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.
