Financial Markets (2008)

ECON 252 (2008) - Lecture 18 - Professional Money Managers and Their Influence

Chapter 1. Introduction [00:00:00]

Professor Robert Shiller: The fundamental point that I want to make today is that while economic theory describes people as managing their — maximizing their — own utility and subject to constraints, most people have a lot of trouble doing that, particularly as regards to investing in financial markets. Most people are confused and find it just very difficult, so we have an industry of people who help people with their investments and we, moreover, have a whole array of regulations regulating the industry of people who help others with their investments. The problem is that most people are not that good at dealing in financial markets. They're mysterious, they're difficult, and, moreover, there's a tendency of psychological biases that cause people to get into mistakes. We talked about overconfidence — that most people think they're smarter than others — and it seems like people can easily get overconfident about their ability to beat the market.

What naturally happens, if not regulated, is that there will be others who will victimize and exploit these people. The classic story is some kind of stockbroker who promises to make great wealth for you by trading your portfolio and, in fact, doesn't really know anything; the guy is just a showman who is just pretending. There was a 1940s book called, Where Are The Customers Yachts?, which was a best-selling book. The title refers to the fact that stockbrokers give the impression that I deal with a very wealthy successful crowd of people and you are now one of the chosen people that I'm managing for. Some stockbrokers will pretend to be very wealthy — create the appearance of that — like they're associated with the rich people and it draws people in. But in fact, the customers often don't do very well because the stockbroker may churn their portfolio, keep coming up with new trades, and the broker is making money from commissions. That's the kind of problem that arises. As a result, a lot of people recognize the importance of giving help to people, so that's what we're talking about.

I want to talk mostly about portfolio managers, but I'll first talk about financial advisors and also financial planners and then I'll move to fiduciaries or institutional investors. We do not live in a world where people freely do business as they would like. The financial world is especially heavily-regulated. The first thing is financial advisor; again, most people don't know about these markets and they need someone to give them advice, so people set themselves up as financial advisors. In most countries, these are heavily regulated by the government. In the United States —

Chapter 2. Financial Advisors and Financial Planners [00:04:01]

Now, what is a financial advisor? I should define that for you. It's someone who gives advice about investments for some kind of fee or commission. It excludes lawyers, bankers, insurance salesmen, reporters from newspapers, professors. Even though these people may all give financial advice, it's not considered as part of law to be central to what they do, so they are excluded from the definition of financial advisor. It also excludes broker-dealers. If someone presents himself or herself just as a broker — that's someone you can call up and say, I want to buy a hundred shares of GM or whatever and the person does the deal — does the trade for you. That is also not a financial advisor, even if that person occasionally dispenses advice. It's only incidental to the business.

Financial advisors includes people who present themselves as offering advice to individuals and also includes analysts. These are regulated and there's something called the National Securities Markets Improvement Act of 1996 that says that all financial advisors with less then twenty-five million under management must register with their state regulator and if it's greater than thirty million, they must register with the SEC in Washington — Securities and Exchange Commission. If it's between, they can choose either one. They're all regulated and the government wants to be sure that financial advisors are — know what good practice is and so that means they have to take an exam. The exam is administered by what's called FINRA, that is Financial Institutions Regulatory Authority — formerly called NASD. See how this is getting complicated?

NASD is National Association of Securities Dealers and they started the NASDAQ stock market index, which you hear about all the time. NASDAQ is NASD Automated Quotation System. NASD merged with the New York Stock Exchange Regulatory Authority last year, so they've been renamed as FINRA. These are all these institutional details that I want you to know because it — it's boring, maybe, but I think it's what's true; it's what's happening; this is what drives so much that happens. FINRA says that if you want to become a financial advisor, you have to pass a Series — they call it Series 65 or 66 exam and then you are eligible, according to FINRA. FINRA is an example of an SRO, a self-regulatory organization. The government in the United States doesn't want to be making all the rules, so they allow industry groups to form their own self-policing organizations.

So, FINRA is the organization for financial advisors and that is an SRO and the SEC accepts their licensing. That's what you have to do to become a financial advisor. You have to take these exams, join FINRA, then you go to the SEC, and then you register as a financial advisor. The exams would warn you about all kinds of bad practices that — for example, about churning a portfolio. I just mentioned that, but I'll repeat it; that's when you call the guy up everyday and you say, I just got a hot new idea for you. Of course, yesterday you bought Microsoft — sell that, move to this. They just keep calling you up and that's — it's a way to get de-licensed if you are caught doing that because it can't work. If you trade everyday there's no — it's virtually impossible to make money because the commissions will eat you alive. You know these guys who are churning are fakes because they can't be getting a new idea everyday, so that's the kind of thing.

Now, financial planners are a little different. The designation of financial planner is not regulated directly, but we do have a self-regulatory association that manages them. We have the Financial Planning Association — that's their website, FPA.org — and they license — they provide their own designation. This is how it works in the U.S., particularly; they will certify someone as a certified financial planner and FPA will require that every financial planner first become a financial advisor. So, that's — this is a big organization. Incidentally, if anyone ever asks you, I need investment advice, where do I get it? It might be a good idea to direct them to that website because they'll help you get a financial planner, which is more than a broker; they're supposed to actually be planning for your life. That's the essential economic problem that we face.

Stockbrokers will often — this comes back to what Henry Paulson said in his proposal for reorganization of our financial markets. He thought — and I think this may reflect some essential wisdom — that we should have objectives-based regulation. Each organization should be focused on an objective. I think the objective of the organization affects what you do. If you are a stockbroker and if you present yourself as someone who will buy and sell stocks for you, you're probably not going to get into financial planning with your clients. If it's on your title, if you write this after your name — John Doe, CFP — then it says planner in your title. I think that affects what you do and it tells — what financial planners do is they say, let's sit down and think about your life goals. Do you expect to have children? Are you going to send them to college? This kind of thought, which is very important.

There's another one called — this is for financial advisors, NAPFA.org, National Association of Personal Financial Advisors. If someone asks you, where should I go for advice? This is another good website to go to because — what I like about NAPFA.org is that they have all of their advisors sign a statement that they will be fee-only advisors and they will never steer someone toward an investment that provides a kickback to them. That's a problem — that often a financial advisor will be really trying to make money selling you things that provide money; they're not unbiased. But NAPFA — it's part of their code of ethics that they're completely separate from any organization. They're pure financial advisors and they don't make money from commissions; it's only from the hourly fee.

What else? So, that's basically what I was going to say about financial advisors; it's a big industry and it's important. Actually, in my new book — I have no — I should say, I have no connection to this industry whatsoever, but I actually was saying that I think as a national policy we should subsidize this industry. I think people need more financial advice. Most people are just not with it enough; they're not getting the basic wisdom that — I think if we need more of this, we should subsidize it. I was just in Mexico over the weekend and I had the opportunity to meet the President of Mexico, which was exciting, and I also heard him say that he thinks Mexico needs more development of financial culture. This seems to be a thing that not enough Mexicans are really used to dealing with — sophisticated financial institutions — and so that's where we have to go with Mexico. I was saying, well it's just the same in every country; I think there's a problem.

The other thing — I won't say more about financial advisors, but let's move now to the other way that happens is that people will turn over their — actually, I want to come back to trusts later. Let me — the other — the really big industry that manages peoples' financial problems for them are institutional investors. These are groups that — organizations — that pool money from many people and invest a portfolio for them. I want to start by emphasizing how important they are. I want to just present you with the balance sheet for households and non-profits and just get some idea of how important institutional investors are. They're more important than these financial advisors because most of people's wealth is really managed by institutions. You don't have to ask any questions they just — you don't have to do anything; it's all done for you.

Chapter 3. Assets of U.S. Households and Nonprofits [00:15:20]

I wanted to show the balance sheet of households and non-profits and that's table B100 of the Flow of Funds Account; this is for the United States, but I think it would be similar in other countries. We have assets on one side and we have liabilities on the other, so we'll have assets and then we'll have liabilities. You might wonder, why do we put households and non-profits together? It's really because there are three types of persons that own things. There are individuals or natural persons; there are non-profit organizations, which are like individuals because nobody owns them — they own themselves. They're like people in contrast to corporations that are owned by individuals. Then, we also have the government, is the third. This is the non-government balance sheet, so it's just about everything in this country.

I just wanted to review — this is from the Federal Reserve and these are estimates, of course, and subject to error; this is for 2007, fourth quarter, which is the latest data. Assets are things that people own and liabilities are things that people owe and your net worth is your assets minus your liabilities. Let's start with assets. The biggest asset that people own in the United States — that households own is — and non-profits — this is almost entirely households though; non-profits are small compared to households. Real estate is the biggest thing and that is 22,438 billion dollars or 22 trillion dollars; people own this directly — it's their house. The second most — the second biggest thing is pension funds and that is 12 billion — I mean it's 12 trillion dollars — 12,779 billion; that comes right after real estate. Then we have equity in non-corporate business and that is 7,389 — sorry, it's 7,892 — it's almost 8 billion.

What is non-corporate business? It's businesses run by individuals, so it's like the low — if a family runs a little grocery store, then their ownership of that is represented here as non-corporate business. Or, if you're a barber and you've got your little barbershop. It all adds up; they valued all of these businesses and they valued them up totally as worth 8 trillion dollars. Then we have corporate equities — that's stock — and that is 5,447 billion or about 5 trillion dollars. That's stocks owned directly by households. Then we have mutual funds. Mutual funds are institutional investors that invest in stocks or bonds, but usually it's mostly stocks — 5.082 trillion. It's almost as big as corporate equities held directly. Then there's consumer durables — that means your car, your furniture; that's 4,035 billion. Bonds — 2,730 billion — not so much, not as big.

Insurance — I have everything ranked by size, so we're going down the scale. Insurance is — this is life insurance — 1,205. Then — I'm running out of room at the bottom — there are some other minor categories, but the total is — I would normally put it at the bottom, but I am running out of room at the bottom. The total assets total is 72,093 billion, so it's 72 trillion dollars.

Liabilities of households are mortgages — home mortgages — and that's 10,509. Consumer credit — credit cards — installment credit of various types — 2,551. Loans and other — 1,315 billion. The total liabilities is 14,315 billion. So, people own 72 trillion; they owe 14 trillion; the difference is net worth — 57,718 billion. So, that's about $192,000 per person in the United States. It's unequally held; this is just consolidating everybody. It's unequally held because rich people own more of this than poor people. The average family of four has about $800,000. I'm just multiplying $192,000 by 4. So, we have a lot of wealth.

The point here is, what form is it in? Well, real estate is very unmanaged; people own their own homes and there's not much institutional involvement except through the mortgage. Note that they owe about half — they only own about half of their home. The average person owes on the mortgage almost half the value of their home. If you took net worth in real estate, it would be only like 12 trillion dollars; assets minus real estate liability. By that account, the biggest asset that people have is apparently their pension fund; that's huge and that is institutional investors. The thing I wanted to make — the point I wanted to make about this is that institutional investors dominate just about everything. I mean, you've got real estate and non-corporate business, which are not easily managed by institutional investors. Beyond that, it's mostly institutional mutual funds and insurance. We live in a country where things are managed by professional investors.

Chapter 4. Mutual Funds, ETFs, and Spendthrift Funds [00:24:09]

Let's talk about — what is a mutual fund? A mutual fund refers to a structure of an investment company. They're much more important than hedge funds. Hedge funds are — we talked about those before — are designed for a small group of wealthy investors. Mutual funds are for the general public and the reason they're called mutual is that the fund is owned by the investors in it. The first mutual fund was called MIT — no connection with Massachusetts Institute of Technology. This was the Massachusetts Investors Trust in the 1920s. At that time, there were a lot of investor funds that were not — relatively — unregulated and they were offering investments to people that were oversold, often.

Often there were classes of shareholders. There was a class of prime shareholders who got the profits from the enterprise and then there was a class of other shareholders who were the hoi polloi. After 1929, many of the investment funds crashed and burned and people got very upset. They were very upset, particularly, that the investment fund was really being run for the profit and benefit of the guys who started the fund, not all the people who were in there. After 1929, there was some looking around as how should investment funds really be organized. Then attention became focused on MIT because it was an honest fund and they thought this should be the model for our investment fund industry.

What Massachusetts Investment Trust did is they said, everybody is equal and we're completely open about what we do. We publish our portfolio and most investment funds were secret. They were saying, well we're going to beat the market; we're not going to publish what we're doing. The MIT published its portfolio and it had only one class of investors. In fact, the fund was owned by the investors; it's a mutual fund, so if you put money in, you join the crowd. We invest for you and if you want to take your money out, we'll share your proportion of the whole portfolio. That was the concept, so the concept became very widely respected and the whole industry grew.

The Investment Act of 1940 — Investment Company Act of 1940 — it doesn't actually define mutual funds, but it defines structures that are used by mutual funds. After the Investment Company Act, starting in the 1950s, mutual funds began to grow and grow. They are regulated in such a way that the — as I said, everyone is equal in the fund; everyone benefits from the portfolio in an equal way. The rule is that if — you don't buy and sell shares in the mutual fund. The fund owns shares; you're putting money into the fund and if you want to get money out of the fund, you call them up or maybe you can do it on the web. You say — you place an order to withdraw money from the fund.

What they will do when you withdraw money is they wait until four p.m. on the day of your order and then they calculate what your share of the fund would be based on — four p.m. is when the stock markets close. So, at four p.m. you would get out at those prices and that was considered a fair and honest thing to do. They don't charge high management fees; there are rules about that. So, they have their own SRO called ICI, Investment Company Institute. That was created, I believe, in the 1940s. This has become the structure for the way most people — well, half the people — most small investors do not own corporate equity directly; they own mutual funds.

There have been some scandals about mutual funds that emerged in the last decade or so. There's something called late trading. What was happening was, sometimes these mutual funds didn't enforce the rules well enough. You would tell your broker, I'd like to withdraw money from the mutual fund. The broker would then sometimes call after four p.m. and say, my client really asked me to sell this at ten a.m. this morning. I know it's five p.m., but trust me, I'd like to get out. Mutual funds would let this happen. Then it turned out to be abusive. Why is that abusive? If you're a mutual fund and you get this call from a broker saying, trust me my client asked me to get out at ten a.m.; I know it's five. Can we get out? Well, that turns out to be a bad practice because what ended up happening was people abused that. They would wait until five or six p.m. and they would observe what seems to be happening in the markets. If it's going up, then they would say, we want to put money into the mutual fund. If it's going down, they would say, we're trying to take money out of the mutual fund.

You see how that hurts the other mutual fund investors because you do it strategically. You do — if you know the market is up, you're trading on stale prices — on old prices. So, obviously you could make money doing that and this got a lot of attention in the newspaper — the late trading. There was another variation on that called market timing, but it's basically the same thing — where mutual funds were not enforcing the rules properly and so some people were trading at four p.m. prices, effectively after it. They've cleaned up this act, so I think that mutual funds are our most trusted way of investing in the stock market and most people won't invest in individual stocks anymore; they just go through mutual funds.

There is another kind of thing that has developed more recently and it's called an Exchange Traded Fund or an ETF. These were created first — these are relatively new. These were created first at the American Stock Exchange in 1993 and they're different from a mutual fund. I didn't show them separately on this; they're much smaller than mutual funds, but I believe they're less than a trillion dollars. They must be in one of these other categories up there.

Exchange Traded Funds are different than a mutual fund in that they are traded on a stock exchange. The first Exchange Traded Fund was a company called the SPDR — that's Standard and Poor's Depository Receipt. But now, there is a proliferation of Exchange Traded Funds. What is an Exchange Traded Fund? Exchanged Traded Fund is epitomized by the — this is the S&P 500 — it's a portfolio that is managed according to rules; it's not judgmental. You cannot call up the Exchange Traded Fund and say, I want my money back. It's different from a mutual fund. If you get — you would buy or sell an Exchange Traded Fund on the stock exchange. The fund is traded — the Exchange Traded Fund holds a portfolio, like the SPDR holds a portfolio equivalent to the S&P 500 and they pay out dividends on that. But in the meantime, you can buy or sell shares in the fund on the stock exchange.

They also have what are called creation units, which are in large denominations, like millions of dollars. Institutional investors can either create or redeem shares in the ETFs, but you as an individual cannot. If the creation unit is one million dollars, then an institutional investor who is an authorized participant and has signed the right papers can go to the AMEX and say, I want to create ten million dollars of new SPDRs. Then, the AMEX will — that's ten creation units. I forget what a SPDRs creation unit is, but let's say it's a million dollars. Then the AMEX would say, alright, you have to give us the stocks in the S&P 500 in the proportion that they are in the S&P 500, equal in value to ten million dollars. That becomes one creation unit and then they'll give the institutional investors the shares to sell.

Conversely, the institutional investor can go to the AMEX and say, I want to go the other way. I've got 10,000 shares of these ETFs; I want the stocks back. So, the institutional investor can present the shares to the AMEX and the AMEX will then give them the shares in the S&P 500. That enforces the price of the ETF equal to the price of the underlying stocks. ETFs were designed so that the price of the ETF tracks the price of the underlying stocks. In contrast, those things called Closed End Funds, which are similar, but they don't have the creation units. Closed End Funds — the price of the fund on the stock market tends to go through either a premium or a discount depending on the market, but ETFs tend to track well. That is, the price of the ETF tends to correspond to the price of the underlying stocks; whereas, closed end mutual funds — closed end funds track poorly. So, ETFs are the new things that have developed.

I said I would talk about personal trusts. This is something that is of less — somewhat less — importance, but it's about a trillion dollars in our modern economy. What is a trust? It's another form of institutional investing. A trust is a — it's often a department of a bank that manages money on behalf of an individual or family. For example, suppose your parents are concerned about you and they don't trust you — they trust the banker, not you — and there's a family fortune. Maybe it doesn't have to be that big, but let's say it's a million dollars. They could give it to you, but they might not. I don't know what your parents are doing; they're doing this behind your back and maybe not telling you in great detail.

Of particular importance, as an example, is something called a spendthrift trust. What is a spendthrift? It's someone who can't save money and squanders it. Your parents can go to a bank and set up a spendthrift trust on your behalf and the spendthrift trust will then pay you an income for life. Or, they could even go beyond your life; they could go to your children or whatever. That prevents you from squandering the money — from going to the casino and gambling it away if your parents don't trust you. You see the idea? The bank then will manage it for the rest of your life and your parents will die and you will outlive them, but that money will be stuck in that trust and you can't get it out because they set it up and it's there.

The manager of the trust is a fiduciary who is, by contract, is supposed to be managing in the interest of the child — the spendthrift child. Of course, everyone — all these people will be dead before you are. Your parents will die; the person they talked to at the bank setting up the trust will die, but when you're ninety years old there will be someone at that bank — some person much younger than you — who was appointed in succession to manage your trust and will continue to pay you that income out of your trust. Now, if there's another reason why your parents might be doing this, which — you might be angry with your parents if they did this, but they might do it for another reason. That is, you could get married and get a divorce and they're worried about this really awful person you married taking half of the family money when you get divorced. They lock it up in a spendthrift trust and then after the divorce the trustee will say, no way, I'm bound to pay this person — not the wife or husband — the amount of money for life. It apparently works. So, that's another reason why families will do this because they don't want to give the money to the awful person you married.

In Common Law countries, trusts are — that's the U.S. and the UK — trusts are well-defined in law and a trustee has well-defined rights. If you are — and it doesn't have to be a bank; you could have a friend of yours become a trustee. In Common Law countries, there's a nice segregation of the assets in the trust and the assets of the trustee. Suppose you ask your brother-in-law to serve as a trustee for your children and then your brother-in-law gets into some bad financial situation and goes bankrupt; courts will not be allowed to take the Trust that the brother-in-law is managing for your children. This wasn't so clear in Civil Law countries, such as in Europe. The typical trust in Europe has been that you would go to a bank and the bank would manage the trust for you. If the bank went under, you might lose the money. Maybe they're more trusting of their banks in Europe, but I think this is also changing. The law is always changing.

Chapter 5. Pension Funds: A History [00:41:53]

Now, I want to come to pension funds, which are the most important kind of institution. You can see up there, that's the twelve trillion dollars. It doesn't include — this pension fund here does not include Social Security, which is of comparable magnitude. The government runs its own pension fund, in effect, called the Social Security System and that's not shown here. Pension funds are private funds managing a portfolio of assets. The Social Security System does not manage a substantial portfolio of assets. The Social Security System, which is a — it's not on here, I'm just mentioning it as an aside — was set up by U.S. Congress in 1935 to provide for the elderly and also for disabled and orphaned children. But, the main Social Security provides for the elderly. It does so without investing — there is something called the Social Security Trust Fund managed by the government, which invests in assets to help the government pay out on social security.

However, the Social Security Trust Fund is only, last time I heard about it, one trillion dollars [Correction: the Social Security Old Age and Survivors Insurance Trust Fund assets rose from 1.07 trillion dollars in 2001 to 2.02 trillion dollars in 2007.]. So, the government is not investing much compared to these pension funds; pension funds are much bigger. These are agencies — private agencies — that invest on behalf of people for their retirement and they are a very important element of our economy. They help us solve the essential problem that everyone goes through their life cycle — you're young; you're healthy for a while; you're working. Then, your health starts to deteriorate and then you have years or decades when you are either not inclined to work or cannot work and this happens with such regularity that it requires some kind of professional management; that's what pension funds do.

I want to talk about these in some more detail. It wasn't until the nineteenth century that we had them, which is kind of surprising because it's such an important problem. Even in the nineteenth century they were few and rare. The first U.S. — I think they go back earlier in the U.K. and in places in Europe, but in the United States the first corporate pension fund was American Express in 1875. American Express, then, was not a credit card company; it was a shipping company or transportation company. This first pension fund was for the employees of American Express and the original terms were, you had to work there for twenty years and past the age of sixty and you had also to be disabled. If you satisfied those — if you were over sixty, you had worked at American Express for twenty years, and also were disabled — you would get 50% of the average pay for the last ten years you worked there.

This is the earliest model in the U.S. and that gradually became copied by more companies. It became more and more important as we moved into the twentieth century because life expectancy was going up. There were relatively few people with — the life expectancy at 1900 was something like forty-five years; I don't have the exact number. So, sixty was a milestone that a lot of people didn't reach. Of course, many did as well, so it's not — this was important even then.

The original pension funds tended to be done for the benefit of the employer in the sense that, like the American Express, you had to work there for all of twenty years in order to get anything; it was all or nothing. If you worked there for nineteen years, then too bad; you got nothing. It didn't seem well-designed, but it was designed to keep people there; they didn't want people leaving. So, once you signed on to American Express, you were kind of stuck there because you didn't want to get out; you'd lose your pension. It wasn't very big — or big institution. In Carnegie Steel — pension plan was 1901 — Andrew Carnegie — which was a milestone because it started to establish the principle on a — this was the first big company to establish a pension fund.

It grew through the first few decades of the nineteenth century and by 1929 there were many pension funds. They started doing union pension funds. There were the cigar makers — that was a union — granite cutters and cigar makers — 1905. Locomotive engineers — that was 1912 — but many of these funds failed in 1929 and they were offered by companies for their employees or unions for their members. When companies offered pensions for their employees, that was a risky thing because companies go bankrupt; it happens all the time. If they go bankrupt, how are they going to pay the pension plan? Well, that was tough luck for the employees. That was a less enlightened time. They didn't — the point was that they rarely funded the pension funds.

In the early decades of the twentieth century, Carnegie Steel just — I don't know about Carnegie, but generally, they just promised to pay. They just said, we will pay you when you retire; out of what, you might ask. Well, that wasn't explained, but it had to be out of profits. What if they weren't making any profits? Well, people didn't seem to anticipate this. After 1929, these pension funds became discredited because so many of them failed. That led to an idea that we had to do something different.

The big milestone in pension history is the General Motors Pension Fund, GM Pension, which was created in 1950 and it was promoted by GM Chairman, Charles Wilson. I visited them recently; they're in that building right across the street from the Plaza Hotel at the corner of Central Park; they're a very big organization now. The thing that GM Pension Fund did, it invested — it funded — so, they started investing money on behalf of the pensioners so that if GM were ever to go bankrupt, there would still be money in the fund. Not GM Stock — this was the most amazing thing — General Motors was investing money for its pension fund and of all things it wasn't buying GM stock. Some people thought, why wouldn't they buy their own stock? That would push the price up. Of course, it's not enlightened to buy their own stock because — that would be stupid to invest the pension fund in your own stock because the stock would become worthless in the same circumstance that you would be unable to make good on the pension, so it wouldn't do any good.

It just seems obvious that companies should fund their pension funds and should invest in something other than their own stock. That may seem obvious, but it took until 1950. One thing that strikes me about financial history is that it seems like we go for such a long time doing things that are obviously not right and, as long as there's no crisis, nobody pays attention to it. Then, we have this huge crisis, like the 1929 stock market crash, and then it's only after the crisis that anyone thinks about it.

I don't know what was happening for the first thirty years of the twentieth century; they had all these pension funds, but the whole idea seemed to be faulty. Why would you think that your company can support you in your old age? That's decades in the future. The chance that your company would go under has to be substantial, but people don't seem to see these risks and they don't think about them until there's a big crisis. That's why I think that we are at an opportune time right now with another financial crisis; it's a time when people might be willing to think about how to do things differently.

The next big crisis in pension fund history was the Studebaker default in 1963. Have you ever heard of Studebaker? None of you have heard of them? They made cars. They were one of the big — I don't know how many carmakers in the '50s and '60s. You probably still see these on the road, but they're getting quite rare because that was forty-five years ago. They were big for a while. Anyway, the company went bankrupt in 1963 and now they claimed to have funded a pension plan. They were learning from GM and they were investing a pension plan for their employees in assets that should have survived a bankruptcy; so they thought.

After the bankruptcy, they found out that they had underfunded the pension plan. That means that they didn't put enough money in to pay what they promised to pay, so while they had it they just didn't put enough in. Then people started getting angry obviously; people that worked their lives at Studebaker — they were told that they had a funded pension fund. When they — later they found that they got nothing or at least very much reduced. People started looking at the union, United Auto Workers. Isn't the United Auto Workers supposed to stand up for the rights of the employees and shouldn't they be looking at the pension fund and demanding that Studebaker fund it adequately? Well, they were not — they were asleep at the switch.

Some people accuse the UAW of complicity with Studebaker — that basically the UAW was not paying attention to the distant future because they didn't think that their members really cared. UAW wanted, when they had negotiations with Studebaker, they wanted big pay increases now; they didn't care about funding the pension fund. Why didn't they care? Well, because the workers at Studebaker didn't know or understand this and so the workers were not attuned to this. So, the union thrives on getting something that looks valuable to the employees, but the employees were being deceived. Both Studebaker and the union were in it together against the employees, in a sense; so, this created a lot of anger about failures of pension funds.

Chapter 6. Modern Innovations for Pension Management: ERISA and Beyond [00:54:53]

I'm talking about financial crises of years past. We're going through a subprime crisis right now and this is just one of a series. Every time we have a financial crisis we make fixes. In reaction to the Studebaker — it took ten years, but the Studebaker default set in force a dialogue about how pensions should be managed. That led to ERISA 1974 — actually eleven years later. ERISA stands for Employment Retirement Income Security Act and it then required funding — it required adequate funding. Studebaker had a funded pension plan, but it was underfunded, so that's what ERISA created. They also created the Pension Benefits Guarantee Corporation, the PBGC. This is a government — well, it's a government-sponsored enterprise that insures — the Pension Benefit Guarantee Corp.

It's like the Federal Deposit Insurance Corporation, which guarantees your bank deposit; it guarantees your pension plan. So, the PBGC then receives dues from pension plans and the pension plans then, if they were to fail, would get — the pensioners would get a payment from the PBGC. The PBGC is supposed to monitor the funds of pension plans — make sure that they're adequately funded. Then if they are not adequately funded, then they would make up the difference. Now, ultimately the PBGC has a portfolio of assets, which it accumulates from the fees paid to it by the pension funds. That portfolio of assets might not be adequate in a huge crisis, so Congress might have to step in to support the PBGC; otherwise, the PBGC is not taking taxpayers' money.

Recently, the PBGC has come under some attack because after the stock market — it's very hard to know whether a pension fund is adequately funded or not because it all depends on assumptions about asset prices. During the run up of stock market in the 1990s, firms started cutting back on the amount they contributed to their retirement funds because the stock market had made their plans look very rich. There are people like me claiming that it was a bubble, so the prices were not going to stay at this level, but it's kind of hard to prove that point.

So, companies in the late '90s were not — they were putting their money in risky stocks and saying they were adequately-funded when there were people like me who were doubting that. The PBGC, being a government organization, didn't protest — after the stock market came down after 2000, it put the PBGC in jeopardy. Fortunately, the market went back up again and kind of bailed them out.

The ERISA Act also embodied something called the Prudent Person Rule. Actually, in 1974 they called it the Prudent Man Rule — that was because '74 was just before we tried to use non-sexist language. So, the Prudent Man Rule is now the Prudent Person Rule, but I'll read what the ERISA said. The Act said, "Investments must be made with the care, skill, prudence, and diligence under the circumstances then prevailing that a prudent man, acting in a like capacity and familiar with such matters, would use in the conduct of an enterprise of a like character and with like aims." That's lawyer-ese, but basically what they're saying — the fundamental problem that even if you get beyond the deliberate underfunding of a pension plan, you still get the possibility that the pension managers will do something wild like put everything in the stock market or they could be leveraged investments in the stock market. They could say, we're funded enough because with this hugely-leveraged portfolio we should have enough money, but that wouldn't be prudent.

If the government is guaranteeing pension plans as they started doing with the PBGC, then they've got to prevent that because they can't just let companies just do wild investments. This put the government in a funny circumstance because it was starting to tell these funds that they had to be doing sensible investing. What is sensible investing? It actually was a difficult thing to define. Look at Yale University. Back in — when David Swensen came to Yale, most universities put their money in sensible, safe, government bonds; stocks were considered risky. But Swensen said, no let's not do that; let's put into these strange, alternative investments and after the fact he turns out to be right. Was he not prudent? Do you want to tell investment companies that they shouldn't do that?

It's a difficult question and the question is: how far should a pension plan go in taking on risky investments? The law created this strange Prudent Person Rule, which says that an investment company should do whatever a prudent person would do; it created an unfortunate environment for pension fund management. Basically, they're telling pension fund managers, don't use your own judgment; do what somebody else would do and you manage the portfolio. I mean, that's law; you've got to do this. It's in the law as a manager, so it's a slippery business to be in.

I have on the — I don't expect you to go to read this because it should be in the library, but O'Barr & Conley [Willam M. O'Barr and John M. Conley, Fortune and Folly: The Wealth and Power of Institutional Investing, Homewood Illinois: Business One Irwin, 1992] wondered how pension funds deal with this strange situation that they're put in. This is O'Barr & Conley, who wrote a book. One of these is an anthropologist, so we're getting a little bit of insight — I mentioned, I like to take insights from all the different social sciences. Anthropologists like to go into some primitive village somewhere in the world and interview people who live in a very different culture and try to learn about them. What an anthropologist does is goes into some village and doesn't disturb their — tries not to disturb their culture; doesn't start explaining things, just listens and tries to understand how they think; has to learn their language and listen to their — presumably to get insights about human behavior from the experience of immersing oneself in some other culture.

These people went to interview pension fund managers with the same techniques that anthropologists use in primitive villages and they concluded that pension funds are — they were rather critical of pension funds. The pension funds are living in this strange world created by ERISA, which requires that they behave as somebody else would. It kind of separates them from any real sense of their mission; they're regulated so heavily.

So, what O'Barr & Conley found is that — they engaged people in discussion; they listed to what managers of pension funds would say on their own without suggesting the topic of conversation. What they found was that managers were very much aware of the Prudent Person Rule and that they were always looking to shift blame — possible blame. They were also thinking of some lawsuit that they could eventually be embroiled in and they were always saying, well this is what a prudent person would do. They talked a lot about the law and relatively little about economics or the objectives that they're supposed to have about how do we get to the management of — how do we manage this portfolio to provide for the benefits to our employees in the future.

It's interesting that as anthropologists, they took note of what anthropologists have noted in many primitive societies. If you let people living in some isolated culture talk, they tend to come up eventually with a creation myth. This is a term that anthropologists use; every primitive society — you can ask them, where did it all start? They will generally have a story about the creation of their little village or their people, which involves some great man or god that founded everything. There's some story about this person and a sense that we are the chosen people — that we're the — we have some values or — and it's built around a story of some great man or woman, I suppose. What they said was, that's one of the things they heard most commonly — the creation myth. So, they would say, our pension fund was started by so and so forty years ago; this person had great insights and we're living in this tradition ever since.

Anyway, ERISA came in at more or less the end of era. There are really two kinds of pension plans; there is defined benefit and defined contribution. There's a fundamental difference. A defined benefit pension plan tells you that the pension will pay you a certain amount. For example, I mentioned the very first U.S. pension fund — American Express. It promised to pay you 50% of your average pay for the last ten years that you were employed. You were told this when you started the job that this was your plan, so that defined the benefit you would get.

Until 1974, virtually all pension plans were defined benefit. There were some exceptions, but it was the overwhelming norm. Labor unions liked defined benefit; it sounded right to them, but the contrary kind is called defined contribution. In a defined contribution plan, the pension plan does not promise you anything about what your retirement income will be. They merely say that we are going to contribute a fraction of your salary to a portfolio that will be managed to provide you income when you retire. The amount you get will be determined by the portfolio and not by any arbitrary rule. There's nothing like 50% of the last ten years of your income. The defined contribution plans got their biggest impetus in 1981. So that's what, seven years after ERISA with the advent of what was called 401(k) plans. 401(k) is a paragraph in the Internal Revenue Service Code — that's the tax — that's the IRS, the agency of the government that taxes everyone.

Section 401(k) of the IRS Code defined circumstances in which money held in trusts for others might not be taxable. In 1981, for the first time, a company invoked this clause to ask that the defined contribution plan that they were setting up would not be taxed. Well actually, to make it clear, what it would be is if the employer or employee made contributions to the plan, then there would be no tax — that would be a tax deduction for the amount of the contribution until later — after the person retires. It would be taxed many years later as ordinary income when they received it. By postponing the tax, it was a significant tax advantage.

After 1981, there was a tremendous revolution in our tax — in our pension system because it led — first of all, people liked tax breaks and it sounds good to get a tax break. But secondly, people start — unions were declining. Unions, which had always advocated defined benefits, were declining as a force in the U.S. and people were developing in the United States more of an investment culture. They liked the idea that they would have a defined contribution plan where there would be a portfolio, which is theirs, which is being invested for their retirement, rather than trust the company to provide a benefit in retirement. The general public showed a strong preference for defined contribution plans after 1981 and so that is a big force.

The U.S. was a leader in defined contribution plans, but it is now spreading all over the world. I think it again reflects the change in our world culture. So, they're growing in Europe and other — I guess Mexico's — Chile — so many of the pension plans now are of the defined contribution variety — even government pension plans. The government social security plan in Chile invests for you and there's a portfolio and you can get on a website, I understand. I've never done it in Chile, but you can see what the balance is in your account.

Another thing that defined contribution plans began to do with the advent of 401(k) is they would allow you, as an employee or as the pensioner, to choose the general categories of investments. That would typically — in a defined contribution plan after 1981, there would be a number of mutual funds that you could invest your pension money in. Though you couldn't take it out until you retired, you could choose which, from a selected list of mutual funds, you could invest your money in. This helped promote mutual funds dramatically and it also created more of an investment culture in our society. That's where we are now. The defined benefit pension plan is declining rapidly; ERISA is still not irrelevant because they're still important, but ERISA is becoming less and less important. We're moving on toward a country — when you get your first job, the first thing you will get, I can predict, will be a 401(k) plan; you will probably not be given a defined benefit pension.

[end of transcript]