As Business Schools Professors, we often have the opportunity to take part in helping policy makers shape the commercial and financial landscape. My colleague at the Hebrew University Business school, Prof. Yishay Yafeh has been recently involved in such a process, in a topic that is critical to all of us – our pension funds. Many people feel often overwhelmed and lost when it comes to the world of financial planning and saving, and Israelis are no exception. To combat these feelings, some turn to experts in the financial field to manage their money as they begin saving towards retirement.
In theory, people who have no professional background in finance would trust the pension funds who have a proven record of consistently high return on investments. However, after deducting all the management fees and other charges, average Israelis must ask themselves if they are financially better off with their money in the hands of the pension fund managers. What would be an alternative? Well, the number one rule in finance is that high average returns are obtained when one diversifies the investment as much as possible. Therefore, an alternative to professional asset management could be to simply take the money and buy a large collection of stocks and bonds which follow one of the leading indices, such as Fortune 500, S&P 500, or Nasdaq, and trust the market spirits to do the job.
The question is, therefore: can I trust my life savings in the hands of the experts? Or perhaps, I should just piggy ride on one of the leading indices.
The answer to that question is unsurprisingly complicated. An external advisory committee to the Capital Market, Insurance and Savings Authority, headed by Prof. Yafeh, has just published an extensive report on the issue of "direct expenses" and management fees that pension funds charge their members.
The term "direct expenses" refers to fees incurred by savers when their pension fund uses external money managers, such as private equity, venture capital or hedge funds, to manage part of the pension fund's portfolio.
The report finds that, in comparison with large stock indices, such as the S&P 500 or the Tel Aviv 135, investments by Israeli pension funds in private equity funds have failed to achieve significantly higher returns, even though they involve "direct expenses" that the client must pay.
In other words, while pension fund members must consistently pay out of pocket for these “direct expenses”, their return on investment is not higher. They are essentially paying higher rates for a service that is not being fulfilled.
On a national level, it is imperative to honestly examine the laws and policies governing both private and public pension funds. Has the structure of these financial institutions been built to protect the interests of the elite investors and money managers, or to ensure the financial security of the clients these financial experts are supposed to be serving?
The answer to this question is undeniably the former. The masses who are not financially literate are trusting their life savings in institutions who are willing to gamble their client’s life savings for the sake of their own paycheck. People who blindly trust in their pension funds are putting their finances in a system that overwhelmingly favors short term executive bonuses over the long-term security of their clients.
In order to combat these issues, the committee has proposed a reform in the financial sector to better align the interests of the individual investor with those of the pension fund managers.
The reform includes the introduction of low-fee pension funds based on index-tracking investments only, a simplified fee structure in standard pension funds, which currently charge two types of fees plus "direct expenses", and a performance-based fee structure for some pension funds, where the fees are determined by long-term performance above and below a certain threshold.
Whether the reform will be ratified is still unknown, but one thing remains clear: the ratification or annulment of the reform has the potential to impact the financial futures of Israelis for a generation to come.