PROFESSOR ROBERT SHILLER: All right.
Well, we're talking about institutional investors today.
I don't know, if that sounds like an enticing topic to you.
''Institutional'' sounds boring, but I'm actually
talking about people, who control much of the wealth of
the world, and they have a lot of influence and importance.
So, I think it's worth considering them, and
considering it's really part of the
governance of the world.
How do things happen?
Who decides what is going to happen?
What's going to be done?
Increasingly, it is professional
institutional investors.
They're kind of unseen, mostly.
They don't make movies about them, not that I've ever seen.
Someone tell me, if there is one.
But they're very important.
So, I thought I would start by just talking about the
importance of --
in this lecture I'm going to include both people, who
manage money for institutional portfolios, and also financial
advisors and financial planners.
They're a very big and important part
of the world economy.
But I wanted to start by just giving some perspective on
them, by looking at what it is that we own,
and what they manage.
So, I thought I would start for the United States, and
show a list of everything, everything that's owned.
And I got this from --
this is from Table B-100 of the Balance Sheet for the
American Economy [addition: as of the fourth quarter of
2010], produced by the Federal Reserve Board in Washington.
So, it's really a sum of everything, everything that
people own in the United States.
And the point I'm going to make from this is, that
institutional investors are quite prominent on this list,
as managers of it.
But let's just first look at the total.
This is $70,740 billion, or let's say, $70 trillion is it.
It's everything that anyone owns in terms of assets that
the Fed can measure.
Of course, there's all these priceless
things that we all own.
They are not on this list.
So, what are they?
Well, number one is real estate.
This is owned by households.
Actually, they lump in nonprofits, unfortunately,
because nonprofit organizations are like people,
because nobody owns them.
So, this is the sum of everything that ultimate
owners own, so it's everything.
But nonprofits are a small part of the total.
So, real estate is $18 trillion.
That's real estate owned directly by households and
nonprofits.
It doesn't include commercial real estate that is owned by
some of these other things.
But that's not held by institutions, that's held
directly by households.
But the next item on this thing is pension funds, and
that's $13 trillion.
Almost as big as real estate.
And what are pension funds?
These are plans, that either businesses create for their
employees, or that people invest in themselves for
retirement.
It's planning for old age.
Then, there's equity in non-corporate business.
Non-corporate business means family businesses.
Well, not necessarily family, but partnerships and family
businesses.
You know, the corner store is a
business, it's worth something.
The Fed has estimated the total value of all of these
non-corporate businesses, and estimates them at $6 trillion.
Again, that's not institutionally held, that's
held by families and people.
So far, we've got more family than institutional.
But then, as you keep going down the list, deposits are
deposits at banks. $8 trillion.
That's savings deposits, time deposits.
Now, that's institutional investors managing that.
Corporate equities, now this is shares in corporations,
owned by households.
That's $8 trillion.
Now, we're back to households owning them directly.
But then, we have mutual funds.
Mutual funds are investment funds for the general public,
that invest in equities and sometimes
bonds and other things.
And that's almost $5 trillion.
Consumer durables.
We're going kind of -- seems like half and half or maybe a
little bit less than half are institutional, but it's a big
share so far.
Consumer durables, about $5 trillion.
That's your cars, your clothes that you're wearing, whatever
else is in your house.
It's estimated at $5 trillion.
Treasury securities are --
now, that's government bonds.
It might surprise you that it's only $1 trillion.
That includes both savings bonds, which your
grandmother gave you.
I don't know if you got that --
you got a $100 saving bonds --
maybe you did.
But that's only $100, doesn't add up to much.
There are big-time treasury securities that are treasury
bonds, treasury notes, but they generally are held by
institutions, not -- households just generally
don't buy them.
The total national debt is now -- in the United States it's
$14 trillion [addition: approximately, as of April 11,
2011], but only $1 trillion, that's only 1/14 of it, is
held by households.
So, the institutions hold the rest. Well, foreigners hold
some of the rest, too, but we're not
counting foreigners here.
Corporate bonds held directly by households, $2 trillion.
Municipal bonds held by households, $1 trillion.
But I'll come to this -- the total municipal bonds
outstanding are more like $3 trillion.
So, households don't hold them generally, except indirectly
through institutions.
Life insurance.
These are reserves at life insurance institutions.
That would be institutional investors again.
So, it seems like less than half, but close to half of all
of the assets in this country are held by
institutional investors.
This is a change from 100 years ago.
100 years ago, virtually none of it would be held by
institutional investors, so our society is becoming more
institutionalized, more and more things are being done by
professionals.
And a related thing I wanted to mention again is that, as
society gets more modern, the importance of the family is
diminished and the importance of government
and business is increased.
So for example, pension funds are taking over what used to
be a family responsibility.
When Grandma and Grandpa get old, they move into your house
and you take care of them.
That's an extra-financial thing that has gone on from
time immemorial.
But now, it works differently.
Grandpa and Grandma commit to a pension fund,
contribute to it.
When they get old, they move to an assisted living
facility, which is a place where maybe they're happier.
I don't know.
At least they can choose.
They don't have just the single choice of living with
you, which they might not like.
They might like it, they might not, but it's working more
institutionally.
So, this is really --
I wanted to talk about thoughts, about where our
society is going, and seeing the increasing
professionalization of it.
I thought to complete this list I should --
remember, the previous slide --
this $70 trillion is assets owned by the households.
But I just wanted to get you in the right
perspective on this.
What about liabilities?
So, the Federal Reserve Board computes that, too.
[addition: The data is as of the fourth quarter of 2010.]
Those assets are owned, but it's not net worth of
households, because the households owe money, too.
So, the biggest debt that households owe is, in the
United States, $10 trillion of home mortgages.
We saw they have $18 trillion of real estate, but they owe
$10 trillion, so that they have a net worth in real
estate of only $8 trillion.
But moreover, consumer credit is $2.4 trillion.
That's credit card debt and some other revolving debt like
department store cards, or when you buy something --
when you buy a car on time, it would go into that total.
So, the total liabilities are $13.9 trillion.
And then, so household net worth is the $70 trillion
assets minus the almost $14 trillion liabilities.
So, it's $56.8 trillion is the total assets.
And in per capita terms, that's $184,000.
That would mean that the average family of four has
about $800,000 --
I'm just multiplying it, 184 by 4.
That's almost $800,000, so we're a country of
millionaires, I guess.
Or soon to be.
But the problem is it's not -- it's only on average.
This is unequally distributed.
But I should also add, the U.S. government has a debt of,
as of this morning [addition: April 11, 2011]
--
I looked it up on a national debt clock --
$14.286 trillion.
And that's not counted as a liability of households.
But it should be, because we have to pay it, and we're
going to pay it through our taxes, eventually.
So, you might subtract off another $14 trillion from the
$56 trillion.
And then, let's not forget, there's state and local
government debt, which is another $3 trillion [addition:
approximately, as of April 11, 2011].
So, what does that bring us down to?
Something like $40 trillion or less.
I wanted to do that just to get perspective on what our
assets and liabilities look like.
The other thing is --
I'm trying to put things in complete perspective, so I
wanted to talk also about something that's not on any of
this, and that's human capital.
Human capital is the value of our people, and what people
can do and produce.
And if you want to develop total national wealth, you
would want to include human capital as well.
So, what is the national wealth for the United States,
if we include everything?
Well, the way I figured that is, right now the national
income, U.S. national income is $13 trillion a year
[addition: as of 2010].
And I want to capitalize that, to value their
present value with that.
If you assume 3% growth in real terms and a 5% discount
rate, that would make wealth equal to $13 trillion --
I'm using the Gordon formula --
divided by 0.05 minus 0.03, or $260 trillion.
That's also just for perspective, because I just
wanted to put this $40 or $50 trillion in perspective.
I'm kind of diminishing my lecture.
I'm telling you institutional investors are important, but
as a fraction of the total national wealth,
it's not that important.
And I think the family is still very important, as a
manager of our wealth.
This is not managed by institutional investors.
One more calculation that will diminish the importance of
institutional investors even more.
What do you think the world is worth?
If we were to take the total national income of the whole
world, and take the present value of that, well, according
to the International Monetary Fund in Washington, which
estimates for the world, world national income in 2010, well,
world income --
actually, this is world GDP, I believe, but I'll use that as
a proxy for income --
is $62 trillion.
And if I use the same discount rate and assumed growth rates,
you know what I get for the value of the world?
World wealth?
It's $1.2 quadrillion.
Again, to put things in perspective, we are going
through an enormous transition in the world.
I'm only assuming a 3% growth rate for the world, and many
countries are growing at 7% to 9% now, so maybe this is
conservative.
But I think that, as the world matures, as we become more and
more modern and capitalist, the importance of the family
will remain.
It will remain important, but it will diminish in relative
importance.
So, as time goes on, we're going to see something like a
quadrillion dollars increasingly managed by
institutional investors.
So that's, what I want to talk about today.
As I was saying, in modern society we do things
differently.
We don't expect young people to take their parents in, to
care for them.
I mentioned that as an example.
Is that, because we don't care about our parents as much as
we used to?
Interesting question.
There's a lot of discussion about that, but my general
take on it is, that most elderly people
like to have choices.
They love their children, but they don't want to
move in with them.
They want to have a savings, some kind of pension, they
want to be able to choose, how they live, with
whom they live with.
Similarly, our health care, we used to depend on our families
to provide health care, but it didn't work very well.
People weren't getting very good health care.
And now, we have it all institutionalized through
trust funds for health plans, and benefits and the like.
This means that it's more and more run
by investment managers.
And investment managers are trained in modern finance and
understand risk management.
So, there's a professionalism to all this.
The family is of limited --
even if they were smart, even if they were brilliant as
investment managers, they're a small unit.
And unless they were to engage in some kind of risk sharing
agreement, they can't manage risk well.
The whole family is too small a unit to manage risk.
But increasingly, investment managers are running risk
management for families, that allows risk
sharing around the world.
We have growing pains with this.
The recent financial crisis shows that investment managers
mess up sometimes, and their attempt to share risks around
the world --
like, for example, the subprime crisis was caused by
the failure to manage mortgage risk appropriately.
But nonetheless, I think they're getting more
professional and more important.
So, right now we have professional risk managers
that are, I think, increasingly important in our
very lives.
Now, they have a fiduciary duty.
If you are managing other people's money --
that's a quote -- ''other people's money,'' then you
might be negligent.
It's not my money, what do I care?
So, the law prescribes that you, as an investment manager,
have a duty to act in the interest of the person you're
managing for, or the group of people you're managing for.
And the law has been trying to prescribe what this duty is.
There's something called the ''prudent person rule,'' which
is a rule that investment managers have to behave as a
prudent person would.
I'll read one definition of it.
ERISA, which was an act of Congress in 1974, defined --
they called it ''prudent man rule'' back then, because our
language was still sexist in 1974 --
they said that ''investment managers running pension funds
must manage with the care, skill, prudence, and diligence
under the circumstances then prevailing, that a prudent man
acting in a like capacity and familiar with such matters
would use in the conduct of an enterprise of a like character
and with like aims."
They're trying to legislate what it is
to be a good fiduciary.
And it seems sensible.
You should ask -- if someone is managing a pension fund for
elderly people, they shouldn't do wild and crazy investments.
They shouldn't invest in racehorses or
something like that.
It should be prudent.
But then, how do you define it?
If you read the act, it says, they would be acting like a
prudent man ''in a like capacity in a conduct in an
enterprise of a like character and was like aims."
The problem is, with the 1974 act, that it's hard to
legislate duty, define what it is.
So, what the law said, and it has said it in many places, is
that you have to -- as a fiduciary, as an
investment manager --
you have to act as a prudent person would act.
And what is a prudent person?
I guess, it's somebody else.
Somebody else, who is of a kind of a
standard or ordinary type.
I don't know what it is.
I mean, I could say that investing in racehorses is the
smartest thing for me to do, but I can't claim that that's
a prudent person act.
So, the law has required institutional investors to
some extent to behave, not as they would behave, but as they
think other people would behave. It was legislating a
requirement, that you don't do what you think is smart, you
do what you think other people think is smart.
And this has been a problem, because what it has done is,
it has created a class of institutional investors, who
live in fear of laws that could come down on them, if
they, with the best of intentions, invest on behalf
of their clients in an unconventional way, and
therefore could be punished for violating the prudent
person rule.
Thus, for example, because of the prudent person rule,
university endowments, which are an example of
institutional investments, for much of the 20th century were
invested in bonds, government bonds, because they thought,
well, that's prudent.
No one can tell me that we're not prudent.
The government bond is safe.
But some investment portfolios, notably
the one that --
we had David Swensen come and speak to us earlier --
took a more aggressive interpretation of the prudent
person rule, and developed an investment strategy that
looked imprudent.
So for example, Yale University was investing in
startup dot-com firms during the dot-com explosion --
managed to sell out just at the peak.
Is that being a prudent person?
Well, the interpretation of the prudent person rule has
changed, and this is part of the phenomenon
that drove the bubble.
Institutional investors, led by people like
David Swensen --
it lead to a more benign interpretation of the prudent
person rule, and allowed them to take chances.
And I think that, that general sense that one could be more
aggressive in investing, was part of the bubble that led to
the financial crisis.
I'm not saying it's a bad thing in itself, but I'm
telling you it was part of the factors
that led to this bubble.
I looked through Dodd-Frank.
The Dodd-Frank Act of 2010 is the most important piece of
financial legislation in the United States since the Great
Depression.
And I did a search for prudent person --
it appears nowhere.
But I found that the word prudential standards appeared
34 times in the Dodd-Frank Act.
So, it seems like the financial crisis is changing
things a little bit.
It's bringing our society to want regulators, government
regulators, to be making the ultimate decisions about what
kind of risks institutional investors will take on.
They're still letting households do what they want,
but in terms of institutional investors, the Dodd-Frank Act
talks extensively about regulators going in and
regulating what institutional investors --
what kinds of risk they can take.
The same thing is true in other countries.
I think, this is a world phenomenon.
The problem is that the prudent person rule didn't
seem to work, didn't seem to work well enough.
It started out, when it was first imposed, as encouraging
a very conservative investment, but then people
thought, as time went on, that that didn't make sense, they
got more loose, and it let to a financial crisis.
So, Dodd-Frank is creating something called the FSOC, the
Financial Stability Oversight Commission, which
has to enforce --
well, it doesn't enforce, but it makes recommendations on
prudential standards, particularly regarding --
well, I wouldn't say particularly --
but including leverage.
Leverage --
we talked about it --
it's a measure of the risk that you've imposed on your
portfolio by borrowing to buy assets.
The economy became increasingly leveraged up
until the financial crisis, when it began around 2007.
And people were concerned about that.
Well, were institutions following the
prudent person rule?
Well, somehow, as time went on, their mind allowed more
and more leverage to be considered acceptable.
So, now what we have in the Dodd-Frank Act is, that the
Financial Services Oversight Commission is supposed to
recommend standards of leverage and prudential
standards for financial corporations, and to put
financial corporations under increasing regulatory
authority to meet those standards.
So, in some sense, it's shifted to the government.
We had seen a historic shift of power over investments from
individual investors to institutional investors, and
to some extent, at least, it's shifting to the government.
And I think --
I'm talking mostly about the U.S., but I think this is a
currently worldwide trend.
It's exemplified also --
I mentioned before, that we had private organizations, the
securities rating agencies such as Moody's and Standard &
Poor's and Fitch, but the governments are trusting them
less, and they're putting standards more on government
regulators now.
I said I would talk about financial advisors.
Financial advisors are people, who don't directly manage
portfolios, they're not institutional investors, but
they give advice to those who do.
And the financial advisors are regulated by governments in
most countries.
So in the U.S., for example, the SEC, the Securities and
Exchange Commission, requires advisors to be approved by
FINRA, to win FINRA approval, where FINRA is the successor
to the National Association of Securities Dealers.
It's a non-government organization that administers
an examination and education program for advisors.
And so, you effectively have to go through FINRA to get
licensed to be a financial advisor.
I'll give you an example of an organization
of financial advisors.
NAPFA is the National Association of Personal
Financial Advisors, that manages the relation between
financial advisors and the public.
These people will typically charge between $75 and $300 an
hour, and you can get one tomorrow.
Just make a phone call, get on to a website, NAPFA website,
and hire one.
And they have a code of standards.
They have to be licensed through the SEC, and they have
to have an oath of loyalty to the
client that they undertake.
This is a big business.
I mention it, because in one of my first lectures I gave
you a count of how many people there are.
But I'm just trying to --
There's also something else called a financial planner.
Financial planners.
Now that sounds like the same thing to me, but somehow, if
you call yourself a financial planner, you don't have to go
through this licensing.
And in the Dodd-Frank Act, I didn't find much new
legislation regarding them.
The Dodd-Frank Act is calling for a study
of financial planners.
The question is, how does the government get involved in
making these people give good advice?
The problem is, that the financial crisis seems to be
led by a lot of bad advice given out.
A lot of people were encouraged to leverage up
their ownership in their home, to borrow heavily to buy
second homes.
I'm sure, that financial advisors were not uniformly
advising that, or financial planners, but there's a
concern now about what kind of advice people were given.
So in 1996, Congress passed a bill in the United States,
saying that financial advisors cannot be convicted felons,
among other things.
But there hadn't been, until then, such a law.
We have something else called mortgage brokers.
It's a little different.
These are people, who give advice on
getting a home mortgage.
There was no licensing of them until the financial crisis.
Because mortgage brokers could be anything.
They could even be a convicted felon, until just a few years
ago, until after the crisis.
Here's the fundamental problem, that
people are getting --
they're confronted by an increasingly complicated
financial structure.
Living is less family, and it's more investing and
getting involved in financial markets, and most people don't
know how to do it.
And that the people, who give them advice often, are not
giving them the best advice.
What can we do about that?
Well, the government is trying, but it's imperfect.
I think that, as the world develops, I think we'll
probably see --
I think there is a trend toward increasing the
professionalization of these groups.
And although it's not a simple matter to straighten out some
of the irregularities, we're moving, as the world gets
better and better, to even stronger such institutions.
Now, I wanted to go through some kinds of
institutional investing.
The mutual fund is --
I've talked about this before --
is an investment company that is owned mutually by the
participants.
It will invest typically in stocks, and it distributes
everything to the owners of the stock [correction: owners
of the fund].
The first mutual fund was the Massachusetts Investor Trust.
That's not the university.
Massachusetts --
I'm sorry --
Investment Trust, which was founded in the 1920s.
And it was very open and direct with its investors.
It published its portfolio.
It promised --
it was completely open about what it did --
and it promised nothing more than it would divide up all of
the returns among the participants.
There were no senior members, who got more of the money than
anyone else.
So, MIT became a model for an investment
fund for the public.
In the 1920s, there were many investment funds that were
exploitative of the public.
They had two classes of investors, and the first class
of investors ran off with the money, at the expense of
everyone else.
So, it took a while after the 1929 crash, but the Investment
Company Act of 1940 set the stage for the
growth of mutual funds.
And so, mutual funds are designed for individuals, and
they are --
this is U.S. --
they are a very successful institution.
So, you know exactly what --
they have regular reports -- you know exactly what they're
doing, and there's no rich person benefiting excessively
from what happens.
In Europe, they have an analogous institution, UCITS.
It refers to a European Union directive, called the
Undertaking for Collective Investment and Transferable
Securities, which is an EU directive, 1985
[clarification: In 1985, it was still the European
Communities, and not yet the EU, which was not established
until 1993.], and then they had revisions in 2001, that
creates a standard investment fund like a
mutual fund for Europe.
It used to be that every European country had its own
securities law, and it made it difficult, because there's so
many European countries.
So, they standardized, and they developed a sort of
European version of the mutual fund.
The key difference, I think, between a mutual fund in the
U.S. and a UCITS in Europe is --
it's technical --
it's how they're taxed.
The mutual fund in the United States --
if you own shares in a mutual fund and you just hold them,
you will still get capital gains taxes every year, even
if you didn't sell it.
Because other people in the mutual fund sell some of their
shares, generating a capital gains, and that capital gains
is then distributed to all of the participants
in the mutual fund.
With a UCITS in Europe, you don't pay capital gains taxes,
unless you yourself sell.
So, I think the UCITS form is gaining on
the mutual fund form.
And some people, notably Robert Pozen at Harvard
Business School is advocating that the U.S. switch to the
European standard.
I wanted to talk about trusts.
What is a trust?
It is money held on behalf of another individual.
Well, particularly a personal trust is something, that you
can set up on behalf of another person or a cause, so
that an institutional investor will manage money on behalf of
that person or cause.
And a company that does trusts is called a trust company, and
trust companies have often been combined with banks, but
they're not necessarily part of a bank.
You see many institutions and the title will be Bank and
Trust Company.
Well, you know what a bank does.
It takes deposits and makes loans.
What does a trust company do?
It creates trusts on behalf of some person and manages the
money for them.
A classic example of a trust is, imagine that you have a
child, who is handicapped in some way and unable to manage
his or her own affairs.
And you, as a parent, know that your child will outlive
you, and so how do you provide for the child
after you are gone?
Well, you create a trust for the child.
And you can go to a trust company and say, I want an
income for my child, managed for the rest of my child's
life, and the bank will outlive you -- or the trust
company will outlive you -- and can do that.
So, this is very important, because it allows people to
create situations that outlive them.
But particularly in common law countries, it doesn't have to
be a company.
You can set up a trust, you can take a young relative of
yours, who will outlive you, and say, I want you to be the
trust manager for my child.
And if you become ill, can you appoint a successor?
You can do that, too.
U.S. trust law recognizes the importance of trusts, and so
that person -- suppose that person that you appoint as a
trustee for your child, suppose that person goes
bankrupt, and then other people are taking, seizing,
that person's assets.
They could not take the assets in the trust, because the law
recognizes the importance of trusts.
There are different kinds of trusts.
But I thought, I should tell you about a particular kind
that may be relevant to some of you in your future.
There's a certain kind of trust called a ''spendthrift
trust,'' which is a trust that your parents may be setting up
for you now.
I don't know.
What is a spendthrift?
A spendthrift is someone who spends money to freely.
Can't be trusted to manage money.
Suppose, you have a child, who's like that, and you're
getting on in years, and you're thinking that you could
leave a will to your child.
But the child might just blow it.
So, what you do is, you go to a trust company, and you say,
I'd like to set up a spendthrift trust for my
child, and after I die, the trust will pay my child an
income, and the child cannot get at the
assets, only the income.
And so, you manage it, and the child comes to you and says, I
want the money, and you say, sorry.
Your parents set up a spendthrift trust. That's all
you can get.
There's various reasons why they do this.
One of them is, that in a divorce, if your child gets
divorced, if you gave money to the children, the divorce
court might give half of the money to the awful spouse your
child married.
But if it's a spendthrift trust, they can't get at it.
It's income to the child.
So, there's all kinds of reasons why
people set up trusts.
But I think trusts are a really an important invention
in our society, and they're not talked about very much.
But I mean, it solves a real problem.
This handicapped child problem is an extreme case,
but it's very real.
You can have assurance, the law makes it clear that that
money is managed by a professional for the child.
These are real and important institutions that help people
get on with their lives, and I think our financial system
does a lot to make these things work well.
I wanted to talk about pensions because --
I've already talked about them, but people do get old
and they can't keep working.
And if you look at the history of the world, the fate of
elderly people is highly variable.
Many of them, if they have good and dutiful children,
will do all right --
who take care of them.
But in the past, you would find a lot of elderly people
out on the streets begging, because they didn't have
children, or the children died, or the children lost
their income.
It's a problem that we've worked substantially to solve,
and again, it's an example of progress of our civilization.
We take it for granted, that people are living as
comfortably as well as they are, but it's substantially a
product of invention.
So, the idea of a pension is actually a
relatively new idea.
The first U.S. pension plan was 1875.
American Express Company set up a pension
plan for its employees.
There's actually an earlier example in the U.K., I think,
but I don't have the name of it here.
But only something like 20 years earlier.
So, until then, there was never a pension plan.
So, American Express set up a plan, and it said employees,
who had worked at --
this, by the way, is not the credit card company, this was
a delivery company.
They had stagecoaches.
This is a long time ago.
And if you worked there for 20 years, past age 60, and were
disabled, you would get 50% of the average of the last 10
years pay for life.
This was the model --
50% of average of the last 10 years pay on retirement.
Because it was tied to how much income.
They thought, you could live on half the income that you
earned when you were working.
In 1901, Carnegie Steel --
that's Andrew Carnegie, the same Andrew Carnegie, who
wrote The Gospel of Wealth that we've been
talking about --
gave what was the first large industrial pension fund.
And it covered a substantial number of people, it was a
milestone that suggested many more such pension funds.
Unions, in the early 20th century, started setting up
pension funds.
For example, the Pattern Makers in 1900, the Granite
Cutters and Cigar Makers in 1905, et cetera.
The union pension funds became popular in the early 20th
century, but there was a collapse of
pensions after 1929.
Many people were promised pensions in the first three
decades of the 20th century, and then the companies just
went out of business and didn't --
moreover, the unions' pension funds failed especially
disastrously.
They didn't manage their money well, or the institutional
investors were not very astute.
You know, it's like the world was very amateurish about how
they handled these things.
Obviously, it's very important that people have money to
retire on, but many of them got wiped out in 1929, so it
lead to further thinking about pensions.
The General Motors pension plan was a landmark pension
plan in 1950.
And in 1950, GM chairman Charles Wilson proposed a
fully funded pension plan.
This was a new idea.
That is, General Motors, in promising to pay you in your
retirement, would set aside and invest now enough money,
so that they would have that.
In other words, they created a trust for the employees.
So, it's just like the parent for the handicapped child.
If General Motors dies, doesn't matter, because
there's a trust managing their pension fund.
You know, it's kind of a funny idea.
Why didn't anyone do that before?
Why didn't the unions, who were looking out for the union
employees, demand that they fund their pension funds?
You know, it seems like financial history shows a lot
of stupidity.
I don't quite understand, how it could be.
It seems obvious, doesn't it, that if a company is going to
promise you for a pension, that they
should set aside money?
Because companies fail all the time.
There may have been some union complicity, that the unions
were not really always working on behalf of their members.
They thought, well, the members don't think about this
problem, so we're not going to think about it, either.
It's going to come years down the road, we're
not going to worry.
So, General Motors, in 1950, set an example
for funding the pensions.
It's very important.
And more and more firms started to do that after 1950.
But the next thing I want to give is Studebaker.
Do you remember Studebaker?
They were one of the major automobile manufacturers.
You maybe don't remember them, because they
went bankrupt in 1963.
That's a long time ago for you, but they were around.
Well, they had a pension plan that was partly funded, but
inadequately funded, and, when they went out of business,
their employees lost. So, this led to arguments about --
and their labor union, again, the United Autoworkers,
supposedly standing up for the employees, didn't do the job.
So, the whole idea of labor management negotiating,
protecting the workers seemed flawed, and so the government
got involved, and it led to ERISA,
which I mentioned before.
1974.
ERISA stands for Employment Retirement
Income Security Act.
This was an act to clean up pension funds, and make them
work well, make them work better.
The government wanted to make sure, not only that pension
plans said they were funded, but that they were really
funded, so that another bankruptcy wouldn't cause
pension plans to fail.
So, ERISA set up a new government agency, called the
Pension Benefits Guarantee Corporation.
That's PBGC.
The Pension Benefits Guarantee Corporation is a government
organization that insures the funding of pension plans.
So, pension plans not only have to undergo scrutiny by
the PBGC that they are fully funded, but they also have to
pay an insurance premium to the PBGC.
And if it turns out that they're not fully funded, then
the PBGC will come in and replace the lost income.
You see, over the century we're trying to come up with
financial structures that solve basic human problems.
The PBGC, by the way, is still here, and it hasn't gone
bankrupt, despite this financial crisis.
Though people were worried about it, it
has managed to survive.
After 1974 --
shortly after this --
after 1974, a new kind of pension plan became popular.
So, ERISA was written in an age of defined benefit pension
plans, like the original American Express pension plan.
What did American Express pension plan in
1875 promise you?
It promised you half of your average income
for the last 10 years.
And if you're going to fund the pension plan, you're
presenting a problem to the managers of the pension money.
They have to hit that target.
They're told, the pension plan has an obligation to fund the
payments equal to whatever percent of last year's income.
And that's kind of a tricky problem, if you're a manager.
How do I do that?
How do I hit that target?
How do I know, how much money to set aside?
Well, it's getting now into government regulators, and
prudent person rules, and it's tricky.
But the point is that in 1974, almost all pension
plans were like that.
They defined the benefit that you would
receive when you retired.
But afterwards, in the 1980s, companies started offering a
new kind of pension plan, called a defined contribution.
The idea was, it's hard for us to hit that target, of say 50%
of your average income for the last 10 years.
How do you expect us to do that?
We don't know, how much these investments will pay out.
We don't even know, how much money you'll be paid in your
last 10 years.
So, it's asking us to do the impossible.
Well, it's not impossible, but it is difficult.
So, many companies decided, instead of requiring a defined
amount to be paid, they would just define the contribution
they'll make to your portfolio.
They give you a portfolio as an employee, and you get
whatever income that portfolio generates when you retire.
The most famous example of that is a 401(k) plan in the
United States.
But ever since, shortly after ERISA, the world has been
moving towards defined contribution pension plans,
where a defined contribution pension plan doesn't promise
what you'll get in retirement.
So then, a portfolio manager for a defined contribution
pension plan doesn't have to worry about hitting targets.
And in fact, the way defined contribution plans are usually
set up, they give the individual employee the choice
of the main portfolio allocation between stocks and
bonds and real estate, or whatever.
But you have investment managers managing within one
of those asset classes.
So, there will be someone managing an equity fund,
another one managing a bond fund, and they try to do as
well as they can as investors, subject to the restriction of
what they invest in, and it's left to the client to choose
the allocation.
Defined contribution plans are going through
growing pains, too.
We still don't have the perfect system.
The problem with defined contribution plans --
one problem is, that you don't have to sign up for them, the
way they've been set up.
It used to be, under the old days, defined benefit plans,
it was just automatically, every employee would get the
pension plan.
But with a defined contribution plan, the typical
rule was, that the company would ask you to make
contributions out of your paycheck to the plan, and the
company with then match them, typically, with additional
contributions.
But something like a quarter of the people would choose not
to participate --
that's, because they're not thinking, they're not
thinking ahead --
and so, when they come to retire, they don't have any
pension plan.
Moreover, some of them take the most
risky investment offered.
They might put it all in the stock market, and if the stock
market does badly, they might end up poor in retirement.
And companies generally would not give any advice to the
people, who were employees, because they didn't want to be
liable for giving bad advice.
So, it led to kind of an amateur
investing for pension plans.
So, there has been work to try to fix that, and I think
federal legislation has made it easier for companies to
give advice to employees.
They've also allowed, recently, in the last few
years, for companies to automatically enroll employees
in a pension plan, and allow them to make allocations, if
they didn't hear anything from the employees.
In other words, they'll put you into a prudent allocation,
and then you're actually there.
You're in it, because you've said nothing.
That's working towards solving the problem.
We still don't have, I think, the ideal solution to any of
these things.
So, I've talked about pension plans.
Let me move on to endowments.
Endowment managers, of which David Swensen is one.
So, an endowment manages a portfolio for some cause or
some purpose, like a university.
And the history of endowments is one of great --
it's just amazing to me, how many serious mistakes were
made in history, but we're gradually becoming more
professional.
So, I give you an example of a mistake.
This is in Swensen's book.
In 1825, Yale University put its entire endowment in an
investment in the Eagle Bank of New Haven.
You know what happened?
It went to zero.
It ended up with nothing.
So, Yale had no endowment after 1825.
So, Elihu Yale may have given us money, and we should have
turned it into a pretty tidy sum, compound interest from
1700 to 1825, but we blew it completely.
This is the first thing you learn, in a portfolio you
don't put all of your money in one investment.
But Yale University did that.
By the way, I was looking it up, 1825 was the year that
Yale College introduced the economics requirement, or they
called it political economy.
Before that there were no economics courses at Yale.
But maybe it was this experience that made them do
that in 1825.
So, I'm going to give you another example.
Boston University --
this is much more recent --
under John Silber, invested not the whole endowment of the
university, but $90 million in one company called Seragen,
which was a genetic engineering company.
And just John Silber decided to do this, and he lost Boston
University 90% of $90 million.
University of Bridgeport, not far from here, blew its whole
endowment, and ended up having to join the Unification Church
to survive.
I think that somehow that's been undone since then.
I'm not sure of the details.
It may not have been, what they would have done, if they
had had an endowment.
See, what Swenson thinks is, what he's doing is protecting
the ability of a university to undergo its financial mission.
And so, because Swenson was not overly constrained by
prudent person rules, because he was free to invest in a
high intellectual standard, he's made it possible for Yale
to pursue its educational objectives.
Right now at Yale University, like other successful
endowment universities, graduate students get their
whole tuition paid, plus a living allowance.
It's like a job, coming to be a graduate student.
The university pays --
you should know this, if you're thinking
of getting a PhD.
Come to one of these universities, and they'll pay
you something like $25,000 a year, something
like that to --
that's a pretty good deal.
It's not a deal, it's a gift.
It's the generosity of the alumni, and it's the success
of the investment strategy that makes that possible.
And then, I wanted to talk about another kind of
institutional investor, and this will bring me back to my
discussion of the family.
I started out by saying that the family is the fundamental
unit of our society.
Its demise has been predicted.
Remember that in the Communist Manifesto, Karl Marx said
we're going to end the family as an economic unit?
Something like that.
Didn't happen.
It's too ingrained in our genes or our long history.
So, I thought, I should come back and talk about family
offices and family foundations, although these
apply only to the more wealthy people in our society.
What is a family office?
These are --
people who have $100 million or more
typically set these up.
Maybe even less.
Maybe, with $20 million in assets.
But if you have $100 million in assets, 5% income is $5
million a year, right?
It would be sensible to take on some full-time employees to
manage your family portfolio, and so that's
called a family office.
I recently spoke at a family office forum, down in Florida.
They seemed to be very numerous.
There's an awful lot of families.
The families come to these conventions, and they hear
people like me speak.
Although I'm different than most of them, because most of
the people speaking there wanted to sell products, and I
wasn't there to sell anything.
So, they typically have two or three or five people working
full-time, managing their portfolio and planning things
like trusts for the children.
And then, there's something else called a family
foundation.
A family office is for the family, and there's something
else called a family foundation.
And this is different from a family office, but they could
be interrelated, and I think most wealthy
families have both.
A family foundation is a charitable organization,
created by a family with the name of the family typically
on the foundation.
I think that most wealthy familes -- or actually, I
don't know.
A large number of wealthy families, at least in the
United States, now set up family foundations.
And the reason they do that --
well, why do they do that?
I think it's partly, because, when you're wealthy, you
realize that you can't spend it all on yourself.
And you reflect on yourself as a member of society.
As people get older, they think, what am I going to do
with this money?
So increasingly, people are setting up family foundations.
I learned, that, as of 2006, there were 36,000 family
foundations in the United States, and
it's growing rapidly.
There seems to be a trend toward that, I think,
reflecting our increasing affluence, but, I think also,
reflecting maybe changing values.
So, the typical family foundation is not huge.
It might be $1 million or $2 million.
So, you can set something like that up, eventually --
not right now --
I want you to think about doing that.
So, whatever it is you believe in, you set up a family
foundation to do that, while you're still young, and you
get it going, and it will then outlive you.
And you endow it, you give it enough -- say, you give it a
couple million dollars.
That would be a small family foundation,
but you can do that.
And then, there's some named cause, like it could be
improving neighborhoods in our city or the like.
And family foundations, I think there's an
important tax advantage.
You don't want to think about this yet, but you should start
thinking about it.
When you start making money, assuming that happens, what do
you do with it?
Now, you're pulling in a million dollars a year.
That's something that you might well do.
And so, I can just put in the bank and not think about it?
One problem is, the government will tax you on it.
And you get a charitable deduction from your tax, which
encourages you to give to charities.
All right.
So, you're now 30 years old, and you're making a million
dollars a year.
And what do I do with all this money?
I'm paying taxes on it.
If I give it away, I get a tax break.
So, there's an incentive to give away.
You're getting all these phone calls at night from --
they found out that you exist --
from United Fund or different charitable organizations.
But you stopped answering the phone, because you're annoyed
by all these phone calls, and you're thinking, I don't want
to just give it away to someone that called
me up on the phone.
I want to think about what I'm --
I want to do something for the world.
The idea is that, while you're still young, you set up a
family foundation, and you give the money to the
foundation irrevocably.
All right?
It has a cause written in its charter or something.
And then, you don't have to spend it now.
You're too busy thinking about what you're doing, so you
start contributing to the family foundation, and it
accumulates.
And meanwhile, you're getting the tax deduction.
So, that's why 36,000 families have done this in the United
States, and I think it's growing, again,
over all the world.
Sometimes, family foundations are plans for children, too,
because your children can then run the foundation.
It becomes an ongoing thing for the family that unites
them in a cause, as time goes by.
I think, this is really important to recognize this
channel -- although it's only 36,000, that's still
a lot of them --
as we think about the growing inequality in the United
States and in other places around the world, and think
about the policy toward that.
I think, we should do something about inequality,
but I think encouraging this kind of a family foundation
activity is a good cause.
I wanted to just think about --
I'm almost done here --
there's a recent book by a Wall Street Journal writer,
Robert Frank, called Richistan.
And he talks about rich people in America and what they do.
And the book --
this is Frank, Robert Frank --
the book talks about excess that some people do.
Some rich people spend money lavishly, and it disgusts
people, who think, what is going on in our society?
But on the other side of it, there is also this
philanthropic trend that Frank talks about.
So, I'll give you an example.
Robert Frank talks, for example, about Paul Allen.
Remember him?
I guess, he was the number two man at Microsoft.
So, is he a good person?
Well, I'll give you two sides to that story, and this I got
from Richistan.
Paul Allen wanted to have the biggest yacht in the world,
and so he went to a yacht company, and
had a 400-foot yacht.
It turned out, they said --
it created problems for him, because he couldn't dock it at
any yacht club.
He had to go to industrial docks for major cargo ships.
So, that's a big yacht, and he called it The Octopus.
Paul Allen has a new book that just came out, or it's just
coming out now, called Idea Man.
In his own recount of himself, he had brutal battles and
arguments with Bill Gates.
It was a revealing thing.
They were really in this for the money.
So, he's starting to look like a bad guy, right?
Because here he is showing off with the biggest yacht
in the world --
and actually, he's been topped by somebody else.
Who was it?
Larry Ellison got a 450-foot yacht.
But on the other side of it is, there is
something called the --
it's the Paul G. Allen Family Foundation, which he has set
up already.
And it turns out, he has already donated over a billion
dollars through this foundation and
otherwise to charity.
So, that's much bigger than the 450-foot octopus.
What does it cost to buy a 450-foot yacht?
I don't know, it's not going to be a
billion dollars, right?
This is one of the ironies that you face in living, that
someone like Paul Allen, he's a tough businessman, an
aggressive guy, he sometimes does extravagant expenditures,
but on the other side, there's this charitable side, so I
think we have to reserve judgment about most people.
Anyway, what he has working for him is a great
understanding, apparently, of financial arrangements, of
endowments, and he's setting these up, and you got to give
him credit for that, and I think we have to consider that
as important.
Institutional investing is an important trend in our society
that can and does work for important and good purposes.
I'll see you on Wednesday.