's request for public comments on lifetime income options will probably find some low-hanging fruit of the regulatory side to providing annuities within DC plans, says Edward Ferrigno, vice president of Washington affairs at the Profit Sharing/401(k) Council of America.

PSCA's latest research shows that about 20% of DC plan and profit-sharing sponsors offer an annuity option.

Still, retirement-income analysts observe that some employers are reluctant to offer annuities within their DC plans because of a lack of demand among participants and the complexity of the product in plan administration. …

A new landscape

Americans are living longer, and many will outlive their retirement assets. Annuities, in part, offer retirees the opportunity to exchange accumulated wealth for a lifetime stream of guaranteed income.

DC plans gradually are becoming the primary source for retirement income for many U.S. workers, given that traditional pension plans are slowly fading away, explains Charlie Nelson, president of Great-West Retirement Services. …

DOL hopes to figure out ways in which people don't run out of money while they are in retirement, says Karen Friedman, executive vice president and policy director of the Pension Rights Center, a Washington, D.C.-based advocacy group for workers and retirees.

Providing lifetime income options is a good idea, considering that "we are facing a retirement-income crisis in this country where people are not saving enough for retirement and millions of people are not going to have enough retirement income," Friedman says.

… "Even before the recession, the median account balance in a 401(k) plan was $25,000 and $40,000 for those nearing retirement, which is really not a lot of money," [Friedman notes].

Therefore, individuals with low 401(k) account balances will be reluctant to hand over those funds to a financial institution for an annuity, Friedman asserts. …

Think again

Jane White, president of Retirement Solutions, LLC, sees federal regulators call for a national discussion on lifetime income options as the brainchild of some key players in the Obama Administration.

The concept of "automatic annuitization is the product of the Retirement Security Project, launched by the Hamilton Project, which is part of the Brookings Institution. That project was run by Peter Orszag, who now runs Obama's Office of Management and Budget and Mark Iwry, who is now deputy assistant at the Department of Treasury," explains White.

"In the same fashion that automatically enrolling employees in 401(k) plans is seen a way of combating inertia, automatically annuitizing their account balances at retirement age is viewed as a paternalistic way of preventing them from shooting themselves in the foot by cashing out of vested balances and spending the money foolishly," White adds.

Many Americans are unable to retire because they only have a 401(k) plan. "Because of the puny 3% employer match, the only Americans who can afford to retire are ones that started saving at age 25," White notes. The rule of thumb for retirement readiness, created by pension actuaries, is that you need to have saved the equivalent of 10 times your final pay - or your salary right before retirement - in order to be able to afford to retire.

"The typical 65-year-old has a median income of $64,000 and savings of only $110,000. Therefore, retirement is not possible and it is irresponsible to sell someone an annuity when it can't make an empty nest egg full," White explains. For example, a 65-year-old with a $100,000 annuity who withdraws 4% a year will get $8,000 a year, or about $650 a month.

White asserts that such an amount will not adequately cover the living expenses for most Boomers, especially those who are still paying off their mortgages and footing the college tuition their children.

More importantly, annuities are expensive ways to create retirement income. White notes that "mutual fund industry has 'managed payout' funds that accomplish the same thing as an annuity at a lower cost." Besides, the only guarantee that the annuity purchaser receives is that the individual gets back the money he or she puts into it, plus any returns that you earned, White asserts. "You will very likely get this promise from a mutual fund as well at a lower cost."

Current hurdles

Employers with DC plans will certainly drill down on the fiduciary liability attached to providing an annuity in a DC plan, says Jan Jacobson, senior counsel of retirement policy at the American Benefits Council, a business association that represents private-sector employers.

"If you look at it from the point of view that you pay out a lump-sum, then whatever liability the employer has is over. The money is removed from the plan and it goes to the plan participant," Jacobson explains. Yet with an annuity, "it's conceivable that participants might come back 20 years later if the annuity provider goes under."

Jacobson also hopes the RFI process will yield clearer and straightforward guidance on some current practices on annuities in DC plans. Presently, DC plan sponsors "are a little bit confused on what the criteria is in selecting annuities to the plan, especially on how to determine the safest available annuities," Jacobson says. … L.C.B.

Five ways CFOs can make cost cuts stick

Successes in cost cutting erode with time. Here’s how to make them last.

McKinsey Quarterly

MAY 2010 • Ankur Agrawal, Olivia Nottenbaum, and Andy West

Optimism is on the rise that a solid economic recovery is taking hold around the world, but the cost cutting so prevalent during the recent recession looks to remain a strategic priority for some time. Indeed, the number of executives reporting steps to reduce operating costs in the next 12 months increased significantly between February and April, even as confidence in the economy grew.¹ Yet any successes companies have at cutting costs during the downturn will erode with time. Many executives expect some proportion of the costs cut during the recent recession to return within 12 to 18 months² —and prior research found that only 10 percent of cost reduction programs show sustained results three years later.³

On either schedule, any programs initiated in the early months of the downturn are already beginning to fail—just as savings would be most useful to finance growth. … While manufacturing efficiencies have enabled an average S&P 500 company to reduce the cost of goods sold (COGS) by about 250 basis points over the past decade, SG&A costs have remained at about the same level (Exhibit 1).

Why is it so difficult to make cost cuts stick? In most cases, it’s because reduction programs don’t address the true drivers of costs or are simply too difficult to maintain over time. Sometimes, managers … look for easily available benchmarks, such as what similar companies have accomplished, rather than taking the time to conduct a bottom-up examination of which costs can—and should—be cut. In other cases, individual business unit heads try to meet targets with draconian measures that are unrealistic over the long term, such as across-the-board cuts that don’t differentiate between those that add value or destroy it. In still others, managers use inaccurate or incomplete data to track costs, thus missing important opportunities and confounding efforts to ensure accountability.

While there’s no single silver bullet to ensure that cost-management programs will stick, large, multibusiness unit organizations can better their chances by improving accountability, focusing on how they cut costs, drawing an explicit connection to strategy, and treating cost reductions as an ongoing exercise.

Assign accountability at the right level

Few would dispute that the support of top executives is necessary for cost-management efforts to succeed. … Yet in our experience, the involvement of top managers is not by itself sufficient—especially in a period of growth, when they naturally turn their attention to other initiatives.

Instead, most cost innovation happens at a very small and practical level. Breaking costs out in this way helps managers to find the specific groups or individuals responsible for them and to identify and swiftly deal with pockets of expense mismanagement. …

Importantly, the process planners who run such programs as Six Sigma improvement efforts are generally the wrong choice to manage cost-cutting programs. … Only someone at the level of, say, a sales manager has the detailed knowledge and authority to decide whether it’s really necessary to travel to one client meeting in person, while conducting another by videoconference. Such informed cuts are more likely to endure because the people responsible for them can be held accountable through appropriate incentives, such as performance evaluations, that consider both costs and business performance.

Focus on how to cut, not just how much

Cost reduction programs often lose effectiveness over time because top management kicks off the effort with broad cost reduction targets (“How much do we want to save?”) but then leaves decisions on how to meet those targets to individual line managers. …[We] have seen too many cases where managing to a number has resulted in flawed decisions, such as delaying critical investments, shifting costs from one accounting category to another, or even cutting costs in a way that directly undermines revenue generation. Clearly, the benefits of such cost cuts are likely to be illusory, short lived, and at times damaging to long-term value creation.

A more enduring approach includes changing the way people think about costs by, for example, setting new policies and procedures and then modeling the desired behavior. If a company announces, say, a new travel policy, senior managers need to set the tone with their own actions—for example, by aggressively using videoconferences instead of travel or eliminating catering for in-person meetings. … And since backpedaling on this kind of behavior when the economy picks up again would send the reverse message, managers should model only cost cuts they intend to stick with. If they know they’ll eventually restore catering for in-person meetings, it could well be better not to cut it in the first place.

Benchmarks matter. External ones on some measures may be difficult to get, but where they are available … they can enable managers to compare performance across different units and identify real differences, as well as trade-offs that may not be in line with the organization’s overall strategy. Internal benchmarks are easier to access and provide great insights, especially because managers are more likely to understand and adjust for differences among their company’s organizational units than among different companies represented by external benchmarks.

One multinational capital goods manufacturer combined the two perspectives, analyzing the major categories of expenditure and developing targets based on both internal and external benchmarks. Using external ones for travel spending, managers found that the company’s travel costs were higher than those of any peer—both per employee and as a percentage of revenue (Exhibit 2). They then set an aggressive target to reduce travel expenses—and, to make the effort stick, instituted new travel policies on booking hotels and airfares. By examining internal benchmarks across suborganizations (such as departments, business units, or locations), managers also identified which executives needed to better educate their organizations on travel policy. In addition, they increased accountability by tracking each unit’s performance on a monthly basis to measure compliance and encouraged underperforming divisions to manage their travel costs more aggressively. The effort changed travel behavior across the entire organization as subunits shared best practices.

Don’t let P&L accounting data get in the way of cost reduction

CFOs often manage cost reduction efforts by tracking accounting data in their companies’ P&L statements. These can be a useful starting point in a crisis, if other data are unavailable. But over the long term, P&L categories, such as overall SG&A costs, don’t give the kind of per-unit insights that help focus cuts in, say, travel expenses on the units that can best afford to cut them.

Unfortunately, few companies have the kinds of systems they need to track costs at a fine-grained level—and they face a number of challenges in establishing them. Multiple data systems may make it difficult to aggregate and compare data from different geographies. Inconsistent accounting practices between businesses or time periods may lead to significant distortions. Changes in organizational structure (as a result of acquisitions, divestitures, or even changes in the allocation of overhead costs) may similarly distort tracking. Finally, one-time expenses in either the baseline or the tracking period may become excuses for deviations from the plan. As a result, business or functional managers often use data issues to divert attention from their lack of progress.

Indeed, one medical-product company experienced all these issues simultaneously in the initial stages of its cost transformation program. Business unit heads objected that tracking numbers from the central financial database were flawed because of a range of factors.⁴ As a result, the company couldn’t reduce costs during the first several months of its program, and discussions focused on the integrity of the data rather than potential initiatives.

To resolve the problem, companies must continuously track, in some detail, the expenses behind the P&L to identify areas of underperformance, without worrying about the formal accounting of the costs. … To manage costs at the necessary level of detail, the CFO of the company above gave each business unit head and controller full access to a centralized cost database linked to the official P&L. Each controller received a standardized template to record any adjustments affecting the baseline, along with exact amounts, periods, and offsetting adjustments. The CFO then aggregated the data into a simple cost-tracking report that he shared with all involved.

After two months, the increased transparency eliminated all data disputes—and the organization met its full-year cost reduction target in just six months. Two by-products were increased standardization of internal accounting and a dramatic reduction in several cost categories bucketed under “other costs.” By getting the data right and moving quickly beyond questions about data integrity, the organization significantly simplified the effort of cost reporting, making it much easier to maintain the cost program over time.

Clearly articulate the link between cost management and strategy

Strategy must lead cost-cutting efforts, not vice versa. The goal cannot be merely to meet a bottom-line target. Indeed, among participants in a November 2009 survey, those who worked for companies that took an across-the-board approach to cost cutting in the recent downturn doubt that the cuts are sustainable. Those who predicted that the cuts could be sustained over the next 18 months were more likely to say that their companies chose a targeted approach.⁵

Yet in our observation, many companies do not explicitly link cost reduction initiatives to broader strategic plans. As a result, reduction targets are set so that each business unit does “its fair share”—which starves high-performing units of the resources needed for valuable growth investments while generating only meager improvements at poorly performing units. Moreover, initiatives in one area of a business often have unintended negative consequences for the company as a whole. For example, a global low-tech medical-device company’s initiatives to reduce manufacturing and product costs were led at the plant level, without input or customer insights from sales and marketing teams. The leaders of the cost-cutting effort in manufacturing nearly rendered several products defective because they did not know how customers used the products. Consequently, the effort led to the loss of accounts and market share.

To create value through cost cutting, managers need to understand the best ways to allocate operating expenses, such as selling costs and R&D. To do so, they must understand, at the most detailed possible level, the return on invested capital (ROIC) and the growth of the markets in which a company plays. Mapping costs against business units and geographies will reveal both opportunities for cost reductions and areas in which the business should increase its investments to take advantage of growth opportunities or to “double down” in high-ROIC businesses. …

With such insights, managers will also be able to deliver a consistent message on how cost reductions would make a company stronger—a message reducing short-term resistance and even inspiring the organization to support the effort. Moreover, once these practices are baked into the company’s standard operating practices, cost reductions will become a more enduring part of its strategy for long-term health.

Treat cost management as an ongoing exercise

Most companies treat cost management as a one-off exercise driven by the need to manage short-term profit targets … Yet such hasty cost-cutting activity typically goes into reverse once the pressure is removed and rarely results in sustainable changes in cost structure. In our experience, the reason is that one-off exercises don’t require internal capability building.

A better approach is to use the initial cost reduction program as an opportunity to build a competency in cost management rather than in mere cost reduction. Cost-management programs need to be scoped as two- to three-year initiatives rather than as immediate-term efforts with one-year horizons. Also, effective cost-management programs … include plans for dealing with changing business conditions …

Companies must improve their processes and capabilities if they hope to reduce or contain costs in a sustainable manner. Rethinking common practices in cost management should help to realize this goal. In particular, achieving a more fine-grained perspective on where costs occur should be a centerpiece of any successful cost-management program.

About the Authors

Ankur Agrawal is a consultant in McKinsey’s New York office, Olivia Nottebohm is an associate principal in the San Francisco office, and Andy West is a partner in the Boston office.

Notes

¹ Fifty-four percent of the executives surveyed in April indicated that they would take steps to reduce operating costs in the next 12 months, compared with 47 percent in February. In April, two-thirds of the respondents rated economic conditions in their countries as better than they had been six months previously, and another two-thirds expected further improvement by the end of the first half of 2010. See “Economic Conditions Snapshot, April 2010: McKinsey Global Survey results,” mckinseyquarterly.com, April 2010. The online survey (in the field from April 5, 2010, to April 9, 2010) received responses from 2,059 executives representing the full range of industries, regions, functional specialties, and tenures.

² See “What worked in cost cutting—and what’s next: McKinsey Global Survey results,” mckinseyquarterly.com, January 2010.

³ Suzanne P. Nimocks, Robert L. Rosiello, and Oliver Wright, “Managing overhead costs,” mckinseyquarterly.com, May 2005.

⁴ These included changed accounting practices that shifted costs from one P&L category to another, the transfer of a shared cost center from one business unit to another, changes in allocations of corporate overhead, and special one-time initiatives, such as product launches.

⁵ See “What worked in cost cutting—and what’s next: McKinsey Global Survey results,” mckinseyquarterly.com, January 2010.

10 Trends That Are Changing the Shape of Workplace Benefits

PLANSPONSOR.com

Change is a reality of life, and establishing and maintaining benefit programs that are competitive and distinctive requires an awareness of trends in the marketplace, in the population, in the legislative and regulatory worlds, and in the needs of the workers you hope to attract and retain.

While product development and enhancements certainly can play a role, there are also the overarching issues that drive and shape those developments. Here are 10 of which you should be aware.

1 Sandwich “Spread”?

Much has been written about the impact of the retirement of the Baby Boomers, the so-called Silver Tsunami. … Indeed, the Boomers increasingly find themselves with a new labeling—the “sandwich” generation—in which they are not only focused on their own financial concerns, but those of their parents and children as well. This may give participants longer to save for retirement (and less time to spend in retirement), providing those still-meager accumulations a much needed cushioning, and it also may ameliorate some of the nascent concerns about talent transitions, but it’s not like that was part of “the plan.”

2 The “To Versus Through” Debate

Target-date funds have long offered an apparent simplicity of design and implementation that have made them appealing to plan sponsors and plan participants alike, a unique combination that allowed participants to do the “right” thing (letting professionals manage their money and rebalance it on a regular basis) while, for the very most part, doing nothing at all. Ditto plan sponsors, …

Of course, the 2008 market brought to light vast differences in the philosophies underpinning these designs in terms of asset allocation and glide path (in fairness, those were in evidence in 2006/2007 when more-conservative models were ridiculed for their lagging returns). Much of that difference was explained later as a function of whether the glide path was designed to take the investor to the anticipated retirement date—or past it (ostensibly until death).

The debate is not yet resolved, nor perhaps can (or should) it be. Still, ahead of changes on the regulatory front, fund manufacturers appear to be making a concerted effort to be clearer about those assumptions; and, if that does not make for an easier decision, it nonetheless makes it more obvious that a “decision” must be made.

3 The Match “Catch”

One of the more troubling trends of the past year was an apparent uptick in the number of employers cutting or suspending their 401(k) match. …

… Perhaps workers no longer will take such things for granted because, after all, “free” money really isn’t.

4 Share Alikes?

While company-stock-related lawsuits still seem to be the most common, that initial series of revenue-sharing suits is still “out there.” For the very most part, the plaintiffs have not fared well, but two widely publicized cases—one a $16.5 million settlement by Caterpillar, and a second involving Wal-Mart, where last December the 8th U.S. Circuit Court of Appeals found triable issues of fact in the case—are likely to keep plan fiduciaries “jumpy.”…

5 “Tell” Tales

…[Beginning] with the 2009 plan-year filings, the Labor Department has broadly expanded the requirements for reporting compensation earned by plan service providers on Schedule C of the Form 5500 to explicitly require the reporting of both “direct” and “indirect” compensation earned by plan service providers. It is clear that the DoL views compliance with the Schedule C reporting requirements as part of a fiduciary’s obligation to evaluate the reasonableness of a service provider’s total compensation—at the same time that it stands to gain a better ability to use this data, which is now also to be filed electronically.

6 Pension Penchants

While many continue to talk about the wisdom of modifying defined contribution designs to more closely resemble the better attributes of their pension predecessors, trillions of dollars (and future benefits) still reside in those traditional defined benefit plans. … [These] programs are responding in a variety of creative ways: some outsourcing more, others less, some taking a more active stance in asset allocation, others opting for a stronger focus on liabilities. However, regardless, most are asking for—and by most accounts, receiving—fresh insights and input from the marketplace.

7 The End in Mind

For years, the retirement plan industry has focused on trying to help participants save as much as they could—all the while acknowledging that the real challenge was likely to be helping them live on that accumulated savings. As it turns out, a new generation of products has emerged that not only will help them do that, but also will help them begin making those investments/preparations while they are still in that accumulation “phase.”

Issues in product design (or perceptions about issues in product design) remain, but those gaps are closing (including the gap in perceptions), and the prospects for future market turmoil seem likely to keep these offerings high on plan sponsor radar screens. Also, let’s not forget that the DoL has been asking for information on “arrangements that provide income after retiring.”

8 Conflict Ed?

… Earlier this year, the DoL took a step back from the position it took in the final regulations on the subject put together … in 2008 before being halted, and then withdrawn last November… The new proposed regulations largely seem to restore the status quo in favor of level-fee advice only. …

9 Executive “Order”

The 2008 elections brought in … new leadership at various agencies that have a large impact on retirement plans. That has already brought about shifts in direction … while the financial crisis has reinforced the need for better disclosures on offerings like target-date funds.

10 Health Care, Reformed?

By most accounts, much of the “oxygen” in Washington for the past year has been sucked up (out?) by health-care talk and proposals. With a bill now signed, employers can begin to focus on what that means for their programs—and their workers. …

Nevin E. Adams
editors@plansponsor.com

Annuities Get a Behavioral Finance Makeover

PLANSPONSOR.com

May 17, 2010  – An appreciation for the influences of behavioral finance has had a critical impact on retirement plan designs – so what about applying those principles to the decumulation phase?

To explore the alternatives and implications Allianz worked with Professor Shlomo Benartzi of UCLA to reach out to a number of academics in the field, several of which were on hand at a meeting in New York City to present some of those findings and their implications.

The findings, which Allianz said it submitted as its response to the February request for information by the Department of Labor and Treasury Department on retirement income products, was produced under the title “Behavioral Finance and the Post-Retirement Crisis”, broadly defined as being “about outliving your assets.”

…To kick things off, Benatzi used the example of ten high school friends who retire at age 65. Of those, Benatzi said that the first of the 10 would die just four years into retirement, at age 69, while the last in the group to die would, according to statistics, not die until age 99.

This post-retirement crisis is magnified by the poor financial decision-making of retirees, who according to the research presented, pay too much attention to recent stock market performance (those retiring after stock market increases of six to 12 months are much more likely to select the lump sum option rather than lifetime income), have trouble making financial decisions, and are "hyper" risk averse. 

“Nudging” the Annuity Decision

Dr. Alessandro Previtero of UCLA … cited a study that found that in a period from 1999 to 2005, only 2% to 6% of retirees elected guaranteed lifetime income [over the default lump sum] when it was available in their 401(k) plans – much lower than expected, and a disparity he referred to as the “Annuity Puzzle" (the puzzle being why people don't choose annuities).

However, Previtero recently conducted new research with …more than 100,000 retirees. Each of these individuals had to actively choose between guaranteed lifetime income and a lump sum. Because there was no default, they had to decide themselves how to withdraw funds – and Previtero said that 49% of retirees making an active choice between guaranteed lifetime income and a lump sum actually picked the lifetime income option.

He went on to note that defined benefit payouts are typically communicated in terms of producing monthly income, and annuity payout options tend to look attractive to participants accustomed to thinking of those benefits in like terms; but he contrasted that with cash balance plans that are often, …communicated in terms of account balances or lump sums. Previtero said he found that retirees in defined benefit plans were 17% more likely to choose the guaranteed lifetime income than their peers in cash balance plans.

The recommendation; make retirement income solutions available in 401(k) plans and … “nudging” retirees to actively make a choice.

Framing

… Professor Jeffrey Brown of the University of Illinois … found that when an annuity choice was presented in a “consumption” frame … as providing monthly income of $650 for life, 70% preferred the annuity. But when it was presented in an “investment frame” (an investment with a $650 return for life), only 21% opted for the annuity. …[Defined] contribution plan designs have “taught” people to think of these accounts in terms of investments, rather than pension plans, where participants are more likely to think of the monthly benefit they provide. The suggestion from the researchers; present the programs with an emphasis on the income they will provide, not the return on the investment made.

Professor Eric Johnson of Columbia University pointed out that for most of us, “losses loom larger than gains.” …[Investors] experience the pain of a financial loss much more acutely than they feel the pleasure of the same size gain – and by a factor of about two to one. … [Recent]research he conducted with ACLI and AARP found that retirees displayed “hyper” risk aversion – …they tended to weight losses about TEN times more heavily than gains.

…[While] Johnson said he assumed that this hyper loss aversion would translate into a preference for products with guaranteed lifetime income, his research revealed that retirees with hyper loss aversion actually responded less favorably to financial products with more protection and guarantees. Johnson said that it seemed that … giving up control of their money was viewed as just another type of loss. Consequently, he said that solutions should emphasize that those guarantees and protections were a way to restore, not surrender, control.

Cognitive “Dissonance”

A study by Professor David Laibson of Harvard University reported a significant decrease in “analytic cognitive functioning” as people age, as well as an increase in the occurrence of dementia. For example, after age 60, the prevalence of dementia roughly doubles every five years, and the research suggests that by the time people reach their 80s, more than half will suffer from either dementia or other “significant cognitive deficits”. The older adults that Laibson studied also showed marked declines in “numeracy”— the mathematical skills needed to cope with everyday life and to understand information in graphs, charts or tables, and they also had “great difficulty” understanding simple measures of risk. The optimal age for making those decisions? 53.

A suggestion to counter this problem; solutions,“including investment strategies and public policies that encourage people to make binding decisions earlier in life and prior to the onset of cognitive impairment”.

One of the reports included in the handouts was based on an interview with Professor. Brigitte Madrian of Harvard University, who suggested that one-size-fits-all-defaults are ill-suited to helping different groups of participants achieve optimal results. … [She] said that plan sponsors would be well advised to evaluate the potential impact of inertia on different types of retirees, and said that policymakers should make it easier for sponsors to customize decumulation options by eliminating non-discrimination rules that require all retirees—even those with unique needs—be presented with the same default payouts.

"Future" Self

Professor Daniel G. Goldstein of Yahoo Research and London Business School said that part of the problem was that people have trouble relating to their “future self” when it comes to making decisions and trade-offs regarding retirement savings …, pointing out that those with a strong connection with the perspective of their future self tend to save more and invest better (in one of the more whimsical parts of the presentation, he suggested the deployment of tools that could age pictures of the individual as a way to better help them visualize that future self).

“Obvious” Decisions

… Professor John Payne of Duke University … said that for lifetime income solutions, retirees are typically presented with materials highlighting the monthly payouts provided by each option – and for many, the optimal choice is obvious: the highest monthly payout. That, in turn, tends to lead them toward choosing single life annuities (with larger payouts), rather than joint and survivor. In fact, 69% of married women and 28% of married men opt for single life annuities rather than joint and survivor annuities, according to the report. But, that tendency to go for the option that is easiest to understand means that retirees may fail to recognize the implications of their decision on their spouse.

Other challenges highlighted in the report; people vastly underestimate the impact of inflation on their cost of living (leading to a suggestion that some kind of inflation protection be incorporated in retirement income solutions), and that the attractiveness of a retirement income solution depends on its perceived fairness. Part of the perceived “unfairness” of the annuity is a perception that an early death on the part of the annuitant benefits the financial institution that issued the product. Professor Suzanne Shu of UCLA suggested countering that perception by positioning it as benefiting other people in the annuity “pool.”

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The complete Allianz report, “Behavioral Finance and the Post-Retirement Crisis," is available at http://www.allianzinvestors.com/documentLibrary/RFIbehavioralFinance/Allianz_DOL_RFI_Response.pdf

Nevin E. Adams
editors@plansponsor.com

Alternative UCITS Luring More Interest

PLANSPONSOR.com

11 May 2010 (PLANSPONSOREurope.com) – Alternative and absolute return UCITS have garnered nearly $200 billion in assets, according to new research.

“The search for better performance and diversification is encouraging innovation in the fund industry, and leading to faster growth of alternative products, some of them unimaginable in a retail context just a decade ago”, says Jag Alexeyev, Head of Global Research at Strategic Insight, an Asset International company.

According to the firm’s Simfund database, investors across the globe have channeled nearly $200 billion of assets into more than 1,000 alternative and absolute return UCITS funds. Based in Europe, UCITS (Undertakings for Collective Investment in Transferable Securities) funds are sold cross-border internationally, with rising commitments from Asia, Latin America, and other emerging regions, as well as from institutional investors in the United States. UCITS are a set of European Union (EU) directives that aim to allow collective investment schemes to operate freely throughout the EU on the basis of a single authorisation from one member state.

“Several alternative UCITS have been quite successful, raising billions of dollars in assets while delivering uncorrelated returns with lower volatility”, adds Alexeyev. According to a press release, many of the winners are traditional fund companies that managed to expand their investment capabilities. A few products are highly innovative, for example, exchange traded funds offering hedge fund exposure linked to a managed account platform.

Hedge firms offering regulated “Newcits” funds represent rising competition, but many of them have yet to show meaningful gains, according to the report. New research from Strategic Insight, released this week in their Managing Investment Fund Innovation book, claims that nearly 75% of alternative and absolute return UCITS so far have raised less than $100 million each.

Concerns by wealth advisors and distributors about risks, performance tradeoffs, fees, and service levels have been among the challenges, according to the report, which notes that as comfort levels increase and track records get established, alternatives “will become hard to ignore” in the industry.

Strategic Insight’s book is available at http://www.strategicinsightglobal.com/innovation.

Strategic Insight is a research firm for the fund and wealth management industry, providing clients with in-depth industry data, research reports, and executive consulting services for product, distribution and business strategy decisions. Strategic Insight assists over 250 firms worldwide, and its Simfund databases and analytical platforms cover more than 70,000 funds.

PLANSPONSOREurope Staff editors@plansponsoreurope.com