Between 1999 and 2002, U.S. private pension funds lost US$1.2 trillion in value.

It turns out that $282.2 billion of the decline in private pension fund value over 1999 to 2002 was due to net withdrawals from these plans, but even so, the drop in market value amounted to $979.7 billion.

It would almost seem that pension fund managers had been speculating with retirement money, attempting to beat each others’ short-term performance statistics, with little interest in safeguarding the assets of plan beneficiaries.

But half of U.S. private pension funds were organized as ‘defined contribution’ plans, such as 401(k)s, in which the fundamental asset allocation decision was made not by fund managers, but by the plan beneficiaries themselves.

During the 1990s, millions of private ‘pension fund’ decisions were made not by pension fund managers but by unsophisticated workers who, believing the “Common Stock Legend“, blindly allocated their long-term assets to equity mutual funds.

In 2004, 44.4 million workers were insured by PBGC under ‘defined benefit’ private pension plans, which comes down to pension assets of about $40,000, on average, per worker — hardly enough to provide much of a ‘defined benefit’ in old age.

History Forgotten?

As history is now being rewritten, the Great Bubble of the 1990s may be remembered merely as a ‘dot-com’ phenomenon and the unfortunate result of accounting tricks and bad ‘corporate governance’ of a ‘few bad apples’, such as those guys at Enron.

Everything has now been fixed by the presence of ‘independent directors’ and the magic accounting-disclosure wands of Senators Sarbanes and Oxley.

(See essay on: “Corporate Governance“)

The fact is, however, that in 1999, price-earnings ratios of ordinary companies had soared to over thirty, while dividend yields had plunged to a two hundred year low. The madness of the nineties was an integral part of American financial culture and has yet to be cured.

(See the tutorial, “Equity Values“, and the essays on “Investment Theory“.)

In retrospect, the prudent thing would have been to invest in bonds in 1997, as the market had reached the traditional high-water mark of twenty-times earnings, and when Chairman Greenspan was warning about ‘irrational exuberance’.

But where had prudence gone?

Why were both professional pension fund managers and ordinary investors speculating with retirement money?

Where Were The Wiser Heads?

Unfortunately, Benjamin Graham, a paragon of commonsense and the father of fundamental analysis of stocks, had passed on twenty years before the Great Bubble of the nineties.

Throughout the Clinton years, ‘defined benefit’ pension funds of American workers were, in theory, supervised by the Pension Benefit Guarantee Corporation, a government bureaucracy with a staff of 800, reporting to a board made up of the Secretary of Treasury, the Secretary of Labor, and the Secretary of Commerce.

• The U.S. Secretary of the Treasury, Robert E. Rubin, a lawyer-deal-maker and ex-co-Chairman of Goldman Sachs, had neither the know-how nor the inclination to do anything to save the assets of future pensioners. His grasp of economics was demonstrated by his role in the Asian crisis of 1997.

(See: “The Chastening: Inside the Crisis that Rocked the Global Financial System and Humbled the IMF“, Paperback, Paul Blustein. )

• The U.S. Secretary of the Labor, Robert B. Reich, a former member of the Harvard faculty at the John F. Kennedy School of Government, also trained in the law, and, like President Clinton, a Rhodes Scholar, was more known for his interest in labor unions and leftist politics than for his command of investment theory and actuarial science.

• The U.S. Secretary of Commerce, Ronald H. Brown, a lawyer and lobbyist, was a former chairman of the Democratic National Committee, official of the National Urban League, and chief counsel for the Senate Judiciary Committee under the Chairmanship of Senator Edward M. Kennedy. Secretary Brown was killed in a mysterious plane crash in the Balkans, while under investigation by independent counsel for corruption and while reportedly negotiating a plea bargain implicating President Clinton.

Arthur Levitt, the Chairman of the SEC, whose job it was to protect ordinary investors, was busy, according to the official biography of that market regulator, “conducting investors town meetings throughout the country to listen to the concern of investors and to give them tips on safe and wise participation in the securities markets” — which did not seem to include advising them to sell stocks and buy bonds, for this would hardly been in character for a former Chairman of the American Stock Exchange.

As far as wise and prudent counsel from the academic world, we only need to look to the prestigious Financial Economists Roundtable, graced by a bevy of Nobel laureates and assorted academic experts in financial risk, who, only a few years earlier had issued, ex cathedra, a soothing “Statement on Derivative Markets and Financial Risk”, signed, among others, by Myron Scholes, architect of Long Term Capital Management, the hedge fund that was to blow up so spectacularly in 1998 — making, as it were, a real-world statement on financial risk.

(See: “Fallacies of the Nobel Gods” and “Uncontrollable Risk“.)

A Picture Is Worth A Thousand Words

The fact is that, during the 1990s, there was no adult supervision over pension fund managers and the U.S. equities market.

Despite prestigious credentials, like “Certified Financial Analyst”, that were liberally sprinkled throughout the sales brochures of pension fund managers, the following graph, taken from the Federal Reserve Flow of Funds Accounts, shows the cost that American investors had to bear for the imprudence of pension fund managers and their own lack of sophistication:

The End of ‘Defined Benefits’

There is no great mystery about how to set up a dependable retirement plan. Anyone can purchase a deferred, fixed annuity, linked to interest rates on U.S. Treasuries, sold by top-rated insurance companies, that will provide income for the life of the investor and his spouse.

A reasonably predictable pension is the essence of a ‘defined benefit’ retirement plan.

If you are willing to assume the lowest plausible rate of interest, almost anyone can buy a ‘defined benefit’ plan from a private insurance company that should be reasonably safe and reliable over decades.

Why then doesn’t everybody have a sound retirement plan? Why wouldn’t everyone want the assurance of ‘defined benefits’ in old age?

Part of the answer is that few want to believe that conservation of assets is the essential element in a long-term investment plan, and that it is unreasonable for everyone to believe that they will get better than average returns — or how low ‘average returns’ actually are likely to be over the next thirty years.

As the graph, derived from Federal Reserve Flow of Funds Accounts, shows, the percentage of private pension plans with ‘defined benefits’ has fallen from 50% to 40% over the decade 1995-2004.

But this is only part of the story.

The next graph shows cash flows in and out of ‘defined benefit’ and ‘defined contribution’ private pension plans over the decade:

While money has been pouring out of ‘defined benefit’ plans — with outflows exceeding $100 billion in 2000 alone — far less money has been going into ‘defined contribution’ plans.

Over the decade 1995-2004, $541.5 billion was withdrawn from private ‘defined benefits’ pension plans, while only $253.8 billion went into private ‘defined contribution’ pension plans.

On balance, private pension plans suffered a net withdrawal of $287.7 billion over the decade.

Obviously, Americans are relying less and less not only on social security, but on private pension plans, for comfortable ‘golden years’.

What Went Wrong?

Although there are many people who understand what is going on in the pension world, the forces that shaped the market were primarily intractable greed, ignorance, and trade unionism.

(See essays on “Workers’ Capitalism“)

The United States came out of World War II controlling the greatest industrial assets on earth. Unfortunately, these magnificent industrial plants were contaminated by a fatal disease: trade unionism.

Unlike Singapore, which was able to curb trade unions and become an advanced economy in thirty years, American big business had been forced to ingest the bitter pill of Franklin Roosevelt’s New Deal and the country’s industrial future had been confiscated by the AFL-CIO, the UAW, and other unions.

With the backing of the Democratic Party, a submissive Congress, and liberal courts, trade unions were able to shut down factories at will, even entire industries, forcing management to cave in to absurd demands for ever higher pay and benefits.

Although United States was said to be a capitalism economy, the free market did not work at all when it came to organized labor. Wages and benefits were not determined by supply and demand, but rather by powerful labor monopolies, acting under the cloak of law.

Industrial management soon figured out that unions could be bought off with attractive retirement benefits, promised twenty or thirty years in the future, even with plans that were not financially sound and unfunded.

By the 1970s, the United States had been grievously wounded by Lyndon Johnson’s two great wars: The War in Vietnam and the War of Poverty, both lost.

American industries were going into bankruptcy, leaving workers to cope with the reality of unfunded or under-funded pensions.

Rather than rectify impossible pension schemes, under pressure from labor unions, lame-duck President Gerald Ford signed into law ERISA, which called for defined benefit plans being funded, under the heavy bureaucratic control of the federal government.

The result was that industry began to move away from ‘defined benefits’ plans, substituting ‘defined contribution’ plans that made no such long-term commitment.

More companies were forced into bankruptcy under the stricter ERISA requirements.

Factories moved overseas; deindustrialization accelerated.

The PBGC had to pick up the tab for unionized workers in the steel, aluminum, and airlines industries, that refused to ‘give up’ benefits obtained by striking decades earlier.

The Impossible Dream

The problem with the private pension fund industry was that investment managers were thrust into competition for short-term ‘performance’, rather than for their ability to provide responsible fiduciary management over twenty or thirty years.

Corporations knew that the higher immediate ‘total return’ provided by their pension fund managers, the less likely it would be that the company would have to spend recent earnings to reinforce pension commitments, reducing the value of executive options.

When competing for ‘defined contribution’ assets in 401(k) plans, these pension fund managers were again constrained to produce short-term ‘total returns’, rather than sell their ability to safeguard assets over the long-haul.

Consequently, in 1997, when Chairman Greenspan issued his ‘irrational exuberance’ statement, fund managers groaned and mocked, for they knew that in the world in which they lived, prudent behavior was not only unfashionable, but would amount to commercial suicide.

Investors were simply not ready to believe that long-term asset protection was more important than short-term paper profits.

We now only have to wait for the bankruptcy of General Motors, Ford, and the remaining big airlines, to finally consign ‘defined benefit’ pension schemes to the ‘ash bin of history.’

The Deadly Virus Has Switched Hosts

The trade unions, of course, like any deadly virus, will not give up at all with the death of their host — industrial America — but have already mutated and are infecting the public sector.

Teacher’s unions and protected civil servants are now under the spell of labor unions.

The Christmas 2005 strike of Transport Workers Union Local 100, shutting down transportation in New York City in the dead of winter, was symptomatic of what awaits America as the virus of trade unionism takes over the public sector.

Although no one claims that New York transport workers were irreplaceable or particularly skilled, their average salary was already $52,000 a year — higher than mean annual incomes in New York City of $49,670, and much higher than the starting salary of college graduates with majors in accounting, finance, and economics ($45,191).

The unionized transport workers wanted to reduce their retirement age, with full pensions, from an already ridiculous 55, to 50.

The strikers eventually went back to work, having inconvenienced millions of New Yorkers, but the unions were not busted, their leaders not put in jail, and life went on.

It would seem that America, and particularly liberal New Yorkers, has yet to learn from the looming fate of General Motors.

Just as the labor unions created the rust belt and devastated the immense industrial plantations that were once the pride of the U.S., they are now ginning up their pension demands in the public sector, at local, state, and federal levels, laying the foundation for some really radical ripping of the social fabric.

And so, private pension funds are already showing signs of a fatal sickness. Can public pensions be far behind?

This entry was posted on Thursday, February 23rd, 2006 at 3:10 pm and is filed under Fund Managers. You can follow any responses to this entry through the RSS 2.0 feed. Both comments and pings are currently closed.

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