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A year and a half after the collapse of the financial markets—and only days after the SEC charged Goldman Sachs with fraud—the debate about necessary “reforms” is still in its early stages, and none of the debaters seriously claims that his or her solution will in fact prevent a new crisis.

The problem is that the proposed remedies deal with superficial matters of industrial organization and regulatory procedure, while the real problems lie on a more profound level.

Banking has always been a business where the profits come over time, as the borrower pays interest on the loan and eventually repays the principal. Principal being much larger than interest, lending officers are paid to have good judgment about which applicants for loans can and will pay what they owe (and which debtors can’t or won’t)—especially on longer loans like mortgages, where one borrower who defaults eats the profits from ten or even twenty of those who pay.

The late Hyman Minsky, whose “financial stability hypothesis,” written in 1966, accurately described what happened to our banks a year and a half ago, liked to say that there was a morality to the lending officer’s work because his prosperity depended on the success of his clients.

In years past, loans were funded from the deposit base of the bank. Bank deposits are the transaction balances of the economy. Banks had the use of this money because they provided the plumbing of the payments system. Their size was determined by the needs of enterprise. Banks could not grow on their own motion; they were forbidden to borrow (except by discounting their customers’ paper) or to acquire bonded indebtedness.

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In the 1950s, the banks began to free themselves from these shackles. What was then Morgan Guaranty established a market for Fed Funds, in which banks “bought” the excess reserves of other banks overnight or for very brief periods. In the 1960s what was then National City Bank of New York began to sell “certificates of deposit” to increase the money available to the bank for lending.

In 1975, I published a book that opened with the words, “A spectre is haunting American business and government: the spectre of banking.” Once the banks could grow by tapping the money markets they controlled, the government was not well equipped—or, to be honest, well motivated—to stop them. What slowed the march of finance was the fact that the profits came at the end of the loan, which had to be financed as long as it lived.

Enter “securitization.” Instead of keeping their loans in their vaults, banks could contribute them to packages of like instruments for sale to investors. Now the money came back to the bank long before the borrower repaid his loan. Absent specific arrangements for “recourse,” the bank didn’t necessarily care whether or not the loan was repaid.

To quote George Shultz, who was an economics professor before he was Secretary of State, the bank no longer had “skin in the game.” The lending officer’s work was supplanted by machines doing complicated and often unrealistic statistical analysis of which loans were likely or unlikely to default.

Moreover, bankers saw no need to make it easier for purchasers to value these pseudo-bonds by limiting the kinds of instruments that could be agglomerated in each “collateralized debt obligation.” The Federal Deposit Insurance Corporation, when cleaning out the S&Ls in the late 1990s, developed the idea of selling “the whole bank” by combining mortgages, credit card advances and business loans in “asset-backed securities.”

Historically, any paper with such characteristics had been “overcollateralized.” That is, it had been backed by loans with total asserted valuations greater than the face value of the bond. The FDIC, working through its subsidiary, the Resolution Trust Corporation, offered another step. If some of the collateral in the initial offer went sour, the FDIC made it possible for the packager of the paper to get a second chance, substituting other assets in the RTC warehouse.

This led to the “total return swap,” and then to the infamous “credit default swap,” an insurance policy disguised as a security. It gave all the little gamblers at the big dice table the opportunity to bet on or against the solvency of some company or government, whether or not they were rolling the dice themselves.

For the participants, these “innovations” were wildly successful. Their triumph, Michael Lewis suggests in his new book, The Big Short, was that the whole world became willing to lend money to instruments—not to businesses or houses, not to land, labor or enterprise, but to artificial contracts created behind closed doors.

The share of the financial sector in the nation’s gross domestic product rose from less than three percent in the decade after World War II to more than seven percent in the first decade of the new millennium. The share of the financial sector in the profits of corporate America grew even more rapidly, to more than 40 percent. The rest of us didn’t do so well.

The labor on Wall Street now is to restore those lovely unexamined days. And Wall Street will pay Washington lavishly—indeed, has already done so—to be of assistance in this effort. We are well on our way to reproducing the disasters of 2008.

Controlling the internal operations of the giant banks is all but impossible, but we can limit their intake and thus their size. Forty years ago, Scott Pardee, then the chief foreign exchange trader for the Federal Reserve Bank of New York, suggested a Food and Drug Administration for financial instruments, with a rule that instruments could not be traded by federally insured institutions unless and until they had a certificate that they were harmless.

Harvard Law professor Elizabeth Warren, chair of the House Subcommittee supposedly policing the government’s solicitude for “troubled assets,” recently offered a similar proposal. The grounds for rejecting would be that the instrument allowed banks to increase their leverage behind the scenes or to book profits from loans the borrowers had not yet repaid.

It’s worth a try. No doubt such a program would stifle innovation, but that’s all right. Honest men can disagree about whether we can afford universal health care, wars in the Hindu Kush, or reduced carbon emissions. But after seven trillion in losses that the taxpayers of the world must find a way to finance, it should be noncontroversial that we can’t afford any more innovation on Wall Street.

Martin Mayer, a guest scholar at The Brookings Institution, is the author of 34 books, including four best sellers—Madison Avenue, USA (1958), The Schools (1961), The Lawyers (1967) and The Bankers (1975).

© 2010 RIJ Publishing. All rights reserved. 

As president of Cincinnati-based Qualified Annuity Services Inc., Joe Bellersen has helped many firms convert their defined benefit plans to group income annuities. Until recently, he also distributed Ca nada Life income annuities in the U.S.

So when the Departments of Labor and Treasury solicited public input on lifetime income solutions for 401(k) participants back in early February, Bellersen needed little prep work in order to write up his answers.

Joe knows annuities. Many responses to the DoL’s RFI have come from angry citizens, most of them warning Uncle Sam to keep his confiscatory hands off their savings. But Bellersen’s 65-page document, with charts and appendices, was informative and enlightening. (Other formal and ambitious comments have since been submitted.)

In it, he offers his explanation for how employer-based retirement plans and individual annuity products came to lose their original lifetime income focus. And he offers suggestions on how we may be able to restore that focus.

As he sees it, the inflation-breaking high interest rates in the early 1980s and the subsequent equities boom helped stimulate the rise in lump-sum payouts from defined benefit plans. And a 1994 Supreme Court decision helped recast variable annuities as accumulation tools and eclipse their annuitization feature.

Now, with the mid-decade boom over and the Boomers slouching toward retirement, Bellersen urges a return to that lost focus on guaranteed lifetime income, particularly the kind that’s funded by life insurance company general accounts and based on mortality pooling.

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Of course, he’s biased. That’s what his business is based on. On the other hand, he doesn’t pretend that putting the annuitization genie into 401(k) plans—or back into DB plans—will be easy. “Joe has some strong opinions,” said Lowell Aronoff, CEO of Cannex Financial Exchanges Ltd., which provides income annuity data to Bellersen’s company. “But he’s very knowledgeable.”

How we got to where we are
Bellersen points to a contradiction that’s lying in plain sight but that hardly anyone ever mentions. Even as we discuss annuities for defined contribution plan participants, most people with defined benefit plan coverage don’t take annuities when they separate or retire. If they have a lump sum option, they usually take it.

[As Vanguard retirement researchers Gary Mottola and Stephen Utkus pointed out in a 2007 paper, “Lump Sum or Annuity? An Analysis of Choice in DB Pension Payouts,” only 27% of lump sum eligible employees in a traditional defined benefit plan took lifetime income at retirement or separation and only 17% of people in a cash balance DB plan did so. Less than 20% of those ages 55 to 60 took an annuity.)

The spike in interest rates in the 1980s, and the long bull market that followed, helped foster the trend toward lump sum payouts from DB plans, Bellersen says. High interest rates reduced the present value of annuities, so that sponsors could save money by paying lump sums. For participants, the rising stock market made lump sums look like a better bet.

“The broader use of LSDs [lump sum distributions] was due to the very high interest rates available for discounting distributions on plan terminations,” he told RIJ. “It gathered steam as plans realized that offering a lump sum as an ‘optional form of an annuity’ allowed the liability to be removed from the sponsor’s balance sheet at a discount.

“The participant will grab the lump sum regardless of whether it’s the right thing to do. You can talk to them till you’re blue and they wont choose a pension. They’ll choose instant gratification. There’s a complete disconnect,” Bellersen added.

He finds it ironic that the government wants 401(k) participants to do what DB plan participants have stopped doing. In his comments to the Labor Department, he writes, “We must pause to ask these questions: 1) Why have DB plans been permitted to become cash bonus plans? 2) If DB plans are cash bonus plans, then why expend efforts on making DC plans income replacement plans?

“There seems to be inherent contradiction with regard to the retirement income policy. This is a paradox.” If we’re going to talk about lifetime income for 401(k) plans, he says, we should also think about restoring lifetime income to DB plans.

Fateful Supreme Court decision
Bellersen points to another inflection point in the saga of the decline of lifetime income over the past 30 years. A single court decision, he said, catalyzed the metamorphosis of variable annuities into tax-deferred investments from retirement income tools.

“In 1994 the Supreme Court held in NationsBank of North Carolina, N.A. et al. v. Variable Annuity Life Insurance Co. et al., that the Comptroller of the Currency was allowed to conduct annuity transactions. The Supreme Court granted rights for banks to sell annuities on the premise that conducting such sales were ‘incidental’ to ‘the business of banking.’”

In the process, variable annuities turned into tax-deferred mutual fund portfolios. “The court went on to cite: ‘The Court further defers to the Comptroller’s determination that annuities are properly classified as investments, not ‘insurance’ within §92’s meaning.’ This decision cleared the hurdles and was a watershed event allowing the sale of annuities by banks and imposing a product-driven mentality.”

If that’s true, it’s easy to see how the Supreme Court decision may have unintentionally enabled the subsequent spate of alleged “unsuitable” variable annuity sales. “This decision eliminated the theory of insurance since it focused solely on the tax deferral aspects of annuity contracts and was supported by professional opinions that ‘no one ever annuitizes.’ Such a bold categorical declaration permitted deferred annuities to be sold on the basis that ‘one size fits all.’ Nothing could be further from the truth,” Bellersen wrote.

Yet another smoking gun in the demise of defined benefit plans was the 50% reversion tax on pension surpluses that was enacted in the early 1990s. As many have pointed, this tax led to underfunding and plan terminations. In response, the sponsors decided that “rather than add contributions and invest in the same way as before, we’ll put in less and take more risk,” he told RIJ.

Recommendations
Introducing a guaranteed lifetime income to employer-sponsored plans will require several reforms, Bellersen concluded. Among them would be the provision of participant education to help people understand the full value of guaranteed lifetime income and the reason why annuities cost more than investments, the resolution of gender differences in payout rates, and the tailoring of income solutions to individuals, so that people with ample defined benefit income, for instance, don’t necessarily annuitize their defined contribution savings.

© 2010 RIJ Publishing. All rights reserved.

The financial crisis of 2008 will continue to hurt state and local government pension funds for at least several years, and a rebound in both the stock market and the economy may be required to restore them to health.

That is the assessment described in a new research brief from the Center for Retirement Research at Boston College, entitled The Funding of State and Local Pension Funds, 2009-2013, by Alicia H. Munnell, Jean-Pierre Aubrey and Laura Quinby.

Funding ratios for public pensions could drop to 72% by 2013, from 78% in 2009, or as low as 66% under a “pessimistic scenario,” the authors said. At 72%, the funding shortfall could rise (in constant dollars) from $728 billion to about $1.2 trillion.

The study was based on 126 state and local plans representing about 90% of the universe of state and local plans. State and local pension plans currently have about $2.7 trillion in assets-enough to cover pension outlays for about 15 years on average even with no investment growth.

“So there’s no immediate cash crisis,” said Munnell, the Center’s director. But she added that in some states public pensions could run short in as little as six or seven years.

“State and local governments are facing a perfect storm: the decline in funding has occurred just as the recession has cut into state and local tax revenues and increased the demand for government services. Finding additional funds to make up for market losses will be extremely difficult,” the brief says.

Nationwide, the funding shortfall will require states, on average, increase their annual pension fund contributions by about $400 per covered employee. Because of the shortfall, contributions for 2009 will be about 8% of state budgets, up from a historical average of 6%.

Others say the problem is much more serious, given the volatility of future market returns and the inability of states to modify their pension obligations. For instance, the American Enterprise Institute (AEI) estimated this month that the size of the state employee pension shortfall alone is more like $3 trillion.

That figure uses the 10-year Treasury rate as the discount rate for the obligations and adds the hypothetical cost of guaranteeing the obligations with put options in the financial markets.

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Because governments may need to raise taxes to cover future pension obligations, the problem has become increasingly political, often characterized by resentment toward teachers and other state, county or city workers with public pensions.

“There is no reason public-sector employees should receive retirement benefits that are either larger or more secure than those received by private-sector workers,” wrote Andrew Biggs of the AEI. He recommends that new public sector employees be offered defined contribution plans instead of traditional pensions.

Munnell said that up until about 50 years ago, state and local governments did little in the way of formal funding of their employee pension plans. But after the Baby Boom created a surge in demand for public school teachers in the 1960s, and a big increase in pension commitments, the funding issue got more attention.

According to CRR, it was said in the mid-1970s: “In the vast majority of public employee pension systems, plan participants, plan sponsors, and the general public are kept in the dark with regard to a realistic assessment of true pension costs. The high degree of pension cost blindness is due to the lack of actuarial valuations, the use of unrealistic actuarial assumptions, and the general absence of actuarial standards.”

In the 1990s, with the creation of a Governmental Accounting Standards Board, benchmarks were established. The funding ratio continued to improve until the financial crisis of 2008. The CRR researchers noted that states and municipalities don’t have many options to respond to the pension dilemma. For various reasons, they can’t raise employee contributions or earned benefits. Because of the recession, tax revenues are down and demand for services are up.

“One small step… would be for states and localities to at least pay their full Annual Required Contribution,” which the Governmental Accounting Standards Board defines as the an amount needed to cover the cost of benefits accruing in the current year and a payment to amortize the plan’s unfunded actuarial liability. “Otherwise, the only option is to wait for the market and the economy to recover.”

The future health of state and local pensions “depends increasingly on the future performance of the stock market. Under the most likely scenario, the funding ratio will continue to decline as the strong stock market experienced in 2005, 2006, 2007, and much of 2008 is slowly phased out of the calculation.”

The AEI’s Biggs made the following recommendations for public pensions:

• Pensions must disclose greater detail regarding investment risk. These details should include the volatility of their investments and the co-variances of returns between different elements of their portfolios.
• Actuarial firms contracted by pensions should calculate the probability that plan assets will be sufficient to meet obligations, such as is currently done for Social Security by the plan’s actuaries and by the Congressional Budget Office.
• Second, pension plans should reform their accounting methods to include the market value of plan liabilities.
• Employee contribution rates should be increased and eligibility for retirement delayed. Where possible, the rate at which future benefits are accrued should be reduced. For instance, most plans currently pay 2% of final salary per year of service; while accrued benefits should be honored, future benefits could be earned at a lower rate.
• States should no longer put off their own pension contributions. Each state must do the maximum to restore its plans to solvency. For newly hired employees, public sector pensions should shift to a defined contribution basis to make them more comparable to plans offered in the private sector.

© 2010 RIJ Publishing. All rights reserved.