Underlying the specific issues affecting our retirement plan system is that our national savings are inadequate. We are directing far too little of those savings into our retirement plans in order to reach the necessary goal of self-sufficiency. "Thrift" has been out in America; "instant gratification" in our consumer-driven economy has been in. As a nation, we are not saving nearly enough to meet our future retirement needs. Too few citizens have chosen to establish personal retirement accounts such as IRAs and 403(b)s, and even those who have established them are funding them inadequately and only sporadically. These investors and potential investors are, I suppose, speculating that their retirement will be fully funded by some combination of Social Security, their pensions, their unrealistically high expectations for future investment returns, or (as a last resort) from their families.
Broadly stated, we Americans suffer from a glut of spending and a (relative) paucity of saving, especially remarkable because the combination is so counterintuitive. Here we are, at the peak of the wealth of the world's nations, with savings representing only about 3 percent of our national income. Among the emerging nations of the world-with per capita incomes less than $5,000 compared to our $48,000-the saving rate runs around 10 percent, and in the developed nations such as those in Europe, the savings rate averages 9 percent, with several major nations between 11 and 13 percent. Our beleaguered pension system is but one reflection of that shortfall.
The Seven Deadly Sins
Let's now move from the general to the particular, and examine some of the major forces in today's retirement systems that have been responsible for the dangerous situation we now face.
Deadly Sin 1: Inadequate Retirement Accumulation
The modest median balances so far accumulated in 401(k) plans make their promise a mere shadow of reality. At the end of 2009, the median 401(k) balance is estimated at just $18,000 per participant. Indeed, even projecting this balance for a middle-aged employee with future growth engendered over the passage of time by assumed higher salaries and real investment returns, that figure might rise to some $300,000 at retirement age (if these assumptions prove correct). While that hypothetical accumulation may look substantial, however, it would be adequate to replace less than 30 percent of preretirement income, a help but hardly a panacea. (The target suggested by most analysts is around 70 percent, including Social Security.)
Part of the reason for today's modest accumulations are the inadequate participant and corporate contributions made to the plans. Typically, the combined contribution comes to less than 10 percent of compensation, while most experts consider 15 percent of compensation as the appropriate target. Over a working lifetime of, say, 40 years, an average employee, contributing 15 percent of salary, receiving periodic raises, and earning a real market return of 5 percent per year, would accumulate $630,000. An employee contributing 10 percent would accumulate just $420,000. If those assumptions are realized, this would represent a handsome accumulation, but substantial obstacles-especially the flexibility given to participants to withdraw capital, as described below-are likely to preclude their achievement. (In both cases, with the assumption that every single contribution is made on schedule-likely a rare eventuality.)
Deadly Sin 2: The Stock Market Collapse
One of the causes of the train wreck we face-but hardly the only cause-was the collapse of our stock market, on balance taking its value from $17 trillion capitalization at the October 2007 high in U.S. stocks, to a low of $9 trillion in February 2009. Much of this stunning loss of wealth has been recovered in the rally that followed, and as 2012 began, the market value totaled $15 trillion. Nonetheless, our nation's DB pension plans-private and government alike-are presently facing staggering deficits. And the participants in our DC plans-thrift plans and IRAs alike-have accumulations that fall short of what they will need when they retire.
Deadly Sin 3: Underfunded Pensions
Our corporations have been funding their defined benefit (DB) pension plans on the mistaken assumption that stocks would produce future returns at the generous levels of the past, raising their prospective return assumptions even as the stock market reached valuations that were far above historical norms. And the DB pension plans of our state and local governments seem to be in the worst financial condition of all. (Because of poor transparency, inadequate disclosure, and nonstandardized financial reporting, we really don't know the dimensions of the shortfall.) The vast majority of these plans are speculating that future returns will bail them out.
Currently, most of these DB plans are assuming future annual returns in the 7.5-8 percent range. But with stock yields at 2 percent and, with the U.S. Treasury 30-year bond yielding 3 percent, such returns are a pipedream. It is ironic that in 1981, when the yield on the long-term Treasury bond was 13.5 percent, corporations assumed that future returns on their pension plans would average just 6 percent, a similarly unrealistic-if directly opposite-projection as 2012 began.
Corporations generate earnings for the owners of their stocks, pay dividends, and reinvest what's left in the business. In the aggregate, the sole sources of the long-term returns generated by the equities of our businesses should provide investment returns at an annual rate of about 7-8 percent per year over the next decade, including about 2 percent from today's dividend yield and 5-6 percent from earnings growth. Similarly, bonds pay interest, which is the sole source of their long-term returns. Based on today's yield, the aggregate return on a portfolio of corporate and government bonds should average about 3.5 percent. A portfolio roughly balanced between these two asset classes might earn a return in the range of 5-6 percent during the coming decade.
Deadly Sin 4: Speculative Investment Options
A plethora of unsound, unwise, and often speculative investment choices are available in our burgeoning defined-contribution (DC) plans. Here, individuals are largely responsible for managing their own tax-sheltered retirement investment programs-individual retirement accounts (IRAs) and defined-contribution pension plans such as 401(k) thrift plans that are provided by corporations, and 403(b) savings plans provided by nonprofit institutions. Qualified independent officials of their employers seem to provide little guidance. What's more, they often focus on spurious methodology that is too heavily based on historical data, rather than the timeless sources of returns that actually shape the long-term investment productivity of stocks and bonds, misleading themselves, their firms, and their fellow employees about the hard realities of investing.
Deadly Sin 5: Wealth-Destroying Costs
The returns in our stock market-whatever they may turn out to be-represent the gross returns generated by the publicly owned corporations that dominate our system of competitive capitalism (and by investment in debt obligations). Investors who hold these financial instruments-either directly or through the collective investment programs provided by mutual funds and defined benefit pension plans-receive their returns only after the cost of acquiring them and then trading them back and forth among one another. Don't forget that our financial system is a greedy one, consuming from 1 to 2 percentage points of return, far too large a share of the returns created by our business and economic system. So we must recognize that individual investors and pension funds alike will receive only the net returns, perhaps in the 4 to 5 percent range, after the deduction of those costs. To significantly enhance that return, less conventional portfolios using "alternative" investments will have to deliver returns that far exceed their own historical norms. To say the least, that is one more speculative bet.
Deadly Sin 6: Speculation In The Financial System
Speculation is rife throughout our financial system (and our world). High stock market volatility; risky, often leveraged, derivatives; and extraordinary turnover volumes have exposed the markets to mind-boggling volatility. As I note earlier, some of this hyperactivity is necessary to provide the liquidity that has been the hallmark of the U.S. financial markets. But trading activity has grown into an orgy of speculation that pits one manager against another-one investor (or speculator) against another-a "paper economy" that has, predictably, come to threaten the real economy where our citizens save and invest. It must be obvious that our present economic crisis was, by and large, foisted on Main Street by Wall Street-the mostly innocent public taken to the cleaners, as it were, by the mostly greedy financiers.
Deadly Sin 7: Conflicts Of Interest
Conflicts of interest are rife throughout our financial system: Both the managers of mutual funds that are held in corporate 401(k) plans and the money managers of corporate pension plans face potential conflicts when they hold the shares of the corporations that are their clients. It is hardly beyond imagination that when a money manager votes proxy shares against a company management's recommendation, it might not sit well with company executives who select the plan's provider of investment advice. (There is a debate about the extent to which those conflicts have actually materialized.)
But there's little debate in the mind of Lynn Turner, former chief accountant of the SEC: "Asset managers who are charging corporations a fee to manage their money have a conflict in that they are also trying to attract more money which will increase their revenues, and that money often comes from companies who set up retirement accounts for their employees. There is not disclosure, from the asset manager to the actual investors whose capital is at risk, of the amount of fees they collect from the companies whose management they are voting on. It appears the institutional investors (including managers of mutual funds) may vote their shares at times in their best interests rather than the best interests of those whose money they are managing."
In trade union plans, the conflicts of interest are different, but hardly absent. Insider dealing among union leaders, investment advisors, and money managers has been documented in the press and in the courts. In corporate defined benefit pension plans, corporate senior officers face an obvious short-term conflict between minimizing pension contributions in order to maximize the earnings growth that market participants demand, versus incurring larger pension costs by making timely and adequate contributions to their companies' pension plans in order to assure long-term security for the pension benefits they have promised to their workers. These same forces are at work in pension plans of state and local governments, where the reluctance (or inability) to balance budgets leads to financial engineering-rarely disclosed-in order to justify future benefits.
Extracting Value From Society
Together, these Seven Deadly Sins echo what I've written at length about our absurd and counterproductive financial sector. Here are some excerpts regarding the costs of our financial system that were published in the Winter 2008 issue of Journal of Portfolio Management: "...mutual fund expenses, plus all those fees paid to hedge fund and pension fund managers, to trust companies and to insurance companies, plus their trading costs and investment banking fees ... have soared to all-time highs in 2011. These costs are estimated to total more than $600 billion. Such enormous costs seriously undermine the odds in favor of success for citizens who are accumulating savings for retirement. Alas, the investor feeds at the bottom of the costly food chain of investing, paid only after all the agency costs of investing are deducted from the markets' returns ... Once a profession in which business was subservient, the field of money management has largely become a business in which the profession is subservient. Harvard Business School Professor Rakesh Khurana is right when he defines the standard of conduct for a true professional with these words: '"I will create value for society, rather than extract it.' And yet money management, by definition, extracts value from the returns earned by our business enterprises."