Financial markets: For whose benefit?

Originally appeared in OECD Observer No. 273, June 2009

Banks and investment companies are more than mere financial firms. They hold and manage assets, such as retirement income, on behalf of others, whether individuals, companies or governments. In short, they have a fiduciary role to fulfil, based on trust. So why have the beneficiaries not really benefitted?

The moment has arrived for an honest conversation about the standards applied to fiduciaries. Fiduciary responsibility has, particularly in the United States though in other countries too, come to mean making money. But the best interest of the beneficiary may not rest on making money alone. If the money is made in a way that engenders a lower quality of life, or a shorter life, the beneficiary has in fact been ill-served.

This past year the world has been thrust into an economic decline brought about by a sharp collapse of credit markets. The millions who have lost their jobs did so not simply because there were greedy investment bankers involved. They fell victim to a system that allows the fiduciary to invest for return, often short-term focused, without considering the overall risks or costs to the beneficiary. We will never know how many of the new unemployed are the direct result of their own pension plan investing in reverse default swaps, but certainly the numbers are high. It has become vividly clear that the way one invests matters. The investments of the past decade were largely the cause of global economic collapse. It is time for government regulators globally to address the biggest enabler in all this, the standard of prudence.

In the US, we have various standards that a fiduciary must look to but the most influential is the Employee Retirement Insurance Savings Act (ERISA), which Congress passed in 1974. This Act is looked to even by trustees of funds not governed under the Act for guidance. It established standards of conduct for fiduciaries and gives court redress when fiduciaries fail.

ERISA section 404(a)(1)(A) provides, in part, that: "A fiduciary shall discharge his [or her] duties solely in the interest of the participants and their beneficiaries and (A) for the exclusive purpose of (i) providing benefits to participants and their beneficiaries; and (ii) defraying reasonable expenses of administering the plan" (see reference below).

While looking after the best interest of the beneficiaries and their dependants sounds like a noble goal, this section, which has come to be known as the "exclusive benefit" section, has created an understanding that nothing but making money can enter into the mind of the fiduciary. But the language of the law, and I would argue the intent of the law, is not stated that way. The language directs the fiduciary to think of nothing but "the benefits".

We need clarification as to the meaning of benefit. To interpret it as meaning "make money" is to accept bizarre consequences.

Under that definition, I may kill people to make money. In fact, under that definition I could kill the beneficiary to make money. It does not make sense that a fiduciary should be encouraged to invest in, for example, a highly polluting industry, one that is either contributing immensely to the creation of greenhouse gases or causing serious health issues; that would be to the detriment of the beneficiary.

Grotesque though it may be, let us carry the line of thinking to another level. As a fiduciary, may I purchase shares of a company whose product is replacement organs? This company perhaps operates under a friendly government with little interest in the disappearance of healthy citizens. Am I as a fiduciary forced to overlook this and plow into the investment?

Oddly, the example is almost real. Some of the best performing stocks in America over the past several decades have been cigarette manufacturers. Current interpretation of ERISA seems to forbid the fiduciary from caring that the investment makes money by addicting and even killing many of its users. It also seems to allow the fiduciary not to consider the cost side of the equation. If we consider the loss of productivity and healthcare costs that beneficiaries pick up in the form of tax bills, the true economic benefit to the investment quickly disappears.

The problem is that the beneficiary is also a citizen. So if the company makes a bit more money by lobbying for and receiving a subsidy, the citizen is hurt; it costs tax money to give a subsidy. If the company makes a bit more money by changing the laws so that unusual and predatory mortgages can be sold, and then sells them to the detriment of the public, the beneficiary has lost economic benefit in the form of taxes paid to clean up the problem, not to mention the direct costs.

Because the US is so influential in setting standards for asset management, ERISA has an outsized influence globally. And for the same reason, the fix is simple. The Department of Labor, which oversees ERISA, must clarify that the intent is to benefit the entirety of what we call the beneficiary, not simply their retirement account. Anything less than this is robbing Peter to pay Paul.

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