David Pitt-Watson explains why the finance industry is giving pension schemes a bad deal
Here is a question that should be of profound importance to anyone working in the finance industry, and particularly to investors who use its services: “Is the industry doing a good job?” Yet we rarely ask that question, leave alone get a coherent answer. As a result we struggle to agree on how the industry can best be improved.
If you want to address the issue, you need first to define the purpose of the industry, against which performance might be measured. Again, if you consult the finance literature it contains thousands of articles, but you will find only a handful that discuss purpose.
Finance has four purposes: to keep our money safe; to help us transact; to allow us to share risk; and critically to intermediate
Those that do might be summarized in the following way. Finance has four purposes: to keep our money safe; to help us transact; to allow us to share risk; and critically to intermediate, that is ‘to take money from point A where it is, to point B where it is needed’.
So important are these purposes, that investors within the capitalist system are given huge powers, to appoint those who run companies. Few chief executives will dispute that their companies are run for some form of shareholder value. Indeed the law in the UK requires boards to “to promote the success of the company for the benefit of its members [that is its shareholders] as a whole”, after giving consideration to the interests of stakeholders. Indeed, engaged investors will often see their role as holding companies to account for delivering on that promise.
Finance is so critical to our welfare that its pioneers are often seen as philanthropists. Even today we award Mohammad Yunnus a Nobel Peace Prize. Why? Because he loaned money to poor people, just like Wonga, but unlike Wonga did it in a way which could transform their lives for the better. Indeed the purposes of finance are so important that there is no wealthy country which lacks a sophisticated finance system.
It is an industry in which we should take great pride
But here is the bad news. If these are the purposes of finance, the industry fulfills them poorly. In one landmark study, Thomas Philippon, looked at the productivity of the US finance industry over 130 years. He found no improvement whatsoever. The central point of competitive markets is to improve productivity, and finance has been blessed with numerous enabling technologies to allow it to do so. Yet it had delivered no productivity improvement whatsoever.
In What They Do With Your Money, we look at how this might have come about. Some of the answers will be familiar to readers of Engaged Investor. They will understand the degree to which the industry now has so many agents, each commissioning work from one another, that, too often, it adds cost, without adding value. And the critical functions it should be carrying out, it often does poorly; for example the US mutual fund which spends over $130m telling its clients how well it stewards their money, and then employs only one person to vote on 10,000 companies.
The industry now has so many agents, each commissioning work from one another, that, too often, it adds cost, without adding value
But there are many other flaws in the system. For example the dangerously simplistic way in which we measure risk; the evidence which suggests that the system we use today for assessing bank stability is worse than the one in use in the run up to 2008.
We look at the various ‘tricks of the trade’ that stop investors and pension funds getting a decent deal from the industry, including charging costs to our account without even telling us. We note how the way we teach finance has become too narrow, assuming away issues of purpose, and how the regulatory system has followed this example, printing vast tomes of rules.
Even if we just understood the costs of fund management that would be a step forward
The prize from fixing the system would be huge. At a simple level, even if we just understood the costs of fund management that would be a step forward. Railpen, for example, has undertaken such an exercise, and discovered that the headline charges of £75m, which it was told it was paying, were just a fraction of the £290m which it was ultimately being charged to its account. As a result it has achieved a considerable reduction in costs.
And here is a startling observation. If a pension saver in the UK or the US were to set aside the same amount of money each year as a saver in Holland, the Dutch person would receive a 50% higher pension.
Many of the problem as in the finance industry are “fixable”
So there is good news. As David Walker, former chair of Barclays, who led the bank following its fall from grace after 2008 says, many of the problem as in the finance industry are “fixable”. Especially if they have the support of engaged investors. And as Walker generously continues, “this excellent book gives a compelling account of how”.
What They Do With Your Money: How the Financial System Fails Us and How to Fix It, by Stephen Davis, Jon Lukomnik, and David Pitt-Watson is published by Yale University Press.