In part 1, I went through some of the history of defined benefit [DB] pensions using a Q&A format. I’m going to continue that in part 2.

Q: What are we supposed to do about pension policy in the US then?

A: Let me start with a quotation from an old article of mine, Replacing Defined Contributions.

Pension plan reform has to face three realities.  The first is people don’t know how much to put away for retirement.  I’ll give you a hint: for almost all people, it should be over 10% of your gross pay.  The second is that people don’t know how to invest, so hand it off to advisors who will do it for them, and cheaply.  The third is silent, and leaves a lot of money on the table — most people would be better off taking an annuity from their pension plan than a third party, or trying to manage a lump sum on their own.  This is usually an option only for defined benefit [DB] plans.

It would be nice if we could give everyone a DB plan, but as I pointed out last time, the costs would be too high.  DC [Defined Contribution] plans are inexpensive enough, but they have the above three flaws.

Q: How could we get people and firms to save more for retirement?

A: I’m not sure you can.  Present needs are large for many people, and they can’t imagine saving anything over 3%, much less 10%+ of pay.  Firms could do more, but it would raise costs, unless it is taken out of other benefits or wages.

Q: Why not “nudge” people to save more — create something that shows how far they are behind their most prudent peers?

A: Think about high school for a moment.  It’s a very peer conscious part of life for many people.  How well would an appeal go over asking the bulk of students to behave well, like the best-behaved students in the class?

Q: It might affect a few, but for the most part people are set in their ways.  They’ve already done their own implicit comparisons, and concluded that they are doing well enough relative to the peers they care about, given the circumstances.  They also might not like the comparison and say something like, “Fine for them, but I have different realities in my life.”

A: Right.  Effects should be small.

Q: Why not force people to save 10% of their pay then?

A: I think that treats adults like kids.  If they don’t want to save, let them be.  They might regret it later, or, they might say, “This is my lot in life.  I have to take care of what I think is important now, and when I am old, I’ll work if I have to.”  Also, people have an incredible ability to ignore reality if they need to.

Q: But isn’t there a public policy reason to encourage retirement plans and savings?

A: Most politicians think so, but retirement is a modern concept that with longer lifespans may not make sense in every situation.  The generation that fought WWII had a unique situation that allowed many of them to retire very comfortably that we don’t have now.  Productivity increases were larger, the demographics were right, global labor competition was a lot lower, and investment returns were a lot better.

You could look at my piece, Ancient and Modern: The Retirement Tripod for more on this.  As it is, it will be difficult to take care of the Baby Boomers to the same degree that their parents were taken care of — it doesn’t matter how you fund it — it is a humongous claim on GDP, and what will be left for those who are younger?

Q: So, you argue for freedom to choose in contributions, but you don’t argue for it in investing or distributions?

A: Uh, yes.  The main difference is that I think most people are capable of estimating their tradeoff of money now versus money in the future, and they are implicitly saying they don’t want to retire, regardless of what they say explicitly.

On investing, most people do not know what to do, and I would strip down most DC plans down to a small bunch of blended funds managed by professionals getting paid at low institutional rates.  There would be at most five funds, ranging from conservative to aggressive, with a default option that adjusts which fund a participant is in based on age.

On distributions, no one, not even professionals, are good at managing a lump sum of money to provide a stream of income.  Dig the ten reasons for that in this article.  People are capable of budgeting, so give them a fixed or slowly rising income to live off of, while investing their slack assets to cover future increases in costs.

Q: It seems inconsistent to me.

A: I’m just trying to be realistic about what people are capable of doing, and what their needs are.

Q: Why not have the government do the investing, or invest all pension monies in government debt?

I don’t think it is wise to entrust so much of the investing in the economy to a single entity.  Backdoor socialism is a real risk here.  Nor is it wise to fund the government via pensions.  Note how well the government did with Social Security.  It would be one thing if the government had used the money to improve infrastructure, but the money was generally spent on current consumption.

Q: The CFA Institute has put out their own plans for an Ideal Retirement System.  Wouldn’t that be a good idea?

A: When I was a kid, one of my friends would say to me, “If wishes were fishes, we’d all have a big fry.”  Like giving everyone a strong DB plan — it fails the cost test.  You could start doing this for a new group of retirees that would retire in the 2060s and beyond, but it is unrealistic for the present cohorts looking to retire sooner that have not saved enough individually or corporately.

Q: This is pretty dour.  Don’t you have anything encouraging to say here?

A: I would note that elderly people tend to be happier than younger people.  Some of it is coming to terms with life, grasping that many of the things that we aimed for when we were younger weren’t worth it, and taking some satisfaction in what good you have in the present.  It’s not all money based, but certainly money helps.  Some will look back at the past and say they did what was best for all their responsibilities.  Others may regret missed opportunities.

There may be some good that comes out of the American tendency toward voluntarism.  Who knows what elderly Baby Boomers might do when they put their mind to it?  Hopefully it won’t be voting more money for themselves from the public purse.

Q: Any final advice?

A: You are you own best guardian of your own retirement.  I encourage you to:

  • Save what you can.  This is one factor you can control.
  • Invest prudently, keeping fees low.  Don’t let yourself give into greed or fear.
  • Use immediate annuities to provide a minimum amount of income, and other assets for growth.
  • Make sure that you have younger friends to watch out for you.  Every older person needs advocates that can watch out for their best interests.

On the home front, I have been doing more basic financial counseling than usual, and I’ve had some say to me that it would be hard to build a buffer of 3-6 months of expenses.  If that is true of you, I would encourage you to build a smaller buffer of one month’s wages.  Why?

  • A change to good habits rarely happens immediately.  You gotta walk before you can run.
  • Psychological changes happen slowly, and there is a mental reward to achieving a smaller, interim goal.
  • The idea of living off of last month’s paycheck is a simple one.
  • Contra Aristotle, money is not sterile.  It tends to beget more money, once you pass a certain threshold.  Why?

There are discounts for upfront payment on large purchases, but the biggest reason is that once you get used to living on less than your full income, and living off of the buffer fund, there is a tendency for the buffer to grow.  You have begun to master a key concept:

Money has importance tomorrow that is more valuable than spending on purchases of trivial importance today.

I’m surprised at how money burns a hole in the pocket of so many people.  Spend down to the last dollar in the pocket and then some.  No wonder the credit card companies are so big and profitable.

I have another article coming up on this, but it is critical to basic financial management that you place importance on the ability to meet future needs with greater certainty.  Thus the need for the buffer, which implies saying “no” to low value and low priority spending.

It’s not a question of the intellect usually, but of the will.  When will you start making money your servant, rather than serving it?  Go build the buffer, even if it is small.  In time, with increased will power on your part, it will grow.


Heroes and Villains of Finance-420x627

I made it through this book while watching my daughter at a softball tryout.  It was an overly easy read, because there is little in the book.  For each of the 50 characters in the book, you get around 1.5 pages of text.  An average article at Aleph Blog would be the length of 2-3 biographical vignettes contained in this book.  At most, you learn the highest points of their lives.

But, I have other criticisms:

  • You don’t even necessarily get the highest points of their lives.  I read through a few of them and thought I could have done a better job summarizing their lives with one hour of time.
  • Many of the characters don’t deserve to be in the book.  Some aren’t important or colorful enough.  Others are too recent to evaluate how truly “colorful” or important they are.   Others aren’t truly in finance — they may be in business, politics, or academic economics, but they had little to do with finance in any direct way.
  • Occasionally, there are factual errors, such as with Nick Leeson, where it attributes his famous “I’m Sorry,” note to February 1994 (twice), while having him flee one year later in 1995.  Both happened in February 1995.

This book is bad enough that the author should be absolved from blame, and that the editors and anyone else in the approval process at Wiley should receive it.  This book should never have seen the light of day in its present form.  Wiley’s quality control is usually quite good — something went awry here.

Now, lest this be purely negative, I have two ideas.  Simple idea one: go buy Kenneth Fisher’s 100 Minds that Made the Market.  This is the book that Heroes & Villains of Finance should be.  As I say in my review:

Some people are hard to buy gifts for.  With books, there is often a trade-off between books that say a lot, and those that people are willing to read.  One book that I think hits the sweet spot is 100 Minds That Made The Market, by Ken Fisher.

Why do I think this?  This book is 100 little books in one volume.  You can pick this book up for five minutes, and read a well-written 3-4 page biography of person who has had a significant impact on how our markets work today.  Then you can put it down, get back to work, and think that you have learned something significant.

So if you want a book of short biographies, this is a better one.  I think it makes an excellent gift.

Idea number two, for the folks at Wiley — here’s a book that could sell: [20-50] Greatest Financial Scandals Ever.  Average people aren’t looking for heroes in finance.  It’s not that there aren’t any.  It’s just that the scoundrels are far more interesting to read about.  Finance, when done right, is boring.  Margin of safety, low debt, ethical management, etc… good to learn from, but won’t tell interesting stories to the same degree.

I would encourage the author to take it one step further as well: add a final chapter to give the common themes that run through the scandals.  Books like Heroes & Villains of Finance leave you with no generality at the end — is there some common thread behind heroes?  What of villains?  Are there lessons to be drawn here from the sum total of the lives considered?


Don’t buy Heroes and Villains of Finance.  Instead, if you want such a book, buy 100 Minds That Made the Market.  If you buy through the link I provide here, I get a small commission.  At present, it is the only revenue source for my blog.

Full Disclosure

I review books because I love reading books, and want to introduce others to the good books that I read, and steer them away from bad or marginal books.  Those that want to support me can enter Amazon through my site and buy stuff there.  Don’t buy what you don’t need for my sake.  I am doing fine.  But if you have a need, and Amazon meets that need, your costs are not increased if you enter Amazon through my site, and I get a small commission.  Win-win.

Dear Readers, I’m going to try a different format for this piece. If you think it is a really bad way to present matters, let me know.

Question: Why do pensions exist?

Answer: They exist as a means of incenting employees to work for a given entity.  It can be a very valuable benefit  to employees, because it is difficult to earn money in old age.

Q: How did we end up with retirement savings being predominantly associated with employment?

A: That’s mostly an accident of history.  First some innovative firms offered defined benefit [DB] plans [paying a fixed sum at retirement for life, often with benefits to surviving spouses, and pre-retirement death benefits] in order to attract employees.  After World War II, many unions insisted and won such benefits, and many non-union firms imitated them.

Q: Why didn’t many defined benefit plans persist to the present day?

A: In general, they were too expensive.

Q: If they were too expensive, why did they get created?

A: They weren’t expensive at first.  The post-WWII era was one of booming demand and excellent demographics — there was only a small cohort of oldsters to support, and a rapidly growing population of workers.  Also, the funding mechanisms allowed by the government allowed for low levels of initial funding to get them started, and they assumed that corporations would easily catch up at some later date.  Sadly, some of the funding was so low that there were some defaults in the 1960s, leaving pensioners bereft.

Q: Ouch.  What happened as a result?

A: Eventually, Congress passed the Employee Retirement Income Security Act in 1974.  That standardized pension funding methods and tightened them a little, but not enough for my taste.  It also created the Pension Benefit Guarantee Corporation to insure defined benefit plans.  It did many things to standardize and protect defined benefit pensions.  Protection comes at a cost, though, and costs went higher for DB plans.

Some firms began terminating their plans.  In the mid-1980s, some firms found that they could get a moderate profit out of terminating their plans.  That didn’t sit well with Congress, which passed legislation to inhibit the practice.  That indirectly inhibited starting plans — few people want to in the “in” door, when there is not “out” door.

Some firms began funding their plans very well, and the IRS didn’t like the loss of tax revenue, so regulations were created to stop overfunding of pension plans.  These regulations put sponsors in a box.  Given the extremely strong asset returns of the ’80s and ’90s, it would have made sense to salt a lot of assets away, but that was not to be.  Thanks, IRS.

Q: Were there any other factors aside from tax policy affecting DB plans?

A: Four factors that I can think of:

  • Falling interest rates raised the value of pension liabilities.
  • Demographics stopped being so favorable as people married less and had fewer kids.
  • Actuaries got pressured to be too aggressive on plan valuation assumptions, leading to lower contributions by corporations and municipalities to their plans.
  • By accident, the 401(k) was introduced, leading to an alternative pension plan design that was a lot cheaper.  Defined contribution plans were a lot cheaper, and easier for participants to understand.  The benefits were valued more than the technically superior DB plan benefits because you could see the balance grow over time — especially in the ’80s and ’90s!

Q: Why do you say that DB plan benefits were technically superior?

A: Seven reasons:

  • They were generally paid for entirely by the employer.
  • A lot more money was contributed by the employer.
  • It gave them a benefit that they could not outlive.
  • Average people aren’t good at investing.
  • Fees for investing were a lot lower for DB plans than for Defined Contribution [DC] plans.  (Employer provides a sum of money to each employee’s account.)
  • The institutional investors were better for DB plans than DC plans, because plan sponsors would go direct to money managers with talent, while plan participants demanded name-brand mutual funds that were famous.  (Famous means a lot of assets recently added, which means poor future performance.  Should you give your kids what they want, or what you know they need?)
  • If the companies could continue to afford the benefits, the benefits would be much larger in present value terms than the lump sum accumulated in their DC plans.

The last point is important, because the benefits promised were too large for the companies to fund.  Eventually, they will be too large for most states and municipalities to fund as well, but that’s another thing…

Q: So people preferred something that was easier to understand, rather than something superior, and companies used that to shed a more expensive pension system.  That’s how we got where we are today?

A: Yes, and add in the relative impermanence of most corporations and some industries.  You need a strong profit stream in order to fund DB plans.

Q: What are we supposed to do about this then?

A: Stay tuned for part two, which I will write next week.  Believe me, there are a lot of controversial ideas about this, and there are no easy solutions — after all, we got into this problem because most corporations and people did not want to save enough money for the retirement of employees and themselves, respectively.

Q: Till next time, then!


If you want to know what is the core problem of the average person approaching the market (though this applies more to males than females, women have more native caution on average), it is chasing a hot idea.  This can take a number of forms:

  • Getting tips from friends who have bought some stock that is currently popular in the market.
  • Doing the same thing with investors who talk or write about investing.  The best investment advice is not flashy, and does not make for good video.
  • Looking at charts and buying something that is rising rapidly, because popular media say this is “The Next Big Thing.”
  • Buying the mutual fund or other pooled vehicle of some manager who has done very well in the past, and seems to never fail.  (If you buy a mutual fund, don’t buy one that has had a lot of money pile into it recently… usually a bad sign.  Spend more time to see if the manager thinks in a businesslike way about assets that he buys.)
  • Going to a broker who is very well-dressed and confident, and talks really well, but who has no obligation to act in your best interests.  If you don’t know how he is earning his money from you, avoid him, because it usually means investments with high fees or hidden ways that you can lose, e.g. structured notes that offer a nice yield, but where possibilities to lose are more significant than you think.  At best, he will give you consensus ideas and managers that deliver him above average remuneration.
  • Buying the newsletter of some overly confident person who claims to know the secrets of the market, which he will share with you and 100,000 other close friends for a mere $299/year!  (Please read Mark Hulbert before buying a newsletter.)
  • Worse yet, giving into the fakery of those who try to bring you into a hidden opportunity.  It can be a Ponzi scheme, a promoted stock, but they suggest returns that are huge… or, like Madoff, decent but not exorbitant returns that are altogether too regular.

Many of these appeal to our desire to get something for nothing, which is endemic — we all have it to some degree, and marketers play off this regularly by offering us “free” this, and “free” that.  Earning returns from your investable assets is a business in its own right, and there are costs to doing it well.  You should not be surprised that doing well with it will take some time and effort.

You also have to avoid the impulse that there is some hidden knowledge, or group of insiders that have found an easy road to riches.  The markets aren’t rigged in any material way.  The principles of investing are well-known, but applying them takes creativity, time and effort.  There are no significant players with a new theory who make amazing money investing in secondary markets for stocks and bonds.

Most of the things that I listed above involve low-thought imitation of others.  There is little advantage in investing to mimicry.  Even if it worked for someone else, the prices are different now, and easy gains have been made.  You will do worse than the one you are trying to imitate with virtual certainty, and likely worse than average.  You need to plan to take an independent course, and learn enough such that if you do choose to use advice of any sort, that you can evaluate it rationally.  If you choose to do it yourself, you will need to learn more than that.  It takes effort, but that effort will pay off, if not in investing itself, but there are spillover effects in intelligent management of your finances, and in improving your abilities in the businesses that you serve.

In most areas of life, most things that pay off well take effort.  If people present you with easy or hidden ways to make above average money, be skeptical.  Doing it right takes discipline and effort.  (If you want the easy route while avoiding all the pitfalls see the postscript.  It is boring, but it works.)


As an aside — you can always index, and beat most average investors over the long haul.  Buy broad funds that invest in a large fraction of all of the stocks that there are, and those that replicate the bond market as a whole.  Make sure they have low fees.  Buy them, hold them, and be done.  You will still face one hurdle: will you be able to maintain your strategy when everything is in a crisis, or when your friends tell you they are earning a lot more than you, and it is easy to do it?  Size the bond portion of your assets to the level where you can sleep soundly in all circumstances, and you will be fine.


Too often in debates regarding the recent financial crisis, the event was regarded as a surprise that no one could have anticipated, conveniently forgetting those who pointed out sloppy banking, lending and borrowing practices in advance of the crisis.  There is a need for a well-developed model of how a financial crisis works, so that the wrong cures are not applied to the financial system.

All that said, any correct cure will bring about a predictable response from the banks and other lending institutions.  They will argue that borrower choice is reduced, and that the flow of credit and liquidity to the financial system is also reduced.  That is not a big problem in the boom phase of the financial cycle, because those same measures help to avoid a loss of liquidity and credit availability in the bust phase of the cycle.  Too much liquidity and credit is what fuels eventual financial crises.

To get to a place where we could have a decent model of the state of overall financial credit, we would have to have models that work like this:

  1. The models would have to have both a cash flow and a balance sheet component to them — it’s not enough to look at present measures of creditworthiness only, particularly if loans do not fully amortize debts at the current interest rate.  Regulatory solvency tests should not automatically assume that borrowers will always be able to refinance.
  2. The models should try to go loan-by-loan, and forecast the ability of each loan to service debts.  Where updated financial data is available on borrowers, that should be included.
  3. The models should try to forecast the fair market prices of assets/collateral, off of estimated future lending conditions, so that at the end of the loan, estimates can be made as to whether loans would be refinanced, extended, or default.
  4. As asset prices rise, there has to be a feedback effect into lowered ability to finance new loans, unless purchasing power is increasing as much or more than asset prices.  It should be assumed that if loans are made at lower underwriting standards than a given threshold, there will be increasing levels of default.
  5. A close eye would have to look for situations where if the property were rented out, it would not earn enough to pay for normalized interest, taxes and maintenance.  When asset prices are that high, the system is out of whack, and invites future defaults.  The margin of implied rents over normalized interest, taxes and maintenance would be the key measure, and the regulators would have to have a function that attributes future losses off of the margin of that calculation.
  6. The cash flows from the loans/mortgages would have to feed through the securitization vehicles, if any, and then to the regulated financial institutions, after which, how they would fund their future liabilities would have to be estimated.
  7. The models would have to include the repo markets, because when the prices of collateral get too high, runs on the repo market can happen.  The same applies to portfolio margining agreements for derivatives, futures, and other types of wholesale lending.
  8. There should be scenarios for ordinary recessions.  There should also be some way of increasing the Ds at that time: death, disability, divorce, disaster, dis-employment, etc.  They mysteriously tend to increase in bad economic times.

What a monster.  I’ve worked with stripped-down versions of this that analyze the Commercial Mortgage Backed Securities [CMBS] market, but the demands of a model like this would be considerable, and probably impossible.  Getting the data, scrubbing it, running the cash flows, calculating the asset price functions, implied margin on borrowing, etc., would be pretty tough for angels to do, much less mere men.

Thus if I were watching over the banks, I would probably rely on analyzing:

  • what areas of credit have grown the quickest.
  • where have collateral prices risen the fastest.
  • where are underwriting standards declining.
  • what assets are being financed that do not fully amortize, including all repo markets, margin agreements, etc.

The one semi-practical thing i would strip out of this model would be for regulators to score loans using a model like point 5 suggests.  Even that would be tough, but even getting that approximately right could highlight lending institutions that are taking undue chances with underwriting.

On a slightly different note, I would be skeptical of models that don’t try to at least mimic the approach of a cash flow based model with some adjustments for market-like pricing of collateral and loans.  The degree of financing long assets with short liabilities is the key aspect of how financial crises develop.  If models don’t reflect that, they aren’t realistic, and somehow, I expect that non-realistic models of lending risk will eventually be the rule, because it helps financial institutions make loans in the short run.  After all, it is virtually impossible to fight loosening financial standards piece-by-piece, because the changes seem immaterial, and everyone favors a boom in the short-run.  So it goes.

A few days ago, I was trying to buy a little bit of a defense company that I own for myself and clients.  It was relatively inexpensive, and had fallen out of favor.  Now, it’s not the most liquid beastie on the US market, so I put in an order to buy 2000 shares, while showing 100 shares, offering to buy at the current bid of $25.50 while allowing purchases at up to $25.57, while the ask was at $25.65.  I then shifted away from my trading application, and went to do other work.

After an hour, I went back to my trading screen, and saw that 1200 shares had executed between $25.50 and 25.57, but now the price was much higher, and by the end of the day, higher still.  It is even higher now.

At the time, I took a look, and lo and behold: I got the bottom tick — the lowest price on that stock ever (for now).  I also noted that I had almost all of the volume when it went down to the low price.  But 1200 shares is small compared to the total trading in the name, and $30,000 is also a small amount of money.  I concluded that it was a happy accident that I got the bottom tick.

I’ve had the same experience working at a hedge fund.  I would occasionally get the bottom tick when buying, or the top tick when selling, and most of the time I ended up saying that it had to happen to someone — it was us that day.  That said, the total amount of volume was almost always low near the top or bottom, so getting that versus a trade nearby was not worth that much.

To have a lot of volume near a top or bottom, you need two or more determined and anxious traders with large capacity to trade, a need for speed, and opposite opinions.  That happens sometimes, but in experience, not that often.  Near a peak, you would need a buyer anxious to buy a lot more NOW.  Near a trough, a seller wanting to sell it all NOW.

Most of the time, large institutional investors are cautious, and try to minimize their impact on market prices — being too aggressive will likely give them a worse result than being patient.  The exception would be someone who thinks he knows a lot more than the market, but feels that edge will erode soon, and therefore has to do the trade in full NOW.

That doesn’t happen often.  Practically, that means to not be so picky about levels in buying and selling.  If you are getting the trade off and there is decent volume at a price near where you want to do the trade, do the trade, and don’t worry much about the small amount of profit that you might be giving up.  Better to focus on ideas that you think have long term potential for profit, than to waste time trying to squeeze the last bit of profit out of a trade where incremental returns will be minuscule.