We have long suspected (since it makes sense) that management will often forego projects which make sense for the company but are too risky for them personally on a portfolio basis because they are already exposed to the firm via their jobs and maybe even options.
Reuter’s Felix Salmon explains why and how….
What’s the correlation between wealth and risk appetite? I suspect that it’s somewhat bell-shaped: when you’re very poor you can’t afford to take any risks, while if you’re entering the middle classes you often feel that you have to take risks, especially with your retirement assets, if you’re going to have a chance of maintaining your standard of living once you stop working.
If you already have more money than you’ll ever spend, however, then you don’t need to take those kind of risks any more, and you start becoming much more conservative again — see for instance the way in which Suze Orman is invested only in wrapped munis.
This big picture can be blurred by the fact that many of the riskiest investments, like venture-capital funds or leveraged hedge funds, are invested in only by the wealthy. But look a bit closer and you’ll invariably find that the investors in those funds are careful to make sure they’re set for life before taking a small percentage of their wealth and investing it in high-risk assets.
But thanks to a new law, we can now see how senior executives invest their money. And it turns out that even diversified stock-market investments are too risky for them:
Top executives at Bank of New York Mellon Corp. could invest their savings in a fixed-income fund that had a 6.6% return in 2008; thanks to electing this fund, Steven Elliott, senior vice chairman, had earnings of $1.3 million on his account, according to filings.
Executives at Cummins Inc. could choose among three options: the return on the S&P 500, “the Lehman Bond Index, or 10 year Treasury Bill + 2%,” according to filings. The executives at the engine maker had a total of $1.4 million in gains on their accounts, suggesting that none of them elected the stock index.
Executives at Illinois Tool Works Inc., a maker of fasteners and adhesives, received returns of 6.1% to 8.4% in 2008, while investments in the employees’ 401(k) lost 25%. A spokeswoman says that so far this year, the average return of employees’ 401(k) plans has been 23%, while the interest credited to the executives’ deferred-compensation plan is just 5.6%.
The WSJ implies, and Ryan Chittum makes explicit, the concept that any executives seeing gains in their retirement accounts were somehow getting special treatment, compared to ordinary employees whose 401(k)s got destroyed.
But the bigger point here is that the rich executives are simply availing themselves of the luxury of being able to afford very low risk, modest-return investments. (As ever, Comcast is the outlying villain, guaranteeing senior executives a 12% return on their savings. Yuck.)
I’d also be interested in finding out how much company-specific credit risk is involved in these schemes. A giveaway is the word “notional”:
These deferred-compensation plans generally provide notional investment elections that mirror the returns on mutual funds available in the employee 401(k) plan.
In other words, we’re not talking about actual returns on actual money, here, we’re talking about notional returns on notional money which is really just an unsecured liability of the company to the executive.
If the company goes bust, the money disappears — and even if it doesn’t, the money might not ever arrive. Just ask Fred Goodwin and Dick Grasso whether promised retirement funds are certain to become real cash.
There’s something to like about the fact that senior executives have an enormous amount of their retirement assets tied up in unsecured obligations of their employer: it gives them a strong incentive to avoid the kind of fat-tailed risks which could really wipe them out. So I’m not as shocked by the WSJ story as Chittum is. Except for that Comcast factoid, of course.