Sunday, September 15, 2013

The New Wall Street Panopticon

Today's post is a short essay describing the Copernican Revolution that is redefining the panopticon of Creative Capitalism.

The Current Wall Street Panopticon.

A panopticon is a building designed on a hub-and-spoke parti, or architectural pattern.

It is useful for giving clear lines of sight into all the activities taking place within a given built environment from a central hub. It is popular these days for libraries, where stacks radiate out from a central circulation hub.

Wall Street can be spatialized as a panopticon, with different classes of investors radiating out from Wall Street at the center. The purpose of this panopticon is to aggregate large pools of constant capital for investment in enterprise from a diverse and constantly changing population of actual funding sources. Its uniqueness is liquidity. A market operates within this panopticon that gives every participant the ability to sell out of any position, at any time. It does this by letting the sell price float to whatever level it must in order to effect a sale. This is the market-clearing price. It provides a certain sale, but at an uncertain price. It does this by connecting investors to other investors, anonymously and asynchronously, through Wall Street, which sits at the hub, finding the matches within the ever-changing population of speculators speculating on valuations in a valuations marketplace.

Pensions in the Current Wall Street Panopticon

Pensions were for a long time only minor contributors of funds for trading in these markets. Traditional interpretations of fiduciary prudence limited these stewards of an open-ended, ongoing, regenerative, and therefor evergreen, trust to buying and holding dividend-paying stocks, as bond alternatives.

A New Interpretation of Fiduciary Prudence.

That changed in 1972. It changed because in 1969 the US tax laws were changed to require private foundations to pay out amounts equal to at least 5% of their entrusted corpus each year, in order to maintain their status as tax-exempt. Under then-prevailing interest rate conditions, returns on a portfolio of bonds and dividend stocks did not return 5%. That meant that foundations like Ford Foundation would have to choose between paying out corpus - which meant liquidating their trust over time, and putting themselves out of a job - or surrendering their tax-exempt status.

Instead, they invented a third alternative. Lead by the Ford Foundation, the stewardship community drove adoption of a new interpretation of the standards for fiduciary prudence. This new interpretation of fiduciary prudence let them pursue total return through capital appreciation by relying on diversification to protect against market volatility, as endorsed by Modern Portfolio Theory.

This change was made in 1972, with the widespread enactment of the Uniform Management of Institutional Funds Act.  Since 1972, pensions have been full-on participants in the Wall Street panopticon for speculating on valuations in the valuations markets, buying and selling stocks in pursuit of capital appreciation that can only be realized by active trading.

New Innovations in Retirement Savings

Pensions are defined benefit ("DB") plans. Actuarial risk pools, actually, that rely on the Law of Large Numbers to socialize the costs of living in retirement across a statistically significant population of current and future retirees. The inverse of life insurance. Contributions vary as actuarial calculations say are necessary to provide income security in retirement to plan participants.

Pensions have always been popular with workers, and society more generally, but problematic for plan sponsors and administrators.  Since the total amount of benefits to be paid are not ever really knowable (the plans being open-ended, ongoing, regenerative and therefor evergreen), it can never be certain that contributions will be adequate.  This uncertainty gets magnified many times if actuarial assumptions about investment earnings are not realized in the event.

In 1978, an alternative approach to retirement savings was written into the US tax laws, in the form of various tax-deferred savings accounts.  These are known as defined contribution ("DC") plans. The amounts contributed determine the amounts available to provide income during retirement. That, together with investment gains (or losses). DC plans put the risk and responsibility for investment management on each individual saver. Income security in retirement is not really assured, as the income runs out when the savings runs out, not when retirement ends.

These DC accounts are allowed to invest savings as the saver may decide. This innovation transformed the previously sleepy mutual fund business into a major market participant.

Changing the Dynamics of the Wall Street Panopticon

The growth in professionally managed retirement plans, both DB and DC, since the 1970s has been explosive. Not just in the US. Worldwide. According to research by Towers, Watson, globally, professionally managed DB and DC plans, combined, doubled over the 10 years from 2002 to 2012, from $15 Trillion to $30 Trillion USD.  This represents something like half of the total estimated $60 Trillion USD available as capital for investment, worldwide.

This explosive growth in professionally managed retirement plans has transformed the dynamics of the Wall Street Panopticon.  There is room for debate over whether that transformation is for the better.

Redistributing Control Over Savings Held for Investment

The diagram below shows the current state of the Wall Street Panopticon, with most of the money available for trading controlled by Mutual Funds and Pension Funds, and with a proliferation of advisors attaching themselves to the lines that connect Pension Funds especially, but Mutual Funds as well, out on the periphery with the Wall Street market-clearing mechanisms at the hub.

Creative Capitalism Becomes Casino Capitalism

Whatever one may think of the larger impact of this redistribution of control over savings held for investment, its impact on pension funds, in particular, has been adverse.  Pensions are experiencing erratic returns, inadequate returns, misalignment of incentives, miscreant market manipulation, the orphaning of social, economic and environmental impacts and a growth in the zero-sum game of extracting value from other market participants, which means increasingly that each retirement plan is seeking to provide for its retirees at the expense of other retirement plans, and other retirees, who are participating in those other plans.

The "everybody wins" of wealth creating capitalism in its original incarnation has degenerated into the zero-sum game of Casino Capitalism that we are living with today.  In consequence, there are those who contend that proper pension plans, DB plans that provide real, sustainable income security in retirement, cannot continue.

As the global financial crisis of 2008 demonstrated most recently and most dramatically, we all suffer adversely from this, as closed-loop trading of retirement savings drives overvaluations in the valuations markets that are unsustainable, creating an illusory prosperity that evaporates when the valuations collapse. We are getting too-big-to-fail that fails nonetheless.

A Copernican Solution: the Evergreen Stewardship Panopticon

The solution is not to be found by tweaking the current Wall Street Panopticon.

The solution is Copernican.  We have to build a new stewardship panopticon that puts professional management of retirement savings at the center of its own investment universe, building for these stewards of open-ended, ongoing, regenerative - and therefor evergreen - trusts clear sight lines into equally open-ended, ongoing, regenerative and therefor evergreen wealth creation through direct engagement with wealth creating enterprises that are also open-ended, ongoing, regenerative, and therefor evergreen.

This is a natural match of evergreen to evergreen through direct participation in wealth creation over time that will empower pensions, in particular, to engineer portfolio returns to match their fiduciary responsibilities and reduce their exposure to systemic overvaluations in the valuations markets, while also simplifying portfolio design, internalizing portfolio management (to the extent they choose), reducing portfolio costs and increasing their control over portfolio impacts on society, the economy and the environment. It will empower defined benefit plans to continue providing real income security in retirement to successive generations of current and future retirees.

In this new evergreen stewardship panopticon, Wall Street is moved from the center to the periphery, where it continues to compete, as one enterprise among others, for funding from the stewards of our retirement security.

This is what makes it Copernican. The earth is no longer the center of the heavens, in which the sun is one object among many. Instead, we have a solar system, with the sun at the center, and the earth, as one planet among many, orbiting around the sun.

The post-Copernican Wall Street Panopticon

In this post-Copernican world, Wall Street will continue as the hub of its own panopticon for speculating on valuations in the valuations markets, with retirement stewards still forming one of many classes of market participants out on the periphery, but the volume of retirement savings being used to fund speculation on valuations within the New Wall Street Panopticon will shrink.

Regenerating Creative Capitalism

In the process, we will see Casino Capitalism shrink back down to a more authentic form of Creative Capitalism, but the new Creative Capitalism will be turbo-charged by access to two competing market systems: the familiar Wall Street panopticon for speculating on valuations in the valuations markets, and the new Stewardship Panopticon for direct engagement of evergreen trusts with evergreen enterprise for evergreen sharing in evergreen wealth creation.

Spatial Representation of the Copernican Revolution in Panopticons for Creative Capitalism

The Current Wall Street Panopticon

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