Bubble-proof your clients' retirement

As retirement investors begin to recover from a devastating financial crisis, a period of honest reassessment is in order. Given that 401Ks have become the retirement plan for America, how did we let bubble economics replace sound financial planning on behalf of retirement plan investors?

To be fair, investment advisors, consultants, retirement plan administrators and mutual funds were only relying on generally-accepted models of how markets and prices are supposed to behave. The efficient market hypothesis told us that prices are always right because they reflect all known information; the capital asset pricing model told us that we could diversify away company risk and achieve optimal systematic risk; and the Black-Scholes formula told us that we could then virtually eliminate systematic risk through options or portfolio insurance - shorting the market as it falls, thereby escaping loss.

So, everyone piled into equities, and where possible, increased their exposure through leverage. Why wouldn't we be irrationally exuberant when the leading financial theories were telling us that we couldn't lose?

The problem is this that these elegant theories didn't work. More importantly, it is now abundantly clear that what may be appropriate investments for high-risk gamblers at Goldman Sachs and assorted hedge funds are quite often inappropriate for retirement investors and their 401K plans. Why? Because the former are short-term investors and their (often outlandish) compensation incentives are aligned with short-term outcomes. Retirement investors, by contrast, are long-term investors, and their nest eggs truly shouldn't be exposed to so much risk - particularly without appropriate disclosure.

Speculative bubbles are fundamentally the triumph of short-term investors over long-term investors. Corporations - including our largest financial institutions - are transformed into vehicles whose primary purpose becomes making a small group of management insiders enormously rich over very short periods of time. Such bubbles do not serve long-term investors well at all.

It is discouraging, therefore, to see certain segments of the financial services community opposing reform and calling for a return to market fundamentalism. The notion that markets (and asset prices) are always right - or that, conversely, government regulation is always wrong - has been devastatingly refuted. There is an urgent need for regulatory reform.

For 401K retirement plans, reforms should include - as Putnam CEO Robert Reynolds has urged - limits on the percentage of stocks that target date funds can hold for those nearing retirement and a national insurance regulator to guarantee annuity products, much as the FDIC insures bank deposits. There should also be greater disclosure of asset allocations in target date funds and greater fee disclosure in general for retirement accounts. Extending the fiduciary standard to brokers should benefit retirement investors as well, as should the creation of a Consumer Financial Protection Agency, as currently proposed.

Finally, taking steps to encourage corporations to focus on long-term value drivers rather than quarterly earnings reports is critically important. To do so, we will need to realign the balance of power between shareowners and corporate management. In this regard, SEC Chair Mary Schapiro should be applauded for issuing a proposal to give long-term shareholders access to the corporate proxy ballot to nominate directors. Extending annual "say on pay" advisory votes on executive compensation to all publicly-traded corporations - not just TARP recipients - would be another positive step. The SEC should also consider mandating greater disclosure by corporations on environmental, social and governance (ESG) issues, as hidden liabilities in these areas can often presage larger problems.

I don't believe the financial crisis would have been as devastating had we had better regulations in place to protect long-term investors, and in particular 401K investors. It would be a shame to let this moment pass without taking affirmative steps to shore up the 401K system and protect retirement investors from such calamities in the future.

Joe Keefe is President and CEO of Pax World Management Corp., investment adviser to Pax World Funds
(www.paxworld.com).