[OPE-L] [Jurriaan re] The "intermediation society" and the "soul of capitalism"

From: glevy@PRATT.EDU
Date: Tue Oct 04 2005 - 16:55:27 EDT

---------------------------- Original Message -------------------------
Subject: The "intermediation society" and the "soul of capitalism"
From:    "Jurriaan Bendien" <adsl675281@tiscali.nl>
Date:    Tue, October 4, 2005 4:35 pm


At the risk of posting excessively, here's an article cited on the A-list,
from the Wall St. Journal, which provides another angle on the
"financialised" intermediation between producers and consumers which I
mentioned in earlier posts - thought it might be of interest. Bogle (about
whom see http://www.vanguard.com/bogle_site/bogle_bio.html ) concludes
"The ownership society is over. The agency (or intermediation) society is
not working as it should." But, of course, there is, meantime, still home



Individual Stockholder, R.I.P.

October 3, 2005; Wall St. Journal, Page A16

The amazing disappearance of the individual stockholder as the backbone of
the U.S. stock market has been one of the least recognized but most
profound trends of the last half-century. As shown in the chart nearby,
direct ownership of stocks by American households has declined from 91% in
1950 to just 32% today. The 9% ownership stake held by financial
institutions in 1950 crossed the 50% mark in 1983, and now totals 68% of
all stocks. It is hard to imagine that our earlier society dominated by
individual stock ownership will ever return.

Of course, individual investors remain major participants in the stock
market, but now do so largely through mutual funds and public and private
pension plans. But such participation lacks the traditional attributes of
ownership such as selection of individual stocks and engagement in the
process of corporate governance.

* * *
But aren't our financial institutions owners of stocks? Not really. They
are owners in name -- agents, in fact, with a duty to act on behalf of
their principals, including our mutual fund owners and beneficiaries of
our retirement plans. Today's agency-dominated investment society is
overwhelmingly composed of those two groups of underlying owners.

At first, the march toward institutionalization was led by pension plans.
Holding less than 1% of all stocks in 1950, they shot up to 19% in 1980
and 27% in 1989-95, only to ebb to today's level of 21%. Growth in
mutual-fund ownership, on the other hand, was stagnant in the early years,
holding at 3% in 1950 and 1980 alike, rising to just 8% by 1990. Since
then, fund ownership of stocks has risen relentlessly to a record high of
28% currently. Within the pension segment, public plans are holding steady
while private pension plans are gradually receding. But the secular
decline in defined-benefit pension plans has been matched by an offsetting
rise in defined-contribution thrift and savings plans in which mutual
funds are the major component. So today's dominant stock ownership by
mutual funds seems destined for continued growth.

Institutional investing is now largely the business of giants. America's
100 largest money managers alone now hold 58% of all stocks. When such a
relative handful of professional managers substantially displaces a
diffuse group of millions of inchoate individual investors, one might have
expected the managers to more aggressively assert their rights of stock
ownership and demand more enlightened corporate governance focused on
shareholder interests. With few notable exceptions, however (some state
and local pension plans, unions, and TIAA-CREF), our institutional
investors have refrained from active participation in corporate affairs.

What explains the passivity of these institutions that in fact hold
effective control over corporate America? First, too many of our financial
agents have their own interests to serve, often conflicting with the
interests of their investor-principals. It is a truism that principals are
likely to watch over their own money with far more care than they take in
watching over the assets entrusted to them as the agents of others. When
there are many masters to serve, it is the master who pays the servant
whose interests are most likely placed front and center. Corporate pension
plans, for example, are controlled by the same executives whose
compensation is based on the earnings they report to shareholders. During
the 1990s, they arbitrarily raised their projections of future pension
plan returns, enhancing operating earnings to meet "guidance" targets,
even as interest rates tumbled and prospective returns eroded.

Similarly, mutual fund managers are compensated by separate corporations
seeking to maximize the return on their own capital (i.e., to enhance their
own wealth), in direct conflict with their duty to maximize the returns on
the capital entrusted to them by their fund shareholders. The excessive
advisory fees, expenses, hefty sales loads, and huge commissions on
portfolio transactions paid to brokers in return for their sales support
consumed something like 45% of the real returns earned on fund portfolios
during the past two decades.

Second, unlike their predecessors in the '50s and '60s, financial
institutions focus on investment strategies that emphasize short-term
speculation in evanescent stock prices, rather than traditional long-term
investing based on durable intrinsic corporate values. From 1950 to 1965,
equity mutual funds turned over their portfolios at an average rate of 17%
per year; in 1990-2005, the turnover rate averaged 91% per year. The old
own-a-stock industry could hardly afford to take for granted effective
corporate governance in the interest of shareholders; the new rent-a-stock
industry has little reason to care.

To further complicate matters, today's typical giant private financial
institution -- managing both pension plans and mutual funds -- faces
serious conflicts in its exercise of the rights and responsibilities of
ownership. When a proxy proposal is opposed by the management of a
corporate client, the money manager is unlikely to vote in its favor. It
is not surprising, then, that governance activists among large private
money managers are conspicuous not merely by their scarcity but by their
absence. And it gets worse. Today, it is difficult to separate the owners
from the owned. Through its defined-benefit pension plans, corporations
own 12% of all stocks, and dominate another 11% through
defined-contribution savings plans. What is more, most of our largest
money managers are themselves now owned by giant financial conglomerates.
Arguably, this circularity of ownership allows corporate America to
control itself.

The problems created by this new and conflicted world of financial
intermediation are hardly trivial. Excessive return projections for
pension plans have played a major role in creating the current shortfall
of $600 billion in private pension plan liabilities relative to plan
assets. The shortfall in public plans has been estimated at $1.2 trillion,
bringing the total deficit to $1.8 trillion, and rising. Individual
retirement savings are also at dangerously low levels. Only 22% of workers
participate in 401(k) savings plans and only 10% in IRAs (9% have both).
Despite having had a quarter-century-plus to build assets in these
tax-sheltered plans, investors have accumulated balances of but $33,600
and $26,900 per participant respectively, a trivial fraction of what would
be required for a decent retirement.

With today's agency society arrogating to itself far too large a share of
market returns, the outlook for future individual retirement savings is
dire. A citizen entering the work force today has an investment horizon of
at least 60 years. If the stock market were to earn an average nominal
return of 8% per year, $1,000 invested today would then be worth $101,000 --
the magic of compounding returns. But if our financial system consumes 2.5
percentage points annually of that total return -- a conservative estimate
of today's reality -- that $1,000, growing now at 5.5% net, would be worth
just $25,000, a minuscule 25% of the accumulation that could have been
obtained simply by owning the stock market itself. The magic of compounding
returns, it turns out, is simply overwhelmed by the tyranny of compounding
costs at today's exorbitant levels.

The serious shortfalls in retirement reserves that represent the backbone
of the nation's savings have arisen importantly because our manager-agents
have placed their own interests ahead of the interests of the
investor-principals they are duty-bound to serve. Our financial
institutions have failed to exercise the rights and responsibilities of
corporate citizenship; to adequately fund pension reserves; and to deliver
to fund shareholders their fair share of the returns generated by the
financial markets themselves.

* * *
Why? Largely because the radical change from an ownership society
dominated by individual investors to an intermediation society dominated
by professional money managers and corporations has not been accompanied
by the development of an ethical, regulatory and legal environment that
requires trustees and fiduciaries, as agents, to act solely and
exclusively in the interests of their principals. In addition, we have
developed a patchwork of tax-deferred retirement programs -- Social
Security, corporate and public pensions, deferred compensation plans,
401(k)s, 403(b)s, individual IRAs, and Roth IRAs -- and are now
considering the addition of Personal Savings Accounts to the list. We
need to undertake a careful appraisal of this often costly mix, and
develop an integrated retirement system that will enhance savings.

The overarching need is for a clearly enforced public policy that honors
the interests of our citizen-investors and puts these beneficiaries in the
driver's seat where they belong. The ownership society is over. The agency
(or intermediation) society is not working as it should.

Mr. Bogle, founder and former CEO of Vanguard, is author of "The Battle
for the Soul of Capitalism," published this week by Yale.

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