Friday, March 27, 2015

A Buyback or Biotech Bubble?

Steven Davidoff Solomon, professor of law at the University of California, Berkeley, wrote a comment for the New York Times, General Motors’ Stock Buyback Follows a Worrying Trend:
General Motors' announcement that it will buy back $5 billion worth of stock raises the question of whether the stock buyback has turned into a shareholder activist shakedown.

G.M. did not open its coffers willingly. Harry J. Wilson, a former member of the auto industry crisis task force led by Steven Rattner, gave it a helping hand. A few weeks ago, Mr. Wilson announced a campaign to press G.M. to buy back $8 billion worth of stock, leading four hedge funds with a total stake of about 2 percent in the automaker. As part of this, Mr. Wilson was nominated to run for a board seat.

Because G.M. was bankrupt only a few years ago, it seems a bit foolhardy for the company to willingly part with billions of dollars of hard-earned cash. But in a world where stock buybacks and shareholder activism are all the rage, it makes perfect sense on paper, if not in reality.

As activist hedge funds take aim at companies left and right from their spreadsheet-laden war rooms in Manhattan’s glass towers, their expertise is financial engineering, not running companies. And so the activists love to argue for sales, split-ups, stock buybacks and other financial machinations. The idea is that a quick financial event is more likely to generate immediate returns than the harder and longer-term work of building value.

According to a report by the law firm Schulte Roth & Zabel, as recently as 2013, 13 percent of activist campaigns sought a cash return. The call to return cash is based on the fact that United States companies are extraordinarily profitable and are building cash mountains when interest rates are at record lows. With limited ability to earn decent returns, activists have pushed hard for companies to return the cash to shareholders.

Companies that want to return money to shareholders have a choice: They can pay a dividend or buy back shares. In the former case, the calculus is easy. Assuming that there are no big tax issues, a dividend is just a return of cash to shareholders. But buybacks do more by taking shares out of the market. A buyback does not create wealth; theoretically, the cash disappears with the shares. But it does increase earnings per share and usually lifts the stock price, giving the remaining shareholders a bigger piece of the upside.

Buybacks make sense if a company’s management thinks its shares are underpriced and thus thinks it is getting a bargain. The peril in any stock repurchase, of course, is that the company pays too much.

But when have executives ever thought their company’s stock was overpriced? So companies choose the buyback. According to a highly influential article criticizing buybacks in The Harvard Business Review by William Lazonick, 54 percent of earnings — $2.4 trillion — went to stock buybacks and 37 percent went to dividends for the 449 companies in the Standard & Poor’s 500-stock index that were publicly listed from 2003 to 2012. According to a Barclays report, stock buybacks totaled $535 billion for the year that ended September 2014.

But returning cash isn’t all that a buyback or even a dividend does. The core idea behind a share repurchase is that it will make the company more disciplined.

Think about a world where you can have all the doughnuts you want. You just might eat a few too many. If a company like G.M. has an extra $5 billion sitting around, the thinking goes, it might decide not to invest wisely in the business or make smart acquisitions but instead simply use the cash less efficiently, like paying higher executive salaries.

Mr. Wilson’s argument for a large stock buyback was based on this conceit. In an interview with CNBC, he said that in the auto industry, when “times are good, they overinvest and make bad acquisitions, they overspend.”

But buybacks can leave a company without needed cash. G.M. had many buybacks before the financial crisis, totaling $20.4 billion from 1986 to 2002. It certainly could have used the cash then. Mr. Wilson is aware of this issue and stated in the CNBC interview, “We have always agreed that the company should have enough cushion” but that it was “enormous.”

And there is always the risk of overpaying for shares, especially now. With zero-interest rates, the stock market is bound to be high, and buying now may not make sense. In fact, most buybacks these days tend to destroy value because of their inflated prices.

Other problems can arise with buybacks. Mr. Lazonick has argued that repurchases leave little for “productive investment” and should be banned. The Economist called them “corporate cocaine” and cautioned that some companies may be borrowing too much to pay for them. Companies may also end up using buybacks to manage expectations for earnings per share, especially when large numbers of stock options are outstanding.

Still, the noted valuation expert Aswath Damodaran asserts that much good could come from share buybacks and that banning or regulating buybacks falls “squarely in the feel-good but do-bad economic policy realm.”

The vibrant debate shows the pros and cons of share repurchases, but G.M. was apparently unswayed by the cons.

The automaker quickly capitulated to the $5 billion buyback, with Mr. Wilson agreeing to withdraw his candidacy for the board, despite disagreement from another large shareholder, Warren E. Buffett. In an interview with CNBC, he said, “I think the idea of trying to do something now that gets a little pop in the stock should not be on” G.M.’s agenda.

At the end of the day, G.M. decided it was better to retreat than to fight. The activists know that the companies are feeling defensive. Even though Mr. Wilson’s group owned just 2 percent of the company, a contest would have been difficult and expensive. The $5 billion turned out to be the cost of doing business. As Marketplace put it, “Please shut up and here’s some money.”

Going forward, G.M. will aim to keep $20 billion in cash on its balance sheet and return free cash flow beyond that to shareholders. It had built up about $25 billion in cash as its sales and profits rebounded after its 2009 government-led bankruptcy.

The G.M. episode may signal a turning point. In good times, it is easy to get too comfortable. Technology companies like Google and Microsoft are stockpiling foreign cash. Others are racing to buy back shares at high valuations. But the good times inevitably end, this time most likely led by the activist stampede.

The haste in which G.M. rushed to comply to Mr. Wilson’s demands, and they and other companies shed cash rather than fight, shows that the activist tide pushing the stock buyback may have gone too far. Let’s hope that it doesn’t wash out companies and shareholders.
The stock buyback bubble is something that receives little attention from the media but buybacks have soared to record levels, and by the way, it has little to do with the "activist tide" and everything to do with a compensation system run amok.

Yes folks, we can blame "evil" activist hedge fund managers but America's CEOs have never had it this good. Ultra low rates, cheap debt, record cash levels are allowing them to buy back shares at a record pace, artificially boosting their earnings-per-share and padding their disgustingly bloated compensation which also includes lavish pensions as they shed defined-benefit plans and jobs to cut costs and increase profits.

Forgive my sarcasm, but if this is the "golden era of capitalism," god help us all. And make no mistake, everyone is in on this buyback binge. I check out news articles on buybacks every day, and it shocks me to see how many big companies are buying back their shares. Yahoo (YHOO) just got approval from its board to buy back an additional $2 billion in company shares, and Merck's (MRK) board just approved a whopping $10 billion repurchase program.

And Apple's buyback activity may not be enough for Carl Icahn, but during the fourth quarter of 2014, it was good enough to top the S&P 500. According to a new analysis from financial research firm FactSet, Apple spent more in buybacks than any other S&P company — even as year-over-year buyback spending for the overall index declined:
FactSet reported that during the fourth quarter, aggregate share buybacks by S&P companies totaled $125.8 billion, down 4.4% compared to the same time in 2013 and down 13.5% over buybacks in the third quarter of 2014. Overall, 362 companies — 72% of the index — participated in buybacks during the final quarter of the year, a figure that is consistent with the average participation rate over the past five years.

On a company-by-company basis, Apple’s $6.1 billion in share repurchases during the quarter was the most of any company on the S&P. This figure marks a 20% increase year-over-year but a 64% drop quarter-over-quarter.

“In the previous quarter, Apple spent the second-largest dollar amount on share repurchases by an individual company in the S&P 500 since 2005 at $17 billion,” FactSet analyst John Butters wrote in the report Tuesday. “Over the past three quarters, Apple has spent $16.9 billion on share repurchases on average. As a result, on a trailing 12-month basis, Apple has now spent the highest amount on buybacks, $57 billion, of all the companies in the index.”

For perspective, that $57 billion spending total is four times higher than the next-highest total: the $13.4 billion IBM spent in buybacks over the same period. Behind Apple and IBM is Exxon, with its $13.2 billion in buybacks over the trailing twelve months, Intel, which spent $11 billion over the same period, and Wells Fargo with $9.1 billion.

While Apple did lead the index in overall spending during the fourth quarter, its $1 billion year-over-year increase in spending was not the largest in the index. Intel — whose $4 billion in buyback activity during the quarter was second only to Apple — increased its spending by $3.5 billion. Johnson & Johnson increased its buyback by $2.3 billion, while Wells Fargo and Yahoo both increased theirs by $1.9 billion.

But of course, since overall buyback activity did dip 4.4% year-over-year, more sectors decreased their buyback than increased it. Seven of the S&P’s 10 sectors recorded a decrease in share repurchases, with the 95.8% drop in telecomm buybacks the largest plunge of the pack.
To be sure, buybacks are no panacea and they have backfired on a few companies. Moreover, there is an increasing unease on how much of the extraordinary stock market gains since 2009 have been fueled by share buybacks. Institutional Investor just published a great article, Stock Buybacks Wrestle With an Aging Bull, which discusses the concerns companies should ponder before approving share repurchase programs.

But as Bloomberg notes, American companies are in love with themselves, and they're not afraid to show it by buying back their shares at a record pace:
Corporate America’s love affair with itself grows more passionate by the month.

Stock buybacks, which along with dividends eat up sums of money equal to almost all the Standard & Poor’s 500 Index’s earnings, vaulted to a record in February, with chief executive officers announcing $104.3 billion in planned repurchases. That’s the most since TrimTabs Investment Research began tracking the data in 1995 and almost twice the $55 billion bought a year earlier.

Even with 10-year Treasury yields holding below 2.1 percent, economic growth trailing forecasts and earnings estimates deteriorating, the stock market snapped back last month as companies announced an average of more than $5 billion in buybacks each day. That’s enough to cover about 2 percent of the value of shares traded on U.S. exchanges, data compiled by Bloomberg show.
No wonder big investors are openly worried and urging corporate titans to focus capital on the long term. Unfortunately, their warnings are falling on deaf ears and truth be told, many pensions are guilty of the same short-term behavior they're openly criticizing.

And while some claim that larger stock buybacks are a sign of increasing stock market efficiency, I agree with those who claim that buybacks are nothing more than a glorified accounting scheme to help boost corporate compensation spinning out of control.

The problem, of course, is that the share buyback bubble is an integral part of the rising stock market, dwarfing everything in the U.S. market. Just how important is buyback activity?  As Oliver Renick of Bloomberg reports, Buyback Blackout Leaves U.S. Stocks on Own Prior to Earnings:
U.S. stocks are entering part of the year when one of their biggest support systems is turned off.

Buybacks, which reached a monthly record in February and have surged so much they make up about 2 percent of daily volume, are customarily suspended during the five weeks before companies report quarterly results, according to Goldman Sachs Group Inc. With the busiest part of first-quarter earnings seasons beginning in April, the blackout is getting started now.

While the data isn’t conclusive, owning stocks during the five-week stretch when repurchases were curbed has generated a return that trails the market average over the past two years, according to data compiled by Bloomberg. That’s not surprising to Eric Schlanger of Barclays Plc, who says companies buying back shares have helped keep equities aloft.

“Blackout periods are on radar screens now because of valuations, the length of the bull market, and the consensus that buybacks have been a major part of the bull market,” Schlanger, head of equities for the Americas at Barclays, said by phone. “With the S&P up around 2,100, people are going to be more attuned to possible fractures or previous areas of support changing than they were at 1,400.”

Companies in the Standard & Poor’s 500 have spent more than $2 trillion on their own stock since 2009, underpinning an equity rally in which the index has more than tripled. They spent a sum equal to 95 percent of their earnings on repurchases and dividends in 2014, data compiled by S&P and Bloomberg show.
How can individual investors play this buyback bubble? It turns out there is an ETF, PowerShares Buyback Achievers ETF (PKW), which assembles companies buying back their shares. You can view the top ten holdings and chart of this ETF below:

(click on image)


(click on image)


But if you ask me, you are better off investing in biotech ETFs (IBB and XBI) and stocks I recommended in my Outlook 2015 at the beginning of the year (read a comment in Seeking Alpha, A Bold Call For Biotech ETFs).

Importantly, I want you all to ignore the talking heads on CNBC and elsewhere warning you of a biotech bubble, and keep using any selloff in this sector to add to your positions just like I did last year during the big unwind and just as I did this week. Keep buying the major dips on biotech.

Here is just a small sample of over 200 biotech stocks I'm tracking (click on image):


Some of the smaller biotechs got whacked hard this past week. As I've repeatedly warned you, if you can't stomach huge swings of 20%, 30% or more either way, it's best to avoid the smaller biotech companies and just focus on the ETFs (IBB and XBI) or just buy shares of the big biotech giants like Biogen (BIIB), Celgene (CELG), Gilead (GILD) and others which make up the top ten holdings of the iShares Nasdaq Biotechnology (IBB).

As someone who suffers from Multiple Sclerosis, Biogen remains one of my favorite biotech companies.  It's an incredible company discovering amazing drugs for patients suffering from neurological diseases, including Alzheimer's disease, where there's nothing really good available.

One thing is for sure, all this talk of a biotech bubble about to burst is absolute rubbish spread by ignorant fools or big hedge funds and mutual funds that are looking to get in on the action. As far as I'm concerned, there is no biotech bubble and investors ignoring this sector will severely underperform their peers in the next few years (you read that right, never mind what Zero Edge claims).

But the buyback bubble does concern me in a market where Nobel laureate Michael Spence rightly notes, equities are overvalued. Of course, as Keynes reminded us a long time ago, "markets can stay irrational longer than you can stay solvent," so I'm comfortable playing this buyback bubble and especially comfortable playing the secular bull market in biotech shares which I foresaw back in 2008 in my comment, The Age of Biotech.

Once more, I remind my readers to support my blog by clicking on the ads and more importantly, by donating any amount via PayPal on the top right-hand side. Institutional investors can donate or subscribe via PayPal using one of the three options provided to them. Please take the time to support this blog, I work extremely hard to provide you with the very best insights on pensions and investments and appreciate your financial support.

Below, an older clip from the Harvard Business Review discussing profits without prosperity. Take the time to watch this clip and you'll understand why American companies are in love with themselves.

And one of my favorite portfolio managers, LMM Chairman and CIO Bill Miller, shares his market forecast, and view of the biotech and homebuilder sectors. Miller says we're in a long lasting bull market, and he really likes Pandora's (P) stock as well as Intrexon (XON), which remains one his largest biotech holdings.

Listen carefully to Bill Miller, he knows what he's talking about, which is more than I can say for most skeptics who are going to get crushed avoiding stocks and the red hot biotech sector.

Thursday, March 26, 2015

America's Pensions in Peril?

John W. Schoen of CNBC reports, Funding shortfalls put pensions in peril:
These days, a pension just isn't what it used to be.

For generations, a defined benefit pension—a fixed monthly check for life—provided an ironclad promise of a secure income for millions of retired American workers. But today, that promise has been badly corroded by decades of underfunding that have undermined what was one of the cornerstones of the American dream.

The safety net that millions of retirees spent decades working toward has been fraying for some time. The Great Recession, and the market collapse that wiped out trillions of dollars of investment wealth, weakened the pension system further, though some of the damage has been repaired since the stock market rebounded and the economic recovery took hold.

Hundreds of billions of dollars in defined benefits are still paid out every year to retirees. State and local public pension benefit payments reached $242.9 billion in 2013, according to the most recent Annual Survey of Public Pensions. And a Towers Watson study of more than 400 major companies that sponsor U.S. defined benefit plans estimated they paid out nearly $97 billion in benefit payments last year, and another $8.6 billion went toward lump sum payments and annuities.

But that's nothing compared to the private employers' projected benefit obligations last year, which climbed 15 percent from the previous year to a whopping $1.75 trillion, while plan assets grew by only 3 percent.

Disparities like that help explain why so many pensions are in peril. Simply put: Obligations have outpaced fund contributions and growth for private and public plans. That means that even workers who have paid into pensions for several years may not get the level of benefits they expect. And many younger employees may never have an opportunity to participate in a pension at all.

The result is that, unlike past generations of Americans, many workers today bear the brunt of the investment risk that underpins their hopes of income security once they are no longer able to work.

In 1975, some 88 percent of private sector workers and 98 percent of state and local sector workers were covered by defined benefit plans, according to a 2007 report by the researchers at the Center for Retirement Research at Boston College. By 2011, fewer than 1 in 5 private industry employees was covered by a pension that paid a guaranteed monthly check, according to the Labor Department.

That historic shift has been blamed by critics for an estimated deficit in retirement savings of more than $4 trillion for U.S. households where the breadwinner is between ages 25 and 64, according to Employee Benefits Research Institute.

"You have this hole in what private sector workers have for retirement. We're coming up on this place where all these people are not going to be able to retire," said Monique Morrissey, a researcher at the liberal Economic Policy Institute.

That shift away from a guaranteed pension check has been slower to take hold among public sector workers, where some 83 percent still have access to a pension that promises to pay monthly retirement income for life after a career of service. But that's changing.

Faced with rising health costs and retirees living longer than expected, many state and local governments are failing to keep up with the annual payments. A CNBC analysis of financial data for 150 state and local pension plans collected by Boston College's research center found that 91 had set aside less than 80 percent of the money needed to meet current and future obligations to retirees. Only six were fully funded.

One big reason: State and local governments aren't making the annual contributions required to fund those liabilities. Of the 150 plans tracked by the center, 47 paid less than 90 percent of what's needed to keep pension benefits funded and 79 paid more. (There was no data available for 24 of the 150 plans.)

"People appreciate services: They want cops and firefighters, they want teachers and all that stuff," said Morrissey. "But if you're a politician in a budget crunch, the one way to not raise taxes is to just not pay your pension bill. In the states and cities where there's a big problem, it's not because they underestimated cost. They simply didn't pay the bill."

In New Jersey, which has averaged less than half its required annual contributions for over a decade, a state judge last month ordered Gov. Chris Christie to make a court-ordered $1.6 billion payment into the state's public pension system after it was withheld from his proposed $34 billion state budget. Christie is appealing the ruling.

In New York, state lawmakers plan to defer more than $1 billion in required pension contributions over the next five years. In Illinois, the state's new Republican governor, Bruce Rauner, last month proposed more than $6 billion in spending cuts—more than a third of which would come from shifting government workers into pension plans with reduced benefits.

In Rhode Island, retirees are suing the state over a 2011 pension overhaul led by newly elected Democratic Gov. Gina Raimondo during her tenure as state treasurer. The reforms, which raised retirement ages and cut cost-of-living increases, were projected to save $4 billion over 20 years. (On Monday, the retirees accepted a proposed settlement that would reduce retirement benefits.)

With state and local politicians loathe to propose the tax increases needed to fund the shortfalls, many have overhauled their pensions systems instead by increasing the burden on public workers and retirees and cutting benefits.

"Nearly every state since 2009 enacted substantive reform to their retirement programs, including increased eligibility requirement, increased employee contributions or reduced benefits, including suspending or limiting (cost of living increases)," said Alex Brown, research manager at the National Association of State Retirement Administrators, a nonprofit association whose members are the directors of the nation's state, territorial, and largest statewide public retirement systems.

Those cuts range from about 1 percent for retirees in Massachusetts and Texas to as much as 20 percent in Pennsylvania and Alabama, according to a survey of state pension reforms last year by the association and the Center for State and Local Government Excellence.

For retirees like David Jolly, 90, that's mean getting by with a little less every year.

Jolly, who retired in 1986 as public works director for Island County, Wash., now lives with his wife on a combined monthly income of $1,888 from his state pension and Social Security. "Every time they try nibbling at it, it just makes it that much harder," he said. "They don't realize what the cost of living of older people is. ... It just keeps going up and the retirement pay just doesn't."

To close the pension funding gap, many state and local governments have also cut access to defined benefit pensions for new hires or increased contributions and minimum retirement age for active workers. "New employees can expect to work longer and save more to reach the benefit level of previously hired employees," according to a survey by the retirement administrators association.

While closing plans to new members may reduce benefit liabilities decades from now, it also cuts into the contributions from active workers to support retirees. For over a decade, the ratio of active workers to retirees has been falling, placing an added strain on the public pension system.

For workers and retirees in the private sector, where defined benefit plans are much less common, funding levels are generally in better shape.

Rising investment returns since the financial collapse of 2008 helped boost funding levels for private industry plans in 2013 to 88 percent of their liabilities, according to a survey of the latest available data by pension fund consultant Milliman. But that still left the 100 largest companies surveyed with a combined pension plan funding deficit of $193 billion.

The pension funding shortfall is even worse for a handful of so-called multi-employer pension plans, which typically cover smaller companies and unions and face a different set of financial challenges. Declining union enrollments, for example, mean there are fewer active workers to cover the cost benefits for retirees, many of whom are living longer than expected than when these plans were established.

Multi-employer plans also face the added burden of their pooled pension liabilities. When one member of the plan fails to keep up with contributions, for example, the burden on the other members increases.

About a quarter of the roughly 40 million workers who participate in a traditional "defined benefit" plan—those that pay retirees a guaranteed check every month—are covered by these multi-employer plans, according to the Bureau of Labor Statistics. In the last four years, the Labor Department has notified workers in more than 600 of these plans that their plans are in "critical or endangered status."

Last year, the Pension Benefit Guaranty Corporation, the government insurance fund for pension plans that go bust, reported that its program backing multi-employer plans was $5 billion in the red. It projected that unless Congress acted, there was about a 35 percent probability its assets would be exhausted by 2022 and about a 90 percent probability by 2032. (Single-employer pension plans are covered by a separate program that is on a much more solid financial footing.)

After funding shortfalls threatened the solvency of the governments' insurance backstop for multi-employer pension plans, Congress eased the rules allowing plan administrators to cut benefits last year. Proponents of the proposed pension guaranty corporation reforms argue that they will help prevent more multi-employer plans from going under and that retirees are better off with smaller monthly payments than none at all.

That's something beneficiaries of private and public pensions are hearing a lot these days.
As you can read above, America's private and public pensions aren't in good shape. There are a lot of reasons why this is the case and my fear is the worst is yet to come.

One thing I can tell you, the attack on U.S. public pensions continues unabated. Andrew Biggs, a resident scholar for the conservative American Enterprise Institute wrote a comment for the Wall Street Journal, Pension Reform Doesn’t Mean Higher Taxes:
The Pennsylvania State House held a hearing on Tuesday about reforms that would shore up the state’s public-employee pension program. The hearing was overdue. Annual required contributions to the state’s defined-benefit plan have soared to more than 20% of employee payroll from only 4% in 2008. Legislators in the state, like many elected officials nationwide, are looking for a way out.

State Rep. Warren Kampf has introduced a bill to shift newly hired government employees to defined-contribution pensions similar to a 401(k) plan. Defined-contribution pensions offer cost stability for employers, transparency for taxpayers and portability for public employees.

But the public-pension industry—government unions and the various financial and actuarial consultants employed by pension-plan managers—claims that “transition costs” make switching employees to defined-contribution pensions prohibitively expensive. Fear of “transition costs” has helped scuttle past reforms in Pennsylvania, as in other states. But the worry is unfounded.

The argument goes as follows: The Governmental Accounting Standards Board’s rules require that a pension plan closed to new hires pay off its unfunded liabilities more aggressively, causing a short-term increase in costs. Thus the California Public Employees’ Retirement System, known as Calpers, claimed in a 2011 report that closing the state’s defined-benefit plans would increase repayment costs by more than $500 million. Similar claims have been made by government analysts in Minnesota, Michigan and Nevada. The National Institute for Retirement Security, the self-styled research and education arm of the pension industry, claims that “accounting rules can require pension costs to accelerate in the wake of a freeze.”

But GASB standards don’t have the force of law; nearly 60% of plan sponsors failed to pay GASB’s supposedly required pension contributions last year. That includes Pennsylvania, where the public-school-employees plan last year received only 42% of its actuarially required contribution. GASB standards are for disclosure purposes and not intended to guide funding. New standards issued in 2014, GASB says, “mark a definitive separation of accounting and financial reporting from funding.”

In fact, nothing requires a closed pension plan to pay off its unfunded liabilities rapidly, and there’s no reason it should. Unfunded pension liabilities are debts of the government; employee contributions are not used to pay off these debts. Whether new hires are in a defined-contribution pension or the old defined-benefit plan, the size of the unfunded liability and the payer of that liability are the same.

More recently, pension-reform opponents have shifted to a different argument: Once a pension plan is closed to new hires, it must shift its investments toward much safer, more-liquid assets that carry lower returns. Actuarial consultants in Pennsylvania have claimed that such investment changes could add billions to the costs of pension reforms.

This argument doesn’t hold. It is standard practice for a pension to fund near-term liabilities with bonds and to pay for long-term liabilities mostly with stocks. A plan that is closed to new entrants stops accumulating long-term liabilities. As a result, the stock share of the plan’s portfolio will gradually decline. But that’s because the plan’s liabilities have been reduced. Plans would not be applying a lower investment return to the same liabilities. They would apply a lower investment return to smaller liabilities.

Many public pension plans apparently believe that a continuing, government-run pension can ignore market risk, while a plan that is closed to new entrants must be purer than Caesar’s wife. The reality is that all public plans, open and closed, should think more carefully about the risks they are taking. But the difference in investment returns between an open plan and a closed one should be a minor consideration for policy makers considering major pension reforms.

Shifting public employees to defined-contribution retirement plans won’t magically make unfunded liabilities go away. Pension liabilities must be paid, regardless of what plan new employees participate in. But defined-contribution plans, which cannot generate unfunded liabilities for the taxpayer, at least put public pensions on a more sustainable track.
The problem with this Wall Street Journal article is it's factually wrong. Jim Keohane, CEO of the Healthcare of Ontario Pension Plan (HOOPP), sent me these comments:
I read the clip from the WSJ you included on your blog, and I thought you would be interested in a piece of research on the subject which was completed by Dr. Robert Brown (click here to view the paper). This is a fact based piece of research which looked at the cost of shifting from DB to DC. Proponents of a shift from DB to DC, such as this article, portray this as a win-win situation, but when Dr. Brown looked into the facts, what he found was that this is in fact a lose-lose situation. The liabilities in the existing plans are very long tailed and putting these plans into windup mode causes the costs and risks to go up, so there are no savings to taxpayers – in fact the costs go up, and the individuals are much worse off having been shifted to DC plans because they end up with much lower pensions.
When I read these articles in the Wall Street Journal, it makes my blood boil. Why? Am I a hopeless liberal who believes in big government? Actually, not at all, I'm probably more conservative than the resident "scholars" at the American Enterprise Institute (read my last comment on Greece's lose-lose game to understand the effects of a bloated public sector and how it destroys an economy).

But the problem with this article is that it spreads well-known myths on public pensions, and more importantly, it completely ignores the benefits of defined-benefit plans to the overall economy and long-term debt profile of the country. Worse still, Biggs chooses to ignore the brutal truth on defined-contribution plans as well as the 401(k) disaster plaguing the United States of Pension Poverty.

Importantly, pension policy in the United States has failed millions of Americans struggling to save enough money to retire in dignity and all these conservative think tanks are spreading dangerous myths telling us that DC plans "offer cost stability for employers, transparency for taxpayers and portability for public employees."

The only transparency DC plans offer is that they will ensure more pension poverty down the road,  less government revenue (because people with no retirement savings won't be buying as many goods and services), and higher social welfare costs to society due to higher health and mental illness costs.

And again, I want make something clear here, I'm not arguing for bolstering defined-benefit plans for all Americans from a conservative or liberal standpoint. Good pension policy is good economic policy. Period.

This is why I wrote a comment for the New York Times stating that U.S. public pensions need to adopt a Canadian governance model (less the outlandish pay we pay some of our senior public pension fund managers) in order to make sure they operate at arms-length from the government and have the best interests of all stakeholders in mind.

But the problem in the United States is that politicians keep kicking the can down the road, just like they did in Greece, and when a crisis hits, they all scramble to implement quick nonsensical policies, like shifting public and private employees into defined-contribution plans, which ensures more pension poverty and higher debt down the road.

Finally, while most Americans are struggling to retire in dignity, the top brass at America's largest corporations are quietly taking care of themselves with lavish pensions. Theo Francis and Andrew Ackerman of the Wall Street Journal report, Executive Pensions Are Swelling at Top Companies:
Top U.S. executives get paid a lot to do their jobs. Now many are also getting a big boost in what they will be paid after they stop working.

Executive pensions are swelling at such companies as General Electric Co., United Technologies Corp. and Coca-Cola Co. While a significant chunk of the increase is the result of arcane pension accounting around issues like low interest rates and longer lifespans, the rest reflects very real improvements in the executives’ retirement prospects.

Pension gains averaged 8% of total compensation for top executives at S&P 500 companies last year, up sharply from 3% the year before, according to data from LogixData, which analyzes SEC filings. But the gains are much larger for some executives, totaling more than $1 million each for 176 executives at 89 large companies that filed proxy statements through mid-March. For those executives, pension gains averaged 30% of total pay.

The gains often don’t represent new pay decisions by corporate boards. Instead, they reflect the sometimes dramatic growth in value of retirement promises made in the past. Nonetheless, they are creating an optics problem for companies at a time when executive-pay levels are under greater scrutiny from investors and the public. Companies now face regular shareholder votes on their pay practices that can be flash points for broader concerns, leaving them sensitive about appearing too generous.

New mortality tables released last fall by the American Society of Actuaries extended life expectancies by about two years. That, as well as low year-end interest rates, helped push pension gains higher than many companies had expected. The result is much higher current values for plans with terms like guaranteed annual payouts, which are no longer offered to most rank-and-file workers.

GE Chief Executive Jeff Immelt’s compensation rose 88% last year to $37.3 million. Meanwhile, excluding $18.4 million in pension gains, his pay actually fell slightly to $18.9 million.

The company says about half of the pension increase came from changes in its assumptions about interest rates and life span. About $8.8 million, however, comes from an increase of nearly $490,000 a year in the pension checks he stands to take home as his pay has risen and he approaches 60 years old, the age at which top GE executives can collect full pension benefits.

In all, Mr. Immelt’s pension is valued at about $4.8 million a year for life. The company puts its current value at about $70 million, up from around $52 million a year ago.

A GE spokesman said that much of the gain reflects accounting considerations and that Mr. Immelt’s recent salary increases reflect balanced-pay practices and board approval of his performance.

The SEC is particular about how companies report pay in their proxy statements. There is a standard table that breaks out salary, bonuses and pension gains, along with totals for the past three years, and other details. GE, encouraging investors to overlook the pension gains, added a final column to the table to show what top executives’ total pay would look like without them. The company says investors find the presentation useful in making proxy voting decisions.

Lockheed Martin is also asking investors to look past pension gains when considering its executives’ total pay.

At Lockheed Martin Corp., CEO Marillyn Hewson’s total pay rose 34% to $33.7 million last year, with $15.8 million of that stemming from pension gains. An extra column in the proxy statement’s compensation table strips out those gains, showing her pay up about 13% to $17.9 million.

Lockheed says that $5 million of the pension gains can be traced to changes in interest rates and mortality assumptions. Most or all of the remaining $10.8 million probably stems from increases in the payments she would receive in retirement: about $2.3 million a year now, up from about $1.6 million a year under last year’s proxy disclosure. Ms. Hewson’s pay rose sharply with her ascent to CEO in 2013 and chairman last year, increasing her pension benefit significantly.

Overall, the company’s obligation for future pension benefits for executives and other highly paid employees totaled $1.1 billion last year, up from $1 billion at the end of 2013.

A Lockheed Martin spokesman said the company broke out a nonpension compensation total in the proxy statement to provide more context for pay.

Executive pensions generally don’t consume the attention that pensions for the rank and file do. For years, as costs of traditional pension plans have risen amid low interest rates and longer lifespans, big companies have been closing them to new employees or even freezing benefits in place, often continuing with only a 401(k) plan for all but the oldest workers.

Last June, Lockheed Martin told its nonunion employees that it would stop reflecting salary increases in their pension benefits starting next year, and that the benefits would stop growing with additional years of work starting in 2020.

“It eliminates a lot of the variability that defined-benefit pension plans can create in our cost structure,” Chief Financial Officer Bruce Tanner told investors during a Dec. 3 conference presentation.

In 2011, GE stopped offering new employees traditional defined-benefit pensions and replaced them with 401(k) plans. At the time, Mr. Immelt cited recent market downturns and lower interest rates as being among the reasons for the shift.
In a cruel twist of irony, America's top CEOs are now enjoying much higher pension payouts while they cut defined-benefit plans to new employees and increase share buybacks to pad their insanely high compensation. I guess longer life spans are fine when it comes to CEOs' pensions but not when it comes to their employees' pensions.

Lastly, my comment on the 401(k) experiment generated a lot of comments on Seeking Alpha. Some people rightly noted that looking at 401(k) balances distorts the true savings because it doesn't take into account roll overs into Roth IRAs. When you factor in IRAs, savings are much higher.

While this is true, there is still no denying that Americans aren't saving enough for retirement and that 401(k)s are an abject failure as the de facto pension policy of America. It's high time Congress stops nuking pensions and starts thinking of bolstering and enhancing Social Security for all Americans, as well as implementing shared risk and serious governance reforms at public pensions.

Below, the pension terminator, Arnold Schwarzenegger, asks Warren Buffett his advice on how to handle unfunded liabilities of public pensions. Listen carefully to the Oracle of Omaha's reply, he understands the dire situation better than most people.

Wednesday, March 25, 2015

Greece's Lose-Lose Game?

Tom Beardsworth and Francine Lacqua of Bloomberg report, Soros Says Greece Now Lose-Lose Game After Being Mishandled:
The chances of Greece leaving the euro area are now 50-50 and the country could go “down the drain,” billionaire investor George Soros said.

“It’s now a lose-lose game and the best that can happen is actually muddling through,” Soros, 84, said in a Bloomberg Television interview due to air Tuesday. “Greece is a long-festering problem that was mishandled from the beginning by all parties.”

Greek Prime Minister Alexis Tsipras’s government needs to persuade its creditors to sign off on a package of economic measures to free up long-withheld aid payments that will keep the country afloat. Since his January election victory, he has tried to shape an alternative to the austerity program set out in the nation’s bailout agreement, spurring concern that Greece may be forced out of the euro.

The negotiations between Tsipras’s Syriza government and the institutions helping finance the Greek economy -- the European Commission, European Central Bank and International Monetary Fund -- could result in a “breakdown,” leading to the country leaving the common currency area, Soros said in the interview at his London home.

“You can keep on pushing it back indefinitely,” making interest payments without writing down debt, Soros said. “But in the meantime there will be no primary surplus because Greece is going down the drain.”

Soros said in January 2012 that the odds are in the direction of Greece leaving the euro region.

“Right now we are at the cusp and I can see both possibilities,” he said in Tuesday’s interview.
Aid Payment

Tsipras is meeting with German lawmakers in Berlin on Tuesday after Chancellor Angela Merkel encouraged him to follow the path set out by Greece’s creditors. European Parliament President Martin Schulz said in an interview with Italian newspaper Repubblica that he expects a deal by the end of this week that will allow the release of at least some money.

The start of quantitative easing by the ECB at a time when the U.S. Federal Reserve is considering raising interest rates “creates currency fluctuations,” said Soros, one of the world’s wealthiest men with a $28.7 billion fortune built partly through multi-billion dollar trades in currency markets, according to the Bloomberg Billionaires Index.

“That probably creates some great opportunities for hedge funds but I’m no longer in that business,” he said. Soros, who was born in Hungary, said the war in eastern Ukraine between government forces and rebel militia supported by Russia’s President Vladimir Putin concerns him the most.

Without more external financial assistance the “new Ukraine” probably will gradually deteriorate and “become like the old Ukraine so that the oligarchs come back and assert their power,” he said. “That fight has actually started in the last week or so.”
Soros is no longer managing money himself but his family office, Soros Fund Management, is alive and well and I can guarantee you it's been shorting the euro aggressively. You can listen to his exclusive Bloomberg interview here (his thoughts on Ukraine and Russia scare me because he and U.S. politicians are playing a dangerous game).

Is Soros right? Could Greece go "down the drain"? It sure looks hopeless but let me take a step back here and offer some additional thoughts, ones that his hedge fund eminence, Soros, chooses to ignore (as he does with his myopic and antiquated views on Russia and the Ukraine).

Kimon Valaskakis, former ambassador of Canada to the OECD and now president of the New School of Athens Global Governance Group, published a comment on LinkedIn, Greece and Europe: The Real Choice Is Win-Win or Lose-Lose:
Greece and Europe are contemplating divorce. In the first of a two part series which I published on March 17 2015 in the World Post, the global division of the Huffington Post. I have argued that this would be a masochistic lose-lose outcome when alternative win-win solutions exist.

The present essay is an expanded version of the World Post article which can be found here. It's also permanently listed in my author archive: http://www.huffingtonpost.com/kimon-valaskakis/

Following the recent Greek election where a new government was elected on an anti-austerity platform, an attempt to renegotiate the Greek Debt under the supervision of the so-called Troika (EU, Euro Zone and IMF) has, so far, been inconclusive. The final agreement (or non-agreement) will be decided upon in the next few months, although past experience has shown that most so-called ‘agreements’ tend to be quite temporary.

Behind this ambivalence and the protracted negotiations, what are the real choices ? How can we fly above the accountants quarrels to higher ground and see the whole forest ?

Many observers have presented the negotiations as a standard win-lose game. Either Europe ‘wins’ and Greece ‘loses’ or vice versa. In this post and its sequel I argue that the real choice is between ‘win-win’ for both or ‘lose-lose’. In developing my arguments I must acknowledge my intellectual debt to a colleague and friend John Evdokias, portfolio manager for his perceptive insights.
Argument 1 : The Debt Issue is Surprisingly Insignificant

The debt issue, blown out of proportion by professional alarmists, is actually relatively trivial for many reasons.

First the debt itself is small by global standards. 315 billion euros is high for you and me but small in the European and world economy. It can be managed.

What is much more problematic is Greece’s capacity to repay it quickly, given current conditions. The debt is 175% of GDP because the Greek Economy has contracted for the last 6 years due to imposed austerity. To ask for quick repayment is like asking an unemployed worker to immediately reimburse his mortgage. Not possible.

Second, since the debt is held not, thankfully, by the Mafia but by supposedly ‘friendly’ institutions including the European Central Bank and the IMF, what should be at issue are convivial repayment modalities, not the principle of repayment which has been accepted by both parties, These modalities involve (a) the date of maturity and (b) the rate of interest.

Concerning the date of maturity, it may surprise the reader to discover that long term loans (going to one hundred years) are increasing in popularity. At one point Disney Corporation obtained such a loan and as Evdokias pointed out “if a Mickey Mouse company can get such a loan, why not Greece”. Some countries allow 100 year mortgages and some companies issue 100 year bonds. What would have been unthinkable many years ago may become commonplace.

So, an extension of repayment of the Greek Debt would not be absurd perhaps to a hundred years but to a long enough time horizon.

As far as the rate of interest is concerned, as we all know, we live in a period of very low rates which are, in some cases, actually negative. What that means is that lenders are now paying to lend, an aberration a few years ago but now more and more frequent.

The reason behind both trends, longer repayment periods and lower interest rates is simple. Contrary to popular belief, the world is awash with capital both private and public (via money creation and quantitative easing). The challenge for investors is, now, not where to get the highest returns but where to park their money, especially when the capital they themselves invest is usually obtained at extremely low rates. When you lend other people’s money, as banks do, you expect less than when you invest your own.

Given the above, a Greece-Europe divorce based on disagreement on debt repayment would be ridiculous. That’s not how things should be settled between members of the same family.

As to future debt, the question of structural reform, (preventing further imprudent borrowing etc.) is valid and will be addressed in my second post. For now, the argument I am advancing is that past debt issues should not be the casus belli or the cause of the divorce.
Argument 2 : Greece’s Exit From The Eurozone Would Be Very Dangerous For Both Parties

The 19 country Eurozone with a common currency, the euro, is a work in progress. It was designed as a one way street leading towards more and better European integration.

In fact there is no clear mechanism to expel a delinquent member. In addition, consider that new members, joining the European Union, are now obligated to eventually join the Eurozone, although this does not apply to the original members.

If Greece leaves the Eurozone, it may have to leave the European Union itself.

The Eurozone was meant to be followed by some sort of fiscal union and ultimately a political union : the United States of Europe. This has not happened yet, because the economic problems of Europe, at large, since the Great Recession of 2008 have created many Euro skeptics.

A withdrawal from the Euro Zone and the adoption of a new national currency by Greece, may well offer short term benefits for that country since the new drachma will, most likely, be devalued vis-a-vis the euro thus making exports more competitive (and imports more expensive).

But how long will that benefit last ? The strategy of devaluation works if one country devalues and not others. In the 1930s Western countries, faced with depression and mass unemployment, resorted to competitive devaluations, which cancelled each other out. As a result everyone lost.

Furthermore, Grexit, as it is called, may not be an isolated phenomenon. If successful, other countries may be tempted to follow suit, including Spain, Italy and even France, if Marine Le Pen were to become the next French President .

Grexit could then be the first step to a break-up of the entire euro zone. It is very easy to destroy something and much more difficult to build it up. The negative momentum which this would entail, not immediately but over time, would be disastrous for the Old Continent and put the entire European Project in grave jeopardy.
Argument 3 : Beyond economics, serious geopolitical dangers lurk for both parties unless the issues are resolved.

If Greece is forced to stay in the Euro Zone under humiliating conditions this may not be the end of the matter. Right now the Syriza Government is the last bastion for left of center ‘respectable’ parties. If Syriza fails, then much more extreme and less ‘respectable’ parties from the far left and the far right, may be elected with ominous consequences.

Greece will then be vulnerable to serious social upheaval. Putin’s Russia may well seek an interesting new pied a terre in Greece, invoking the common link of orthodoxy. This will not please Western oriented Greeks. The upheaval, may, God forbid, lead to armed violence, including a potential civil war. It must not be forgotten that Greece went through a particularly bloody civil war, on class lines, after the end of World War II, where the extreme left opposed the extreme right. The scars are still there.

Not only would an unstable and weakened Greece be bad news for itself, it would also be very bad news for the entire European Union.

Beyond economics, Europe faces three additional threats. One comes from a newly aggressive Russia, as discussed above seeking to reverse the demise of the Soviet Union. A second one comes for the expansionist and disruptive ambitions of ISIS and radical jihadi terrorism. A third comes from the disaffected euro-skeptics, all over the Continent, some advocating a departure from the euro zone, others against the European Union itself and still others, promoting separatist movements designed to break up existing countries.

The balkanization of Europe would be bad, not only for this continent but for the world, because the European integration experiment which was started after the Second World War was initially seen as a model for better global integration. It could still serve as such a model, once it is restructured, perhaps even reinvented.

To give all this up for a mere question of debt, in a world drowning in unused capital would be to show unbelievable myopia and even masochism.

The Greece-Europe marriage can and must be saved. A reasonable accommodation is quite possible because of the win-win vs. lose-lose potential.

As self appointed ‘marriage counselor’ my recommendations for this accommodation will be found in a subsequent post.
I respect Kimon Valaskakis and John Evdokias and think they're absolutely right, in a world awash in debt and capital, there is no reason to kick Greece out of the eurozone based solely on its debt.

But as I've stated many times in my blog comments, Greece desperately needs major structural reforms. Amazingly, even during Greece's do-or-die moment, there has been no serious austerity whatsoever in the bloated Greek public sector. And by serious austerity, let me be crystal clear, they cut pensions and wages but they didn't cut any public sector jobs.

Importantly, this huge imbalance between the Greek public sector and private sector is the root of all evil in Greece and all political parties have maintained this farce because Greek politicians never dared to cut the hand that feeds them. Powerful public sector unions keep threatening to crush them if they ever dared cutting the Greek public sector beast down to size (keep in mind over 60% of the few jobs remaining in Greece are directly or indirectly related to the public sector, a staggering figure for a country of just 11 million population).

What Greece needs now is a Maggie Thatcher, someone with the courage to stand up to self-entitled Greek oligarchs, special interest groups and ever powerful public sector unions and crush them. This may sound like sheer right-wing lunacy but the reality is that unless Greece implements serious reforms to its grossly antiquated economy, the country will never grow properly and will always remain one step away from bankruptcy.

Of course, as my friend's father reminds me, in the history of Greece, Greeks haven't been kind to heroes like Eleftherios Venizelos, Ioannis Kapodistrias and many others who have tried to change the country for the better. "Greeks have a long, sordid history and the country won't change until they change their collective mentality and stop blaming others for their mistakes," he keeps telling me.

I'm afraid he's right which is why while it pains me to see the big fat Greek squeeze -- knowing full well that more austerity without proper growth initiatives will only exacerbate the euro deflation crisis -- but something has to be done to finally break the Greek public sector shackles and introduce proper reforms in an economy that desperately needs them.

But I warn Germany and other creditors, ramming more austerity onto Greece and other periphery economies without infrastructure growth projects will be a lose-lose proposition for the eurozone.

And it's not just the periphery economies that worry me. Marine Le Pen may not achieve her 'Frexit' referendum promise but she's absolutely right when she recently stated on Greek television that "as long as the government tells the Greek people they can remain in the eurozone while fighting against austerity, it will at worst be lying and at best wrong." 

In a weird twist of irony, the "economic and financial disaster" of Greece's ruling Syriza party has hit the chances of other populist parties gaining power in Europe, analysts told CNBC, after surprising shifts in voting in local elections in France and Spain this weekend. Perhaps this is why Le Pen wants Greece to exit the euro.

As far as Yanis Varoufakis, Greece's "rock star" finance minister, he wrote antoher comment on Project Syndicate, Deescalating Europe’s Politics of Resentment, where he states:
The fact is that Greece had no right to borrow from German – or any other European – taxpayers at a time when its public debt was unsustainable. Before Greece took any loans, it should have initiated debt restructuring and undergone a partial default on debt owed to its private-sector creditors. But this “radical” argument was largely ignored at the time.

Similarly, European citizens should have demanded that their governments refuse even to consider transferring private losses to them. But they failed to do so, and the transfer was effected soon after.

The result was the largest taxpayer-backed loan in history, provided on the condition that Greece pursue such strict austerity that its citizens have lost one-quarter of their incomes, making it impossible to repay private or public debts. The ensuing – and ongoing – humanitarian crisis has been tragic.

Five years after the first bailout was issued, Greece remains in crisis. Animosity among Europeans is at an all-time high, with Greeks and Germans, in particular, having descended to the point of moral grandstanding, mutual finger-pointing, and open antagonism.

This toxic blame game benefits only Europe’s enemies. It has to stop. Only then can Greece – with the support of its European partners, who share an interest in its economic recovery – focus on implementing effective reforms and growth-enhancing policies. This is essential to placing Greece, finally, in a position to repay its debts and fulfill its obligations to its citizens.

In practical terms, the February 20 Eurogroup agreement, which provided a four-month extension for loan repayments, offers an important opportunity for progress. As Greece’s leaders urged at an informal meeting in Brussels last week, it should be implemented immediately.

In the longer term, European leaders must work together to redesign the monetary union so that it supports shared prosperity, rather than fueling mutual resentment. This is a daunting task. But, with a strong sense of purpose, a united approach, and perhaps a positive gesture or two, it can be accomplished.
There is a lot of truth in what Varoufakis writes but as someone who has visited the epicenter of the euro crisis many times throughout my life, let me tell you, Greeks are perennial whiners and they never take responsibility for their economic failures.

But it's also high time that Germany and other creditors take responsibility for the euro deflation crisis which threatens to spread throughout the world. Something is fundamentally broken in the eurozone and all this endless political dithering is hardly inspiring confidence among nervous global investors and worse still, it's betraying an entire generation of young Europeans looking to work and start a family.

Also, I think my readers should read another comment on Project Syndicate by Yannos Papantoniou, Greece’s former Economy and Finance Minister, where he discusses Sustaining the Unsustainable, as well as a superb comment by Robert Skidelsky, Messed-Up Macro.

On this Greek Independence Day, let us all hope that Greece and the eurozone aren't embroiled in a lose-lose game. The Marine Le Pens and Nigel Farages of this world may want the dissolution of the eurozone but this is not in the best interest of Europeans or the global economy, which looks increasingly more fragile.

Below, Greece risks running out of cash by April 20 unless it secures fresh aid, a source familiar with the matter told Reuters on Tuesday, leaving it little time to convince skeptical creditors it is committed to economic reform.

Greece said it will present a package of reforms to its euro zone partners by next Monday in hope of unlocking aid to help it deal with a cash crunch and avoid default. See the Reuters clip below.

And professor Stephen Cohen, America's top Russian expert, says that he and other authorities have no input into US policy toward Russia. He says that there is no discourse, no debate, and that this is unprecedented in American foreign policy.

Cohen says that the "ongoing extraordinary irrational and nonfactual demonization of Putin" is an indication of "the possibility of premeditated war with Russia." Key points from Cohen's speech can be found here, and you can watch it below.

Keep his comments in mind as U.S. politicians voted on Monday to send lethal arms to Ukraine, dangerously escalating an already tense situation. That, Mr. Soros, is the real lose-lose game you're funding.


Tuesday, March 24, 2015

The Great 401(k) Experiment Has Failed?

Kelley Holland of NBC News reports, Retirement Crisis: The Great 401(k) Experiment Has Failed for Many Americans:
You need to know this number: $18,433. That's the median amount in a 401(k) savings account, according to a recent report by the Employee Benefit Research Institute. Almost 40 percent of employees have less than $10,000, even as the proportion of companies offering alternatives like defined benefit pensions continues to drop.

Older workers do tend to have more savings. At Vanguard, for example, the median for savers aged 55 to 64 in 2013 was $76,381. But even at that level, millions of workers nearing retirement are on track to leave the workforce with savings that do not even approach what they will need for health care, let alone daily living. Not surprisingly, retirement is now Americans' top financial worry, according to a recent Gallup poll.

To be sure, tax-advantaged 401(k) plans have provided a means for millions of retirement savers to build a nest egg. More than three-quarters of employers use such defined contribution plans as the main retirement income plan option for employees, and the vast majority of them offer matching contribution programs, which further enhance employees' ability to accumulate wealth.

But shifting the responsibility for growing retirement income from employers to individuals has proved problematic for many American workers, particularly in the face of wage stagnation and a lack of investment expertise. For them, the grand 401(k) experiment has been a failure.

"In America, when we had disability and defined benefit plans, you actually had an equality of retirement period. Now the rich can retire and workers have to work until they die," said Teresa Ghilarducci, a labor economist at the New School for Social Research who has proposed eliminating the tax breaks for 401(k)s and using the money saved to create government-run retirement plans.

A historical accident?

It wasn't supposed to work out this way.

The 401(k) account came into being quietly, as a clause in the Revenue Act of 1978. The clause said employees could choose to defer some compensation until retirement, and they would not be taxed until that time. (Companies had long offered deferred compensation arrangements, but employers and the IRS had been going back and forth about their tax treatment.)

"401(k)s were never designed as the nation's primary retirement system," said Anthony Webb, a research economist at the Center for Retirement Research. "They came to be that as a historical accident."

History has it that a benefits consultant named Ted Benna realized the provision could be used as a retirement savings vehicle for all employees. In 1981, the IRS clarified that 401(k) plan participants could defer regular wages, not just bonuses, and the plans began to proliferate.

By 1985, there were 30,000 401(k) plans in existence, and 10 years later that figure topped 200,000. As of 2013, there were 638,000 plans in place with 89 million participants, according to the Investment Company Institute. And assets in defined contribution plans totaled $6.6 trillion as of the third quarter of 2014, $4.5 trillion of which was held in 401(k) plans.

"Nobody thought they were going to take over the world," said Daniel Halperin, a professor at Harvard Law School, who was a senior official at the Treasury Department when 401(k) accounts came into being.

Rise of defined contributions

But a funny thing happened as 401(k) plans began to multiply: defined benefit plans started disappearing. In 1985, the year there were 30,000 401(k) plans, defined benefit plans numbered 170,000, according to the Investment Company Institute. By 2005, there were just 41,000 defined benefit plans-and 417,000 401(k) plans.

The reasons for the shift are complex, but Ghilarducci argued that in the early years, "workers overvalued the promise of a 401(k)" and the prospect of amassing investment wealth, so they accepted the change. Meanwhile, companies found that providing a defined contribution, or DC, plan cost them less. (Ghilarducci studied 700 companies' plans over 17 years and found that when employers allocated a larger share of their pension expenditures to defined contribution plans, their overall spending on pension plans went down.)

But the new plans had two key differences. Participation in 401(k) plans is optional and, while pensions provided lifetime income, 401(k) plans offer no such certainty.

"I'm not saying defined benefit plans are flawless, but they certainly didn't put as much of the risk and responsibility on the individual," said Terrance Odean, a professor of finance at the University of California, Berkeley's Haas School of Business.

Early signs of trouble

That concept may not have been in the forefront of employees' minds at the start, but problems with 401(k)s surfaced early.

For one thing, employee participation in 401(k) plans never became anywhere near universal, despite aggressive marketing by investment firms and exhortations by employers and consumer associations to save more. A 2011 report by the Government Accountability Office found that "the percentage of workers participating in employer-sponsored plans has peaked at about 50 percent of the private sector workforce for most of the past two decades."

The employees who did participate tended to be better paid, since those people could defer income more easily. The GAO report found that most of the people contributing as much as they were allowed tended to have incomes of $126,000 or more.

In part, that is because the ascent of 401(k) plans came as college costs started their steep rise, hitting many employees in their prime earning years. Stagnating middle-class wages also made it hard for people to save.

Fees have been another problem. Webb has studied 401(k) fees, and he concluded that "as a result of high fees, fund balances in defined contribution plans are about 20 percent less than they need otherwise be."

The Department of Labor in 2012 established new rules requiring more disclosure of fees, but it faced strong industry opposition, including a 17-page comment from the Investment Company Institute.

Failure of choice

Most employees also turned out to be less than terrific investors, making mistakes like selling low and buying high or shying away from optimal asset classes at the wrong time.

Berkeley's Odean and others have studied the effect of investment choice on 401(k) savers, and found that when investors choose their asset class allocation, a retirement income shortfall is more likely. If they can also choose their stock investments, the odds of a shortfall rise further.

"401(k)'s changed two things: you could choose not to participate, and you chose your own investments, which a lot of people, I think, screw up," Halperin said.

Benna, who is often called the father of the 401(k), has argued that many plans offer far too many choices. " If I were starting over from scratch today with what we know, I'd blow up the existing structure and start over," he said in a 2013 interview.

Another problem is that when 401(k) savers retire, they often opt to take their savings in a lump sum and roll the money into IRAs, which may entail higher fees and expose them to conflicted investment advice. A recent report by the Council of Economic Advisors found that savers receiving such advice, which may be suitable for them but not optimal, see investment returns reduced by a full percentage point, on average. Overall, the report found that conflicted investment advice costs savers $17 billion every year.
The result of all these shortcomings? Some 52 percent of American households were at risk of being unable to maintain their standard of living as of 2013, a figure barely changed from a year earlier—even though a strong bull market should have pushed savings higher and the government gives up billions in tax revenue to subsidize the plans.

In a hearing last September on retirement security, Sen. Ron Wyden, D-Ore., declared that "something is out of whack. The American taxpayer delivers $140 billion each year to subsidize retirement accounts, but still millions of Americans nearing retirement have little or nothing saved."

Retirement worries rise

As problems mount with 401(k)s, Americans' worries about retirement security are intensifying.

A 2014 Harris poll found that 74 percent of Americans were worried about having enough income in retirement, and in a survey published recently by the National Institute on Retirement Security, 86 percent of respondents agree that the country is facing a retirement crisis, with that opinion strongest among high earners.

Changes may come, but for now, 401(k) plans and their ilk remain Americans' predominant workplace retirement savings vehicle. They may be a historical accident, but for the millions of people now facing a potentially impoverished retirement, the fallout is grave indeed.

As a former Treasury official, Halperin witnessed the creation of 401(k) accounts, But, "on balance, I don't think it was a big plus" that the accounts were created, he said. "I don't take credit for it. I try to avoid the blame."
Welcome to the United States of Pension Poverty where rich and powerful private equity and hedge fund titans make off like bandits charging public pension funds excessive fees while the restless masses work till they die, or more likely, retire in poverty because they simply can't save enough money to retire in dignity.

I commend Kelly Holland for writing this article. Of course, it didn't surprise me one bit. In July 2012, I discussed America's 401(k) nightmare and explained why it was going to lead to more pension poverty down the road.

And now that America's private and public sector are following the rest of the world, shifting out of DB into DC plans, you can bet there will be more pension poverty down the road, pretty much ensuring global deflation. That's why I laugh at all the bond bears claiming we're in for a major bond market bruising, they simply don't get it. Rising inequality, including the growing retirement divide, is bad for the overall economy and will dampen growth prospects for decades to come.

What else? America's ongoing retirement crisis (and ongoing quality jobs crisis) will place considerable constraints on public finances, exacerbating total debt due to higher health and social welfare costs. This is why I'm a stickler for enhancing the Canada Pension Plan for all Canadians and doing the same thing via enhanced Social Security for all Americans.

Sure, America's rich and powerful will shout "we can't afford it" and I will counter their warped ideological arguments with a good dose of basic economic theory and tell them we simply can't afford the status quo because it is the real road to serfdom (Hayek got it wrong).

Importantly, policymakers around the world and their rich and powerful backers need to open their eyes and understand the benefits of defined-benefit plans to the overall economy (and overall debt profile of a country) and also recognize the brutal truth on defined-contribution plans.

One thing I can guarantee you, the growing angst of Americans unable to retire will be an issue in the 2016 elections. Senators Warren and Sanders will make it a point to remind Americans that they bailed out Wall Street's elite following the 2008 financial crisis but nobody is going to help Main Street retire in dignity and security.

Below, CNBC's Kelley Holland discusses how $18,433 is the median amount in a 401(k) savings account, according to a recent report by the Employee Benefit Research Institute, highlighting the failure of 401(k)s.

And Emily Wittmann paid for years into a 401(k), but dipped into those retirement savings during the economic downturn. She's not alone. The scars of the 2008 crisis remain fresh to many Americans petrified to "invest" in these increasingly volatile markets dominated by computer algorithms.

Lastly,  a 2009 report which explains the 401(k) nightmare. As the default retirement plan of the United States, the 401(k) falls short, argues CBS MoneyWatch.com editor-in-chief Eric Schurenberg. He tells Jill Schlesinger why the plans don't work.