The Inadequacy of Our National Savings

Deadly Sin 2: The Stock Market Collapse   One of the causes of the train wreck we face—but hardly the only cause—was  the collapse of our stock market, on balance taking its value from $17  trillion capitalization at the October 2007 high in U.S. stocks, to a low of  $9 trillion in February 2009. Much of this stunning loss of wealth has been  recovered in the rally that followed, and as 2012 began, the market value  totaled $15 trillion. Nonetheless, our nation’s DB pension plans—private and  government alike—are presently facing staggering deficits. And the  participants in our DC plans—thrift plans and IRAs alike—have accumulations  that fall short of what they will need when they retire.

Deadly Sin 3: Underfunded Pensions   Our corporations have been funding their defined benefit (DB) pension plans  on the mistaken assumption that stocks would produce future returns at the  generous levels of the past, raising their prospective return assumptions  even as the stock market reached valuations that were far above historical  norms. And the DB pension plans of our state and local governments seem to be  in the worst financial condition of all. (Because of poor transparency,  inadequate disclosure, and nonstandardized financial reporting, we really  don’t know the dimensions of the shortfall.) The vast majority of these plans  are speculating that future returns will bail them out.

Currently, most of these DB plans are assuming future annual returns in the  7.5–8 percent range. But with stock yields at 2 percent and, with the U.S.  Treasury 30-year bond yielding 3 percent, such returns are a pipedream. It is  ironic that in 1981, when the yield on the long-term Treasury bond was 13.5  percent, corporations assumed that future returns on their pension plans  would average just 6 percent, a similarly unrealistic—if directly  opposite—projection as 2012 began.

Corporations generate earnings for the owners of their stocks, pay dividends,  and reinvest what’s left in the business. In the aggregate, the sole sources  of the long-term returns generated by the equities of our businesses should  provide investment returns at an annual rate of about 7–8 percent per year  over the next decade, including about 2 percent from today’s dividend yield  and 5–6 percent from earnings growth. Similarly, bonds pay interest, which is  the sole source of their long-term returns. Based on today’s yield, the aggregate  return on a portfolio of corporate and government bonds should average about  3.5 percent. A portfolio roughly balanced between these two asset classes  might earn a return in the range of 5–6 percent during the coming decade.

Deadly Sin 4: Speculative Investment Options   A plethora of unsound, unwise, and often speculative investment choices are  available in our burgeoning defined-contribution (DC) plans. Here,  individuals are largely responsible for managing their own tax-sheltered  retirement investment programs—individual retirement accounts (IRAs) and  defined-contribution pension plans such as 401(k) thrift plans that are  provided by corporations, and 403(b) savings plans provided by nonprofit  institutions. Qualified independent officials of their employers seem to  provide little guidance. What’s more, they often focus on spurious  methodology that is too heavily based on historical data, rather than the  timeless sources of returns that actually shape the long-term investment  productivity of stocks and bonds, misleading themselves, their firms, and  their fellow employees about the hard realities of investing.

Deadly Sin 5: Wealth-Destroying Costs   The returns in our stock market—whatever they may turn out to be—represent  thegross returns generated by the publicly owned corporations  that dominate our system of competitive capitalism (and by investment in debt  obligations). Investors who hold these financial instruments—either directly  or through the collective investment programs provided by mutual funds and  defined benefit pension plans—receive their returns only after  the cost of acquiring them and then trading them back and forth among one  another. Don’t forget that our financial system is a greedy one, consuming  from 1 to 2 percentage points of return, far too large a share of the returns  created by our business and economic system. So we must recognize that  individual investors and pension funds alike will receive only the net  returns, perhaps in the 4 to 5 percent range, after the deduction of those costs.  To significantly enhance that return, less conventional portfolios using  “alternative” investments will have to deliver returns that far exceed their  own historical norms. To say the least, that is one more speculative bet.

Deadly Sin 6: Speculation In The Financial System   Speculation is rife throughout our financial system (and our world). High  stock market volatility; risky, often leveraged, derivatives; and  extraordinary turnover volumes have exposed the markets to mind-boggling  volatility. As I note earlier, some of this hyperactivity is necessary to  provide the liquidity that has been the hallmark of the U.S. financial  markets. But trading activity has grown into an orgy of speculation that pits  one manager against another—one investor (or speculator) against another—a  “paper economy” that has, predictably, come to threaten the real economy  where our citizens save and invest. It must be obvious that our present  economic crisis was, by and large, foisted on Main Street by Wall Street—the  mostly innocent public taken to the cleaners, as it were, by the mostly  greedy financiers.

Deadly Sin 7: Conflicts Of Interest   Conflicts of interest are rife throughout our financial system: Both the  managers of mutual funds that are held in corporate 401(k) plans and the  money managers of corporate pension plans face potential conflicts when they  hold the shares of the corporations that are their clients. It is hardly  beyond imagination that when a money manager votes proxy shares against a  company management’s recommendation, it might not sit well with company  executives who select the plan’s provider of investment advice. (There is a  debate about the extent to which those conflicts have actually materialized.)

But there’s little debate in the mind of Lynn Turner, former chief accountant  of the SEC: “Asset managers who are charging corporations a fee to manage  their money have a conflict in that they are also trying to attract more  money which will increase their revenues, and that money often comes from  companies who set up retirement accounts for their employees. There is not  disclosure, from the asset manager to the actual investors whose capital is  at risk, of the amount of fees they collect from the companies whose  management they are voting on. It appears the institutional investors  (including managers of mutual funds) may vote their shares at times in their  best interests rather than the best interests of those whose money they are  managing.” In trade union plans, the conflicts of interest are different, but hardly  absent. Insider dealing among union leaders, investment advisors, and money  managers has been documented in the press and in the courts. In corporate  defined benefit pension plans, corporate senior officers face an obvious  short-term conflict between minimizing pension contributions in order to  maximize the earnings growth that market participants demand, versus  incurring larger pension costs by making timely and adequate contributions to  their companies’ pension plans in order to assure long-term security for the  pension benefits they have promised to their workers. These same forces are  at work in pension plans of state and local governments, where the reluctance  (or inability) to balance budgets leads to financial engineering—rarely  disclosed—in order to justify future benefits.

Extracting Value From Society   Together, these Seven Deadly Sins echo what I’ve written at length about our  absurd and counterproductive financial sector. Here are some excerpts  regarding the costs of our financial system that were published in the Winter  2008 issue ofJournal of Portfolio Management: “…mutual fund  expenses, plus all those fees paid to hedge fund and pension fund managers,  to trust companies and to insurance companies, plus their trading costs and  investment banking fees … have soared to all-time highs in 2011. These  costs are estimated to total more than $600 billion. Such enormous costs  seriously undermine the odds in favor of success for citizens who are  accumulating savings for retirement. Alas, the investor feeds at the  bottom of the costly food chain of investing, paid only after all the  agency costs of investing are deducted from the markets’ returns … Once a  profession in which business was subservient, the field of money management  has largely become a business in which the profession is subservient. Harvard  Business School Professor Rakesh Khurana is right when he defines the  standard of conduct for a true professional with these words: ‘“I will  create value for society, rather than extract it.’ And yet money  management, by definition, extracts value from the returns earned by our  business enterprises.”
These views are not only mine, and they have applied for a long time. Hear  Nobel laureate economist James Tobin, presciently writing in 1984: “…we are  throwing more and more of our resources into financial activities remote from  the production of goods and services, into activities that generate high  private rewards disproportionate to their social productivity, a ‘paper  economy’ facilitating speculation which is short-sighted and inefficient.”  (In validating his criticism, Tobin cited the eminent British economist John  Maynard Keynes. But he failed to cite Keynes’s profound warning, cited  earlier, that business enterprise has taken a back seat to financial  speculation.) The multiple failings of our flawed financial sector are  jeopardizing not only the retirement security of our nation’s savers but also  the economy in which our entire society participates.