Rent capture by financial intermediaries

The key consequence of asymmetric information about financial assets is the ability of financial intermediaries to capture "rents", or excess profits. Rent extraction has become one of the defining features of finance and goes a long way to explaining the sector's extraordinary growth in recent years, as well as its fragility and potential for crisis. Mispricing of assets and rent capture are the two main culprits in in combination lead to what might appropriately be described as "predatory finance". Each is damaging, but in combination they are devastating. Those two effects interact causing loss of social utility and exploitation on a scale that could ultimately threaten capitalism. To minimize losses (forget about profits) for individual 401K investor it is important to understand why are financial markets so inefficient and exploitative.

I think that one of the reasons is that 401K investors delegate virtually all their involvement in financial matters to professional intermediaries - banks, fund managers, brokers - who therefore dominate the asset pricing process. they can only vote with legs, switching assets from one fond to another. This kind of delegation creates a typical agency problem with a twist. First of all agents have access to more and better information than 401K investors. Second the interests and objectives of agents radically differ from those of their principals even if the lip service to synergy of interests are paid in fund prospects. Due to voting with legs problem, fund managers concentrate of highly profitable short term moves instead of strategic consideration, which create high turnover of assets (enriching financial intermediaries) and the rat race for higher returns no matter what. See Chapter 3- Why are financial markets so inefficient and exploitative – and a suggested remedy. Mad scramble for fees, and infighting within  firms are very well documented in many business articles.  If they can, they always take advantage of 401K investors ignorance. Their goal is to build a dependency to increase and annualize their fees.

As Martin Wolf noted:

Beyond these broader objections to the growth of inequality, in general, and of unjust rewards, in particular, concern is expressed over more specific defects to do with incentives in the financial sector.

The argument here has several steps.

1. Financial sector booms and busts create gigantic losses for society, not only via the direct costs of bail-outs, but still more via the indirect costs of economic instability on the economy.
2. To the extent, that institutions take synchronized risks, they increase the likelihood and severity of such crises, by creating the conditions in which ultimately ruinous bets are rewarded, at least for a while. 
3. Asymmetric information is pervasive. Thus, strategies with zero expected excess returns in the long run may look successful in the short run, either as a matter of luck or because of the nature of the strategy – high probability of small gains with a low probability of huge losses, for example. Such strategies are extremely common: the ―carry trade is such a strategy; so was the strategy of buying AAA-rate collateralized debt obligations, in place of the liabilities of AAA-rated governments. As Raguram Rajan of Chicago University‘s Booth School of Business has rightly noted: ―true alpha can be measured only in the long run and with the benefit of hindsight . . . Compensation structures that reward managers annually for profits, but do not claw these rewards bank when losses materialize, encourage the creation of fake alpha.
4. Shareholders, lack the capacity to monitor risks in complex institutions. Worse, in highly leveraged limited liability companies, they also lack the interest to monitor such risks properly, since - as Lucian Bebchuk and Holger Spamann of the Harvard Law School point out, convincingly - they enjoy the upside, while their downside is capped at zero. Thus, leveraged bank shareholders have an incentive to increase the volatility of bank assets, which enhances their potential gains.
5. Not only shareholders, but also creditors, lack the interest to price properly the risks being assumed, since they enjoy a high probability of rescue in the event of failure: this is the operational core of the idea of "too big to fail."
6. Managers also have an incentive to bet the bank to the extent that their interests are aligned with those of the shareholders. Since share options are a leveraged play on the gains to shareholders, they make management even more prone to bet the bank than shareholders. Moreover, the fact that managers sometimes lose does not show that they were wrong to take such bets. Yet the evidence even suggests that even the management of failed institutions have been able to cash out substantial winnings before the collapse.

Finally, the combination of asymmetric information with the complexity of such institutions makes it effectively impossible for regulators to monitor the risks being taken.

Hypertrophied financial sector contributes to instability one form of which is self-reinforced runs of asset  prices, which in extreme form produces bubbles and crashes. The existence of momentum created by financial intermediaries has been extensively documented in empirical studies of securities markets. The presence of such price momentum is incompatible with efficient market hypothesis, although it was a junk theory from the very beginning.

The financial crisis has uncovered how the actions of bad actors within the financial industry has diverged from the ‘bright line” of ethical and legal business practices.  To think that they behaves differently toward 401K accounts owners that to subprime owners is extremely naive...

401K Plans as Pension Apartheid: High fees, hidden Fees, embezzlement, limited selection of funds in 401K Plans

Defined contribution programs like 401K effectively allow employers to shift this responsibility, and repercussions, of investment decisions to the employees greatly increasing the 401K investors risk on not achieving their retirement objectives.  High fees and action very close to embezzlement of funds practiced by many 401K managers is another risk factor. As a reaction employees tend to contribute max amount possible creating additional profits for financial intermediaries and the size of the market creates condition for survival and prosperity of various types of parasites like hedge funds, derivative traders, annuities peddlers and so on and so forth. The employees are faced with selection for their hard earned money (with minimal matching: 4-5% is typical), from a limited list of funds, often with ridiculously high fees.  If you have Vanguard funds in you 401K account consider yourself blessed.

Some cases of "401K management" are as close to embezzlement as one can get. Wal Mart is a good example of this type of blatant rip off: they use Merrill Lynch as a manager of their 401K (probably the worst selection possible, so backroom deal with management is suspected).  Funds available has high fees and low returns. Sometimes they play really nasty tricks. For example in March 2011 they decided to wind down their "Retirement Preservation Fund", a stable value fund which was run by (another very shady company that individual investors better avoid)  Blackrock and poor Wal Mart employees who has had funds in "Retirement Preservation Fund" (note the irony of the name) lost 0.5%. Fund paid almost nothing in interest so to lose 0.5% in March 2011 when there was no sign of another financial crisis there should be real fraud involved (or derivates games that continued past 2008).  Please remember that RICO offences include embezzlement of funds (Wikipedia):

Under the law, racketeering activity means:

• ... ... ...
• Any act of bribery, counterfeiting, theft, embezzlement, fraud, dealing in obscene matter, obstruction of justice, slavery, racketeering, gambling, money laundering, commission of murder-for-hire, and several other offenses covered under the Federal criminal code (Title 18);
• Embezzlement of union funds;
• Bankruptcy fraud or securities fraud;
• ... ... ...

If applied strictly by the definition provided such firms as Blackrock and Merril Lynch could easily lose their executives on related charges. But that just a pipe dream (actually there is one pending lawsuit against Merrill Lynch that charges it under RICO statute (from Overstock Goldman Sachs And Merrill Lynch Implicated In Short Sale Scheme, but it is from a company not individual investor).

If at retirement age you are short of necessary funds, the adjustment falls on you, not the employer.

Establishing 401K plan with high fee, mostly stock mutual funds as primary source of retirement security is justly called "A pension apartheid ". They essentially converted 401K investors into second-class citizens who pay additional fees for third-rate services.  In additional they are subject to corporate rip-offs. I wonder why the limit for IRAs ($5,000 in 2010) is so much lower than the contribution limit for 401(k) plans ($16,500 in 2010).

The classic story of 401K investors rip-off is Wal-Mart.  Please keep in mind that this is common knowledge and standard practice. Majority of corporate 401K plans really rip the captive participants off with exorbitant fees.  It’s not uncommon to see a 401K S&P 500 fund with an 0.85% expense ratio (the federal employee Thrift Savings Plan has an expense ratio of .019% )  Not that that makes it any better, but singling out Wal-Mart in this instance is not entirely fair.

But the real irony here is that Wal-Mart is the world, most tough negotiator when it comes to getting low prices for the stuff it sells. Yet it allows Merrill Lynch charge exorbitant fees for horrible funds. Despite that total assets of 401K holders in Wal Mart are approximately $10 billion in assets to swing like a club.”. When the world’s experts at negotiating bargain prices do not bargain even half-way intelligently for 401K for its employees, it’s usually due to corruption or hidden agenda or both.  They might also get a break on the administration fees (which can be considerable, especially with lots of low balance accounts) in exchange for letting Merrill screw their employees with high expense fund options. Here is one account of their shameful behavior (Why Is Wal-Mart Paying Retail Prices « The Baseline Scenario):

Ted K. points out (and comments on) Stephanie Fitch’s article in Forbes on Wal-Mart’s 401(k) plan. The crux of the matter is that Wal-Mart seems to have done a lousy job creating a good 401(k) plan for its employees. Until recently, it had ten funds, only two of which were index funds; the other, actively managed funds all had high expense ratios (the ones Fitch quotes are above 1 percent).* More shockingly, the expense ratios paid by plan participants were the same as the expense ratios paid by individual investors in those mutual funds. It didn’t even pool its employees’ money together to get institutional investor rates. The irony, of course, is that Wal-Mart is the world’s best, most powerful negotiator when it comes to getting low prices for the stuff it sells, yet it exercised no negotiating power in getting low prices for its employees — even though it had $10 billion in assets to swing like a club.

One allegation of the current lawsuit is that Merrill Lynch, which administered the plan, may have chosen funds for the plan because of (legal) kickbacks it was getting from the fund managers. In other words, Merrill was pushing specific funds onto Wal-Mart employees because it was effectively getting sales commissions for those funds. This is classic banking behavior, of course, but it’s a bit of a mystery to me why Wal-Mart would put up with it; since it’s just as easy for Wal-Mart to create a good 401(k) plan for its employees as a bad one, why did it create a bad one? (I don’t actually think Wal-Mart would actively go out of its way to screw its employees if it didn’t benefit it some way.)

I say it’s classic banking behavior, because of course banks will try to sell you products that give them bigger profits; it’s their interests they have in mind, not yours. The basis of the lawsuit, however, is that Wal-Mart violated its fiduciary duty to plan members under ERISA. Unfortunately, the fiduciary duties under ERISA seem (as far as I can tell on a very cursory reading) to be pretty flimsy, having to do mainly with disclosure. In other words, you can create a lousy plan for your employees; you just have to tell them all about the plan so they can figure out that it’s lousy. (And in any case, since most employees are effectively captives of their employers, there’s nothing they can do about it, anyway.)

401(k)s are in many ways a feeble substitute for traditional defined-benefit pensions. Among other things, unless you get an employee match, it’s all your money — your employer isn’t contributing anything. The tax deduction you get from a 401(k), like all tax deductions, is valuable in direct proportion to your marginal tax rate and the amount you are able to put aside, meaning that it is extremely regressive. But still, it’s a modest benefit for working people (and a better benefit if there’s an employer match). However, like all investments, the tax benefits can be rapidly swallowed up by fees.

One hundred years from now, people will look back and say we were all suckers for paying expense ratios of over 1 percent to fund managers who generally fail to beat the market. Unfortunately, we will all be dead before then, and in the meantime we’ll be paying those fees.

(This is what Wal-Mart had to say about the issue: “We are proud to provide a high-quality, innovative retirement plan to help more than one million of our Wal-Mart associates prepare for the future.” Reminds me of something Google recently said.)

* I don’t think having a small number of funds is bad in itself. Too much choice can be counterproductive, especially if some of the choices are bad; it’s better to have three cheap funds than to have three cheap funds and seven expensive ones.

The term "pension apartheid" also reflects the fact that 401K crowd is in huge disadvantage to state employees (who can get up to 60% of their pre-retirement income as a defined benefits pension) and big brass (with one year salaries that are close to hundred years of salary of  regular folks):

401(k) plans have no such oversight board. Hence, yet another way in which defined contribution plans are a worse deal than defined benefit to the employees. The ERISA law could be amended to mandate employee oversight. This would not solve all the problems, since not many employees have the expertise for meaningful oversight, and the elections/ratifications can be rigged by the company. Again, financial services lobbying efforts would have to be overcome.

In its current form 401K plans are designed to feed middlemen (often a crony fund management firm selected by company brass without any restraint; that's how high fee mutual funds creep in 401K plans) or if the management company provides other services to the company (like is often the case with Fidelity).  This middleman plays the role of croupier in casino: he gets zero risk along with stable returns no matter how the funds are performing. Regulated institutional investors typically charge fees as a proportion of assets managed, not a share of profits. This is a direct consequence of the regulation of compensation, and arguably has been a source of great harm to investors, since it encourages asset managers to maximize the size of the funds that they manage, rather than the value of those funds. Managers who gain from the size of their portfolios rather than the profitability of their investments have strong incentives not to inform investors of deteriorating opportunities in the marketplace and not to return funds to investors when the return relative to risk of their asset class deteriorates.

There is a nice government publication with the checklist A Look At 401(k) Plan Fees that can alert you to the fraud in your 401K account. For additional information regarding the level of fees typically charged to 401(k) plans and 401(k) plan fees and expenses generally, see the Employee Benefits Security Administration’s Study of 401(k) Plan Fees and Expenses.

Here is a quote from CBS' 60 Minutes talked about how retirement dreams disappear with 401(K)s. If you did not see it, click here to watch this segment. They also  talked about how retirement dreams disappear with 401(K)s. If you did not see it, click here to watch this segment. I would like to quote the following:

When employers began turning 401(k)s into retirement plans, the financial community was not shy about promoting them as such. The prospect of trillions of dollars in the hands of unsophisticated investors opened the door for all sorts of potential abuses.

"The fact is that the typical 401(k) investor is a financial novice. They don't know a stock from a bond. And we give 'em a list of 20 or 30 mutual funds with really, really powerful names, you know, they sound like, 'Gee, that's where I want to have my money,'" Hamilton said,

"What are the, generally, the quality of the mutual funds in 401(k) plans?" Kroft asked.

"Mediocre," Hamilton replied. "I'm being real honest with you, with half the funds on the list really dogs, what people would characterize as dogs shouldn't be on the list to start with."

"There clearly has been a raid on these funds by the people of Wall Street. And it's cost the savers and the future retirees a lot of money that would otherwise be in their account, independent of the financial collapse," Rep. George Miller [D-CA] said.

Congressman Miller is chairman of the House Committee on Education and Labor, and a staunch critic of the 401(k) industry, especially its practice of deducting more than a dozen undisclosed fees from its clients' 401(k) accounts.

"Now you got a bunch of economic wizards jumping in and taking money out of your retirement plan, and they don't wanna tell you how much, you can't decipher it in simple English, and they're not interested in disclosing it, or having any transparency about it," Miller told Kroft.

"And most of the people that look at their 401(k)s have no idea that these fees are being taken out?" Kroft asked.

"No. Where would you find it? Where would you find these fees in this prospectus? You can look on any page you want, and when you're all done reading it, and you will find some of the fees and the commissions here, but you won't find them all, and I'll bet you won't find half of 'em," Miller said.

There are legal fees, trustee fees, transactional fees, stewardship fees, bookkeeping fees, finder's fees. The list goes on and on.

Miller's committee has heard testimony that they can eat up half the income in some 401(k) plans over a 30-year span. But he has not been able to stop it.

"We tried to just put in some disclosure and transparency in these fees. And we felt the full fury of that financial lobby," he said.

David Wray, a lobbyist for the 401(k) industry, says he favors disclosing the fees, but his partners in the financial industry don't.

Asked if he thinks most people know these fees exist, Wray said, "I think they know that there are fees. They don't know exactly how large they are."

"Why do you think the financial services industry is opposed to fee transparency?" Kroft asked.

"I don't know that they're opposed to it. I think the issue is that…," Wray replied.

"You don't think they're opposed to it?" Kroft asked. "You're a lobbyist in Washington, right? You know they're opposed to it. …George Miller hasn't been able to get a bill to the floor."

"I think they want to keep the systems as simple and not make changes. They like the way things are. And whenever you push people out of their comfort zones, you know, it's an issue," Wray replied.

"I mean, they're comfortable with the situation because they're making a ton of money or they have made a ton of money," Kroft said.

"Well, and their systems are set up in certain ways. You know, this is gonna be a big change," Wray replied.

60 Minutes wanted to ask Wray, who's been so bullish on 401(k) plans, one last question about what the future holds for people like Terry and Donna McNally and Kathleen Coleman.

"Most of the people that we've talked to are 50 and 60 years old and have sustained these losses say there is no way they're ever gonna make them back. Do you agree with that?" Kroft asked.

"I think we have to be truth tellers," Wray replied. "I think that when a person has hit this point, and we've had this unfortunate situation, I don't think we can misrepresent what the possibilities are."

"And reality is that money's not coming back that they've lost," Kroft said.

"They can't count on it," Wray replied. "They have to…it may. Maybe they have long, maybe if they work ten more years, it'll come back by the…but it's important that they not have unrealistic expectations."

To understand how this toll has ballooned, imagine for a moment that all American corporations are, and always will be, owned by a single family. We’ll call them the Gotrocks. After paying taxes on dividends, this family – generation after generation – becomes richer by the aggregate amount earned by its companies. Today that amount is about $700 billion annually. Naturally, the family spends some of these dollars. But the portion it saves steadily compounds for its benefit. In the Gotrocks household everyone grows wealthier at the same pace, and all is harmonious.

But let’s now assume that a few fast-talking Helpers approach the family and persuade each of its members to try to outsmart his relatives by buying certain of their holdings and selling them certain others.

The Helpers – for a fee, of course – obligingly agree to handle these transactions. The Gotrocks still own all of corporate America; the trades just rearrange who owns what. So the family’s annual gain in wealth diminishes, equaling the earnings of American business minus commissions paid. The more that family members trade, the smaller their share of the pie and the larger the slice received by the Helpers. This fact is not lost upon these broker-Helpers: Activity is their friend and, in a wide variety of ways, they urge it on.

After a while, most of the family members realize that they are not doing so well at this new “beat my- brother” game. Enter another set of Helpers. These newcomers explain to each member of the Gotrocks clan that by himself he’ll never outsmart the rest of the family. The suggested cure: “Hire a manager – yes, us – and get the job done professionally.” These manager-Helpers continue to use the broker-Helpers to execute trades; the managers may even increase their activity so as to permit the brokers to prosper still more. Overall, a bigger slice of the pie now goes to the two classes of Helpers.

The family’s disappointment grows. Each of its members is now employing professionals. Yet overall, the group’s finances have taken a turn for the worse. The solution? More help, of course. It arrives in the form of financial planners and institutional consultants, who weigh in to advise the Gotrocks on selecting manager-Helpers. The befuddled family welcomes this assistance. By now its members know they can pick neither the right stocks nor the right stock-pickers. Why, one might ask, should they expect success in picking the right consultant? But this question does not occur to the Gotrocks, and the consultant-Helpers certainly don’t suggest it to them.

The Gotrocks, now supporting three classes of expensive Helpers, find that their results get worse, and they sink into despair. But just as hope seems lost, a fourth group – we’ll call them the hyper-Helpers – appears. These friendly folk explain to the Gotrocks that their unsatisfactory results are occurring because the existing Helpers – brokers, managers, consultants – are not sufficiently motivated and are simply going through the motions. “What,” the new Helpers ask, “can you expect from such a bunch of zombies?”

The new arrivals offer a breathtakingly simple solution: Pay more money. Brimming with self-confidence, the hyper-Helpers assert that huge contingent payments – in addition to stiff fixed fees – are what each family member must fork over in order to really outmaneuver his relatives.

The more observant members of the family see that some of the hyper-Helpers are really just manager-Helpers wearing new uniforms, bearing sewn-on sexy names like HEDGE FUND or PRIVATE EQUITY. The new Helpers, however, assure the Gotrocks that this change of clothing is all-important, bestowing on its wearers magical powers similar to those acquired by mild-mannered Clark Kent when he changed into his Superman costume. Calmed by this explanation, the family decides to pay up.

And that’s where we are today: A record portion of the earnings that would go in their entirety to owners – if they all just stayed in their rocking chairs – is now going to a swelling army of Helpers. Particularly expensive is the recent pandemic of profit arrangements under which Helpers receive large portions of the winnings when they are smart or lucky, and leave family members with all of the losses – and large fixed fees to boot – when the Helpers are dumb or unlucky (or occasionally crooked). A sufficient number of arrangements like this – heads, the Helper takes much of the winnings; tails, the Gotrocks lose and pay dearly for the privilege of doing so – may make it more accurate to call the family the Hadrocks.

Today, in fact, the family’s frictional costs of all sorts may well amount to 20% of the earnings of American business. In other words, the burden of paying Helpers may cause American equity investors, overall, to earn only 80% or so of what they would earn if they just sat still and listened to no one.

See pretty instructional video on Bloomberg News. From this video, which I highly recommend to watch, is clear that tables are stacked against 401K investor,  often by the company which employs him//her.  Companies treat 401K as an opportunity to offset other costs and use various tricks in selecting funds that are specifically designed to fleece the 401K investors (for example, selecting funds with high fees with the arrangement that some additional services to the company are provided for free). The most dangerous are so called revenue sharing fees. For example, according to Bloomberg, Wall Mart has special arrangement not to disclose those fees charged by Merrill Lynch (its 401K provider) from investors.  Fund deducts those charges from investor returns without informing investors. Those hidden costs can be double of those of what are disclosed. Americans have 3 trillion dollar in 401K accounts and  even 0.05% from this amount is a pretty neat sum.

The truth is that most companies consider 401K plan as a hidden profit center not the service to their employees (106826)

Schlichter, Bogard and Denton, a law firm based in St. Louis, has filed more than a dozen lawsuits in the last two years, including actions against Kraft Foods, Boeing, and Bechtel, the global engineering, construction, and project management firm based in San Francisco. The Bechtel trial opens in December in San Francisco, according to partner Jerome Schlichter.

"The duty of the plan fiduciary is to look out for interest of employees and operate the plan for their exclusive benefit," says Schlichter. "The cases that we have filed allege a pattern of ignoring fiduciary responsibility, and also in some instances, putting the interest of the fiduciary ahead of that of employees and retirees.

"If the employer uses the company's investment managers in the plan with whom it has other relationships -- investment banking, lines of credit -- you can't have the 401(k) plan participants subsidize those other services," Schlichter continues. "You can't have them pay a higher fee so their employer can get lesser fees on corporate services. That's not putting plan participants ahead of plan sponsors."

A Lawsuit Boom

Retirement plan litigation could become a cottage industry following a crucial Supreme Court decision earlier this year, according to David Loeper, author of "Stop the 401(k) Rip-Off!" and CEO of Wealthcare Capital Management in Virginia.

In LaRue v. DeWolff, Boberg & Associates, Inc., the court ruled that individual plan participants can sue the plan's fiduciaries if they "impair the value of plan assets in a participant's individual account." Previously, filing suit required that everyone in the plan be affected by the mismanagement. (LaRue had instructed his 401(k) plan to sell certain investments in his portfolio and the company never followed through, resulting in large losses when those investments subsequently declined sharply.)

The lawsuits are part of a recent groundswell of concern over the amount of disclosure provided to workers who participate in defined contribution plans. According to the Labor Department, there are an estimated 437,000 participant-directed individual account plans covering some 65 million participants, with almost $2.3 trillion in assets.

Fee Busters

Meanwhile, several members of Congress have proposed legislation to force more disclosure, and a Labor Department proposal introduced over the summer would require plan fiduciaries to disclose more detail on investment expenses and administrative costs in actual dollars on a quarterly basis.

Administrators would have to spell out the costs for legal, accounting, and record-keeping services in terms of what it costs an individual account holder. These costs are typically so well hidden that two-thirds of workers in a 2007 survey thought they paid no fees at all in their 401(k) plans. As it stands, "you're not going to get the answer [on fees] by contacting the benefits department because they don't know, or by looking at your statements because it's not in there," says Loeper. "You have to go on a little treasure hunt to come up with documents."

The Labor Department estimates that plan participants would save more than $2 billion in fees over the next decade, as greater transparency boosts competition and forces plan administrators to cut their fees.

Break It Down

So what difference can 1 or 2 percent in fees really make to a worker? "It has profound implications to investors later in life, and they don't recognize it," says Loeper.

Consider someone who joins a 401(k) at age 25, contributes $2,500 a year for 40 years, and receives a $1,000 annual company match, says Loeper. Assuming the portfolio returns 7.5 percent annually, the participant would end up with more than $1.2 million. Someone who's charged 1.5 percent more in additional expenses over the life of the investment will pay out $500,000 in extra fees by the time they're ready to retire, Loeper calculates.

"You think about the compromises you make -- what did it take for that person to accumulate that $1 million in retirement?" he says. "For 40 years he worked in that job, made compromises to save. What did the [retirement plan] salesman do to justify getting that $500,000?"

Getting Personal

Loeper wrote his book after discovering his own company plan administrator was covertly charging hidden fees to his firm's plan. "We put our company plan up to bid every year to be a prudent fiduciary, and the sales pitches were some of the most unethical things I've ever heard," he says.

For the providers of those plans: the Third-Party Administrators (TPAs), mutual funds, insurance companies, and brokerage firms who have been annually skimming, often surreptitiously, on average 2% of the trillions of dollars invested in these plans this was a gravy train.

Now suddenly, we have all these 401(k) horror stories. NPR devoted an hour  to discussing Teresa Ghilarducci's new book: When I'm Sixty-Four: The Plot Against Pensions and the Plan to Save Them. That same day Daniel Solin appeared on CNN discussing his new book: The Smartest 401(k) Book You'll Ever Read.

This review could replace the book., August 17, 2008

By	Mark Spinosa (Richmond, KY USA) - See all my reviews (REAL NAME)

This review is from: The Smartest 401k Book You'll Ever Read: Maximize Your Retirement Savings...the Smart Way! (Hardcover) The title is very clever; the book, however, less than par. There are a few good points in the book which could be summed up in much fewer pages.

Basically, here's the summary of the book:
1.) Passively managed, commission free (or low commission) index funds perform much better (and have, historically) than hyper-actively managed, high commission funds.
2.) Diversification is key. Some good recommendations in book on suggested funds to have to achieve proper diversification, based on risk tolerance.
3.) The Roth IRA dominates. Open one if you're eligible.
4.) The majority of 403(b) plans suck, because most are involved in some fashion with annuities. If yours sucks, speak up or get screwed.

I might have missed a few things, but my FREE review is probably pretty close to the NOT FREE book I bought, and hopefully you're smart enough to avoid.

The same territory was covered last year by David B. Loeper in his book: Stop the 401(k) Ripoff.  Here is one review from Amazon:

Most people I talk to would like to be millionaires by the time they retire. That means that investment in retirement accounts or general brokerage accounts should be increased by a couple thousand dollars a year and maintain a decent return. The percentage of return is the main factor in attaining that million-dollar status (especially when the interest starts to overtake the voluntary contributions as the main annual investment). What Loeper shows in fascinating detail in Stop the 401(k) Rip-off is that the companies (insurance companies) that sell the 401(k) plans to employers take a sizable chunk of the return -- often before you even see your statement (which may have additional fees shown).

The total damage is scary and may force you to immediately reconsider your retirement planning. After fund expense ratios, administration fees, wrap fees, M&E charges, and countless other fees that make retirement account statements start to look like cell phone statements, the total return may be 4% off of what your money has really made. In other words, a 401(k) plan makes almost as much money for the insurance companies as the employee.

Loeper utilizes multiple charts and examples to make his point that the 401(k) program is a rip-off and we should stop using them. Everyone who invests heavily in these accounts should know what they're getting themselves into and read this book.

For companies it's been an open secret that there was gold to be mined in those 401(k) hills. Here's how it worked as delineated in these books and based on participants accounts:

1. Sell a company on putting in a 401(k) plan, possibly replacing their costly defined benefit plan, where all investment risk and costs of administration are borne by the participants.
2. Load these plans with funds that offer the biggest kickbacks. Mutual funds charge fees that investors have to absorb -- fees that dramatically reduce any possibility of outperforming the market and that are set by captive boards of captive management companies, not one of which has been replaced for inadequate performance, violating their duty to guard the interests of the fund investors for whom they supposedly work.
3. Rake in the dough.

A perfectly viable pension system that provided comfortable, if not luxurious, retirements for working people over the last fifty years has been gutted by companies looking to shed those costs, plan providers looking for fees, and government looking the other way.

We appear to be entering a stage where the providers are being singled out for blame, but the other two legs of the stool that propped up the 401(k) myth are also culpable.

Those that work in the public sector can typically collect about 60% of their pay for the rest of their life (plus COLA, of course) once they enter retirement.  The math is simple. The public sector people are set for life; the private sector people simply cannot work long enough to contribute to their 401K in sufficient amounts to match the payout rate of the public sector.

The 401K scam is abhorrent. Likewise, companies like, Fidelity and  TIAA-CRAP who are in bed with companies (and universities in case of TIAA-CRAP) offer pitiful return rates on retirement accounts. You can get better money market returns at your local corner bank or in Treasuries Direct than what TIAA-CRAP offers. And the funds offered by CRAP  (really CREF, but I prefer the modification) perform so poorly, there is no chance of even matching the rate of inflation over a lifetime. TIAA-CRAP has relatively low transparent fees in comparison with some funds in 401K portfolios, but in return they readily lose your money and there is nothing anyone at the employee level can do about it. One study concluded:

"if all TIAA-CREF participants were restricted to only TIAA-CREF over a forty-year horizon, our estimate of the terminal wealth loss is between $700 billion and $4.2 trillion, depending on the mix of investor sophistication levels." p. 141

And the fact that most 401K investors were susceptible to "cult of equity" plays significant role in under funding their future retirement.

The selection of funds in 401K portfolios usually is heavily biased toward stocks. 401K plans should probably be structured like the Canadian RRSP or the Chilean Individual Pension Plans. That is, anyone can invest a certain amount tax-free per year in any vehicle they wish out of nationally approved list. This problem with 401K plan is known for a long time. Still in the "deregulation era" federal government did nothing to prevent this large space scam (Resuscitate your 401k in 5 steps - MSN Money):

"When you invest through your 401k, you are at the mercy of whatever your employer has plugged you into," said Gerald Wernette, a certified public accountant and employee-benefits specialist in Farmington Hills, Mich. "You have a couple of equity funds, a bond fund, an international fund, and away you go. Aside from screaming at your employer, there's not a lot that Joe Participant can do."

Adopting  the Canadian RRSP or the Chilean Individual Pension Plans means no more typical 401K scam and not money for powerful financial intermediaries that such you dry.

"Here, you got 5 mutual funds to invest in and please be happy about it" in the current motto and you pay with your hard earned dollars for the limitation which more then anything else suggests the unequal nature of the relationship. 

Returns should be controlled and underperforming funds kicked out of participation is 401K plans on a regular basis (say once in five years). Right there, 75% of the mutual funds industry would get a much needed kick in the pants. Performances should be reported before all fees and after each and every fee then after all fees are accounted for.  A mandatory graph would show projected losses generated by said fees at 10, 15, 20 and 30 years, and included in ANY prospectus. Every trade performed during last 3 days before end of quarter should be disclosed on every mutual fund web site. ("window dressing?"). In Buttonwood Gored by the bull published by Economist in May 2007 the author states:

According to Chris Watling of Longview Economics, the top 1% of households owns around 40% of America's wealth—the highest proportion since 1929. In the 1970s, they accounted for just 20%.

This creates its own problems, especially when workers are increasingly expected to provide for their own retirement. After all, many companies are retreating from the provision of defined-benefit (final salary) pension schemes because of the cost. As companies switch to defined-contribution (money purchase) schemes, workers not only receive, on average, lower contributions from their employers; they also lose an insurance policy against poor stockmarket returns (because the companies were committed to make up any shortfall in the pension fund). Such a policy would be very expensive to buy in the open market.

Workers trying to replicate a final-salary pension have two further problems. The first is that high share and bond prices imply low yields (the two are inversely related). So they need a larger sum to generate a given retirement income.

The second problem is that, when asset prices are high and yields are low, future returns are likely to be subdued. It thus takes a lot more effort to generate a given lump sum for retirement.

But 401K investors were slow to recognize that they were lured into "lose-lose" scheme and will con lose their shirt due to market volatility and that they can only count on dollars they put as inflation and middlemen eat all returns and more.  You can't get water from a dry well. Salaries are stagnant for many years and with annual inflation around 3% for many 401K participants now it is difficult even contribute the amount that are matched by the employer.  Still most 401K investors like lemmings went into a pre-determined trap. Many were kicked out of from defined benefit plans as companies face financial problems. 

The real shift in public sentiment start happening only in 2008. On Feb 8, 2008  naked capitalism reported:

In the last month or so, I have noticed a marked increase in hostility towards the financial services industry, both in the number of cynical, critical comments on this blog and the intensity of their venom. These are a few from the last week:

The wealth creation over the past decade plus has been on the back of a system that has grown more corrupt by the year. It is a parasitic system that is rotten to the core and feeding off the real economy, empowered by the bankrupt foreign economic policy that has essentially given away our competitive advantages and gutted out industrial base. Who said American's aren't generous? ......

Global collusion and financial engineering gurus fused together packages of localized loan pools into globalized loan pools in hopes that the default rates would be insignificant and thus any impairment or dilution would be diluted to zero risk.

The result of what these gurus engineered is a global systemic financial failure resulting in denial on their part, no accountability on their part and defaults on a global scale never before seen. These gurus will return to Davos with new derivatives and be held in high regard, versus being placed into global prison cells! .....

Wall Street has become a conduit unto itself and a zero sum wealth "creator" for the financial economy at the expense of the real economy. We are heading for a complete disaster and the more you read this moronic commentary [from a Wall Street strategist] the more you realize that never has there been a better time to sell. Rotten to the core.

While the question about financial services are good or bad is mainly philosophical for 401K investor and he/she need to use the one provided for him/her no matter what, we needs to see bigger picture:  getting reasonable returns without unreasonable risks in 401K portfolio is a very difficult task. So there are two main strategies: take higher risk (and the tables are turned against you) or accept low, single digit  returns. I think the second strategy is the most reasonable for people with salaries blow 100K per year as the lower is the salary the lower risk you can afford. Yes, that informally means that you will get essentially close to zero returns after inflation: on each dollar you contributed to 401K you get exactly one dollar back. Which, in a way, is better then losing 10% or more due to either your own mistakes or unfavorable market conditions.   Here is one interesting observation from the forum for Resuscitate your 401k in 5 steps - MSN Money

mich9402 Tuesday, June 02, 2009 9:30:34 AM

 Looking at how the cost of living has escalated in the past 30 years shows that whatever the average person saves for retirement will not be enough unless they get rid of housing and car expenses.

I was 29 years old when I bought my second new car. It was a really hot 1975 Camaro, loaded with all of the goodies available at the time including leather seats. Get this: it cost $4550.00 and I had it paid off in 3 years. My apartment at the time was in the newest complex in the best area. It was 1250 square feet, 2 bedrooms 2 full baths. It cost $270.00 per month.

Needless to say, my income has not increased exponentially over 30 years as have the cost of these two items. Now the same quality of car is $28,000.00 and the same apartment is $1400.00 per month.

I don't think any kind of investment portfolio is going to keep up with rising costs in housing and cars. Get rid of those expenses as in drive your car longer and pay off the house to the point where you can get a reverse mortgage down the road if need be. Think of how much easier life would be today without your income being sucked up by those two expenses.

But what is important that with some false moves you very easily get negative returns of -20% or more after inflation and that means that each programmer needs diligently work on acquiring all the necessary knowledge required to avoid this scenario. Here is Buffett's letter to shareholders that explains the typical fallacy of double digit returns from stocks and "queen in Alice in Wonderland" situation with helpers (a.k.a. investment advisors): 

I should mention that people who expect to earn 10% annually from equities during this century – envisioning that 2% of that will come from dividends and 8% from price appreciation – are implicitly forecasting a level of about 24,000,000 on the Dow by 2100. If your adviser talks to you about double digit returns from equities, explain this math to him – not that it will faze him. Many helpers are apparently direct descendants of the queen in Alice in Wonderland, who said: "Why, sometimes I've believed as many as six impossible things before breakfast." Beware the glib helper who fills your head with fantasies while he fills his pockets with fees.

There are no "long-term" straightforward investment  answers for 401K accounts assets allocation anymore. Moreover, most of 401K investors including myself should be more properly called "401K donors"  as few of us will be able to get returns above inflation. We are just feeding financial intermediaries (in a typical bond fund with return 4.5% (your harvest) and fees 0.5% the mutual fund share of profits is 11% of returns, the share greater then the share landlords used to demand from serfs during middle ages -- 10% of harvest were usual at this time; but the landlord gave serfs land, while financial intermediaries just take your money).

Most 401K investors would be much better off investing directly into Treasuries as most 401K plans contain very eclectic set of funds, the  "straight jacket" on your investing options (you cannot for example invest your 401K directly in gold, or government saving bonds).  Also some companies deliberately have 401K plans infested with funds with high fees (Wal Mart is a prominent example of such behavior: they use dismal from fees standpoint Merrill Lunch funds in 401K portfolios).

The question arise what allocation of assets between stocks and bonds is most resistant to eroding from inflation and confiscation by mutual fund industry. First of all most 401K plans have both stocks (often represented by index fund like S&P500 or a value fund like Windsor II) funds and one or more bond funds (as a minimum so-called a "stable value fund" -- an ultra short bonds fund, but often an intermediate bond fund like Pimco Total Return and one high yield fund like Vanguard High-Yield fund are also present). 

My general feeling is that bonds should play more prominent role in 401K portfolios and that some kind of age based sliding scale allocation between bonds and stocks might at least diminish losses as your portfolio automatically becomes more conservative with age (100-your age is the simplest strategy). Please not that  target date funds as a rule overinvests in equities; if you use such deduct at least ten years from your retirement date and check the percentage of assets in stocks before investing).  You also need to understand the additional fees imposed on you. Often such finds charge more then 0.5%, while your own combination of, say, Vanguard bond fund and Vanguard S&P500 fund would have less them 0.25% fee with very similar if not better returns.  

To a large extent your success depends on honesty of your own effort in understanding the options you have, educating yourself in major economic concepts and trends, keeping your own records, doing your own simulations using Excel, and reaching your own conclusions.  In way in a way investing is betting on long term trends; while speculation is betting on short term trends. For example, the person who invest all his money in S&P 500 makes pretty bullish bet; how bullish depends on P/E ration (which is very raw measure with high error as E in this equation is often just an accounting trick and has nothing to do with the reality) and other investment metrics.

It is important to understand that the advocated by the author age-based split between stock and bonds (100-your age) is not a panacea. But it might be a good starting point for your own efforts for adaptation of this simple approach to your particular situation. The key advantage is that 100-your age strategy (with rebalancing after, say, 10% deviation from the prescribed share, where

deviation=(stocks_value-bonds_value)/100

is  simplicity. 

It is trivial to simulate in Excel using data from Yahoo for any programmer. My simulations had shown that many other, more complex allocation strategies does not produce statistically significant higher returns without tweaking parameters to fit the data ("data mining").

But we need to remember that every investment strategy that seems to be well-grounded and working well in the past might at one time stop working (in a sense that returns are less then either 100% bond or 100% stock index fund portfolio whatever is greater).  Typically that happens during the crisis when correlation between asset classes diminish or even reverse or during prolong bear markets which favor even more conservative strategy.  Right now (as of 2008) we have a period of such uncertainty so please take my advice with the grain of salt. 

That means that for any investment strategy, before you invest real (your hard earned) money, you need to test this investment strategy both on normal periods as well as on the period of crisis like 2000-2003 and 2007-2009 (for both periods the data are available from Yahoo). 

Generally it is reasonable to assume that expansions are longer then contraction but exact share of expansion vs. contraction in simulations is a more difficult question (you can start with 60:40 ratio). For programmers there is no excuse to skip this the simulation step as it is able to show what are maximum losses you can suffer during bear markets, the losses that you need to be able to tolerate by increasing your allocation for future years. And you need always to cut you level of tolerance by half if the year is OK. It losses are higher then you intuitively understood risk toleration level you need to increate bond part of the allocation or introducing "stop loss " rules for stocks.  For those of us who prefer Unix, Perl with Apache is a suitable substitute for Excel and it is perfect for implementing stop rules with emails on the days when market drops below them. Some brokerages provide simple alerts mechanism via email that works OK for short periods like a week or two. 

There is also a distinct danger of data mining in strategies that are published in popular media (for example portfolios based on Financial alchemism. Data mining means that the allocation was tuned to perform well on particular historic data. I have found a good and pretty simple test for  simulation model that discovers data mining: if you replace in your model one fond with another similar one, the model that was tuned by data mining stop working and does not produces similar return.  The same is true if you replace one ten year period for another (I personally use a set of ten year periods for testing Excel models).  If the return is considerably different that means that you tuned your model too much to the data on which you debugged it.  There is also tendency to make model more complex than it should to increase returns. You should fight this trend as historic data does not predict the future and a simple, even very crude model has tremendous advantages over a complex one as you can understand it behavior and limitations better.

Also you need to take into account rare events like deep recessions.  Among things "Things That Can't Happen but Happened Anyway" Mish recently listed:

• One of the reasons the Fed was created was to manage the economy and prevent further depressions. Guess What? The biggest deflation in history, the great depression, happened 17 years later.
• At one time economists thought that inflation and recession could not happen at the same time. It happened anyway. A new term was coined for it "Stagflation".
• Deflation supposedly couldn't happen in a fiat regime. Japan proved otherwise.
• If you asked anyone in Japan if housing prices could fall for 18 straight years, they would have said "It can't happen". It did happen.
• For 30 years people have said US housing prices would never again decline on a national scale. They were wrong. It happened.

I would add to the list the hypothesis that diversified stocks index like S&P500 outperforms bonds ("stock for the long run" or naive Siegelism hypothesis). Yes, it might be true for certain periods (for example ten year periods starting in any month in 1990 and lasting till 2000, and some months of 1991-2001,  and then again, 1996-2006 and 1997-2007 periods). But if we assume cost averaging starting from zero, then Vanguard institutional stable value outperformed S&P500 for most of exact ten year periods with the start at random month in 1990-1998 timeframe (2008 is not over yet but it looks like underperformance will hold for the rest of 2008.)

The difference between stocks and bonds returns for some "stock positive" periods like Jan-Jun 1996 -  Jan-Jun 2006 are within the rounding error and generally can be reversed by using different from Vanguard Institutional Stable value bond fond.

Also the latest trends due to subprime crisis make the situation with S&P500 returns in 2009 more problematic as financial stocks constitute  approximately a quarter of S&P500.  That means that S&P 500 might also underperforms stable value fund for 1999-2009 period and may be 2000-2010. If this is true, that for all for ten 10 year periods with starting years of 1990 to 1999 and cost averaging starting from zero naive Siegelism hypothesis is demonstrably false.

Moreover difference is even  larger if instead of stable value fund one is using bonds funds like Institutional PIMCO Total Return or Vanguard bond index.

It is important to understand that in case of 401K investor all the money are not available at the start of investment period and the model should include the usage of  value averaging and (often erratic and irrational) human actions like reallocations from stocks to bonds when situation becomes too tough. If we account for those, then for many 401K investors the "Bush II recovery (2003-2007)" after the dot-com crush was actually not a complete recovery from losses. Traumatized by losses in 2001-2002 they sold some or most of their stock holdings during the slump, missed large part of the rally which started in 2003 and were lured into stock market closer to 2005-2007 when the same dangers (but different type of bubble) start lurking again and materialized in 2008.

For those who remember 1999 and 2000 the key investment ideas promoted by media in 2007 are again foreign markets and, especially, emerging markets with an additional spice of decoupling theory. But decoupling might not work in 2008.  It did not worked in 2001-2003 recession where emerging market behaved almost exactly like tech stocks.  In some areas our current situation of subprime collapse might be even more dangerous for 401K investors then dot-com bubble deflation: both commodities boom and emerging markets boom of 2003-2007 which provided some outsized returns were out of the reach for most 401K investors.  As Angry Bear blog noted:

Earlier today Cactus posted on the real Dow over the past seven years. Another comparison is to look at the alternative strategy, investing in cash or 3 month T bill.  If in January, 2001 you had placed your investments in 3 month T bills and reinvested the income in 3 month T bills, at the end of December, 2007 your total returns would have been almost exactly the same as if you had invested in the S&P 500 with daily dividend reinvestment.

... ... ...

P.S. In looking at the current stock market and listening to strategist this chart is an important lesson to think about. You will hear from Wall Street analysts that if you do not go back into the market and miss the first leg off the bottom you are missing a great opportunity. Of course they are right. But if you miss that first bounce off the bottom and wait to go back into the market as long as you return while the market is below the cash line you are still better off than if you rode the market down and back up.

Also important is that in the fairy tale of free-market economies, the financial markets provide for the efficient allocation of capital. In the real world the financial markets among other things efficiently provide for the transfer of wealth from the working people (and that explicitly includes 401K investors) to people in positions of power (large banks brass, hedge funds owners and new financial elite in general, which is the essence of  Bushonomics). And there is enough money in the financial system to hire talented people who will do their best to sustain any desirable myth in media, no matter how absurd it is. The problem is that according to iron law of oligarchy if top 20% has all the money, then their business decisions control the directions of the economy, and their political contributions control the direction of the country. Middle class can do nothing about this trend even if it hurts their well-being. They became just milk cows.

Another interesting sign of the complexity of the current situation and dangers lying ahead for 401K investors is that when financial sector became hypertrophied a side effect is the dramatic rise of the level of corruption in the system, the level which  might actually undermine the economic security of the nation. "Things happened" during S&L crisis and it looks like the same thing but in much wider scale unfolds in the subprime crisis. Just look at Countywide saga. 

In any case for a regular 401K investor its important critically access the situation and resist negative effects of being brainwashed by the mainstream press. Among such effects the following were recently listed: 

• Millions of investors buy into the technology bubble on the bad advice of analysts, then lose most of their savings.
• Employees spend their adult lives working for a corporation, only to watch their pension plans crumble in size and significance.
• Mutual funds let outside investors steal from their customers for a share of the loot.
• Borrowers are encouraged to take on more debt, then get squeezed into bankruptcy by rising rates.
• Loyal employees face layoffs when private equity firms take over a company and extract every penny and ounce of worth that they can find.

The essential fallacy of the 401(k) has been exposed. It took a historic market collapse -- one that threatens to impoverish workers already in retirement and those who are nearing it. But then, crushing hardship is often what's required to usher out an era of ideological  brainwashing.

The advent of the 401(k) in the late 1970s and early 1980s was a leading indicator of what became a political mania for shifting the risk and responsibility for life's big challenges -- health care, an adequate income in retirement -- from employers and other broad-shouldered institutions to the narrower, weaker backs of individuals themselves.

It was never sold this way, of course. The pitch for the 401(k) was a contemporary version of the get-rich-quick scheme: The promise of strolling along a sun-dappled beach in retirement would be realized with ease, so long as workers regularly contributed modest amounts to the accounts, then let the compounding magic of the market work.

To hear the mutual fund companies and the media tell it, only fuddy-duddies and dinosaur employers would be foolish enough to opt for the old-fashioned defined-benefit pension, the type employers paid for and professional managers oversaw, and which guaranteed monthly payments in old age. The type that gave the hard-boiled men and women of the industrial age security, but would never reward them with riches.

The offer seemed good to media observers, and to the politicians who nurtured the do-it-yourself retirement with successive legislative schemes. During the stock market boom of the 1990s, esteemed business publications published breathless articles featuring manufacturing workers who would use their lunch breaks to track their mutual fund balances and ponder the possibilities of the loan they would take out for a cabin on the lake or an anniversary trip to Hawaii.

But despite the hype, the data on 401(k)s have never -- ever -- shown that these accounts were creating a mass of workers who would be able to retire with security, let alone luxury.

The 401(k)s didn't expand the proportion of the work force with pension coverage, notwithstanding claims that shifting to accounts that required workers to contribute would make employers more willing to offer the benefit. Less than half of workers have any type of pension coverage from their current employer at all, according to the Center for Retirement Research at Boston College.

For those who do have retirement accounts, the bottom line has long been grim. In 2004, the last year for which data are available, the median balance in IRA and 401(k) retirement accounts was $35,000, according to the Federal Reserve. For those nearest to retirement -- households headed by someone between 55 and 64 -- the median balance in 2004 was $60,000. That's enough to generate just about $400 a month in retirement income...

Demographics is destiny

An increasingly large segment of the 401K investor population is simply too old to be holding lots of stocks. About 22% of Americans, some 68 million people, will reach retirement age by 2020, and as baby boomers start drawing down their assets, they can’t risk wild fluctuations. From the 1980s to the 1990s, the U.S. economy benefited as this large segment of the population upped its spending. Now, as baby boomers are losing their relatively high paid jobs and/or retire, the trend reverse. Certainly, there will always be younger investors with a stomach for risk, but this category likely bet on emerging­markets economies with more growth potential than the more mature U.S. stock market.

 New legislation has impelled pension funds to match the duration of their assets to their liabilities, and as a consequence they are adding bonds, greatly downplaying equities and making their portfolios more conservative. The Pension Protection Act of 2006 made corporations pay stricter attention to funding and prevented them from smoothing their plans’ returns over many years. If the plans underperformed, their corporate earnings could take a hit. In response to these pressures, 26 percent of plans have adopted conservative, liability-driven investment strategies, and a further 38 percent are very likely to adopt them, according to a survey by CFO Research Services and Prudential Financial.

Moreover, if we assume that "demographic is destiny" that means that in its current form 401K plans have additional elements of Ponzi scheme: only first "converters" from stock to cash can get anything like a decent return on equities (if we assume that 2007 was not a multi-year peak that might not be matched in a decade or more )

Red Queen Race to outpace inflation

Combination of low returns and inflation creates for 401K investors the situation which is called The Red Queen's Race after a scene from Lewis Carroll's Through the Looking-Glass were the Red Queen and Alice constantly running but remaining in the same spot:

The Queen kept crying "Faster!" but Alice felt she could not go faster...

"Now! Now!" cried the Queen. "Faster! Faster!" And they went so fast that at last they seemed to skim through the air, hardly touching the ground with their feet, till suddenly, just as Alice was getting quite exhausted, they stopped, and she found herself sitting on the ground, breathless and giddy. The Queen propped her against a tree, and said kindly, "You may rest a little now."

Alice looked round her in great surprise. "Why, I do believe we've been under this tree all the time! Everything's just as it was!"

"Of course it is," said the Queen: "what would you have it?"

"Well, in our country," said Alice, still panting a little, "you'd generally get to somewhere else -- if you ran very fast for a long time, as we've been doing."

"A slow sort of country!" said the Queen. "Now, here, you see, it takes all the running you can do, to keep in the same place. If you want to get somewhere else, you must run at least twice as fast as that!"

This quote aptly demonstrates that in their current form 401K plans is a no win situation for 401K investors who should be more correctly called 401K donors. 

The reality of 401K plans is they actually impose tax on your savings -- for most investors 10 years returns are below inflations. Yes they can be well called 401K tax, the tax you pay essentially to Wall Street. Many people does not understand that, but many people does not understand that the USA actually have VAT tax -- it is only paid to credit card companies instead of government.

The more aggressive you are in 401K plan the more you will lose. And no matter where you put their 401K money just to preserve buying power of your principal is a tough task both because interest rate risk, inflation risk and fees you are paying to financial intermediaries are all on you. But you can approximate "safe returns" what you should get from you 401K portfolio by comparing behavior of your portfolio with the behavior of government TIPS and T-bonds (in its inherent wisdom the US government prohibits 401K investors to buy Treasury bonds directly).   Other things equal higher returns mean dramatically higher risks and potentially devastating losses like was the case in 2001-2003 and 2008-2009.  In 401K like in many areas of life less risk and fees means more money (Frugality). Minimization of risk and fees is a viable strategy in a very subtle way:

Common strategies of frugality include the reduction of waste, curbing costly habits, suppressing instant gratification by means of fiscal self-restraint, seeking efficiency, avoiding traps, defying expensive social norms, embracing free (as in gratis) options, using barter, and staying well-informed about local circumstances and both market and product/service realities.

Most 401K plans use large mutual funds that are managed by financial services juggernauts like Vanguard, Fidelity, PIMCO, etc. Those guys have their own interests in mind. It is probably prudent to avoid mutual funds which charge more then 0.5% fees despite the fact that recently many companies stock mutual funds usually operate like a passive index providing little or no protection for investors in case of market downturns.  Also funds manager compensation depends on volume not return, so they are not eager to rock the boat.  In 2007 Vanguard Windsor II fund walked into subprime mess being heavily invested in finance institutions; before that Vanguard Primecap walked into tech bubble burst being heavily invested in tech sector.  And none of managers was fired for incompetence.

It is reasonable to assume that in this new brave world of self-funded pensions 401K investors also are paying the price of keeping financial intermediaries well fed and happy. Your desperate attempts to increase your nest egg by trying to increase returns by moving funds into riskier investment strategy might backfire unless you are very, very careful: in most mutual funds higher returns mean taking disproportionally higher risks. As 2002-2003 and 2008 demonstrated all too well many 401K investors risk substantial amount of  principal for  additional 2-4% of return. For example using S&P500 or high-yield bonds as major part of you portfolio before the subprime crisis backfired in 2008 in the most dramatic way. Such 401K investors paid for that decision with 20%-40%  drop of principal and God known what future will bring us. As subprime crisis had also shown that bonds funds are not immune to large losses: even marginally higher returns often mean significantly higher risk.  

Now the rich person having $60M/year in fresh investment money can invest that money very efficiently and can afford to have very competent investment advisers. They might very well make an after-inflation return of 3% off of conservative investments.

Our poor but thrifty person either puts the money in the bank (getting perhaps -3% after inflation) or follows the advice on the TV networks and loses even more money buying overpriced stock and getting caught in pyramid schemes.

Another telling quote from FSO Editorial  Here Come the Modern 1930s  by Thomas Au (03-20-2008):

Former Fed Chairman Alan Greenspan, one of the major architects of the current crisis finally "fessed up" the other day when he referred to the current crisis as the "most wrenching since the end of the Second World War." But the end of the Second World War marked the start of the boom times in America (at least for those who lived to tell the tale) so he must really be referring to the crisis since the beginning of the Second World War, which would be the late 1930s. And this decade is basically where we're now at.

The modern 1930s are the logical consequence of the "New Economy" of the past decade, just as the original was a logical consequence of the "Roaring Twenties." In each case, technology and leverage combined to create a potent but ultimately poisonous brew of wildly inflated asset prices. In essence, greedy CEOs (and investment managers) said, "we brought you the new economy, please cash us out now."

And a gullible American public affirmed this by bidding up prices to insane levels, expecting to share, rather than subsidize, the wealth of the selling shareholders. First the tech companies, then the financial intermediaries were then caught in traps of their own making, and escaped as sorely crippled entities, if they survived at all. But by this time, the more privileged players had "taken their money and run."

The 10-yr. adjusted for inflation annualized gain of the S&P500 turned negative quite recently for the first time since 1973-83, the worst bear market in after WWII history. Dean Baker in his Year of the fat cats  made a very similar observation:

...If we go back 10 years, we find that the ... average real return on [the S&P 500] ... has been 3.2%, a bit lower than the yield that was available on inflation-indexed government bonds 10 years ago.

This is rather striking. It is unlikely that many people invested in stock for the sort of return that is typically associated with government bonds, which are much less risky. At least for the last decade, stockholders have not been rewarded for taking this risk. [ It was Wall Street that was rewarded for all the risk 401K investors had taken --NNB] 

This brings us to the topic of CEO pay. We saw an explosion in CEO pay that began in the 1980s and has continued into the current decade. ...

This explosion of pay at the top was justified by many economists based on the returns that they produced for shareholders. The argument was that even these incredibly high salaries still were just a small fraction of the value that the CEOs generated, so their pay was money well spent. These exorbitant salaries gave the CEOs the necessary incentive to produce extraordinary returns.

The first thing we need to understand that 401K plan is a deficient inferior substitution for traditional pensions. We will discuss this topic in more details later, but essentially it is a good choice only for families who can do without it -- wealthy individuals (say with annual income above $250K). AND it is was designed this way: initially it started essentially as a supplementary executive level saving program. 

Teresa Ghilarducci, an  economist who moved this year from the University of Notre Dame to the New School for Social Research in New York City recently wrote a book The Plot Against Pensions and the Plan to Save Them; the less contentious main title is When I'm Sixty-Four.

She correctly stated that defined contribution plan offload all the risk from the employers on the shoulders of  owners. In addition they suffer from  high fees (including hidden fees, see below), limited selection of funds and risk of one sided (mostly stocks based) allocations. 

It would be better to replace the 401(k) with a mandatory, government-run pension plan and suggested that Congress immediately allow retirees to swap 401(k)s battered by the stock market's collapse for monthly payouts from the government.  As Justin Fox wrote in Times  (Should the 401k Be Killed)

The 401(k) gets its name from a section of the Internal Revenue Code that, a clever benefits consultant discovered in 1980, could be used to build tax-sheltered employee retirement plans. It was at first seen as a supplement to the existing system of workplace pensions, but during the 1990s the 401(k) largely replaced pensions in the private sector.

Therein lies the problem, or problems. Unlike pensions, 401(k)s are voluntary, and many workers either don't participate or don't set aside enough money to give them a shot at a comfortable retirement. Those who do save enough often bungle their investment choices. Those who choose well pay higher investment fees generally than pension funds do. Even participants in the best-run, lowest-cost retirement funds face the risk that the market will tank — as it has done this year — when they're close to retirement. At retirement comes another issue: pensions insure against the risk that you'll outlive your money, because they pay until you die; 401(k)s don't. And finally, the tax breaks built into the 401(k) — about $80 billion a year — fall mostly in the laps of high earners. (See 10 things to do with your money.)

The one big positive of the 401(k) is that it's portable, while most pensions aren't. But on balance, there's widespread agreement among those who study retirement matters that the 401(k) has so far proved a less-than-adequate replacement for disappearing corporate pensions. "It may be a good tax-free-savings system for wealthy individuals," sums up George Miller, the California Democrat who chairs the Education and Labor Committee and plans to spearhead a re-examination of the 401(k). "It may not be the best retirement-savings system for working families."

That leaves the question of just what the best retirement-savings system for working families might look like. There have been several proposals (including one by Barack Obama during the campaign) to create modestly subsidized, automatic IRAs, at least for the more than 50% of private-sector workers who don't have access even to 401(k)s. Ghilarducci wants more — a government-run plan, financed in part by the end of the 401(k) tax deduction, that would guarantee a 3% return above inflation. Don't think that's a good deal? Fine. But remember that for most Americans, the 401(k) isn't either.

We cannot change the situation in which we have found themselves, but we can adapt better if we think about it and more clearly see the tradeoffs we have.  The key question here is the actual level of risk we are taking. It is easy to be content with 50% drop when market is going up and you put answers in your investment profile (questionable PR trick used by investment firms to lure 401K investors into more risky stock funds as more profitable for them class of assets.)  The situation is quote different when you face real 50% drop in your 401K principal what is commonly called "conversion of 401K into 201K". That's especially hard for baby boomers who already lost money during dot-com bubble burst.

A lot of 401K investors now became "womped" ("Working On, My Pension Entirely Disappeared"). Significant percentage is the same 401K investors who lost their 401K saving during dot com bust. for them it was double hit -- they recovered large part of losses incurred in 2001-2003 in late 2007 but in 2008 they are back to square one.  That happened because risk of investment in stock market were grossly misrepresented.

Massive, pervasive self-enriching of the top brass of major financial corporations

We live in an era of tremendous increase inequality in western economies, which leads to the situation many describe as a new Gilded Age with a new generation of robber barons. While the firs generation of robber barons were mostly industrialists that created new enterprises, the new generation is overrepresented by CEOs of large financial corporations and hedge funds.   Unlike industrialist who played a positive social role, the tremendous rewards to top echelon of financial corporation is based either on merit or skill, but is a pure rent extraction, or as some define it "heads-I-win-tails-you-lose" gambling. As Martin Wolf noted ( ):

Contrary to the already notorious statement by Lloyd Blankfein, chairman and chief executive of Goldman Sachs, that his company does ―God‘s work‖ it is now widely felt that they are instruments of the devil, instead, making their practitioners wealthy beyond the dreams of avarice, while laying waste economies, only to benefit from state-led rescues when threatened with destruction themselves.4

The extraordinary rewards secured by top brass in the financial sector have played a substantial part in this growing inequality. Many would argue that such inequality is itself socially damaging, whatever the explanation for it: it undermines the sense of social cohesion, worsens social tensions and undermines equality of opportunity.

In 1980, more than 60% of Americans who had retirement plans at work enjoyed traditional pensions, with the employer providing fixed monthly payments throughout the retirement. Now the numbers are reversed. Also wages and salaries are at an all-time low as a percentage of nation wealth: despite relatively strong growth, manageable inflation, high corporate profits and a bullish stock market, real wages continue to stagnate.

Actually the hidden story of the last election was the middle class revolt due to almost unbearable financial squeeze that occurred last decade. Middle class professionals like computer programmers had found themselves living with far more job risk, financial risk and income volatility than a decade ago.

Top brass became really embolden during the last two decade to take larger and larger slice of the pie/

The CEO Pay Slice, by Lucian Bebchuk, Martijn Cremers, and Urs Peyer, Commentary, Project Syndicate: ...In our recent research, we studied the distribution of pay among top executives in publicly traded companies... Our analysis focused on the CEO “pay slice” – that is, the CEO’s share of the aggregate compensation such firms award to their top five executives.

We found that the pay slice of CEOs has been increasing over time. Not only has compensation of the top five executives been increasing, but CEOs have been capturing an increasing proportion of it. The average CEO’s pay slice is about 35%,... typically ... more than twice the average pay received by the other top four executives. Moreover, we found that the CEO’s pay slice is related to many aspects of firms’ performance and behavior.

To begin, firms with a higher CEO pay slice generate lower value for their investors..., such firms have lower market capitalization for a given book value. ... Moreover, firms with a high CEO pay slice are associated with lower profitability. ...

To begin, firms with a higher CEO pay slice generate lower value for their investors..., such firms have lower market capitalization for a given book value. ... Moreover, firms with a high CEO pay slice are associated with lower profitability. ...

What makes firms with a higher CEO pay slice generate lower value for investors? We found that the CEO pay slice is associated with several dimensions of company behavior and performance that are commonly viewed as reflecting governance problems.

First, firms with a high CEO pay slice tend to make worse acquisition decisions. ... Second, such firms are more likely to reward their CEOs for “luck.” They are more likely to increase CEO compensation when the industry’s prospects improve for reasons unrelated to the CEO’s own performance... Financial economists view such luck-based compensation as a sign of governance problems.

Third, a higher CEO pay slice is associated with weaker accountability for poor performance. In firms with a high CEO pay slice, the probability of a CEO turnover after bad performance ... is lower. ... Finally, firms with a higher CEO pay slice are more likely to provide their CEO with option grants that turn out to be opportunistically timed. ...

Mutual funds industry is structured so that managers are most often compensated based on short term performance measures and this encourages them to take on high levels of risk with investor capital. Sometimes they are engaged in illegal behavior. Market timing scandal  blew up in 2003 when regulators determined that funds were engaging in front running (tipping off favored investors before making trades) and illegal late trading. Some of the culprits included Janus, PBHG, Bank of America, and Putnam. The scandal greatly undermined investor confidence. Short-term incentives, such as annual performance fees, cause fund managers to concentrate on high-turnover, trend following strategies that add to the distortions in markets, which are then profitably exploited by other financial sharks siphoning money from 401K holders to Wall Street.

As this behavior of fund managers produced boom/bust cycle in fond prices, that means that you should watch fund price and reduce your holdings if you suspect that the bubble is formed (if performance is just too good). As Andy Kern in What Makes Warren Buffett Successful - Seeking Alpha noted:

The most important less-learnable characteristic Buffett possesses, though, is very uncommon. It is emotional discipline. By this I mean the ability to resist the natural human instincts of fear, greed, pride, regret and all the other irrational biases to which people are inherently inclined to succumb. I have been trying myself to master these biases for years and, let me tell you, it is tough. Even once an investor is cognizant of these biases he may find it extremely difficult to control them. I can't let myself buy because stocks are going up (greed) or sell because they are going down (fear). I have to base my decisions entirely on an unbiased assessment of the underlying business. [in case of S&P 500 the US economics as a whole --NNB]  This is far easier said than done.

We do not need to talk about this long. This is a common fact that during last two decades both mutual fund industry managers and many CEO single-handedly siphoned 1%-9% of company profit. If you Google "How CEO steal from your 401K you will get a lot of interesting and educational links. Here is one recent example. In her March 2, 2009 article at MSN Money   Kathy Kristof wrote (How CEOs steal from your 401(k) ):

Did a gang of greedy CEOs make off with your 401(k)? A surprising number of seasoned experts maintain they did -- or at least could be held responsible for a substantial amount of your losses. Now, as the Obama administration attempts to rein in executive pay for companies that take tax dollars in bailouts, it's worth considering how that pay affects everyday investors trying to save for retirement.

Pay's impact on profits

"CEOs look at public companies like personal ATMs," said Daniel Pedrotty, the director of the office of investment at the AFL-CIO, which represents members managing $300 billion in pension assets. "They (the companies) are machines from which they extract as much personal wealth as possible."

Pedrotty's comments may come off as union rhetoric, but Harvard law professor Lucian Bebchuk puts real dollars behind the claim. The top five officers at major U.S. public companies extracted roughly a half-trillion dollars in pay, stock and perks over the past 10 years, pocketing about 9% of average corporate profits.

That's up from about 5% of profits a decade earlier, Bebchuk said. And it doesn't include severance or retirement pay so rich that it can make a shareholder's eyes bleed. The problems:

• Executive largesse siphons off profits that could have raised share prices. Americans invest roughly two-thirds of their 401(k) savings in stocks, which trade at a multiple of profits. A company that earns $2.20 a share might sell for $22 -- or 10 times annual profits, a fairly average multiple.

  If executives took a smaller slice, profits would be higher, and it's fair to assume share prices and 401(k) totals would be higher as well, said Paul Hodgson, a senior analyst with The Corporate Library, a research firm in Maine. How much higher is impossible to say, but "it's significant," Hodgson said.

• Pay isn't tied to performance. Investors might forgive this if CEOs were being rewarded for raising profits. But that's often not how it works. Some of the most spectacular rewards of recent years went to CEOs of companies now near collapse. (See "As banks broke down, CEOs cashed in.")

  With performance falling through the floor, Bebchuk is scrambling to update his pay-versus-profit figures to see just how badly shareholders are being savaged. He suspects that the percentage of profits going to CEO paychecks has soared as the bear market and recession have shredded bottom lines.

• Wild pay encourages bad behavior. Many watchdogs contend the lure of big paydays is part of what led bank and brokerage CEOs to encourage excessive risk taking, one of the causes of today's mortgage market meltdown. The resulting bear market has cost retirement savers $2 trillion and counting, The Wall Street Journal reports.

How do hefty paydays hit your 401(k)? Let's consider one shareholder horror story: KB Home (KBH, news, msgs)...

Everything that can be stolen was stolen. I refer to the perverse incentives built into the compensation plans of many financial firms, incentives that encourage excessive risk-taking with OPM -- Other People's Money.

At the end of the day nothing but losses are left for regular 401K investor.  As Dan Gerstein aptly noted in Forbes (The Most Distrusted Institution In America)

To wit, when Americans were asked the week before Christmas if they thought the Madoff ripoff was an isolated case or common behavior among financial advisers and institutions, 74 percent told CNN they thought it was the norm. That is truly staggering: three-quarters of Americans believe that Wall Street is rife not just with ethically challenged behavior but with outright criminal fraud.

Interested in the details of this mass fraud people can browse FT.com Overpaid CEO award. Here is a small sample:

CEO pay
by Tony 

12 Sep 2008  12:49 AM

Robust CEO pay accountability will never be achieved with boards and compensation committees unless they are backed by a shareholder base that is motivated and has the power to enforce that accountability. Having that power means owning enough shares in the company to have the voting power necessary to enforce accountability.

One idea is to look at retirement funds. Legislation could be passed whereby 401K's, IRA's, Defined Benefit Plans etc, are compelled to invest in a government run low cost index stock market fund. This fund would have trillions of dollars and lots of clout. The government body running the fund would have similar prestige and power to the Federal Reserve, SEC etc

Advantages would include:

1. Creating a shareholder on the register of companies that will have the size and power to enforce management oversight
2. Companies will no longer be able to use defined pension funds to manipulate earnings
3. Provide the taxpayer with a retirement fund that is low cost and will outperform cash and managed funds over the long term.

---

>Overpaid CEO Award
by M Ramsay 

07 Sep 2008  06:30 PM

The answer, I'm afraid, is all of them!

Whatever happened to the idea of doing a job because you enjoyed it and were fulfilled by it?

Link reward to share price performance, for example, and you get distorted behavior like axing final salary pension schemes and wholesale redundancies - or threats of them to control people - culminating in short-term financial gain at the expense of long-term stability and performance.

A precursor to restoring integrity and competence has to be a return to balance, common sense and value-for-money!

---

William McGuire, MD
by J Llewellyn 

04 Sep 2008  03:52 PM

On leaving in United Healthcare, on December 1, 2006, Dr. William McGuire's 'golden parachute' was a record breaking $1.1 billion.

However, the SEC brought charges of backdating options against Dr. McGuire.

A preliminary settlement was reached which required Dr. McGuire to disgorge $468 million, leaving him with $632 million.

The net company's net income for 2006 was $4.17 billion, which would put Dr. McGuire's initial claim against the company at roughly 26.5 % of the profits, for the whole company, for that year.

The preliminary settlement would still leave Dr. McGuire with 15.2 % of the profits for 2006. However, further charges are still pending.

Share holders be d****d!
Corporate clients be d****d!

---

Finding the most overpaid
by Michael 

26 Aug 2008  09:10 AM

I can’t nominate any individual. But there’s an exercise I used to enjoy when I had access to a Datastream terminal. For any company you plot a five-year graph of the remuneration of the highest paid director against the movement in earnings per share. In some cases the results were hilarious and needed no written commentary. Works best when company profits are already reflecting a recession, but might be worth doing even now. Highest paid director against average salary of UK workforce can also be amusing.

Regards,

Michael

In an Op-Ed for the New York Times, "The Madoff Economy," Paul Krugman asked a very interesting question: "Was the behavior of the investment industry all that different from Madoff scam". His answer is no:

The revelation that Bernard Madoff — brilliant investor (or so almost everyone thought), philanthropist, pillar of the community — was a phony has shocked the world, and understandably so. The scale of his alleged $50 billion Ponzi scheme is hard to comprehend.

Yet surely I’m not the only person to ask the obvious question: How different, really, is Mr. Madoff’s tale from the story of the investment industry as a whole?

The financial services industry has claimed an ever-growing share of the nation’s income over the past generation, making the people who run the industry incredibly rich. Yet, at this point, it looks as if much of the industry has been destroying value, not creating it. And it’s not just a matter of money: the vast riches achieved by those who managed other people’s money have had a corrupting effect on our society as a whole.

Let’s start with those paychecks. Last year, the average salary of employees in “securities, commodity contracts, and investments” was more than four times the average salary in the rest of the economy. Earning a million dollars was nothing special, and even incomes of $20 million or more were fairly common. The incomes of the richest Americans have exploded over the past generation, even as wages of ordinary workers have stagnated; high pay on Wall Street was a major cause of that divergence.

But surely those financial superstars must have been earning their millions, right? No, not necessarily. The pay system on Wall Street lavishly rewards the appearance of profit, even if that appearance later turns out to have been an illusion.

Consider the hypothetical example of a money manager who leverages up his clients’ money with lots of debt, then invests the bulked-up total in high-yielding but risky assets, such as dubious mortgage-backed securities. For a while — say, as long as a housing bubble continues to inflate — he (it’s almost always a he) will make big profits and receive big bonuses. Then, when the bubble bursts and his investments turn into toxic waste, his investors will lose big — but he’ll keep those bonuses.

O.K., maybe my example wasn’t hypothetical after all.

So, how different is what Wall Street in general did from the Madoff affair? Well, Mr. Madoff allegedly skipped a few steps, simply stealing his clients’ money rather than collecting big fees while exposing investors to risks they didn’t understand. And while Mr. Madoff was apparently a self-conscious fraud, many people on Wall Street believed their own hype. Still, the end result was the same (except for the house arrest): the money managers got rich; the investors saw their money disappear.

The same conclusion is voiced in many discussions about top brass compensation, for example (SEC Stonewalls at Senate Hearings on Madoff (and Congressional Fireworks!) )

Anonymous said...

I think the problem with executive compensation is that it is such that the people who are setting the rules have only their interests at heart. When the companies were owned by founders or families, they always had desire to expand or at least manage to maintain status quo so that it can grow and prosper for years. With professional managers, usually, the goals are very short term. They can make $10-$100M dollars in few years, why do they care if the company goes down after that. Their legacy may go down, their reputation tarnished, and that may be an incentive in future for not showing this greedy behavior. But, think about it - if you can make so much money that future generations may not have to work at all, would you not do the same thing. I would say a lot of people (if not everyone) would be motivated. I think it is same behavior you see with Silicon Valley companies (even with ordinary employees ) forget about CEOs. Tjos early employees want to make quick buck (few millions) and run for the exits.

The pay packet encourages that behavior. You cannot control everyone, and at every level, but, it has to start from the top, and compensation plans should be based on long term objectives, and delivery of those long term goals rather than short term of (1-2 years), and that means they do not get paid unless they show results for 5 years or even 10 years or longer. Then people would be forced to stick around, and think of working at the firm for their entire life rather than cashing out their chips early. Of course, there are various ways you/government/shareholders/board of directors can do this.

The government has to come in because individual shareholders cannot have much impact. The institutional shareholders have impact, but, Board is usually in CEO's pocket, and they are just gaming the system for mutual self-interest rather than overall interest of the company while creating the illusion that they are working for the overall good.

However, there has to be a delicate balance, we cannot go overboard either, and that is the message that President, and American people have to send. But, I would not be surprised if the pendulum swings to the other end completely, and short of lynching, there would be significant regulation, and controls.

 

Inapt enforcement agencies with perverted incentives

We are well over a year into the financial meltdown, and the regulatory officialdom was (at best) asleep at the wheel. Yet we've had almost no real inquiry as to who in power knew what when. Madoff was a particularly egregious case, due to the longevity of the fraud, the scale of the losses, the clear and multiple warnings, and SEC's reluctance to do even basic follow up on detailed leads involving prominent and well connected members of the financial community (look what happened with the insider trading allegations against hedge fund Pequot Capital: like Madoff, precisely nothing). As NYT noted (How to Repair a Broken Financial World) :

...S.E.C. itself is plagued by similarly wacky incentives. Indeed, one of the great social benefits of the Madoff scandal may be to finally reveal the S.E.C. for what it has become.

Created to protect investors from financial predators, the commission has somehow evolved into a mechanism for protecting financial predators with political clout from investors. (The task it has performed most diligently during this crisis has been to question, intimidate and impose rules on short-sellers — the only market players who have a financial incentive to expose fraud and abuse.)

The instinct to avoid short-term political heat is part of the problem; anything the S.E.C. does to roil the markets, or reduce the share price of any given company, also roils the careers of the people who run the S.E.C. Thus it seldom penalizes serious corporate and management malfeasance — out of some misguided notion that to do so would cause stock prices to fall, shareholders to suffer and confidence to be undermined. Preserving confidence, even when that confidence is false, has been near the top of the S.E.C.’s agenda.

IT’S not hard to see why the S.E.C. behaves as it does. If you work for the enforcement division of the S.E.C. you probably know in the back of your mind, and in the front too, that if you maintain good relations with Wall Street you might soon be paid huge sums of money to be employed by it.

The commission’s most recent director of enforcement is the general counsel at JPMorgan Chase; the enforcement chief before him became general counsel at Deutsche Bank; and one of his predecessors became a managing director for Credit Suisse before moving on to Morgan Stanley. A casual observer could be forgiven for thinking that the whole point of landing the job as the S.E.C.’s director of enforcement is to position oneself for the better paying one on Wall Street.

At the back of the version of Harry Markopolos’s brave paper currently making the rounds is a copy of an e-mail message, dated April 2, 2008, from Mr. Markopolos to Jonathan S. Sokobin. Mr. Sokobin was then the new head of the commission’s office of risk assessment, a job that had been vacant for more than a year after its previous occupant had left to — you guessed it — take a higher-paying job on Wall Street.

At any rate, Mr. Markopolos clearly hoped that a new face might mean a new ear — one that might be receptive to the truth. He phoned Mr. Sokobin and then sent him his paper. “Attached is a submission I’ve made to the S.E.C. three times in Boston,” he wrote. “Each time Boston sent this to New York. Meagan Cheung, branch chief, in New York actually investigated this but with no result that I am aware of. In my conversations with her, I did not believe that she had the derivatives or mathematical background to understand the violations.”

How does this happen? How can the person in charge of assessing Wall Street firms not have the tools to understand them? Is the S.E.C. that inept? Perhaps, but the problem inside the commission is far worse — because inept people can be replaced. The problem is systemic. The new director of risk assessment was no more likely to grasp the risk of Bernard Madoff than the old director of risk assessment because the new guy’s thoughts and beliefs were guided by the same incentives: the need to curry favor with the politically influential and the desire to keep sweet the Wall Street elite.

And here’s the most incredible thing of all: 18 months into the most spectacular man-made financial calamity in modern experience, nothing has been done to change that, or any of the other bad incentives that led us here in the first place.

SAY what you will about our government’s approach to the financial crisis, you cannot accuse it of wasting its energy being consistent or trying to win over the masses. In the past year there have been at least seven different bailouts, and six different strategies. And none of them seem to have pleased anyone except a handful of financiers.

Gross Misrepresentation of Investment Risks

Investment risk, especially risk in investing in common stocks are grossly misrepresented. Here, there is essentially, people who promotes such investments know that the house is made of cards, but advertise it as being made of bricks anyway, and assure people that it is perfectly safe.

Fraud could cause the victim to misperceive risk, but we need to separate excessive risk taking brought about by intentional misrepresentation from excessive risk taking brought about by errors in judgment (or, perhaps more accurately in some cases, from negligence) on the part of 401K investors.  One of such fraud is pseudo-scientific notion known under then name of efficient market hypothesis. On November 20, 2004 Barry Ritholtz ( of the The Big Picture  fame ) in his entry The kinda-eventually-sorta-mostly-almost Efficient Market Theory wrote:

One of the most widely believed theories on Wall Street is the Efficient Market Hypothesis (EMH). Adherents of this charmingly naive thesis believe that markets are an incredibly effective distributor of information. Because of this, say EMH theorists, it is impossible, therefore, to beat the market, because prices already incorporate and reflect all relevant information.

Given the random nature in which market and company information comes to investors, and the assumption that prices react/adjust almost immediately to reflect this information, no one can consistently outperform the market over time.

Or so goes the theory.

The thesis has two problems: 1) Many fund managers and investors HAVE outperformed the market. Theorists have never come up with an adequate response to this reality, claiming instead that chance or mere short term market swings explain the out-performance; and 2) it imbues the market with an almost mystical ability to disseminate information, regardless of the emotions and analytical failures of its human participants.

... ... ...

Your own belief system will help determine which camp you may find yourself in:  If you think that Human Beings are rational, calculating machines, without systematic biases, whose behavior can be predicted with mathematical models, then EMH is for you. If you believe that investors are fallible, emotional, biased and error-prone, than the behaviorist school will be more to your liking.  

As someone who has long scoffed at EMH, I particularly enjoyed Yale University economist Robert Shiller's comments on the subject: EMH proponents have made one huge mistake: "Just because markets are unpredictable doesn't mean they are efficient." The leap in logic, he wrote in the 1980s, was one of "the most remarkable errors in the history of economic thought."

Indeed. I doubt it will be the last . . .

I don't find the naivety "charming" however. I think it encourages some  assumptions that work to ruin 401K investors wealth and justifies the status quo. all-in-all like almost everything from Chicago school of economics (it was Professor Fama who put forward this pseudo-theory and he is from Chicago University) it works against the people.

We will try to talk about this problem in Protecting your 401K from Wall Street part of the paper.

The key  here is to understand is how fraudulent is the notion of "risk tolerance" as promoted by major investment firms: answering biased toward stocks "risk tolerance questionnaire" is not the same as tolerating actual dire circumstances after the fact. Moreover they misrepresent potential losses which for S&P500 can reach 60% for 10 years period even if cost averaging is used. And in no way stocks are "self-correcting with time, unless trading is used.  If secure (long term) trend is down the investor is under the bus and there is no way to recover losses.  

In other words the "risk tolerance" questionnaires is snake oil salesman trick designed to lure you into stocks investment as your answer will for sure be different if you answered the same questionnaire in the market situation of March 2003 or December 2008. As  Money Magazine observed in Dec. 3, 2008:

During such good years, you tend to believe that you have a high tolerance for risk. At times like these, your willingness to take chances drops sharply.

Such mood swings can lead you to jump in and out of the market and chase good performance, with devastating results.

The reality is that with the exception of stable value fund, short term bond funds and TIPs none of the investment comes even close to the level of risks that 401K investors are ready to tolerate. So if such investments are used they should constitute a tiny portion of your portfolio. As there are more stocks funds then tradable stock you can leave this casino to rich folks, those who have money to lose (and as Modoff case suggests a lot of them were taken for a ride).  See Naive Siegelism

Can we lose less money in our 401K plans

Positive returns are good and are definitely better then negative returns that many of us got in 2008, but what really matter are returns after inflation. While having consistent positive returns after (headline) inflation (which is currently running around 3-5%) is pretty difficult, it is not impossible (it also depends on how you measure inflation, an interesting topic that we will discuss later.)

 Anyway that should be the goal: your allocation should be just as risky as to beat inflation by one or 2 percent.  Otherwise you assume excessive risk.  And the first and foremost duty of any 401K investor is to protect own capital.

But inflation and fees aside still the main threat of losing quite a bit of money for 401K investor is due to our own limitations (arrogance, incompetence and excessive risk taking are probably the most dangerous troika). Of course limitations of 401K plan and economic circumstances (like dot-com bubble and burst and housing bubble and burst) are also important factors. I think that threats to 401K portfolio can be broadly classified into three categories:

• Threats from yourself.   That's probably is a self-evident truth :-(.  The key issue here is what investment strategy is consciously or subconsciously adopted and how viable and consistent this investment strategy is.  The typical mistake here is the adoption of too aggressive strategy despite the fact that chairs are stacked against 401K donors (aka 401K investors).  The first and foremost duty of 401K investors is to protect their capital. If they can get above inflation return that's fine, but such an opportunity should be secondary to the main task of protecting the capital.  But this goal presuppose that they can invest among money to provide a decent pension. In cases of low and middle paid employees (earning less then 100K a year) this is patently not true: even with maximal 20% contribution for the last 15 years of your career you barely get equivalent of 60% of your salary in retirement.

  So people try to take additional risk to compensate for insufficient contributions. and there is nothing surprising that many 401K investors use equities to achieve that. But there is no free lunch.  Equities are a very ambiguous promise: volatility is high and can exceed 50%. You get very low rate of dividends (1-2%).  And is essence equities are just an option on company growth prospects. And as any option it is far from safe bet.  First of all management can steal too much for the company to survive or dilute shareholder value to save the company (as is in case is most banks in 2008). Then adverse market conditions can negatively affect company growth. You can continue this ad infinitum. Peter Lynch once said  "When equities are regarded as safe is when they are most risky, and when they are seen as speculative is when they are the best buy."  It requires a very serious work and analysis to really understand a company. Add to this the fact that  markets as frequently irrational. Of cause America is adaptable, we'll get through the current crisis as we have past crises, and there are always good stocks even in bad markets. but some caution is prudent.

  Growths of economy is reflected in the sum of returns of stocks and bonds. For a long time the lion share of those returns was returned via stocks appreciation; but that does not mean that situation cannot reverse any time: there is no inherent reasons why stocks should be more attractive and systematically produce better returns then bonds. Actually for the level of risk we are talking in case of S&P500 on bond side we should compare index not with regular investment grade bonds but with junk bonds and they return approximately the same 6.5% annualized return as S&P500.  Current GDP growth oriented measurement of economic growth is very deceiving as it does not reflect growing treats the nation faces due to depletion of hydrocarbons, overpopulation and infrastructure that is addicted to cheap oil. GDP is a very crude and somewhat suspect indicator of economic growth. The question to ask is "Does doubling of strip malls, restaurants, banks,  or number of personal cars on the road is such a good thing ?". Where is the level after which they does not increase standard of living and might contribute to decrease (traffic jams in case of cars is a good example). Also some contributors to GDP like alcoholic beverages consumption, soda consumption,  tobacco products, medical insurance costs,  obesity drugs costs, etc actually represent externalities and in no way are positive to the economics or reflecting the prosperity of the population. GDP is a very crude, self-deceiving and one dimensional measure.

  Think about stocks as a fiat currency of the company. The value of stocks of individual companies can and often drop to a single digit or even zero.

  All-in-all the professionals like programmers has been lately (probably since 2000) under serious financial and social pressure, which makes the economic experience of the past ten years significantly different than the preceding decades. It also justifies  more efforts to protect your 401K investment. In any case expect you payment to be lower that in case of pension unless you contribute the maximum allowed amount (currently 20%).  So in a sense you can think about replacement of defined benefit plans with 401K plans as a 20% haircut on your salary.
   

• Threats from Wall Street. One is perma-bull propaganda and tremendous pressure to adopt high-stock-content/all-stock portfolios that got many programmers and IT specialists into severe problems during dot-com crash.  This problem is also can be named  "acquired idiotism" problem or, more politically correct,  "immunization from rational understanding of risks".

  Please note that mutual fund industry is a part of Wall Street and has its own, often very damaging for 401K investors tricks, and in some cases criminal agenda. Vanguard funds are generally better then the rest but they are far from being immune and their recommendations are completely unscientific. Like other funds families (of fund mafias) it is involved in borderline to criminal behavior.  See Vanguard Managers Invested in Web Gambling, Suit Says (Update2)

  You should not "misunderestimate" the damage from brainwashing. Many 401K investors hurt themselves  because they focused is only on stocks (and stock funds) who are promoted by sleek, very intelligent and extremely well paid "Wall Street photo models" like talented "stocks circus entertainer" Jim Cramer (the host of the chair-hurling, stupid financial advice-shouting circus called Mad Money; Cramer's show is on so often, that it seems to run like a film loop). Another notable "stocks promoting photo model" is CNBC's Maria Bartiromo (aka Money Honey; see From Disco Queen to Business News Diva and Maria Bartiromo Is No Fool ) 
   

• Threats from government. Among key factor here is the threat of inflation. Inflation is highly individual category: for example if you do not drive car you are only indirectly affected by the price of gas. If you drive Suburban to work you are affected more directly.

  Among other things the depreciation of dollar against major currencies is the sign of the same process as replacement of defined benefit pension plant with 401K plans although it does not influence the buying power directly. But there is no doubt that the dollar plunge against other currencies can influence retirement of baby boomers in a profound way. All-in-all the threat of inflation is definitely is the most important threat to 401K portfolios due to high probability of subpar performance of stock and bond markets in the coming decade.  That increases importance of having TIPs in your 401K portfolio (see  Bonds-based strategy)

  Among other less important are threats to Social Security (possible insolvency, privatization, etc) as well as danger of making investment decisions based on biased statistics (for example false GDP growth number, fudged unemployment statistics, etc, but few 401K investors are that savvy). But it is interesting to note that despite tremendous amount of published statistics there is a notable absence of reliable economic information. On the contrary there is a statistical fog that is very difficult to penetrate even for people like professional programmers, who live and flourish in a world of complex obscurity ;-)    

Etc

Society

Groupthink : Two Party System as Polyarchy : Corruption of Regulators : Bureaucracies : Understanding Micromanagers and Control Freaks : Toxic Managers :   Harvard Mafia : Diplomatic Communication : Surviving a Bad Performance Review : Insufficient Retirement Funds as Immanent Problem of Neoliberal Regime : PseudoScience : Who Rules America : Neoliberalism  : The Iron Law of Oligarchy : Libertarian Philosophy

Quotes

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Bulletin:

Vol 25, No.12 (December, 2013) Rational Fools vs. Efficient Crooks The efficient markets hypothesis : Political Skeptic Bulletin, 2013 : Unemployment Bulletin, 2010 :  Vol 23, No.10 (October, 2011) An observation about corporate security departments : Slightly Skeptical Euromaydan Chronicles, June 2014 : Greenspan legacy bulletin, 2008 : Vol 25, No.10 (October, 2013) Cryptolocker Trojan (Win32/Crilock.A) : Vol 25, No.08 (August, 2013) Cloud providers as intelligence collection hubs : Financial Humor Bulletin, 2010 : Inequality Bulletin, 2009 : Financial Humor Bulletin, 2008 : Copyleft Problems Bulletin, 2004 : Financial Humor Bulletin, 2011 : Energy Bulletin, 2010 : Malware Protection Bulletin, 2010 : Vol 26, No.1 (January, 2013) Object-Oriented Cult : Political Skeptic Bulletin, 2011 : Vol 23, No.11 (November, 2011) Softpanorama classification of sysadmin horror stories : Vol 25, No.05 (May, 2013) Corporate bullshit as a communication method  : Vol 25, No.06 (June, 2013) A Note on the Relationship of Brooks Law and Conway Law

History:

Fifty glorious years (1950-2000): the triumph of the US computer engineering : Donald Knuth : TAoCP and its Influence of Computer Science : Richard Stallman : Linus Torvalds  : Larry Wall  : John K. Ousterhout : CTSS : Multix OS Unix History : Unix shell history : VI editor : History of pipes concept : Solaris : MS DOS :  Programming Languages History : PL/1 : Simula 67 : C : History of GCC development :  Scripting Languages : Perl history   : OS History : Mail : DNS : SSH : CPU Instruction Sets : SPARC systems 1987-2006 : Norton Commander : Norton Utilities : Norton Ghost : Frontpage history : Malware Defense History : GNU Screen : OSS early history

Classic books:

The Peter Principle : Parkinson Law : 1984 : The Mythical Man-Month :  How to Solve It by George Polya : The Art of Computer Programming : The Elements of Programming Style : The Unix Hater’s Handbook : The Jargon file : The True Believer : Programming Pearls : The Good Soldier Svejk : The Power Elite

Most popular humor pages:

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The Last but not Least Technology is dominated by two types of people: those who understand what they do not manage and those who manage what they do not understand ~Archibald Putt. Ph.D

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Last modified: March, 12, 2019