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Thornton Parker

bipartisan Senate panel recently reported that "groupthink" was a major reason why the CIA misread Iraq's weapons capabilities. The agency had not used a "red team" to challenge the data and consensus assumptions behind its intelligence estimates.

A similar groupthink is guiding how America uses its capital and prepares for its aging baby boomers. If what "everybody knows" is wrong and is not corrected in time, future panels will hear testimony from leaders of government, pension plans, the financial services industry, companies and business schools on why they missed the warning signs that retirement plans that depend on stocks are seriously flawed.

This is the first of four articles that are like a red team challenge. They do not predict that boomers' retirement plans will fail, but they explain why that could happen. Despite widely held assumptions, there is no sound explanation of how the nuts and bolts of the plans can work. Unless the mechanics are explained soon, Americans should revise their flawed retirement assumptions and investment practices before failure becomes inevitable.

Those who recommend stocks and stock mutual funds as retirement investments often point to the record of stocks since the mid-1920s to support their claim that despite price fluctuations, stocks have provided outstanding returns. But as the table shows, there were two very different periods during the 74 years before the bull market ended in 2000. During the first 56 years, slightly less than half of the total returns came from gains and stock prices declined during 21 years or more than a third of the period.

While dividends less than doubled during the second period, gains increased by more than 12 times, providing 86.7 percent of the total returns, and had only two down years. These gains provide much of the case for using stocks in retirement plans. In order to project the plans' future, one must know why the two periods were so different.

Many factors influenced stock prices after 1981. Non-financial developments included the end of the Cold War, the emergence of new technologies, globalization and deregulation of the power, communications and transportation industries. Important trends also included the displacement of many small businesses by large companies, particularly in marketing; industry consolidation and rationalization, often along horizontal rather than vertical lines; and aging of the boomers, the oldest of whom reached 40 and their peak earning years in 1986.

Financial developments included restrained inflation and declining interest rates; growth of the venture capital industry and the NASDAQ which funded the emerging technologies; the "shareholders' rights" movement and LBOs; and deregulation of stock markets which led to discount brokerages and low trading costs.

The development that probably had the greatest effect on stock prices was the change in IRS regulations that took effect in 1982, which let employers and employees put regular earnings into 401(k) plans. This led to a major shift of retirement risks and responsibilities from employers to employees. Thousands of mutual funds were created and marketed to individuals and to retirement plan managers who were measured by the performance of their portfolios. Appreciation or gains were emphasized because they contributed more to total returns than dividends. Competition among mutual funds increased and a new industry of analysts, advisors, writers, publications and electronic media evolved to help individuals and portfolio managers increase their returns. Except for short-sellers and a few grumpy bears, nearly everyone wanted stock prices to rise. Dividends, which are limited by earnings, were deemed too small to be important, particularly when companies appeared to produce larger total returns by buying back shares than by paying dividends with the same amount of money.

The conventional way to explain how stocks will help boomers retire is to point to their historic "total returns" and project their growth like compound interest. This groupthink about total returns and retirement plans is flawed for four reasons.

1. Most total returns consist of dividends and gains, but few investors consider the nature of those components and where they come from. They are completely different.

Dividends come directly from companies, usually in cash, and are made possible by what companies have achieved in the past. In terms of the life sciences, dividends are endogenous - meaning they originate within the organism.

Gains are just the opposite. Until stocks are sold, any gains are merely bookkeeping entries that are based on stock prices which traders set on the basis of what they think will happen in the future. Any gains that are received when stocks are sold come from the buyers, not the companies. They are exogenous - meaning they originate outside of the organism.

Lumping these components of income into "total returns" leads to serious mistakes.

2. Now that stocks pay relatively small dividends, retirement plans buy them for gains. But unlike dividends, gains cannot be converted into retirement income until the stocks are sold. Few people understand the stocks-for-retirement cycle. Boomers and their retirement plan managers are being urged to buy stocks in the front, or build-up half of the cycle but there has never been a published, due diligence analysis that explains how the stocks can be sold to produce any gains during the back, or selling half of the cycle.

3. Federal Reserve and Investment Company Institute data indicate that pension plans, 401(k) and 403(b) plans, mutual fund shares in retirement plans, IRAs, and other tax-advantaged portfolios hold about half of the stocks of U.S. public companies. Except for stocks that are in retirement portfolios primarily designed to shelter estates from taxes, nearly all of those stocks will be have to sold. Company pension plans that are being phased out are already selling. Never before has half of the capitalized value of America's public companies been sold to support consumption, so projections of total returns that are based on what stocks have done in the past are useless and misleading.

4. Although boomers are urged to save more and buy more stocks, the retirement incomes provided by those stocks will largely be determined by what future buyers will pay for them. Unless someone can identify another source of purchasing power, the primary domestic buyers will have to be some of the same younger workers who may not continue Social Security in its present form. By 2030, there are projected to be only 2.2 workers to support each Social Security retiree. Actuaries call this the support ratio.

Despite proposals to use stocks to supplement or replace Social Security, the support ratio for stock-based plans may be only half of the 2.2 that is projected because the main domestic stock and mutual fund buyers are workers in their peak earning years during the second half of their careers (or their employers). By 2030, there may be only 1.2 peak-earning workers to buy the stocks of each boomer. Unless other buyers are found, stock prices are more likely to decline and destroy the boomers' savings than rise and provide the retirement incomes that boomers are told to expect.

Gains can be misleading before they have been converted into cash. As shown in retirement plan statements and stock and mutual fund tables, they look like money in the bank, but they are not. They are just phantom wealth.

Phantom wealth is created in two steps. First, a few shares are traded and a market price is set. Second, all shares are then treated as being worth the market price and, periodically, all portfolios that hold a stock are marked-to-market. For example, both GE and Microsoft have about 10 billion shares outstanding. If the price of either goes up a dime, when all portfolios that hold either stock are marked-to-market, $1 billion seems to appear and no one knows where all the money came from - or cares. If the price goes down a dime, the $1 billion disappears - it was just phantom wealth.

Unfortunately, phantom wealth is a primary component of most retirement plan portfolios. As was seen after 1999, it can simply vanish.

We know that Social Security has a problem because each year, its trustees publish a forward-looking report that treats the Old Age, Survivors, and Disability Insurance fund as a single portfolio and projects what must happen in the future to meet the program's commitments. In contrast, employer and individual retirement plans are evaluated as millions of unrelated entities and their futures are projected with backward-looking analyses that are based on what stocks have done in the past.

Opposite approaches - opposite conclusions.

But retirement plans now have what engineers call the "scale effect problem." Centuries of experience has shown that when materials, methods, designs and formulas are used to build ever larger structures, eventually a scale may be reached where factors that were not important for smaller structures cause large ones to fail. Boomers' retirement plans are designed and evaluated as millions of supposedly independent entities, but they are actually parts of the national stocks-for-retirement cycle. The cycle is a structure of unprecedented scale and its most critical factor - adequate purchasing power when the stocks must be sold - is being ignored for the independent plans.

The limit on how many retirees a country can support is also being overlooked. Workers and their employers make the national pie of goods and services. Except for durable items like housing, autos, major appliances and some clothing, most of the pie must be consumed as it is being made (electricity) or shortly thereafter (food). Retirees are unemployed adults who consume slices of the pie that they no longer help to make. Retirement plans transfer income from workers (and their employers) to retirees so they can buy larger slices of the pie. Social Security makes the transfers with taxes; pension plans do it by selling stocks when there are not enough employee contributions; and individually-managed plans that depend on stocks will do it by selling the stocks. As boomers age, the number of retirees will increase and the total amount of the transfers must increase or retirement standards of living will decline. Regardless of how the transfers are made, whatever retirees consume, workers must do without.

Conventional methods for projecting the future of retirement plan investments on the basis of what stocks have done in the past do not take either these important factors into consideration.

Proponents of stock-based plans say that this reasoning ignores foreign stock buyers, but that is not quite true. Most other countries in the Organization for Economic Cooperation and Development have more serious problems with their aging populations than the U.S., and Japan is in the lead. They must provide support to millions of older people with transfer payments from younger workers; provide jobs for their older people that immigrants and workers in developing countries would perform at a fraction of the cost; or allow their older people to become destitute. They don't seem to have many other options. But few of the countries are facing up to the problems of aging that will have major effects on their economies and societies.

Further, it is hard to see how workers in developing countries whose economies are growing rapidly would pay high prices for stocks in the S&P 500 instead of buying shares of their own, rapidly growing companies. Foreign interests may well acquire U.S. companies for their markets and resources, but the purchases are more likely to be made by companies seeking assets at bargain prices than by low-paid workers building retirement plan stock portfolios.

Projecting the rolling stocks-for-retirement cycle for 75 years as the future of Social Security is projected raises another issue. If a significant number of the boomers’ stocks wind up in foreign hands, younger U.S. workers will not have acquired them. Once boomers sell their stocks outside of the country, the younger workers may have to pay premium prices to bring them back, which would dilute any profits.

This is not to say that foreign investors will not help save the day for boomers' retirement plans. But so far, all the explanations of how that can happen seem to be founded on unsubstantiated hope - and hope is not a strategy or method. Before Americans rely on foreign buyers, they need a solid analysis that explains the chances of that happening and the risks that would be involved.

All this comes down to a vitally important question that should be answered as soon as possible:

If boomers' retirement plans will have to sell the stocks they hold to pay retirement incomes, who can be expected to buy them at prices adequate to support their retirements?

Like the burden-of-proof test in law, system-failure analysis in engineering, due diligence analyses in investing or feasibility studies, this question requires a forward-looking examination of the risks that all retirement plans face and identification of the reasons why they can be expected to work. It must treat the sum of all stock-based plans as a single national portfolio and show how what must happen in the future can be expected to happen - just as Social Security is evaluated.

The engineering design technique of system-failure analysis is a good model. Based on the premise that any complex system includes critical components that must function if the system is going to work, it requires identifying all of the critical components of a system and analyzing or testing each one to ensure that it is dependable. Like the logic that a chain is no stronger than its weakest link, if any critical component is undependable, the system must be treated as undependable and failure-prone.

There is no reason to buy stocks for retirement plans in anticipation of gains unless the gains can be converted into retirement incomes. If that requires selling the stocks, the most critical component of the boomers' stocks-for-retirement cycle is adequate purchasing power to buy them at prices high enough to provide the income during the back half of the cycle. Few pension plan managers would knowingly fly in a plane that had not been designed this way, but it is not a conventional part of their own tool kit. It should be.

The next article in this series will examine how retirement plans have affected companies and markets. This is important because if retirement plans do fail, much of what they have done to increase stock prices will either reverse automatically or have to be reversed. In addition, much of what they have done may have to be reversed in the near future in order to prevent their failure.