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Investment Strategies for 401K plan: Keep It Simple Stupid

I wouldn't exactly say the financial-services industry is at
war with your average American consumer, but it's d- close."

WSJ.com


Skeptical News Selected Reviews Financial Humor Slightly Skeptical Dictionary of Financial Terminology for 401K
Investors

Contents

Introduction

"The Invisible Hand is giving 401K investors The Finger".

First of let me state that I am not a specialist in the area this page devoted too. I am more of regular 401K lemming taken for a ride :-).  And that's why I wrote those note. It was written first of all for my own consumption as an exercise of increasing my understanding of the previously unknown to me field, the field that actually is not that different from programming  (Excel is actually a great simulation tool that should be used much more widely, but this is a separate topic). Also I have found that people with very limited understanding of statistics and primitive simulation models are often treated as geniuses in this area ;-). 

While I wrote those notes mostly after dot-com bubble crush, now there is new wave, bigger and more dangerous for 401 investors then previous. So my notes again are popular ;-). Of course, the bleeding will eventually staunch, but the loss of the wealth and economic stability accumulated in the postwar boom will reverberate to the end of baby boomers lives. As Griff Rhys Jones  aptly noted in Times (It isn't very funny to lose your pot of money): 

Like Winnie-the-Pooh, I'm left scratching my head. How could a ‘safe' deposit account evaporate, leaving the bankers unscathed?

This will cheer you up. I lost a big sum of money recently. It evaporated with Lehman Brothers. As it happens, I was hardly aware that I had anything deposited with this distinguished banking house (or hopelessly greedy incompetents, depending on the way you choose to look at them) until I telephoned the manager of my account at a hedge fund.

Now let's go back. I am a financial innocent. I distrust all wealth management and fund manager types. I distrust them from a deep, puritanical atavistic well. But I happen to have savings and pension funds to consider. We drones make our money by luck and talent, by inventing things or creating things, and not by accountancy, so we are doomed to be the patsies of the financial sector. We are the wildebeests by the waterhole. We are the ones who have to die to feed these ghastly, lazy, incompetent predators.

I made the notes available on the WEB in a hope they might be useful for other programmers and 401K investors in general.  After all it's one thing to suffer the pain and its quite another to try to understand the situation and avoid repeating the same mistakes in the future. Academic studies suggest that we are good at some kinds of risk assessments and very bad at others. And unfortunately, the kinds of risks that we face in 401K investment are precisely those we are most likely to overlook. Moreover economic losses for families are often like system failures in engineering -- they cascade from seemingly small events into major crises as drop in 401K can correlate with the drop in house value and loss of job. Generally in crisis seemingly uncorrelated assets are suddenly highly correlated and financial junk that is fed by financial planners and grace pages of Vanguard, fidelity and other behemoths of 401K business became hopelessly detached from reality.

Yet most 401K investors systematically underestimate the risks involved in 401K investing and the predatory nature of financial intermediaries. That's why realistically they should never be considered to be investors, but donors: most 401K account have negative returns after inflation. In other words you pay  "Wall Street Tax" on your savings.

401k investors systematically underestimate risks involved and as a result on average have negatives returns after inflation for the last 10 years with approximately 27% drop in 2008. Those payment of Wall street Tax should better be stopped.  I guess you cannot make money on Wall Street advising 401K investors hold cash or treasuries.

It's still not too late to understand that the road ahead for "stock for a long run" brainwashed 401k investors who used static allocation strategy and cost averaging (which brokerages like Fidelity and Vanguard to say nothing about 401K sharks like Merrill Lynch and Putnam love so much, as it guarantees their profits) is very dangerous and fraught with risks that will be impossible for anyone to ignore or avoid.

Even worse, recent developments signify changes to a new, far more challenging environment. We need to understand that for a large extent 401K plans in their current form is a scam designed to fed Wall Street sharks. That's why instead of trying to maximize returns, 401K investors should concentrate on preservation of the capital. Only those who are flexible, open-minded, resilient, and fully prepared for the worst will be able to do that,  let alone to beat the inflation. Those who refuse to take these risks seriously (and to hedge against stock market risks by keeping a substantial portion of 401K savings in TIPs, stable value funds, etc) and sill live is la-la land of  "stocks for along run"  could lose a large part of their 401K savings. In this respect 2002-2003 and 2008-2009 might just be a harbingers of the future change of the rules of the game.  Some long runs suddenly come to the end.

Those note were started in 2003 after suffering dot com bust losses. It is important to avoid repeating mistakes that led to this situation. And I hope that for some people those pages help to avoid large losses in 2008. If so this might be the small value of those pages that I written. Writing those pages definitely helped me to avoid losses in 2008.

And their value definitely increased in 2009 when we are  in much more precarious position then in late 2001 and the advocated position looks much more reasonable than in mid of stock run of 2003-2007.  By providing the focus on preserving your capital instead of taking unnecessary risks and more conscious selection of your investment strategy based on my ad hoc classification of 401K investment strategies.

There is no more trust in the fairness of the system and this is not limited to the author. As  Robert Reich noted:

Typical Americans are hurting very badly right now. They resent people who appear to be living high off a system dominated by insiders with the right connections. They've become increasingly suspicious of the conflicts of interest, cozy relationships, and payoffs that seem to pervade not only official Washington but our biggest banks and corporations. In short, many Americans who have worked hard, saved as much as they can, bought a home, obeyed the law, and paid every cent of taxes that were due are beginning to feel like chumps.

Their jobs are disappearing, their savings are disappearing, their homes are worth far less than they thought they were, their tax bills are as high as ever if not higher -- but people at the top seem to be living far different lives in a different universe. They're the executives and traders on Wall Street who have lived like kings for years off a bubble of their own making while ripping off small investors, the financial louts who are now taking hundreds of billions of taxpayer bailout money while awarding themselves huge bonuses and throwing lavish parties, the corporate CEOs who are earning seven figures while laying off thousands of workers, the billionaire hedge-fund and private-equity managers who are paying a marginal tax rate of 15 percent on what they say are capital gains while people who earn a fraction of that are paying a higher rate, and, not the least, the Washington insiders who have served on the Hill or in an administration and then gone on to pocket millions as lobbyists for the same companies they once regulated or subsidized. To the American who's outside the power centers ... the entire system seems rotten. ...

And 401K investors should not be sitting still and wait until last drops of their wealth disappeared. We need to fight back:

"The middle class and working poor are told that what's happening to them is the consequence of Adam Smith's 'Invisible Hand.' This is a lie. What's happening to them is the direct consequence of corporate activism, intellectual propaganda, the rise of a religious orthodoxy that in its hunger for government subsidies has made an idol of power, and a string of political decisions favoring the powerful and the privileged who bought the political system right out from under us."

-- Bill Moyers, Keynote speech, June 3, 2004

Excerpt:

You just can't make this stuff up. You have to hear it to believe it. This may be the first class war in history where the victims will die laughing.

But what they are doing to middle class and working Americans -- and to the workings of American democracy -- is no laughing matter. Go online and read the transcripts of Enron traders in the energy crisis four years ago, discussing how they were manipulating the California power market in telephone calls in which they gloat about ripping off "those poor grandmothers." Read how they talk about political contributions to politicians like "Kenny Boy" Lay's best friend George W. Bush.

... ... ..

Let's face the reality: If ripping off the public trust; if distributing tax breaks to the wealthy at the expense of the poor; if driving the country into deficits deliberately to starve social benefits; if requiring states to balance their budgets on the backs of the poor; if squeezing the wages of workers until the labor force resembles a nation of serfs -- if this isn't class war, what is?

It's un-American. It's unpatriotic. And it's wrong.

Shell-shocked 77 million baby boomers for whom 401K became 201K and retirement planning is now an urgent imperative -- know they have no choice other than to save more.  The main problem is how not to pay huge "Wall Street Tax" again and again.  In order to avoid that one needs better understand the sources and mechanisms of last rip-off.  It is very important to stop thinking about any real returns at all and make the best efforts to  remain at par relative to inflation.  Both stocks finds and bond funds are very dangerous instruments now: they became just a chew gum for maniacal Wall Street and hedge funds robots.  The autodafé of the 401K investors in 2008 was the final act of the huge wealth transfer from middle class to financial oligarchs. Probably the biggest in the USA history (robber barons were children as for robbing in comparison with current generation of oligarchs; also they created their companies from scratch  ;-),

We are entering uncharted waters. Those in power have successfully undermined the foundations of Pax America post war order. 401K investors are exposed to currency risks vulnerable to stagflation and the sharks are circling.

Notes are pretty raw as I have no time to polish them.  All usual disclaimers applies.

401K Investors as Financial Plankton

The name plankton is derived from the Greek word πλανκτος ("planktos"), meaning "wanderer" or "drifter".[1] While some forms of plankton are capable of independent movement and can swim up to several hundreds of meters vertically in a single day (a behavior called diel vertical migration), their horizontal position is primarily determined by currents in the body of water they inhabit. By definition, organisms classified as plankton are unable to resist ocean currents. This is in contrast to nekton organisms that can swim against the ambient flow of the water environment and control their position (e.g. squid, fish, and marine mammals).

The key idea to understand that 401K is not designed to help people to fund their pensions. It was designed as a new tax on middle class by money-center banks, mutual and hedge funds. The rapacious removal of wealth from farmers and small communities by large money center banks is not new in the USA history.

This was the case during the Gilded Age. And what was done for the last 25 years is nothing but a blatant attempt to restore worst excesses of Gilded Age under the cover of deregulation. 

The problem here is that Wall Street proved to be extremely skillful in separating 401K investors and their money. This "rape" of 401K investors is underreported by MSM.  Moreover If you think about the real life purposes of financial intermediaries the purpose nothing but this centuries old trick. the role of fools here is assigned to 401K investors. Jeff Wenniger from Harris Private Bank says an army of baby-boomers have seen their old age plans shattered by the housing bust. Now they will have to spend less, and save more. "Generational destruction of a society's balance sheet down not rectify itself in a matter of months".  

In the current situation of financial instability it is probably wrong to look at the stocks as real capital. Stock markets are examples of fictitious capital like chips in casino (or fiat currency). They don't produce wealth themselves, but represent a claim on income produced by something else. However, they are bought and sold as if the former were the case. That means that gains can be made but only speculatively.

Just ask yourself, what is the social purpose of a casino ? Stock market social function is very close, although not identical.  Now ask how casino attract its customers. It looks like in both cases the demand is based on a huge number of people each of which thinks he/she is above average.

This is not a new situation but just the number of 401K investors changed the rules of the game. Losers' money were always here for taking. And Wall Street never miss a chance to loot: retirement savings are being used to prop abusive short selling at major investment banks and hedge funds with tacit approval of major mutual funds that hold the 401K money. Short sellers and traders can make a killing while most people see their retirement accounts dwindling. Unfortunately we have "CNBC lobotomized population that doesn't question anything." 401K investors have to start questioning more and they'd better start by scrutinizing how 401K accounts  are being managed and by informing themselves of what is really going on in financial markets. Otherwise your funds might be lost in the largest casino of Casino Capitalism: 401K casino.

The 401(k), as the plan is known, is literally a do-it-yourself retirement plan completely dependent on the vagaries of the (highly manipulated) market.  The 401(k) plan places the responsibility and all risks of the market entirely on the worker. While today 401(k) is a household word,  it is a relatively recent phenomena that corresponds  to the rise of Reaganomics in the USA. It was nearly unknown 20 years ago. During the dot-com  boom of the  late 1990s the 401(k) was associated with the promise of easy wealth. William Wolman and Anne Colamosca, authors of The Great 401(k) Hoax, write,

“it appeared as a device that made it easy for the average worker to participate in the biggest boom in history. It seemed the 401(k) would be a perpetual wealth machine for each and every member of the great American middle class.” 

With the rapid rise of high-tech stocks, many workers saw their contributions grow exponentially. And most of them were severely burned by subsequent bust. Then slow recovery happened in 2003-2007. Now we see a new bust that evaporated most gains and put more then a third of 401K owners who invested in stocks into situation when they lost 60-65% in comparison with people who from 1996 invested in stable value fund. 

Essentially there are two markets. One market is for 401K investors were gains are non-existent and 401K is just a tax on retirement earning. The second is speculative market of hedge funds and major Wall Street firms that feeds on the first and use it for self-enrichment via huge bonuses and dubious operations.  The latter include illegal naked short selling, stock manipulation, and the destruction of public companies. See Deep Capture Blog

In reality workers were simply invited to spend in casino their retirement money: the long-term financial interests of workers became directly tied to the fortunes of Wall Street and they instantly became feeding ground for Wall Street sharks.

The US pension system is entirely inadequate. Social Security, which came into effect in 1935, provides  to this day a very limited benefit that can prevent starving but not much more. It was never conceived as being more than a supplemental pension. Defined benefit pension plan were a very good development but even at its height, fixed pensions covered only a fraction of the workforce; mainly large manufacturing unionized industries such as auto and steel.

The 401(k) became the new model for pensions during the 1970s recession. Faced with the economic downturn, major corporations, with the collaboration of the unions, began severing long-term commitments to their employees. According to the authors of The Great 401(k) Hoax, “It wasn’t the current cost of pension plans that most frightened corporate America. The real financial trauma was the implication of these obligations for the future of corporate balance sheets. Long-term pension liabilities were virtual black holes.” Here is one Amazon review of the book:

5.0 out of 5 stars A good perspective on the risks inherent in 401k plans, July 13, 2005 By Sanjib Das (Shelton, CT USA) - See all my reviews
(REAL NAME)    The authors set out to prove that 401k plans are inherently risky and in many cases inadequate to meet the retirement needs of people. They make their case by using historical analysis and they manage to do it well. They draw a parallel comparison between the politics, culture and economics of the 1920s and the 1990s. Just as the 1920s led to the Great Crash and the Depression, the new millennium looks ready for similar economic hardships. This can have a devastating effect on the retirement plans for most Americans.

Before 401(k) plans came into the picture, "defined pension plans" had become popular ( though not as popular as 401k was eventually to become). Those were the Golden years of the American economy (1945-1973). It represented a certain commitment by American companies to their workers. Most companies were doing well in those years and could guarantee the monthly pension checks to retirees.

As America suffered slow-growth years from 1973 to the mid 90s, the solution that emerged for improving corporate balance sheets was simple: Design a pension system that depended not on defined benefits for employees but on defined contributions made mainly by employees. As corporations were having more trouble making money, the 401(k) became the new model for pensions.

Various other factors contributed to Americans shifting more and more of their assets into stocks/Mutual funds/401k plans over the years:

1. First is the Wall Street propaganda resulting from the massive drive to capture the public's resources. Andrew Smithers, the brilliant British financial analyst, once told the authors that he could make a lot of money by being a bull and being wrong than by being a bear and being right.

2. Delusive academic research, demonstrating that stock investments, patiently made over the years, were a safe and superior source of investment. Professor Jeremy Siegel's book "Stocks for the Long Run" has been one of the most respected sources of delusion. To Siegel, the failure to grow rich is an individual's failure to save enough or to be patient, not of the way in which society as a totality works.

3. The economic boom years from 1995-1999 provided much incentive and validated the Wall Street propaganda and the delusive academic research.

The authors discuss the various evils in the stock market, the current American economy and the 401k plan. They propose various reforms such as banning of company stock contributions, allowing employees to shift their funds at any time they want to, keeping transaction fees low and discouraging conflicts of interest between employees and their corporate employees.

Until new legislation arrives to fix our 401(k) plans, we are stuck with what exists. Investing in Inflation-indexed government bonds, though not frequently made available in 401(k) plans, come across as the best way to plan for retirement in the current situation.

This book is worth a read just to get a historical perspective of the US economy and of the retirements plans that existed through the times.

401K investors serve very similar to plankton role of feeding ground for Wall Street. That's why it is more correct to call them not investors, but donors: few 401K investors make any money after inflation. Most lose as they need to feed other financial animals higher in the food chain.  Inability to move against the current in this context first of all means inability to determine real risk of investments and that fact that the types of funds 401K investor can invest in are fixed by often very unfair corporate 401K plans.

The role of 401K investors is very similar to the role of plankton in marine food chain. They serve mainly as a feeding ground for Wall Street whales. That's why it is more correct to call them not investors, but donors: very few 401K investors make any money after inflation.

In general investment community looks a lot like a marine food chain. Complex and evolved creatures like whales are at the top of food chain and depends for their feeding on simple plankton directly or indirectly, eating fish that feed with plankton.

In the financial community, the plankton is some guy who buys the stocks or bonds for his 401K plan dreaming about it appreciation. And the guy who buys the house, dreaming about its appreciation. Both the buying operation itself and the ability to short or buy on margin and using derivatives brings pretty fat paychecks to some other guys, the guys which are generally higher in the financial food chain. The problem is that like in many ecosystems plankton is became more and more scares: the USA does not  manufacture many things, and the percentage of 401K investors with good paychecks have been shrinking. So Wall Street need to stimulate remaining plankton to spend more of a paycheck in order to survive.  This is done usually via Ponzi schemes (and during any bubble stock market is nothing but a special case of a Ponzi scheme). Without Ponzi schemes and naive investors,  they would starve.

There are several reason for this situation and one of them is the restructuring of the USA society that took place during the last 25 years (so called Reagan revolution).

Bushonomics

Bushonomics is the continuous consolidation of money
and power into higher, tighter and righter hands

George Bush Sr, November 1992.

Bushonomics was specific stage of development of Reaganomics at which FIRE (finance, insurance and real estate) sector became dominant (which happened around mid 90th). 

Reaganomics or as it is often called "market fundamentalism" was a powerful political movement which came to the front stage in early 80th and was not that different from the religious fundamentalism:

Market Fundamentalism is the exaggerated faith that when markets are left to operate on their own, they can solve all economic and social problems. Market Fundamentalism has dominated public policy debates in the United States since the 1980's, serving to justify huge Federal tax cuts, dramatic reductions in government regulatory activity, and continued efforts to downsize the government’s civilian programs.

Five centuries ago, Niccolo Machiavelli explained how to undertake a revolution from above without most people even noticing. In his Discourses on Livy, he wrote that one

"must at least retain the semblance of the old forms; so that it may seem to the people that there has been no change in the institutions, even though in fact they are entirely different from the old ones."

Reagan followed Machiavelli's advice very closely. Actually Reagan himself used the word "Reaganomics". In a July 10, 1987 White House Briefing for Members of the Deficit Reduction Coalition, he said,

"America astonished the world. Chicago school economics, supply-side economics, call it what you will — I noticed that it was even known as Reaganomics at one point until it started working — all of it is fast becoming orthodoxy. It’s not just that Milton Friedman or Friedrich von Hayek or George Stigler have won Nobel Prizes; other younger names, unheard of a few years ago, are now also celebrated."

The most important part of Reaganomics was the "financization of the US economy": freeing investment banks from all previous restrictions and constrains imposed by New Deal as well as repealing of key legislation from this era. In a way adoption of Reaganomics meant that Great Depression was wiped out from the country institutional memory and new players were eager to repeat the early XX century mistakes on a new technological level.  

For example Gramm-Leach-Bliley which legitimized credit default swap, along with the repeal of Glass-Steagall (with no enforcement or oversight of the newly liberated “Financial Services”), led directly to the problems we are experiencing today.

The important part of Reaganomics as "revolution (or counter-revolution, to be more exact) from above was not only the general commitment to give FIRE industry green light and abolish all speed limits but also wiping out capital intensive manufacturing industry in the US as part of a drive to increase short-term profit opportunities in the financial sector. Conversion of the USA into new Switzerland so to speak...

Reaganomics is characterized by growing political dominance of  FIRE industries  (finance, insurance, and real estate) and diminished role of other and first of all manufacturing industries as well as tremendous growth of inequality.  In the latter sense it is similar to Guided Age. In Martin Wolf's  words its defining feature is "the triumph of the trader in assets over the long-term producer" It was serviced by pseudo scientific theories of Milton Freedman and supply side economics (Economic Lysenkoism).  As one comment for Krugman article Was the Great Depression a monetary phenomenon stated:

Market fundamentalism (neoclassical counter-revolution — to be more academic) was more of a political construct than based on sound economic theory. However, it would take a while before its toxic legacy is purged from the economics departments. Indeed, in some universities this might never happen.
Actually, this is more like religious doctrine than political philosophy — and that could be a bigger problem.

Bushonomics aka "casino capitalism" is just one (and probably the last) stage or development of Reaganomics. Minsky defined three stages of Reaganomics, each of increasing fragility: 

Essentially Bushonomics is the Ponzi finance stage of Reaganomics. One out of many definitions of Ponzi Scheme is: transfer liabilities to unwilling others. And the name casino capitalism suggest that they are playing with your money, including your 401K money

Bushonomics is the Ponzi finance stage of Reaganomics. And the name casino capitalism suggests that they are playing with your money, including your 401K money...

There were derivatives exploding all over the world and the rating agencies basically admitted that they didn't understand the structuring of these new products, but it would be a mistake to not capture some of the market action and earn some bucks. Not only the rating agencies and government regulators (and first of all Greenspan's Fed and SEC) were totally unaware of what was going on, They wanted to be unaware.

Criminal negligence of regulators was connected with the "free market fundamentalism",  the political agenda of The Bush Ownership Society, based on total lack of regulation and accountability. Similar to Great Depression this is unfolding as " The Perfect Storm!".  Too many people at high positions got greedy (aka demonstrated high tolerance for risk), and this resulted in massive bad investments and the United States and Europe. As a result most major banks are now massively in debt and barely able to meet the interest payments. As one commenter to the Naked capitalism post Why the Failure to Understand the Global Financial System noted:

Anonymous said...
hahaha, they understand it Yves. They really get it. But you have to understand, the whole point of government is to protect corporations and banks.

The vast majority of people just provide cheap labor. Obama and Co are pretty smart people but they protect the interests of the elite first.

Everyone knows there was massive fraud and greed going on, but no one is going to do a thing. A few fish here and there will get fried but otherwise same old, same old.

It is the Bushonomics that brought the USA to the point of near bankruptcy.  This implementation of this radical economic ideology by the Fed (led by Greenspan), U.S. Treasury (led by Rubin) and major regulating agencies (SEC, etc) created a threat (and eventually damage) to the country in comparison with which most acts of radical Islam in terms of economic damage to the USA look like teenagers pranks. I am not sure if many people fully understand the real level of risk they of “structured finance”.

The major players in implementing Bushonomics were Greenspan, Rubin, Gramm along with three last presidents (Bush I, Clinton and Bush II).  The key was complete deregulation of financial sector along with reckless monetary policy. As for deregulation, if we compare national banking system with the national transportation network it was much like moving state police from patrolling highways to patrolling just areas in front of  Dunkin’ Donuts ;-).  At the beginning there were two important events that shaped subsequent development of Bushonomics which are important for 401K investors to understand:

Those two tendencies collided with the decision of elite to convert the country from large factory to a large casino. Like in Gilded Age in the unforgettable words of George Bush Sr., that resulted a strong movement toward "the continuous consolidation of money and power into higher, tighter and righter hands"

That means that from the very beginning the proper name for 401K investors would be 401K donors. And the name of the game were fees for financial institution and their ability to use the pools of investment supplied by 401K investors as collateral for their more risky and more profitable operations  without or with very little responsibility.  As WSJ stated (Some Consumers Say Wall Street Failed Them - WSJ.com):

Thirty years ago, a typical consumer had a fixed-rate mortgage, a life-insurance policy, a bank account and an employer-paid pension plan. Nowadays, that same consumer may have a payment option adjustable-rate mortgage, a 401(k) retirement-savings plan, a home-equity line of credit and perhaps even a health-savings account instead of traditional employer-sponsored health insurance.

In the process, risks previously borne by big banks and employers have been placed squarely on the shoulders of consumers. Individuals increasingly bear the risk of interest-rate fluctuations, rising health-care costs, stock-market gyrations and outliving their retirement savings.

Essentially 401K accounts is a way to extract "Wall Street tax" from hapless 401K donors, not to help you with the retirement. That means that what matter most for 401K investors is not the return on your money, it's the return of your moneyGiven restriction of 401K plans to a small set of pre-selected mutual funds (often with high fees) beating inflation is an achievement that should not be underestimated: most 401K investors lose money, not gain money, during their 15-35 years investment cycle.

Most middle-class 401K investors should be more correctly called "401K donors". What matter most for 401K investors is not the return on your money, it's the return of your money.

Financial intermediaries represent an additional tax on economy, the same way as defense and lawyers. In 1980, financial firms accounted for 8% of S&P earnings. During the peak of our last stock market cycle, their profits were over 40% of the total.  That's a significant tax that people, including 401K investors, need to pay.  It is ironic that free market fundamentalists have so vociferously argued for "free markets", without understanding (or perhaps understanding all too well) that the house always wins.   And that means that you always lose...

While it's true that "no one goes to Wall Street to save the world" it is equally true that no one on Wall Street should be permitted to destroy our 401K savings...

Even without privatizing social security  the things became very interesting for 401K investors: both dot com bust and subprime bubble bust plunge proved that the shift from traditional (defined benefit) pension plans to 401K-based ( "defined contribution") plans was the "rip off of the century" for middle class. And 401K plan is as close to scam as one can get. Not only it shifted all the market risks from the corporate balance sheet to the individual, it also shifted the source of funding as meager "match" (usually around 4%) did not compensate even half of traditional (defined benefits) corporate pension plans.

Both dot-com bust and subprime bubble bust plunge proved that the shift from traditional ("defined benefit") pension plans to 401K-based ("defined contribution") plans was the "rip off of the century" for middle class.

Here is pretty telling quote from the Associated Press about implicit conflict of interest of Congress:

Lawmakers' retirement benefits start earlier and accrue faster than in plans offered to other federal workers, or by the average private company. Lawmakers also get cost-of-living increases, increasingly rare in the private sector.

Only 5 percent of private sector workers have defined benefit pension plans, in which the employer pays into an account and promises them benefits based on years of service, salary levels and other factors. That's down from 1980, when 60 percent of workers had such plans, according to the Center for Retirement Research at Boston College.

Increasingly, employers are putting the responsibility for retirement -- and the risk -- onto workers themselves by switching to investment plans like 401(k)s. About 30 percent of workers have 401(k)s, in which employees contribute to their own accounts, often with employers matching a small percentage of contributions, according to the Employee Benefit Research Institute. Thirteen percent have both defined-benefit pensions and 401(k)s. The remaining workers don't have retirement coverage from their employer, according to the institute.

Despite the financial crisis -- and the fact lawmakers' retirement benefits are out of step with most ordinary Americans -- Congress has made no effort to revisit its unusually sweet retirement deal.

Rep. Howard Coble, R-N.C., who has declined participation in either the congressional pension or thrift savings plan, said his efforts to scale them back have not been welcomed.

 
Chart shows breakdown of retirement plans in the private sector

"It would certainly be a timely gesture at this juncture," said Coble. "It certainly appears to be a different standard and I can see how people on the outside of that standard might resent it."

The generous retirement arrangement for members of Congress is meant to respond to the job insecurity that comes with elected office, according to Barbara Bovbjerg, director of education, work force and income security issues at the Government Accountability Office.

Members elected before 1984, like Miller, get a better deal on their pensions than do those elected since, because the rules changed that year to bring lawmakers into the Social Security system as well.

But any member with five years of service is eligible for full pension benefits at 62 -- though Social Security benefits conform with those of other workers, with early retirement bringing reduced benefits. Lawmakers with 20 years in office can get full pension benefits at 50, younger than most workers.

"The government plans are certainly very rich even if you compare them to the pension plans in corporate America," said Robyn Credico, national director of defined contribution consulting at Watson Wyatt, an employee benefits consulting firm.

"I certainly believe it affects policy," Credico said, suggesting that members of Congress don't experience the harsher reality of ordinary workers' retirement plans. "If you're not impacted yourself it's very easy to make different rules."

Indeed, Congress has in recent years promoted the dramatic movement in corporate America away from defined-benefit pensions to 401(k)s with policies encouraging automatic enrollment and raising contribution limits. Under 401(k) plans employees contribute to their own investment accounts and assume the risks and rewards that go with them. Lately, with the crisis on Wall Street and across the globe, it's been more risk than reward.

Earlier this month, Miller's House Education and Labor Committee found that Americans' retirement plans -- pension plans and 401(k)s included -- have lost as much as $2 trillion in the past 15 months -- about 20 percent of their value. At a committee hearing Wednesday in San Francisco, Miller cited new research suggesting that the losses might be as much as double that.

And although private sector employees with defined benefit pensions are guaranteed their pensions even if the value of the plan drops, employers may make up for the extra cost in other ways, like layoffs, cutting other benefits or even freezing the pension or eliminating it, experts say.

That risk was underscored Wednesday at Miller's hearing in San Francisco, where he announced that the federal agency charged with backstopping pension benefits for 44 million Americans has lost at least $3 billion in stock investments during the last fiscal year on assets of $68 billion, and invested a significant portion of its funds in mortgage-backed securities. The agency, the Pension Benefit Guaranty Corp., insures approximately 30,000 defined benefit pension plans. It does not insure 401(k) plans.

401K plan traditionally are associated with the "stock mania" and for many 401k investors the dominant part of 401K saving are in stock mutual funds, often diversified indexes like S&P500.  But for the last 12 years (1996-2008) S&P500 real returns are less then stable value fund.  That means that those 40K investors who used primarily S&P500 or similar large cap funds lost approximately 50% of money in comparison with stable value fund. that means that they lost 50% of money after inflation or even more. If this is not a robbery then what is. High way robbery of 401K investors which occurred during dot-com bubble is repeating now with subprime crises as in search of returns many 401K investors assumed too much risk moving considerable part of their 401K saving (often 100%) into stock funds. 

The problem is that most "401K donors" did not even realize that they are being pick pocketed by very smart fellows from Wall Street.  As WSJ recently wrote "the whole 401K complex is merely a fee machine, and always was." That means that only the most lucky and the most cautious guys will get back what they put in ( after inflation). Everybody else will get skimmed...   Will Roger, a popular actor, columnist and radio personality, after 1929 stock market crash quipped: "I am not so much concerned with the return on capital as I am with the return of capital."

"I am not so much concerned with the return on capital as I am with the return of capital."

Will Roger

BTW among other famous quotes of  Will Roger, who tragically died in a place crash, are:

That quote suggests a very simple test (let's call it Softpanorama 401K reality test ;-) of your 401K allocation and level of contribution for baby boomers: "Using Excel try to model the situation in which the stock market is going up 5% a year till your retirement date, then stock market collapsed 30% the day after you retire, fully recovers in five years and continue to provides 5% return all years after. Also assume that bonds provide 4.5% all this period.  If  this situation necessitates the limiting of withdrawals to less then 60% of what you are expecting you might think about a more crash resistant allocation or increase your 401K contributions.  

Cult of Equities and 401K Plans Implementation Scam

A reporter contacted me today with the following question: 
 
“I am a reporter and I am doing a story on Bernard Madoff's life after pleading guilty. As part of this I was wondering if you could comment on what significance he will have in the history of this period. Will he represent more than a scamster who stole a lot of money from a lot of people? As Bernie Ebbers and Ken Lay came to embody corporate greed and deceit, what will Madoff symbolize? I would really appreciate your insights on this”. 
 
Here is my answer fleshed out in full: 
 
Americans lived in a Made-off and Ponzi bubble economy for a decade or even longer. Madoff is the mirror of the American economy and of its overleveraged agents: a house of cards of leverage over leverage by households, financial firms and corporations that has now gone bust. 
 
When you put zero down on your home and you thus have no equity in your home your leverage is literally infinite and you are playing a Ponzi game. 

Noriel Roubini

 

According to Minsky, Ponzi borrowers are those who need to borrow more to repay both principal and interest on their previous debt: cannot service neither interest or principal payments on their debts. They need persistently increasing prices of the assets they invested in to keep on refinancing their debt obligations. 
 
By this standard, many US households and businesses whose debt relative to income went from 65 percent 15 years ago to 100 percent in 2000 to 135 percent today were playing a Ponzi game.  Using homes as an ATM machine and borrowing against it to finance Ponzi consumption is not feasible any more.

The same is actually true for those 401K investors who put 100% or close to that into stocks.

But the problem is wider in the economy where the total debt to GDP ratio (of households, financial firms and corporations) is now 350% is a Ponzi economy.  The bursting of the housing bubble and the equity bubble showed that most of the "wealth" that supported the massive leverage and overspending of agents in the economy was a fake bubble-driven wealth; now that these bubble have burst it is clear that the emperor had no clothes and that we are the naked emperor.
 
Madoff may now spend the rest of his life in prison. But he was not alone. The US financial firms tricks with 401K accounts are pretty close to what Madoff did and they should look in the mirror before engaging iin hot rethorics about his misdeeds.

Those who populated 401K accounts with crap that lost 50% or more of value in 2008.  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.

This term also refers to 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):

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 (if this period did not end in 2007 )

And the fact that most people put considerable chunk of their 401K savings in stocks is well known (this delusion can be called "cult of equity").  From the beginning 401k plan was oriented on luring middle class into stock investments.  Only in 2008 mainstream press start asking question (‘Cult of Equity’ Is Under Attack, Citigroup Says By David Wilson)

Feb. 9  | Bloomberg

“The cult of the equity” that arose in the past half-century has come under attack and may be headed for the dustbin, according to Robert Buckland, Citigroup Inc.’s global strategist.

The CHART OF THE DAY compares the total returns since 1990 on MSCI Inc.’s World Index of developed markets and a global government-bond index compiled by JPMorgan Chase & Co., as Buckland did in a report last week.

“Miserable returns and extreme volatility” in stocks this decade have led some investors to reappraise their ownership of equities, their favored holding since dividend yields dropped below bond yields in the late 1950s, he wrote.

And for some time 401K plans with high stocks allocation did OK producing decent annual returns as baby boomers increased their contribution due to nearing retirement and  the techno bubble lifted the stock market.  But after dot-com bust this Ponzi scheme folded and later tremendous machinations of Wall Street bankers with securitized mortgages further damaged the confidence in stock markets.

In 2008 it became clear even for the most enthusiastic "stock-only" 401K participants that they were duped: it will be difficult or impossible to recover 30-50% loss during the next decade. Environment is just not favorable for huge stocks runs. That means that those money probably are gone forever (that's why events of 2008-2009 are sometimes called "autodafé of the 401K investors ").

E

 

And comments in mainstream press suggest that more and more people understand that (From Here to Retirement - Readers' Comments - NYTimes.com):

Relentlessly for soooo many years we were told - this is the way to go - take control of your own retirement - with all of the many choices to invest in with the 401k - remember don't worry be happy (Reagan). Well The 401k has finally been revealed as a massive fraud/Ponzi scheme hoisted onto the American working and middle class. And we don't hear a single mea culpa - out of anybody on Wall Street, from any of the right wing talking heads who have been screaming for years ad nausium the blessings and virtues of the (so-called) free-market system or certainly nothing -not a peep, not a word- from any of the Republicans who incessantly mocked Social Security and ANY attempt to direct additional funds to the underclass and middle class (except of course tax cuts for the wealthy). We reap what we sow. Please Preident Obama - do the right thing and implement the needed changes - especially to support Social Security.

It was a brilliant scam and many participants in 401K plans were simply duped/coerced into abandoning defined benefit plans and decided to take control (and responsibility) for their own retirements. But what they did not understand is that company contributions are minimal and in low interest rate and negative stocks return environment in order to match previous plan they need to contribute max allowed amount, effectively cutting their salary 20% (and still bearing all the risks including currency risk).

Not only baby-boomer (who now are called "baby-groomers) are affected. Here is one apt comment to Naked Capitalism blog entry  naked capitalism Object Lesson Consumer Frugality in Japan

David said...

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 obeservation from the forum for Resuscitate your 401k in 5 steps - MSN Money

mich9402
#5
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).

With the return of 4.5% and fees 0.5% the financial intermediary takes 11%

With the return of 2% and fees 0.5% 

With return of 1% and fees 0.5%

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.

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.

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:

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 underperform 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: 

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 about $400 a month in retirement income, according to the research center.

 

Red Queen Race

This is an impressive crowd: the Have's and Have-more's. Some people call you the elites. I call you my base

George W. Bush

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 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. 

401K plans offloaded all the risks and most of the contributions on the shoulders of employees.

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

Wall Street is about to become the new Catholic Church--the most distrusted and vilified institution in America.

It's hard to top priestly pedophilia (and bishops covering up for them) for sheer despicability, but Bernie Madoff and his fellow hucksters are giving the men of clod a close run for their--and our--money.

Dan Gerstein, Forbes

We do not need to talk about this long. This is a common fact that during last two decades many CEO singlehandedly 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 behaviour like axeing 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

“While rational expectation is returning to part of the investment community, most are still trapped in institutional weaknesses that make them behave irrationally. The Greenspan era has nurtured a vast financial sector. All the people in the business world need something to do. Since they invest with other people’s money, they are biased towards bullish sentiment. Otherwise, if they say it’s all bad, their investors will take back the money, and they will lose their jobs. Governments know that and create noises to give them excuses to be bullish.”

This institutional weakness has been a catastrophe for people who trust investment professionals. In the past two decades, equity investors have done worse than owning bonds in the U. S. market, lost big in Japan and emerging markets in general. It is
astonishing to see how a value-destroying industry has lasted for so long. The bigger irony is that the people in this industry have been 2-3 times as well paid as in other industries. The key to its survival is volatility. As markets collapse and surge, it creates the possibilities for getting rich quickly. Unfortunately, most people don’t get out when markets are high like now. They only go through the ride.”

Andy Xie, former Morgan Stanley star economist

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

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

Hidden Fees in 401K Plans

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 will face 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 goverment 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."
So called investment professionals are by-and-large snake oil sellers that promote some kind of faux science, or financial Lysenkoism if you wish.  For instance, the academic literature has repeatedly found that investors benefit from diversifying their capital into different asset class. But snake oil salesmen from mutual fund industry often treat the notion of "asset class" just another stock fund (Vanguard is especially guilty over-promoting its stupid S&P500 fund that lost money for the last 20 years.  The industry try to substituted asset classes with styles of investing and produces all sorts of fake analyses over pretty short (by historical standards) periods (no more then 10 years) to show a low covariance of fund X versus, say, the S&P 500. Most firms are pretty adept at data-mining the history to prove their points. I have little confidence in anything not produced by someone who has no skin in the game (and an investment consultants have every reason to propagate fake methodology, as this is how they justify their fees).  It's all about fees, not help. As Warren Buffett noted:
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 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.

Many companies consider 401K plan as a 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 same territory was covered last year by David B. Loeper in his book: Stop the 401(k) Ripoff.

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.

On a more basic level, I sincerely believe that the general population has no idea of the huge disparity between defined contribution and defined benefit plans in regards to the amount of money one will have available in retirement. If people really understood what was going on here, they would not be so apathetic about voting the keep taxes under control. What a fantastic deal the public sector has! Guaranteed benefits not tied to stock market performance with basically insignificant personal contribution rates. Just raise taxes when you run out of pension money...

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

Can we lose less money in our 401K plans

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!"

Lewis Carroll's, Through the Looking-Glass 

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:

For mid-income working families 401K plan was and always will be an inferior replacement for pensions

When we think about the middle class, we tend to think of Americans whose lives are decent but not luxurious: they have houses, cars and health insurance, but they still worry about making ends meet, especially when the time comes to send the kids to college. Now in addition to paying the cost of kid's tuition they need to collect money for their own retirement. The Section 401(k) of the tax code was enacted in 1981 as a way for people to save money for retirement outside of the traditional pension retirement plan  gradually replaced the traditional pension being vastly inferior for everybody but the top earners (let's say above $200K per family or above $100K per individual). It also has several side effects (as in "road to hell is paved with good intentions" ) and one of them is relative impoverishment of the lower middle class: 

Actually very few  programmers and other middle-class professionals are individual stock purchasers operating through brokers; most are dependent upon mutual fund managers navigating market or on index funds. In 1990th mutual funds became huge industry and saturated mass media with expectations of  quick and easy profits. Although they were not the primary factor, they were constructive in creating and maintaining dot-com boom.  The need to slow down and prepare for contracting credit after the biggest in the century Credit Boom was lost in the fast-paced world of momentum trading.

Now let's discuss if 401K plan has properties of the Ponzi scheme.  If this hypothesis is true, than as in any Ponzi scheme only those who are able to cash out early (the first wave of boomers) will preserve those gains.   The key question is "What is percentage-wise contribution of  401K investors to equities ?".   If it is dominant then this really looks like  a variant of classic Ponzi scheme.  This question can be simplified to the question: "What is the percentage of mutual funds holding of all outstanding shares ? "  as households own dominant part of mutual funds (see FRB Z.1 Release--L.214--Mutual Fund Shares--September 17, 2007).  Here are some facts which suggest that mutual funds did become the major players in equity markets:

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. 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.  That means that you should resist temptations and adhere to a strict discipline to a greater extent as any of them will possibly be amplified by the fund managers. 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.

It continues to fascinate me that many 401K investors including myself are entirely willing to base their financial security on concepts that looks quite unconvincing even a cursory look at historical data and a few Excel imitations model runs.   As a computer professionals we work long hours trying to acquire hard to get skills. We try to get certifications to motivate ourself to study consistently. But when it comes to the decision related to those hard eared money we display amazing stupidity and are ready to believe into almost any nonsense propagated by mainstream press.  It continues to fascinate me that many computer science professionals who are better then others are equipped to do simple Excel-based simulations and test hypothesis on historical data are willing to base their financial security on "ad hoc" concepts from some guru that can be disproved with even a cursory look at historical data with Excel in hand. This list until recently included myself.

It continues to fascinate me that many 401K investors including, until recently, myself are willing to base their financial security on "ad hoc" concepts from some guru that can be disproved with even a cursory look at historical data with Excel in hand.

We need to understand that suddenly 401K became "the pension plan", the replacement of traditional pension plans as they disappeared into thin air.  And it requires the respect and amount of leg work that is proper for pension plan. That means a lot... The big lesson to be learned from 2001-2003 is the importance of having a properly constructed investment plan and sticking to it -- not being distracted by short-term "noise":

Continued

Webliography

Internal links

External links

Continued



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Last modified: August 31, 2009