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Feb 27, 2006 7:11 pm =x&r=0%2E3652918

Stocks: The Fatal Flaw in Retirement Plans?
By <?:namespace prefix = st1 ns = "urn:schemas-microsoft-com:office:smarttags" />Thornton Parker
Feb. 27, 2006
  <?:namespace prefix = o ns = "urn:schemas-microsoft-com:office:office" />

Baby boomers have long taken it to heart that the best way to save for retirement is to invest in equities. However, this conventional wisdom may have created its own bull market. One contrarian maintains that four erroneous assumptions will doom pension funds, investment savings, and—in the end—retirees.

Everyone knows that stocks are good retirement investments, because over the years they have produced larger total returns than most other investment classes, while buying them provides capital that companies need to grow, provide jobs, and help the economy. But what "everyone knows" may not be true.

The most important reason to question the received wisdom is that there is no accepted explanation of how total returns from stocks can be converted into retirement incomes. And the deeper you probe into the way stocks actually work in relation to what retirees need, the more flawed the idea appears to be. Indeed, there is a fundamental mismatch between how stocks work and the dependable streams of cash that retirees need.

The stocks-for-retirement cycle: inputs

There is a stocks-for-retirement cycle. Money is saved, stocks are bought, and portfolios are managed to increase their value during the input half of the cycle. Most of the stocks will have to be sold during the output half of the cycle to provide cash for retirement. We'll look at four important factors about stocks that relate to the input part of the cycle and then consider how these factors affect the cash outputs.

Factor 1: Statistical fictions in equity performance

Stocks are portrayed as having produced outstanding total returns for investors over long periods of time, but that is not the whole story. Standard and Poor's data for its 500 Composite Index show there were two distinct periods in stock market history—the first 56 years, from 1926 through 1981, and from 1982 on. During the first period, 21 of the years produced annual losses—the sum of dividends paid was slightly higher than the total gains, and gains grew at a compound rate of only 4.1%.

But those data can be misleading. Nobody bought a share of the S&P 500 at the end of 1925 for $12.76 and let it grow, complete with compounding, because the index was not created until 1957. Data the company provides for the earlier years, including the $12.76, are extrapolations that are based on other smaller indexes it maintained. Even at that, few investors could link their portfolios to an index (because of commission costs) until 1976, when the first index fund was created. Thus, for all practical purposes, the popular tale of the first period is statistical fiction.

During the second period—which began in 1982 and ran through 1999—there were only two down years, and gains increased by more than 12 times, while dividends did not quite double. Gains grew at a compound rate of 14.8% and provided 86.7% of the total returns during these 18 years. Much of the case for buying stocks for retirement plans is based on this period. To anticipate what may happen in the future, it is important to understand what drove the bull market.

Factor 2: How retirement plans ramped up demand

Many things—both financial and nonfinancial—happened to make the bull market so different from the years that preceded it: the end of the Cold War, industry and market deregulation, emerging technologies and venture capital, declining interest rates, and the self-reinforcing effects of the S&P 500 Index itself.

But one event stands out: the 1982 IRS ruling, which built on the Employee Retirement Income Securities Act (ERISA), that let companies and their employees put current earnings into 401(k) plans. That, along with the oldest baby boomers reaching their peak earning years, led to the growth of defined-contribution plans and the shift of retirement risks and responsibilities from employers to employees. By the end of the century, nearly half of all American families owned stocks directly or indirectly through pension and mutual funds, and tax-advantaged retirement portfolios owned half of the country's traded stocks.

A new industry of financial advisors, writers, media programs, and mutual funds blossomed during the second period. Mutual funds, which at the start of 1982 owned only 2.7% of the country's stocks, owned 21.5% by the end of 2004. The financial services industry fueled much of this growth, using the goal of retirement to stimulate the demand for stocks and mutual funds. Meanwhile, Federal Reserve data show that companies actually withdrew slightly more stock from the market than they issued during the period.

Stocks are appealing because they are liquid and prices are set in open competition by the supply offered for sale in relation to the demand. Data for the boom period, however, show that the goal of retirement helped to stimulate the demand for stocks while the supply declined slightly—obviously a formula for higher prices. Put another way, retirement plan purchases and promotion helped drive the bull market.

Retirement plans affected more than supply and demand. As billions of dollars of retirement savings flowed into pension and mutual funds, the managers were pressed to make the money grow. The managers—particularly of large state pension plans—gained unprecedented power, which they used to press companies for higher stock prices. Companies responded by cutting costs, downsizing, outsourcing, merging, laying off domestic and older workers, promoting deregulation and globalization, ignoring the environment, linking executive compensation plans to stock prices, misrepresenting their financial conditions, and buying back their stocks—all to increase stock prices. Much of the social and political discord of the past 20 years has been at least partly due to pressures from pension and mutual fund managers for higher stock prices.

Factor 3: Corporate insiders fed the boom

As companies were reducing the total number of shares outstanding, few people wondered about who sold the stocks that retirement plans bought. If stocks are such good investments, why would anyone want to sell them? Much of the answer can be found by analyzing data from the Federal Reserve's "Flow of Funds Accounts," the Wall Street Journal, and Forbes.

The Fed data show that households were the primary stock sellers from 1982 on, while company pension plans were also net sellers. The primary domestic buyers were largely retirement-related—mutual funds, state and local pension plans, and life insurance companies. Taking the beginning balances for each group—adding or subtracting their net purchases or sales during the period in relation to their ending balances—shows that the household sellers made far more money from stocks than the net buyers. Life insurance companies came into the game late to cover annuity contracts and actually lost money through 2002.

Those whose names appear in the Forbes lists of the country's wealthiest people trace most of their fortunes to stocks. This is reinforced by Journal reports of insider transactions, which are listed every day and summarized on Saturday. The two publications show that founders, early investors, executives, and in some cases rank-and-file employees who get large blocks of stock or options at low prices can enjoy spectacular profits when they sell at much higher prices on secondary markets.

As the world's richest person in Forbes, Bill Gates is the poster child for this. He retained 45% of the Microsoft shares when the company went public. Adjusted for splits, he sold two billion shares by the end of 2004, still owned 1.2 billion, and was selling 20 million shares each quarter. He has enough stock to keep that up for 15 years. Most retirement portfolios hold Microsoft stock, and statistically, a fifth of their holdings were sold into the market by Gates himself. He recovered all of his costs from his first sale, and every penny he's received since is net profit. Most of the Microsoft stock in retirement plans came originally from the estimated 10,000 "Microsoft millionaires."

Retirement plans helped create a market for insiders by acquiring many of the shares they sell and helping to set the price on the shares they retain. In fact, the plans now own half of the domestically owned stocks traded on U.S. markets. As retirement plans rose to prominence, they facilitated a direct transfer of cash from workers to insiders, which added to the growing wealth gap between the middle class and the country's richest people.

Factor 4: The problem of phantom wealth and "total returns"

Phantom wealth is created (or destroyed) in two steps: First, a market price is set at the end of each trading day. Second, the holdings of most large portfolios are routinely marked to market. For example, Microsoft has more than 10 billion shares outstanding. If the price goes up a dime, a billion dollars are created when all portfolios are marked up, and no one knows where all that money came from. If the price goes down a dime, the billion dollars vanish—they were just phantom wealth. Phantom wealth is a large component of most retirement-plan stock portfolios, and the FASB is exploring whether company reports should smooth its peregrinations.

It is customary to combine dividends and gains into one number, called "total returns," but they are mirror opposites. Dividends are endogenous—they come directly from companies as continuing streams of cash and are made possible by what the companies have already accomplished.

Most gains are exogenous—they come from outside of companies. They first appear when phantom wealth is created by marking up portfolio statements because buyers somewhere have paid higher prices based on what they think will happen in the future. But gains can be converted into cash only by selling the stocks. When that is done, the cash comes from the buyers, not the companies.

Pension plans typically project that their total returns will be in the range of 8% to 11%, but the dividend yield of the S&P 500 was less than 1.9% at the end of 2005. Assuming that dividends will be 2%, the plans expect gains to contribute from 6% to 9% to their total returns. This compares with the 4.1% return that S&P data show stocks provided during the 1926–1981 period, before retirement plans began exerting their major force. There are no responsible predictions that the economy can grow for years and support the growth of phantom wealth at anything like those rates. During the seven years since the end of 1998, the S&P 500 has grown at a compound annual rate of less than 0.2%.

When companies use total returns to smooth the projected growth of their pension plans, they are really attempting to project the future sales prices of their stocks and book any profits in the current year—as Enron did with futures contracts.

The stocks-for-retirement cycle: outputs

When engineers design a system, they first specify what it is to do or produce—the intended output. However, when the inputs to any system or its design are faulty, the output may differ extensively from what was expected.

Will stock prices continue to climb?

It is a mistake to assume that prices will continue to climb as boomers shift to the output half of the stocks-for-retirement cycle. Rather, it appears that boomers created a wave in stock prices as they did in schools, jobs, and houses. If so, the wave can be expected to crest and subside. If that happens, trillions of dollars of phantom wealth that boomers expected to receive as cash will just vanish.

Demographics will spark the problem as the support ratio of workers to retirees declines. However, the declining support ratio threatens stock-based plans more than Social Security because the problem is not just demographic. Until recently, wealthy people used stocks to pass wealth down to their younger heirs. The stocks-for-retirement cycle is an experiment in reversing the historic flow and using stocks to transfer income up from younger workers to retirees to an extent that hasn't happened before. The idea that stocks will be good retirement investments over the years has yet to be proved. Especially since most domestic buyers of the boomers' stocks will have to be the same workers who are also supporting Social Security.

Steel, airline, and auto parts industries show how the support ratio affects pension plans when companies mature and reduce their employment. If their ratio of employees to retirees declines and their stock portfolios are inadequate, they have trouble competing in the marketplace and meeting their commitments to retirees, and their plans go to the Pension Benefit Guaranty Corporation. Recent pension fund problems are an early warning of what may happen eventually to most retirement plans that depend on pass-through payments from employees and stocks to retirees.

Corporate insiders, who have been the primary source of the stocks that retirement plans bought, will continue to convert their shares into cash. But as boomers' retirement plans shift from buying to selling, the symbiotic relationship between corporate insiders and retirement plans will change. Instead of each providing what the other wants, they will compete for the limited purchasing power of the younger workers. There is a high risk that many more shares will offered for sale, stock prices will fall, and large amounts of phantom wealth will vanish. If that happens, retirement plans will take the brunt of the hit. Insiders who paid pennies or less per share can make money at prices that will wipe out retirement portfolios that bought stocks at market prices.

Can foreign investors save the day?

Unless a realistic analysis shows how foreign buyers can be expected to sustain prices, it is not wise to count on them. Other developed countries face more serious problems with their aging populations than we do, and the economic and national security implications of exporting control of U.S. companies to foreign competitors has not been analyzed.

Some observers, such as Jeremy Siegel, believe that rapidly growing countries like China and India may acquire many U.S. company stocks. That may well happen, but not necessarily to the benefit of retirement plans. Those countries face serious population aging problems because of their low birth rates. Their companies are growing primarily because their workers receive much less than U.S. workers, and they rarely provide retirement plans. It is hard to see how individual savings would be used to pay high prices for U.S. stocks when their own companies are growing much faster.

On the other hand, it is easy to see how foreign companies may want to buy U.S. companies for their facilities, resources, and markets at bargain prices. The Daimler Benz acquisition of Chrysler is an example, and in that case, stock was the medium of exchange, not cash.

Aging is not limited to baby boomers, so discussions of Social Security stress the need for remedies that will last 75 years or more. But boomers' stocks that are sold to foreign buyers will not be available to help forward-fund retirements of younger workers. Selling the stocks out of the country would be a one-time fix.

Finally, many boomers are not saving enough to even hope for long retirements. They will need jobs with adequate pay and benefits even if their skills are obsolete and their capabilities are declining. But those are just the jobs that companies are eliminating or exporting to inflate stock prices for retirement plans that appear destined to fail.

The coming storm

Despite the widely held view that stocks are good retirement investments, there is no generally accepted explanation of how the stocks held by retirement plans can be sold at prices high enough to provide the cash streams that boomers and younger workers are being told to expect. If something has never been done before, and no one can explain how it can be done, there is a high risk that it can't be done. If anyone can explain why this analysis is wrong, it would be very good news that everyone should hear. If not, there may still be enough time to prevent a disaster by thinking seriously about how the country can provide for older Americans. But time is not on our side.

Feb 27, 2006 7:24 pm


Feb 27, 2006 9:05 pm

Ah, the mantras and platitudes of “Buy and Hold” Why, just look at this Ibbotson chart showing stocks have returned 10%+ (Or whatever the hell the # is) for the last 77 yrs. Well I’m here to ask the question, “Who here has a 77 yr horizon?”. The fact is that most of the wealth in this country is controlled by those 50+. 77 yr horizon for those 50+??. The S&P has shown +.54%/yr. for the past 5 yrs. Let’s “financial plan” around those #'s. Well? Go ahead and do the “plan”. Running 12 inflation #'s are @ 4% (not counting FOOD & ENERGY!) Why not disclude water and air while we’re at it? Go ahead and do the “plans” @ 8% growth (conservative enough don’t you think?) and using inflation @ 3% (pretty conservative historically isn’t it?) This whole thing we do is ENTIRELY flawed if you/we accept these mantras and platitudes. How about THIS fact. The baby boomers are JUST STARTING to liquidate their positions accumulated in the last 10/20 yrs. MORE TO COME. This market is not going to embark on a new bull from these valuation levels. Don’t agree? OK, go ahead and do the 77 yr “thing”. I’ll do something else with my $$.   

Feb 27, 2006 10:17 pm


If you place all of your money in the S & P 500 your a moron.  I am doing my feburary reviews and most clients are up 12-15% from prior year. 

Doom and gloom your paid to ignore the crap and focus on the future, of course the boomers are going to sell their stock, they'll sell it to purchase goods, which will generate profits, which will be dispersed to present company executives, shareholders and employees (In that order :) ), do you think the money is going to vanish?

Feb 27, 2006 11:47 pm

In case Dude’s post wasn’t enough of a bummer:

"In the February 20, 2006 edition of Fortune (“The Tragedy of General

Motors”), reporter Carol J. Loomis suggests that a GM bankruptcy will be a

major event for the U.S. economy and, more importantly, for the U.S.


"It is the instinctive wish of most American businesspeople, even those

unlikely to be directly affected, that General Motors not go bankruptcy.

True, some people will say, ‘They had it coming to them.’ But the majority

will be more practical, telling themselves that the company is so central

to the economy, so sprawling in its commercial reach, that bankruptcy –

‘going into chapter,’ as restructuring folks say – is ominous almost

beyond contemplation. And yet the evidence points, with increasing

certitude, to bankruptcy…Bankruptcy isn’t going to occur next week. But

down the road – say, past 2006 – its probability is high."

A GM bankruptcy, which HCM views as inevitable (with Ford soon to

follow), will be such a monumental psychological event because it will toll

the death knell of the American industrial model. No longer will

politicians and business leaders be able to defend a system that includes

prohibitively expensive legacy costs (healthcare, pensions), uncompetitive

union demands (i.e. work rules, uneconomic wage and benefit packages),

and a dysfunctional tort system. It is obvious to a child of elementary

school age that the system is broken; it is a true American tragedy that it

is going to take the bankruptcy of an American business icon to force the

point home. And even then, in today’s political and economic system,

there is no guarantee that anything more than a band-aid will be applied

to the problem while America’s industrial system is allowed to slide

further into the abyss. "

More to come tomorrow…

Feb 28, 2006 12:33 am

Dude’s post is only a bummer for those who think they’re going to retire by investing in large cap stocks and index funds alone.

For those who explore alternatives, there are still plenty of options for the future.

Thanks dude…good stuff!

Feb 28, 2006 8:56 am

Bankrep: This “moron” has a personal investment portfolio in multiple 7 figures. Point is that you rookies continue to believe the BS put out by your "investment strategy,planning, ad nauseum " depts. Read Mon. WSJ re retirement “planning” trainwrecks about to happen. Oh,I forgot, most of you rookies don’t read the WSJ. After all you have all the answers.

Feb 28, 2006 11:29 am

The main idea behind Economics in general is supply and demand.  No one can argue that by virtue of sheer # of investors alone (baby boomer retirees), demand for US stocks by US investors will go down.

Returns CAN be generated by an money manager by properly playing the volitility of the market (i.e. buying low, selling high), but that has little to do with actual GROWTH, just good timing. 

I don't think it's gonna be THAT bad for another decade or so, but I do tend to agree with the article for the most part.  If you want to invest in stocks and grow your money, you have two choices IMO...

1.  Go where the growth is (international, small cap, private placement, etc)

2.  Time the market (invest in cyclical sectors, buy low/sell high)

I choose #1

Mar 2, 2006 12:33 pm

BankFC makes a good point.  I would add that “innovation” will always create investment opportunities.  Areas that I’m find attractive are:  nanotechnology, biotechnology, anything wireless, alternative energy and natural resources.   

Mar 2, 2006 12:55 pm

or concentrate in VA’s with the principle protection and guaranteed income riders. This is where future is with most average baby boomers. Compared to the cost of managed money. they’re outstanding values with the guarantees.

Mar 2, 2006 7:29 pm

[quote=Revealer]Ah, the mantras and platitudes of "Buy and Hold" Why, just look at this Ibbotson chart showing stocks have returned 10%+ (Or whatever the hell the # is) for the last 77 yrs. Well I'm here to ask the question, "Who here has a 77 yr horizon?". The fact is that most of the wealth in this country is controlled by those 50+. 77 yr horizon for those 50+??. The S&P has shown +.54%/yr. for the past 5 yrs. Let's "financial plan" around those #'s. Well? Go ahead and do the "plan". Running 12 inflation #'s are @ 4% (not counting FOOD & ENERGY!) Why not disclude water and air while we're at it? Go ahead and do the "plans" @ 8% growth (conservative enough don't you think?) and using inflation @ 3% (pretty conservative historically isn't it?) This whole thing we do is ENTIRELY flawed if you/we accept these mantras and platitudes. How about THIS fact. The baby boomers are JUST STARTING to liquidate their positions accumulated in the last 10/20 yrs. MORE TO COME. This market is not going to embark on a new bull from these valuation levels. Don't agree? OK, go ahead and do the 77 yr "thing". I'll do something else with my $$.   [/quote]

Thanks for the comments Revealer.  What are you doing to address this issue? 

Mar 2, 2006 7:38 pm

[quote=skeedaddy2]BankFC makes a good point.  I would add that "innovation" will always create investment opportunities.  Areas that I'm find attractive are:  nanotechnology, biotechnology, anything wireless, alternative energy and natural resources.    [/quote]

I'm there with you.  My portfolio is up 5% YTD vs S&P of about 1.7% (I also smoked the S&P last year) because of concentration in tech, precious metals and emerging Markets, although my PIMCO commodity real return fund is sucking wind this year.  I'm resisting the urge to sell it, since I still believe that long term there will be upward pressure on commodity prices, I hope I'm right.

Mar 2, 2006 10:04 pm

What am I doing to address these issues? In the inimitable words of Sgt. Esterhaus on Hill Street Blues, “Let’s be careful out there.” #1 SAVE MORE. How do y’all like the US personal savings rate? #2 Realize that we are going to see less than normal rates of return for the forseeable future.(Refer to #1) #3 Use non-correlating assets such as Pimco Commod.Real.,etc. I would ask all who read these boards and advise folks to “Quit using the (magic wand) of irrational expectations.” It will be a sad day when everyone who is using poor assumptions come up WAAAAY short come college day and/or retirement day. It ain’ta gonna be pretty. Keep asking yourself if 4-5% (current bond rates) are ALL we can expect for the forseeable future? If us advisors cut most of the BS out of the equation, it’ll all work out. By the way, I don’t want anyone responding that THEY are earning 12,14,20% or what ever using some magic elixer portfolio manager. I don’t believe it, and if you REALLY are, the Oracle of Omaha wants your name.