CFA Institute

The Trillion Dollar Promise by James A. KujacaReview by: Victor F. MorrisFinancial Analysts Journal, Vol. 52, No. 5 (Sep. - Oct., 1996), pp. 86-87Published by: CFA InstituteStable URL: http://www.jstor.org/stable/4479950 .

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BOOK REVIEWS

A Critique of Pension Funds and Insights into Globalization

Martin S. Fridson, Editor

The Trillion Dollar Promise. By James A. Kujaca, CFA. Irwin Professional Publishing, 1333 Burr Ridge Parkway, Burr Ridge, IL 60521-0085, 800-634- 3966, 191 pages, $27.50.

Reviewed by Victor F. Morris, CFA, an investment consultant in Teaneck, NJ.

Subtitled "An Inside Look at Cor- porate Pension Money, How It's Managed and for Whose Benefit," this book is described by John English, former chief investment officer of the Ford Foundation, as "the long-awaited, definitive book concerning the little-understood U.S. pension fund industry."

Whether this book is the de- finitive work on the subject is ques- tionable, but apparently it is the only comprehensive presenta- tion-in terms the average pen- sion beneficiary can understand- of the critical issues facing this im- portant industry. Another virtue it has is that the author is a pension fund manager himself, with a CFA charter and an MBA, so this book is a cut above the popular muck- raking "exposes" produced by journalists in recent years.

A limitation of the book, ac- knowledged in the introduction, is that it deals almost entirely with defined-benefit plans. Most of the problems the author discusses are

not applicable to defined-contri- bution plans. Putting this limita- tion into perspective, the author says there are about 65,000 corpo- rate-sponsored defined-benefit plans covering 41 million people with more than $1.4 trillion of pen- sion assets, a figure that can be compared with more than $3.1 tril- lion for just the top 1,000 pension funds of all kinds.

A defined-benefit plan prom- ises a retiree a specific monthly dollar amount at retirement based on the participant's age, salary, length of service, and so forth. To finance this promise, an actuarial calculation is made to determine the monthly contributions that mustbe paid into the plan. The cal- culation is based on assumptions regarding mortality, length of ser- vice, early retirements, and other factors that could affect demands on the plan's invested assets and, most importantly, on the rate of re- turn those assets are expected to earn. If the assumptions turn out to be conservative, the plan is said to be fully funded and excess funds can allow the company to "take a contribution holiday," with obvi- ous benefits to its earnings. The re- verse is true if the assumptions turn out to be too optimistic: The plan is underfunded, and the com- pany has to make up the shortfall by increasing its monthly contri- butions.

Conflicts of Interest We have here a potential con-

flict of interest between the com- pany's management and the plan

participants. If the assumptions are conservative, contributions mustbe larger; if they are aggressive, (e.g., if they assume a high rate of return on investments), contributions can be smaller. Who makes the assump- tions and how they are motivated are of critical importance. Kujaca suggests that individuals who are given the responsibility for oversee- ing the pension fund investments derive their power from the com- pany's management, which could give them a bias in favor of the com- pany. In many cases, this bias is re- inforced, he says, by executive compensation arrangements that focus senior managers' attention on increasing corporate earnings at the expense of the company's pension promises.

This bias is not the only one that can divert pension fund man- agers from their legally mandated fiduciary responsibility to act in the sole interest of the plan partic- ipants. According to Kujaca, self- serving chief investment officers use the fund's assets to advance their wealth and careers by pass- ing out lucrative contracts to out- side portfolio managers, the master trustee, consultants, and other suppliers, who return the fa- vors one way or another. Directed brokerage is perhaps the most fa- miliar perk. The pension fund, Ku- jaca says, becomes the chief investment officer's personal wealth foundation.

Specific examples are rarely given. Kujaca says he is not interest- ed in finger pointing but in describ- ingtheproblem and recommending

Martin S. Fridson, CFA, is chief high-yield strategist at Merrill Lynch & Company in New York.

86 ?'Association for Investment Management and Research

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reforms. Unfortunately, if we do not have real-life cases to consider, we do not really know how serious the problem is. Pensions & Investments, the industry's trade paper, is up in arms about this book, denouncing it as "filled with innuendo and no ev- idence, no company names to back up [its] pervasive charges."

This reviewer, with some ex- perience in the money manage- ment business, believes the book realistically describes potential abuses that could become wide- spread, and as such, it should be taken seriously. Kujaca shows how various types of wrongdoing can be covered up-he says they are being covered up-and recom- mends procedural and regulatory steps that should be taken to pre- vent the wrongdoing. He shows how various abuses can weaken a fund and compromise its ability to meet its obligations to the plan par- ticipants.

The Role of Government The book contains a good

summary of the role of govern- ment in these matters, starting in 1974 with ERISA, the Pension and Welfare Benefits Administration, and the Pension Benefit Guaranty Corporation (PBGC), which are administered by the U.S. Depart- ment of Labor. Because of the tax- exempt status of pension plans, the IRS also gets into the act with Sec- tion 415 limitations that are de- scribed in some detail. When one adds the powers of the SEC over securities law violations such as insider trading and front running, it would seem that adding a few more restrictions, such as those Kujaca recommends, would not make much difference.

The problem, according to Kujaca, is that the only way wrong- doing can come to light is for hon- est pension fund employees to report it, something that they are not likely to do because they are not adequately protected against retaliation by their superiors. He

explains why ERISA's antiretalia- tion provision is ineffective and how it must be strengthened.

Most professionals who are involved in pension fund manage- ment are members of the Associ- ation of Investment Management and Research (AIMR), and many, like Kujaca, are also CFA charter- holders. As such, they are subject to AIMR's Standards of Profes- sional Conduct, which specifically forbid questionable practices de- scribed in Kujaca's book, or at least require their disclosure to superi- ors and clients.

The problem of corrupt exec- utives is an old story throughout industry. Purchasing managers who are on the take beyond the usual lavish entertainment tend to get found out because their perfor- mance suffers. They are ineffective buyers. Their superiors, if they are competent, notice that their costs of purchased materials or compo- nents are out of line with those of their competitors. If performance can be measured accurately, the problem can be controlled.

The same is true in the invest- ment business. What keeps most pension fund managers honest is that performance is measurable, and the drive to outperform the benchmarks and the competition is so demanding that it leaves little room for decisions based on cro- nyism, politics, or other illegiti- mate considerations that might detract from their goal, mandated by ERISA, to "discharge [their] du- ties with respect to a plan solely in the interest of the participants and beneficiaries."

V.F.M.

Editor's Note: Readers who wish to delve more deeply into the workings of the U.S. private pen- sion system, without considering only the investment management aspect, should read The Uncertain Retirement: Securing Pension Prom- ises in a World of Risk, by James H. Smalhout (Irwin Professional

Publishing, 1333 Burr Ridge Park- way, Burr Ridge, IL 60521-0085, 800-634-3966, 366 pages, $32.50). Smalhout, a visiting fellow at the Hudson Institute, addresses such issues as funding adequacy, the value of insurance provided by the PBGC, and ethical considerations. He compares pension systems around the globe and offers con- crete proposals for reform of the U.S. system.

Market Unbound: Unleashing Global Capitalism. By Lowell Bryan and Diana Farrell. John Wiley & Sons, 605 Third Avenue, New York, NY 10158-0012, 212- 850-6000, 268 pages, $27.95.

Reviewed by Martin S. Fridson

In the past 20 years, the market capitalization required to rank among the top 20 nonfinancial companies in the world has soared from about $1 billion to more than $43 billion. This statistic, reported in Market Unbound: Unleashing Glo- bal Capitalism, dramatizes the accelerating pace of cross-border economic integration. Authors Lowell Bryan and Diana Farrell, both senior consultants at McKin- sey & Company, observe that glo- balization is progressing even in industries long thought to be inherently local, including cement production and funeral services.

Inevitably, internationaliza- tion of the real economy links fi- nancial markets all around the world. Borrowers, lenders, and ar- bitragers have learned to scour the planet for minute interest rate dis- parities. Already, Bryan and Farrell contend, it is feasible to infer a sin- gle global risk-free rate of return from quoted rates and implied risk premiums. The authors further as- sert (although the evidence is not conclusive) that yield curves in all countries are converging. In time, suggest the authors, risk-adjusted corporate bond yields and even eq- uity valuations will be perfectly aligned everywhere on earth.

Financial Analysts Journal * September/October 1996 87

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