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Softpanorama
(slightly skeptical)
Open Source Software Educational Society |
May the
source be with you,
but remember the KISS principle ;-)
|
 |
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
|
Contents
"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.
| 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:
A good perspective on the risks inherent in 401k plans, July 13,
2005 By
Sanjib Das
(Shelton, CT USA) -
See all my reviews
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 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:
- Hedge finance: income flows are expected to meet financial
obligations in every period.
- Speculative finance: the firm must roll over debt because income
flows are expected to only cover interest costs.
- Ponzi finance: income flows won’t even cover interest cost,
so the firm must borrow more or sell off assets simply to service its debt.
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 money. Given 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:
- The short memory of voters is what keeps our politicians in office."
- "We've got the best politicians that money can buy."
- "A fool and his money are soon elected."
- "Things in our country run in spite of government, not by aid of it."
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.
|
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 ").
|
Events of 2008-2009 are sometimes
called "autodafé of the 401K investors"
|
|
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...
- Investors often look at behavior to forecast what will happen in the
stock market. But consider the effect on behavior from the fall in the stock
market especially if it falls another 50%.
-
- Most people in their 20s-40s have most of
their 401K in stocks. That is what their financial advisors said they should
do.
-
- Even people nearing retirement have a large fraction in stocks, maybe
40%. If the S&P hits 500 like I think it might, they will have lost 2/3
of their retirement money. In addition they will have lost anywhere from
$50K to $200K on their house.
-
- Many will lose their jobs to boot. I find it amazing that you hear economists
predicting that Americans will raise their savings rate to 5%. That doesn't
get them anywhere.
-
- The normal rate was 10% for much of the century. For the past 20 years
it has fallen from 10% to -1%. Savings is a cumulative thing. They need
to overshoot on the upside to get back to 10% averaged over their lifetime.
That means 15-20% savings rates over the next ten years.
-
- What does that imply for retail spending?
It is not pretty.
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.
|
"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% the financial intermediary
takes 25%
With return of 1% and
fees 0.5%
the financial intermediary takes 50%
|
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:
- One of the reasons the Fed was created was to manage the economy and
prevent further depressions. Guess What? The biggest deflation in history,
the great depression, happened 17 years later.
- At one time economists thought that inflation and recession could not
happen at the same time. It happened anyway. A new term was coined for it
"Stagflation".
- Deflation supposedly couldn't happen in a fiat regime. Japan proved
otherwise.
- If you asked anyone in Japan if housing prices could fall for 18 straight
years, they would have said "It can't happen". It did happen.
- For 30 years people have said US housing prices would never again decline
on a national scale. They were wrong. It happened.
I would add to the list the hypothesis that diversified stocks index like
S&P500 outperforms bonds ("stock for the long run" or
naive Siegelism
hypothesis). Yes, it might be true for certain periods (for example ten year
periods starting in any month in 1990 and lasting till 2000, and some months
of 1991-2001, and then again, 1996-2006 and 1997-2007 periods). But if
we assume cost averaging starting from zero, then Vanguard institutional stable
value outperformed S&P500 for most of exact ten year periods with the start
at random month in 1990-1998 timeframe (2008 is not over yet but it looks like
underperformance will hold for the rest of 2008.)
The difference between stocks and bonds returns for some "stock positive"
periods like Jan-Jun 1996 - Jan-Jun 2006 are within the rounding error
and generally can be reversed by using different from Vanguard Institutional
Stable value bond fond.
Also the latest trends due to subprime crisis make the situation with S&P500
returns in 2009 more problematic as financial stocks constitute approximately
a quarter of S&P500. That means that S&P 500 might also 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.
| 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.
| 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:
- Creating a shareholder
on the register of companies that will have the size and power to enforce
management oversight
- Companies will
no longer be able to use defined pension funds to manipulate earnings
- 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!) )
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.
“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 (
of the
The
Big Picture fame ) in his entry
The
kinda-eventually-sorta-mostly-almost Efficient Market Theory wrote:
One of the most widely believed theories on Wall Street is the
Efficient
Market Hypothesis (EMH).
Adherents of this charmingly naive thesis believe that markets are an incredibly
effective distributor of information. Because of this, say EMH theorists, it
is impossible, therefore, to beat the market, because prices already
incorporate and reflect
all relevant information.
Given the random nature in which market and company information comes to
investors, and the assumption that prices react/adjust almost immediately to
reflect this information, no one can consistently outperform the market over
time.
Or so goes the theory.
The thesis has two problems: 1) Many fund managers and investors HAVE outperformed
the market. Theorists have never come up with an adequate response to this reality,
claiming instead that chance or mere short term market swings explain the out-performance;
and 2) it imbues the market with an almost
mystical ability to disseminate information, regardless of the emotions
and analytical failures of its human participants.
... ... ...
Your own belief system will help determine which camp you may find yourself
in: If you think that Human Beings are rational, calculating machines,
without systematic biases, whose behavior can be predicted with mathematical
models, then EMH is for you. If you believe that investors are fallible, emotional,
biased and error-prone, than the behaviorist school will be more to your liking.
As someone who has long scoffed at EMH, I particularly enjoyed Yale University
economist Robert Shiller's comments on the subject: EMH proponents have made
one huge mistake: "Just because markets are unpredictable
doesn't mean they are efficient." The leap in logic, he wrote
in the 1980s, was one of "the most remarkable errors in the history of economic
thought."
Indeed. I doubt it will be the last . . .
I don't find the naivety "charming" however. I think it encourages some
assumptions that work to ruin 401K investors wealth and justifies the status quo.
all-in-all like almost everything from
Chicago school
of economics (it was Professor Fama who put forward this pseudo-theory and he
is from Chicago University) it works against the people.
We will try to talk about this problem in
Protecting your 401K from Wall
Street part of the paper.
The key here is to understand is how fraudulent is the notion of "risk
tolerance" as promoted by major investment firms: answering biased toward stocks
"risk tolerance questionnaire" is not the same as tolerating actual dire circumstances
after the fact. Moreover they misrepresent potential losses which for S&P500 can
reach 60% for 10 years period even if cost averaging is used. And in no way stocks
are "self-correcting with time, unless trading is used. If secure (long term)
trend is down the investor is under the bus and there is no way to recover losses.
In other words the "risk tolerance" questionnaires is snake oil salesman trick
designed to lure you into stocks investment as your answer will for sure be different
if you answered the same questionnaire in the market situation of March 2003 or
December 2008. As
Money
Magazine observed in
Dec. 3, 2008:
During such good years, you tend to believe that
you have a high tolerance for risk. At times like these, your willingness to
take chances drops sharply.
Such mood swings can lead you to jump in and out of the market and chase
good performance, with devastating results.
The reality is that with the exception of stable value fund, short term bond
funds and TIPs none of the investment comes even close to the level of risks that
401K investors are ready to tolerate. So if such investments are used they should
constitute a tiny portion of your portfolio. As there are more stocks funds then
tradable stock you can leave this casino to rich folks, those who have money to
lose (and as Modoff case suggests a lot of them were taken for a ride). See
Naive Siegelism
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:
- 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.
- 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.
- 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:
-
Threats from yourself.
That's probably is a self-evident truth :-(. The key issue here
is what investment strategy is consciously or subconsciously adopted and how
viable and consistent this investment strategy is. The typical mistake
here is the adoption of too aggressive strategy despite the fact that chairs
are stacked against 401K donors (aka 401K investors). The first and foremost
duty of 401K investors is to protect their capital. If they can get above inflation
return that's fine, but such an opportunity should be secondary to the main
task of protecting the capital. But this goal presuppose that they can
invest among money to provide a decent pension. In cases of low and middle paid
employees (earning less then 100K a year) this is patently not true: even with
maximal 20% contribution for the last 15 years of your career you barely get
equivalent of 60% of your salary in retirement.
So people try to take additional risk to compensate for insufficient contributions.
and there is nothing surprising that many 401K investors use equities to achieve
that. But there is no free lunch. Equities are a very ambiguous promise:
volatility is high and can exceed 50%. You get very low rate of dividends (1-2%).
And is essence equities are just an option on company growth prospects. And
as any option it is far from safe bet. First of all management can steal
too much for the company to survive or dilute shareholder value to save the
company (as is in case is most banks in 2008). Then adverse market conditions
can negatively affect company growth. You can continue this ad infinitum. Peter
Lynch once said "When equities are regarded as safe is when they are most
risky, and when they are seen as speculative is when they are the best buy."
It requires a very serious work and analysis to really understand a company.
Add to this the fact that markets as frequently irrational. Of cause America
is adaptable, we'll get through the current crisis as we have past crises, and
there are always good stocks even in bad markets. but some caution is prudent.
Growths of economy is reflected in the sum of returns of stocks and bonds.
For a long time the lion share of those returns was returned via stocks appreciation;
but that does not mean that situation cannot reverse any time: there is no inherent
reasons why stocks should be more attractive and systematically produce better
returns then bonds. Actually for the level of risk we are talking in case of
S&P500 on bond side we should compare index not with regular investment grade
bonds but with junk bonds and they return approximately the same 6.5% annualized
return as S&P500. Current GDP growth oriented measurement of economic
growth is very deceiving as it does not reflect growing treats the nation faces
due to depletion of hydrocarbons, overpopulation and infrastructure that is
addicted to cheap oil. GDP is a very crude and somewhat suspect indicator of
economic growth. The question to ask is "Does doubling of strip malls, restaurants,
banks, or number of personal cars on the road is such a good thing ?".
Where is the level after which they does not increase standard of living and
might contribute to decrease (traffic jams in case of cars is a good example).
Also some contributors to GDP like alcoholic beverages consumption, soda consumption,
tobacco products, medical insurance costs, obesity drugs costs, etc actually
represent externalities and in no way are positive to the economics or reflecting
the prosperity of the population. GDP is a very crude, self-deceiving and one
dimensional measure.
Think about stocks as a fiat currency of the company. The value of stocks
of individual companies can and often drop to a single digit or even zero.
All-in-all the professionals like programmers has been lately (probably since
2000) under serious financial and social pressure, which makes the economic
experience of the past ten years significantly different than the preceding
decades. It also justifies more efforts to protect your 401K investment.
In any case expect you payment to be lower that in case of pension unless you
contribute the maximum allowed amount (currently 20%). So in a sense you
can think about replacement of defined benefit plans with 401K plans as a 20%
haircut on your salary.
-
Threats from Wall Street.
One is perma-bull propaganda and tremendous pressure to adopt high-stock-content/all-stock
portfolios that got many programmers and IT specialists into severe problems
during dot-com crash. This problem is also can be named "acquired
idiotism" problem or, more politically correct, "immunization from rational
understanding of risks".
Please note that mutual fund industry is a part of Wall Street and has its
own, often very damaging for 401K investors tricks, and in some cases criminal
agenda. Vanguard funds are generally better then the rest but they are far from
being immune and their recommendations are completely unscientific. Like other
funds families (of fund mafias) it is involved in borderline to criminal behavior.
See
Vanguard Managers Invested in Web Gambling, Suit Says (Update2)
You should not "misunderestimate" the damage
from brainwashing. Many 401K investors hurt themselves
because they focused is only on stocks (and stock funds) who are promoted by
sleek, very intelligent and extremely well paid "Wall Street photo models" like
talented "stocks circus entertainer"
Jim Cramer (the host of
the chair-hurling, stupid financial advice-shouting circus called Mad Money;
Cramer's show is on so often, that it seems to run like a film loop). Another
notable "stocks promoting photo model" is CNBC's
Maria Bartiromo (aka
Money Honey; see
From Disco
Queen to Business News Diva and
Maria Bartiromo Is No Fool )
-
Threats from government.
Among key factor here is the threat of inflation. Inflation is highly individual
category: for example if you do not drive car you are only indirectly affected
by the price of gas. If you drive Suburban to work you are affected more directly.
Among other things the depreciation of dollar against major currencies is
the sign of the same process as replacement of defined benefit pension plant
with 401K plans although it does not influence the buying power directly. But
there is no doubt that the dollar plunge against other currencies can influence
retirement of baby boomers in a profound way. All-in-all the threat of inflation
is definitely is the most important threat to 401K portfolios due to high probability
of subpar performance of stock and bond markets in the coming decade.
That increases importance of having TIPs in your 401K portfolio (see
Bonds-based
strategy)
Among other less important are threats to Social Security (possible insolvency,
privatization, etc) as well as danger of making investment decisions based on
biased statistics (for example false GDP growth number, fudged unemployment
statistics, etc, but few 401K investors are that savvy). But it is interesting
to note that despite tremendous amount of published statistics there is a notable
absence of reliable economic information. On the contrary there is a statistical
fog that is very difficult to penetrate even for people like professional programmers,
who live and flourish in a world of complex obscurity ;-)
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:
-
First it launched huge growth of mutual fund industry which before
that were a small portion of financial markets.
-
Later the American public has actually been forced into the stock market
(or more correctly into stock mutual funds) with the evaporation of pension
plans because most 401K plans are heavily and openly
biased toward stocks.
-
In late 90th 401K investors involvement in stock markets acquired some properties
of Ponzi schemes, when the stocks purchases by 401K participants due to
the numerical strength of baby boomers became important factor that drives stock
prices up and provide cover for speculators ("401K investors put" similar to
"Greenspan's put").
-
Recently it became replacement for pension but
without adequate matching of employee contribution by employer to provide equal
returns (matching traditional person requires approximately 12% matching)...
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:
- According to Wilshire Associates, the total U.S. market cap is approximately
$15.35 trillion (May 23, 2007).
- According to the World Federation of Exchanges, global market cap stood
at 51.23 trillion in January 2007.
- According to USA Today investment columnist
John Wagonner
"The public has nearly $7 trillion invested in stock funds — $6.4 trillion
invested in traditional stock funds and $479 billion in exchange traded
stock funds. In total, mutual fund assets equal
about one-third of the $19.6 trillion U.S. stock market.
(Many funds invest in international stocks, so the amount of fund assets
as a percentage of the U.S. market is somewhat lower than a third.)"
- According to
ICI in
2004 mutual funds owned 22% of publicly held U.S. equity,
which has sparked debate over whether fund flows
drive stock market price levels (and that means that stock market
has distinct features of Ponzi scheme)
- In 2000 Fed published paper [PDF]
Mutual
Funds and the U.S. Equity Market generally confirmed this potential Ponzi
scheme like behavior during market crashes but noted that it was damped by the
cash reserves of the mutual funds. The authors stated:
Total retirement assets increased threefold over the past decade, to
almost $13 trillion in 1999 (table 8).27 Mutual
funds have played an increasingly important role in this growth, accounting
for almost one-fifth of total retirement assets in 1999.
Moreover, retirement assets held within mutual funds have risen significantly
relative to total mutual fund assets, accounting for 35 percent of total
fund assets in 1999. Households have chosen to allocate the bulk of the
retirement assets they hold in mutual funds to equities, thus bolstering
the total share of mutual fund assets allocated to equity funds (table 9).
In 1999, 73 percent of mutual fund IRA assets and 81 percent of mutual fund
defined contribution pension plan assets were invested in equity funds.28
Retirement account assets in mutual funds are much more likely than non-retirement-account
assets in mutual funds to be devoted to equity investments.
...households' decisions to invest new cash
in, or request redemptions from, equity mutual funds significantly affect
equity prices. This possibility can be evaluated by looking
at the relationship between domestic equity fund flows and equity prices.
Net new flows into domestic equity funds as a percentage of the value of
the U.S. stock market have tended to increase over the past fifteen years
(chart 10).29 The monthly percent change in the Wilshire 5000 index of stock
prices over the same period shows that while equity fund flows were becoming
more stable, equity prices were becoming more volatile (chart 11).30
A related development is that the response of mutual fund investors to large
market declines—specifically, the equity price declines in October 1987,
August 1990, and August 1998—has become progressively smaller.
In October 1987, when the Wilshire index
fell more than 20 percent (the worst monthly performance for the stock market
since World War II), domestic equity funds experienced net outflows of more
than $6 billion. This outflow amounted to 0.2 percent of
the total value of the stock market, or just under 3 percent of domestic
equity fund assets; this was the largest monthly outflow as a percentage
of fund assets to date. Indeed, domestic equity funds experienced outflows
in fourteen of the sixteen months following the October crash, outflows
that summed to a net total of more than $18 billion. All told, mutual fund
shareholders withdrew more than 11 percent of domestic equity fund assets
in the aftermath of the October 1987 episode. 31
The next large decline in stock prices occurred in August 1990, when
the Wilshire index fell about 10 percent in the wake of concerns about the
Gulf War in Kuwait and Iraq. In that month, mutual fund shareholders withdrew
about $21⁄2billion from domestic equity funds, which amounted to less than
0.1 percent of the value of the stock market, or about 1 percent of domestic
equity fund assets. Outflows from August through September 1990 were only
$3 billion, or a little more than 1 percent of fund assets. Although the
Wilshire index fell half as far in August 1990 as it had in October 1987,
fund withdrawals during the 1990 episode were less than half those during
the 1987 episode. Domestic equity funds did not experience a net monthly
outflow again until August 1998, when the Wilshire index declined 15 percent
in the midst of the Asian financial market crisis and Russian bond defaults.
Shareholders in domestic equity funds requested net redemptions of about
$61⁄2billion in that month, an amount equal to about 0.3 percent of total
domestic equity fund assets. Domestic equity fund inflows resumed the following
month.
...Although investors have withdrawn money from domestic equity funds
during severe market declines, mutual fund managers have not necessarily
had to sell stocks immediately to cover redemptions. In addition to holding
stocks, equity funds also hold safe, liquid money market assets, usually
referred to as ‘‘cash.'' The proportion of a mutual fund's total assets
held in cash is known as the cash ratio. To the extent that net outflows
can be met by cash on hand, they need not translate into forced sales of
equities by fund managers. The asset-weighted mean cash ratio for all domestic
equity funds has generally been trending down and recently stood a little
above 4 per-cent (chart 12). Despite the decline,
funds have had, on average, more than enough cash on hand to cover monthly
redemptions throughout the past fifteen years.
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":
- The first step is to understand that using 401K as a substitute for pension
with the typical meager employer matching (say 4.5%) requires higher level of
individual contributions (probably 10% is the minimum if we assume 20 years
contribution period) to match the pension plan. The latter
makes life of retirees more risky and more frugal:
-
Traditional pension plans offered better returns and more personal security
than you'll ever get from your investments. In a typical 401K plan,
you need sum of your own and company annual
company contribution of approximately 15% of salary to provide for 3/4 of
the salary -- typical top pension for "long timers" in the traditional pension
plan.
-
When your contributions are equal to the contributions of the company
and the company pays 4.5-6.5%, you'd either wind up with a lower retirement
income or need to put additional 5-7% yourself. That means that
you should contribute at least 10% of your salary Plus probably Roths
as an insurance and "emergency fund".
- If 401K is such an important for our retirement thing that it should be
treated as a very conservative investment. Don't take excessive
risk and don't put all your eggs in one basket. That means two
things:
-
Avoid "totalitarian" or close to them portfolios: 100% stock,
100% bonds or 100% cash portfolios are more risky then balanced between
those three classes of assets. This is a very simple idea but it has profound
meaning, My limited simulations suggest that how your assets are divided
between different classes (stocks vs. bonds/cash) might actually be more
important than the individual stocks and bonds funds you hold (you can actually
hold cash instead of bonds, if you have more then 20% in stocks).
I actually respect "cash investors" despite the fact that I am skeptical
about their allocation choice. But they can predict their future income
with high precision. At the same time chasing returns many 401K investors
had thrown any caution into the wind. Cash returns are so low - courtesy
of Greenspan's ultra easy monetary policies that turn the 401K investors
'returns mad'. But that does not mean that higher returns are risk free
and nobody knows what will be the size of the crash and when it will come.
-
The second important idea is that as 401K selections are mostly limited
to stocks and bonds both stocks and bonds should constitute the sizable
portions of portfolio and close to 50:50 allocation strategies like a simple
100-your_age formula of splitting stock
and bond assets might be one of the best 401K investment advices money can
buy. The more secure you feel that you reach your financial goals the less
stocks in the portfolio you can afford
-
Unfortunately it looks like most programmers prefer heavily loaded
(80% or more) stock portfolio. The tendency to overload 401K plans with
stocks might have been one of the contributing factors and in a perverse
way simultaneously a consequence of the first Greenspan bubble (tech
stock bubble of 1996-2000) despite the fact that a lot of professionals
(most programmers who I know) dearly paid for such an allocation.
I was one of them and that actually stimulated me to research the subject.
-
As a quick reality check even S&P500 might not those days provide
safe store of value as financial stocks now serve as a proxy of tech
stocks in 2001-2003 stock crash (mortgage crises and deleveraging crisis).
The reason for the strong performance of stocks over the last 10-20
years or so might replacement since the early 1980s consumer price inflation
with the asset inflation.
- If some money can be saved in Roths the second level of strategy should
include consideration of what kind of assets to keep in in each. You can invest
in commodities here, the opportunity that is not available in 401K. The idea
is that by better planning you might slightly ( this is not a panacea)
increase the amount of money after taxes that you end up with in retirement.
For example one
2004
paper on asset location suggested the max difference can be as high as 15%.
While this is probably an overstatement even 5% is a huge difference.
-
You need to understand that another even more dangerous part of this situation
is that government offloaded inflation risks on
the shoulders of individual investor.
As Alan Greenspan noted well
before his famous monetary base expansion efforts "In the absence of the
gold standard, there is no way to protect savings from confiscation through
inflation. There is no safe store of value."
-
Your investment horizon is pretty limited (for most people it is approximately
20 years (40-60). If all you can afford is a couple of decades of active investing
that means that "stocks for a long run" idea might not work in your situation:
-
Professionals, especially programmers over 55, are the most frequent
target of layoffs (chances to be laid off for people over 55 are more than
two times higher than in other age brackets). Those days to expect to survive
till 62.5 as a programmer is somewhat a stretch.
-
The typical period after layoff and finding new job now can last not
several month but several years (as happened with some of my friends
who lost jobs in 2002 and found jobs only in 2006) and in most case older
folks are unable to get even 80% of the previous salary on a new job.
Often they are "50% off"...
-
Many former programmers and IT specialists are unable to find professional
job at all and are pushed into semi-qualified labor pool.
-
That cuts the most intensive 401K investment period to approximately
10-20 years (45-55 in worst case and 40-60 in the best). And that
means that you better do not make costly mistakes during this period and
after as at this point you contributed maximum amount of money that you
can relay later on.
Internal links
External links
Continued
Copyright © 1996-2009 by Dr. Nikolai Bezroukov.
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August 31, 2009
