‘Uninvested’ by Bobby Monks despaired of the rise of Defined Contribution (DC) plans in the private sector while an issue paper out of the Manhattan Institute sees DC Plans as cost-effective. Both provide some interesting information (which I excerpt below) but both miss THE major point as to why Defined Benefit (DB) plans dominate in the public sector:
You can lie about the costs of DB plans since public workers are happy to believe the promises, politicians are happy to accept low-ball contribution amounts, and actuaries are happy to supply those phony numbers – for a fee. Add to this mix the total lack of informed oversight – from either regulators, the media, or taxpayers – and default becomes inevitable. DC plans are the only alternative for public plans but their inherent transparency makes them anathema to public workers who would not be happy having everyone know the real cost of their benefits, politicians unhappy about having to pay that real cost, and actuaries unhappy about losing all those fees.
Excerpts from ‘Uninvested’ which includes eerily familiar criticism of the financial-product sales system
8. Zero Accountability. In an industry that’s far less concerned with generating returns than collecting fees, there’s little incentive to enforce accountability internally or externally.
9. Dirty Data. Most Money managers base their investment decisions on unreliable information sources, such as accounting statements and conventional credit ratings that are paid for by the very companies they profess to examine. (pages 14-15)
Then Enron scandal and the crisis in mortgage-backed securities exposed the impotence of conventional accounting, auditing, and credit-rating practices. Other traditional watchdogs such as government agencies and investigative journalists are less equipped than ever to take on a financial sector with superior power, resources, and influence. (pages 17-18)
The US government launched an investigation into the raft of defaults, and in 1967, Senator Jacob Javits introduced legislation to develop stronger rules for governing the pension system. (page 24)
many firms that sell and manage IRAs and 401(k)s steer their customers into an investment designed specifically for people who don’t know what they’re doing – the mutual fund. (page 33)
Another issue is that 401(k) advisers and administrators often double as brokers. In exchange for managing a company’s 401(k) at a reduced cost, or for free, that administrator may be allowed to handpick the investments offered in the plan….IRA plans may also steer consumers into non-optimal investments. Fidelity offers a number of IRA plans that exempt customers from setup, maintenance, and transaction fees – as long as deposited funds are used to buy Fidelity mutual funds. (page 34)
Defined benefit pensions are rarely offered by new companies and startups today. Though the amount of assets held by these plans remains significant, especially in the government sector, the model creeps inevitably toward extinction. The risk and responsibility of saving for retirement has been shifted, perhaps permanently, from employers to employees. (page 35)
Or perhaps they thought that someone – their financial advisers, elected officials, or government regulators – would protect their interests and watch their backs. (page 38)
Dependent on their corporate masters, accounting firms, auditors, and credit-rating agencies have become a dangerous source of misinformation, and investors and their money managers should recognize this when basing investment decisions on their analyses. (page 50)
The truth is that no one is watching while investors sleep. (page 52)
The SEC, a US government agency, regulates RIAs. Brokers are supervised by FINRA, a self-regulating organization funded and managed by financial corporations. (page 61)
Indeed, fund managers make money whether they win or lose. Investors pay fees no matter what. This model has its roots in poorly designed regulations that distort the investor-financial adviser relationship with misguided incentives. Remarkably, one of the most significant laws governing today’s financial industry was passed more than seventy years ago. The Investment Advisers Act of 1940 forbids investment advisers from being compensated “based on a share of capital gains on, or capital appreciation of, the funds of a client.” This statue effectively prohibits investors from rewarding their money managers for investing their capital successfully. The rationale is that paying them based on the returns they generate would encourage irresponsible risk taking in order to maximize pay. Congress has exempted high-net-worth individuals and institutional investors from the Investment Advisers Act’s compensation provisions, however. The “performance fee” restriction leaves a loophole for “persons that the Commission determines do not need the protections” – that is, high-net-worth individuals and institutions -” who are financially experienced and able to bear the risks of performance fee arrangements.” This is why direct access to private equity and hedge funds is generally restricted to wealthy clients. (page 94-5)
hedge funds are directly accessible only to wealthy investors: individuals and organizations such as pension funds, mutual funds, and other hedge funds with a net worth of at least $1 million. (page 107)
The standard arrangement, known colloquially as “two and twenty,” features a management fee of 2 percent, which the fund collects simply for managing the money. There is also often an incentive fee that entitles the fund to pocket 20 percent (or more) of any returns it generates with an investor’s capital above some threshold. (page 107-8)
Hedge funds are extremely opaque and have no obligations to disclose details about fund management, holdings, fees, expenses, or performance. They are not required to maintain any level of liquidity. They are not compelled to make shares easily redeemable. They are not required to protect investors from conflicts of interest or even to price shares “fairly.” (page 109)
Excerpts from ‘Defined-Contribution Pensions Are Cost-Effective’
Governments that have considered switching to DC plans have encountered significant resistance from organized labor, managers of current public-retirement systems, and the cottage industry of consultants that supports public DB plans.
Perhaps the most vocal critic of DC plans is the National Institute for Retirement Security (NIRS), a Washington, D.C.–based nonprofit started by public DB plan administrators and associated inter- est groups. In 2008 and in 2014, NIRS published reports asserting that DB plans provide benefits at nearly half the cost of those provided by DC plans. Such advantages are inherent in the DB model, NIRS asserts—any plan sponsor who selects a DC plan over a DB plan is thus choosing an inferior benefit at higher cost.
This paper finds that claims that DB plans are more cost-effective are not supported by empirical evidence, are driven by false assumptions, and ignore pension debt as a significant cost driver for DB plans. Both theory and practice suggest that well- designed DC plans can deliver benefits at least as efficiently as DB plans.
The bottom line: most DC plan members now invest in well-designed, diversified, professionally managed in- vestment products—thereby mitigating many advantages that institutional investors formerly enjoyed.
There is also evidence that institutional investors are susceptible to shortcomings of their own. Recent papers have found that state and local pension plans tend to over-invest in in-state equities and alternative investments. Further, there is evidence that ac- counting rules for U.S. public pensions incentivize riskier investment behavior than do those of other countries. Pension-plan investments have become politicized, too: activists have demanded that pension plans invest in or divest from various companies— from producers of green energy to fossil fuels to weapons—for reasons unrelated to shareholder value.
NIRS’s 2014 paper acknowledges that DC plans can achieve investment-return results on par with DB plans but only, it asserts, in the rare case of the “ideal” DC plan. This paper finds that the results embodied in such a plan are far less rare than the NIRS assumes—in fact, for at least a decade, DC plans have delivered investment returns as good as those achieved by DB plans.
In practice, however, the fee estimates used by the NIRS and other DC plan critics generally under- state DB plan costs and/or dramatically overstate DC plan costs. Recent work has shown that DB plan fees, at least in the public sector, have increased significantly over the past decade, with average total cost roughly double the figure used in the NIRS papers. A Pew Charitable Trusts / Laura and John Arnold Foundation paper showed that public-sector DB plan investment practice has changed dramatically during the past 30 years: in 1952, only 4 percent of plan assets were invested in equities or alternatives; by 2012, more than 70 percent were.48
Within this shift toward risky assets, alternatives have recently begun to make up a larger share of public DB plan portfolios—more than doubling during 2006–12, from 11 percent to 23 percent. Public DB plan money-management fees have also grown significantly for statewide public plans— from approximately 28 basis points in 2006 to 37 basis points in 2012.