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November 10, 1997 12:00 AM

EDITORIAL: FLAWED REACTIONS

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    A big danger in worldwide market shocks is that they could lead to flawed thinking about institutional investing: For example, that 401(k) investors are corporate chumps; that indexing and international diversification are flops; that capitalism isn't the answer for challenges confronting societies globally, such as providing for Social Security programs. Such simplistic conclusions should be resisted.

    On 401(k) plans, the stock market declines could breed "victims." The "victims" or participants of 401(k) plans could blame corporate greed for fobbing off the risk of providing pensions on to unsophisticated workers: "You want pensions, well, here's your 401(k) plan" - and now a Dow crashing 554 points.

    But 401(k) plans offer employees in today's increasingly dynamic work force advantages defined benefit plans cannot provide for most workers, including portability, portfolio choice and the possibility of capturing fully the market returns, as well as, alas, investment losses.

    The 401(k) is a long-term investment program; it's not perfect. Potential problems with 401(k)s lie with employees not saving enough, with sponsors providing poor or insufficient education and limited investment choice. The recent market drop, and possibility that if the market had not quickly rebounded employees may have been enraged, should jolt sponsors into improvements.

    On another front, defined benefit sponsors and 401(k) investors may - in the aftermath of the market drop - question allocations to indexing, emerging markets, as well as the benefits of international diversification.

    But any plan sponsors waking up to this allocation issue only now have more profound, intractable problems in managing the pension fund.

    On indexing, those riding it on the way down with the markets ought to recall passive investing has produced spectacular returns throughout the 15-year bull market, and at low costs. Few active managers have equal records, and they charge higher fees, which is why index funds became so popular. The recent market decline and rapid recovery mean few active managers will have produced any better results than passive vehicles.

    On another allocation issue, perhaps international and U.S. markets are more closely correlated than thought, diminishing the value of international diversification. Correlations will tend to converge when the markets follow similar policies, e.g., privatizing, liberalizing the economy, increasing trade; yet some economies will grow at a faster rate than the U.S. economy. Pension executives may temporarily pull back on international diversification for tactical reasons following the 1997 market gyrations, but strategic decisions shouldn't be reactive.

    On still another issue, the stock market declines could lead to a retreat in the debate to convert Social Security to a private program.

    In reality, government programs like Social Security crashed years ago. These programs were never viable solutions; they created a false security, made possible by unsustainable payroll tax growth and favorable demographic trends.

    Social Security programs around the world are, or soon will be, in financially desperate shape. The Chilean way of providing direct worker-ownership of Social Security is a real viable option.

    Market-based solutions provide no guarantee of prosperity, but government-run programs often survive only because they can draw on immense taxing power and because they have no competition.

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