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What is the Future of Retirement Plans?

Felix Salmon, an insightful finance blogger for Reuters, writes in yesterday’s NYT about Wall Street’s Dead End. Salmon notes that the sale of the NY Stock Exchange to the Deutsche Bores combined with the significant decline of companies listed on major exchanges point to a future in which corporate wealth and control is pushed into the hands of a small financial elite.  For Salmon the very notion of shareholder democracy is at stake.

And yet, much more than shareholder democracy is at stake.  The retirement and pension plans of millions of retirees (many of whom are baby boomers about to tap into their nest eggs) are also at stake.

Our retirement system depends upon robust equity markets.  It was not always so.

In the not so distant past, most retirement plans were invested in bonds.  Pension plan liabilities were projected by the actuaries and bonds were purchased to meet those liabilities.

By the mid-to-late 1970s,  a confluence of events created the pension investment world as we now know it:  1) modern portfolio theory gained traction, 2) analysts began reporting that stocks generate higher returns than bonds, “over the long term”, 3)  ERISA codified the concept of diversification, and 4) the seeds were planted for the pervasive investment and business culture which bloomed in the 80’s and beyond.

Since pension costs are “real” costs, meaning that they are a hit to earnings, CFO’s and CEO’s were all too thrilled to adopt stragegies to reduce these costs.  With pension plans it became easy.

If equities generate higher returns than bonds, and riskier equities generate even higher returns (so says modern portfolio theory), then it is an easy logical progression to shift pension plans into riskier assets.  But, forget logic …. These were real dollars, real increases in earnings and therefore real increases in share prices.

The tsunami of pension assets flowed from fixed income, to domestic equities, then international equities, to emerging markets, along with real estate, joint venture, private equity.  Even in the fixed income arena, boring treasury and corporate bonds were jettisoned for international and emerging market bonds, and bonds backed by everything from mortgages, credit cards, car loans and now even life insurance.

And of course, the Holy Grail:  the Hedge Fund.  Managers given the unfettered discretion to zap investments around the globe in any asset class, at any time.  Whatever suits the fancy of the omniscient hedge fund manager.

While Salmon might decry the loss of shareholder democracy ….I’m a little bit more selfish and I’m thinking about my retirement, and our whole retirement system.   This system is critically dependent upon the very shrinking capital pool that Salmon has identified.

The issue goes far beyond even the shrinking pool because, in fact, the pool hasn’t shrunk. Instead, as Salmon implies, it has simply passed into the control of a small elite.  The thousands of well educated college students who marched through the top rated business and law schools over the past 3 decades who now populate the investment industry.

The critical problem, however, is that our retirement system requires access to these markets and securities.  In effect, the demand has remained constant but the financial elite now controls access.  Like the robber barrons of the 19th century,  the financial elite are able to extract a high trarriff on the commodity they control.  This tariff takes the form of a “2 and 20 fee” — 2% management fee and 20% performance fee.  This entire structure (and the financial theories which underlying it) merely reinforces the control and wealth of the financial elite.

The robber barrons met their match in Teddy Roosevelt’s trust-busing zeal.  This current system is far more resilient.  In fact, a global financial crisis, a legislative overhaul of the financial system, and a joint congressional inquiry could not lay low the power of the investment industry.  Hedge Fund managers and their brethren still earn billions of dollars in a single year.

Rather than turn to our elected officials for a systemic change (remember, their campaigns all seek funding from the financial elite), I suspect that the solution lies in the streets of Tunis and Cairo.  Please bear with me.  This is not so farfetched.

Again, in yesterday’s Times, the lead article, Tunisian-Egyptian Link That Shook Arab History, explains that collaboration among educated professional young Tunisians and Egyptians, as facilitated by various forms of social networking, contributed enormously to the toppling of these regimes.

Collaboration by educated, well informed and connected people works.

While I do not want to suggest parity between the needless physical and emotional suffering of exploited populations and the inequities of our financial system.  I do think that the techniques of reforming entrenched power structures can be similar.

Our system has gotten to where it is, in part, because retirement plan decision makers –our financial stewards — have allowed it to develop.  They continue to pour money into hedge funds, private equity and other similar investment strategies.  The allure of these returns is too great.  Unfortunately, individual returns can fall far short of promised possibilities.  And, the huge fees remain.  And these managers remain empowered.

The solution? Retirement plan fiduciaries must, “Just Say No”.  No more to extravagant fees; no more excuses for underperformance; and no more allowing managers to avoid fiduciary responsibility.  Collectively and loudly they must object to this entrenched system.

Plan fiduciaries must demand that investment managers put client interests first.  Not simply as an advertising campaign, but as statements of their core values and business ethics.

Systemic transformation does not come form a change in rules by those vested in the status quo.  That is a recipe merely for change at the margins.  True change comes when people tap a latent but unrecognized source of power. This power transforms behavior which in turn transforms systems and institutions.  Yes, the answers can be found in the streets of Cairo and Tunis.

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Beware Real Estate Hubris

In the late 1970’s/early 1980’s, AT&T unveiled an attention grabbing new corporate headquarters on Madison Avenue — complete with its chippendale crown.  On 1/1/84, however, AT&T was dismantled, broken up into its regional operating companies.  Twenty-five years later, Lehman brothers presented its sleak new global headquarters.  And, poof in September of 2009, Lehman was no more.

Remembering this architectural and corporate history, I read with great interest about 510 Madison Avenue — a fancy new “trophy” home for hedge funds.

Could this herald the beginning of the end of hedge funds?

The Times reported, last week, that 510 Madison suffered a significant detour (namely the ’08/’09 financial crisis) in its quest to capture $100/ft rents paid by ever-flush hedge fund managers.  Under new ownership and a brighter financial environment, however, high-end amenities are once again playing well to the Hedge Fund set.

Characterized as “more like country clubs, than workaday offices”, 510 Madison includes, a spacious lobby, restaurant, pool, and fortunately, a landscaped terrace.  I mean doesn’t everyone need a terrace to relieve the stress of managing $ billions of other people’s money.

And yet, here’s the problem …. It is other people’s money (OPM) as the cognoscenti well know.

While many hedge fund investors include high net worth and super high worth individuals — presumed to be sophisticated and capable of making their own investment decisions — most hedge fund managers also welcome the deluge of pension assets they have received over the past decade (as long as the pension assets don’t constitute more than 50% of the fund.)

It is not too hard to connect the dots and recognize that the hard earned pension assets of millions of workers are supporting the lavish work digs (not to mention the mansions, summer homes and private planes) of many hedge fund managers.

Sarcasm aside — plan fiduciaries must answer a pretty difficult question before investing assets in a hedge fund.  Are the “2 and 20” fees (2% management, 20% performance fees) justified?  Or, more appropriately are these fees “reasonable”.  Hedge fund managers can only afford their toys and lush office towers because fiduciaries sign-off on these fees.  And remember, ERISA requires that the fees be reasonable.

Last year the S&P 500 returned slight more than 15%, whereas the Barclay Hedge Fund Index returned 10.9% (other indices reported even lower performance). That is pretty expensive underperformance for 2010..   Of course, one year is not a fair comparison. However, before any fiduciary can justify investing in hedge funds, they need to examine, carefully, very carefully, the  3, 5 and 10 year performance returns.

Pension plans are under enormous pressure to generate competitive returns.  Unfunded pension liabilities are staggering.  However, reaching for the latest hedge fund du jour can lead to disappointing and mediocre investment results.

The beauty of the hedge fund business model, however is that even if performance remains mediocre, the managers remained ensconced in their fancy offices, sipping lattes on the landscaped terraces. Unfortuantely, the brunt of the pain is borne by the pension plan investors.

Certainly, ERISA didn’t contemplate these results.  And someday, fiduciaries are going to have to justify the reasonableness of their actions in authorizing these investments.

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