Skin in the Game: The Advent of a New Kind of Risk?

Here is another friend of Money Smart Radio, Paul Petillo, who had left quite an impression by commenting on our blog.  I had a chance to visit his site and was impressed, utterly speaking (no pun intended – look at his book titles) and how we is able to create a process to help people understand such complex financial strategies.

I hope you enjoy his guest post here.

Enter Paul Petillo…

What if your company offered you an investment option you couldn’t refuse?  Not simply an investment that would do better for you but also for the very businesses your company works with?  Would this be a smart move?   Would you cave to peer pressure and perhaps company pressure as well? Can a company that creates an index fund based on its clients being doing what is best for their employees?

A recent article in the New York Times focused on a start up mutual fund crossed my desk recently. The article, written by Stuart Elliott, dealt with the advertising agency Kirshenbaum Bond Senecal & Partners in New York,

part of MDC Partners.

While Mr. Elliott normally deals with the advertising industry, this particular article offered something different. Two employees of the firm believed that if the company had an investment stake in the clients they represent  (eighteen of the thirty clients they work with are traded on major exchanges), the focus on their client’s success would improve – with any luck, as their employee’s interest in those businesses via investment would as well.

To that end, MDC launched a new index with those companies as the template for the fund. “The index,: Mr. Elliott writes, “was the brainchild of two Kirshenbaum Bond employees: Aric Cheston, partner and creative director, and Matt Powell, chief technologist. They will each receive a cash bonus of $10,000 from MDC.” The fund, with the ticker symbol KBSPX has yet to show up on any searches as yet.

“Agency executives are opening a brokerage account with another client, the Vanguard Group, into which will be deposited 300 shares of each of the 18 companies.

Mr. Elliott explains further that “The 300 employees of Kirshenbaum Bond will be offered long-term cash and compensation incentives to mirror the performance of the stocks in the index, which they will be able to track each trading day on an intranet on the agency’s Web site.

“MDC is spending an estimated $500,000 to start the index, which includes contributing four restricted shares of MDC stock to the fund for each Kirshenbaum Bond employee, for a total of 1,200 shares.”

Why is this important?

For two reasons: First, this is a continuing example of employers acting without regard to the fiduciary responsibility their plans are supposed to exercise. We often bemoan the fact that numerous 401(k) plans force employee to purchase stock in the employer, and in a great many instances, this is the only match the employer offers. The result is an over-purchase of their own firm’s stock.

Employees make several mistakes when they do this. The biggest mistake is the failure to diversify their retirement portfolios when they hold so much of one investment. They do this in large part because they feel as though they have some sort of inside knowledge about the company they work for and if they feel good about this knowledge will buy even more. And if history is any indication, they will either be handsomely rewarded some of the time; and severely penalized most of the time.

The second reason is the incentives. Given no other choice, the employee is forced to buy what they should possibly consider a greater risk. The mini-mutual fund has yet to be ranked by any of the major firms that do such work (in all fairness, it only launched on Tuesday). Instead, I turned to Brightscope.com to look for the plan’s ranking.

There was none. What the site did provide was a bit of an overview, albeit telling. “Kirshenbaum Bond & Partners Llc 401K Plan,” as described by Brightscope “is a defined contribution plan with a profit-sharing component and 401k feature. This plan is in the top 35% of plans for Participation Rate. Kirshenbaum Bond & Partners Llc 401K Plan currently has over 200 active participants and over $7.5M in plan assets.” The downside is the average account balance of around $20,000 per participant. With this index offering such generous incentives, two things are bound to happen: the average balance will likely go up while rating, if Brightscope gains enough information about the plan, will go down.

What’s Next? A Grocery Index?

The worrisome nature of this idea will, without a doubt become infectious. Company administrators will look at exchange traded companies they do business with and begin an index of their own. Would the auto industry have done better if many of the auto maker’s 401(k)s been tied up in supplier stocks? Should major grocery chains offer their employees an index of the top 100 companies selling merchandise on the shelves, perhaps indexed based on sales of those items? Would software makers offer their employees an index consisting of end-users for their products?

If they do, they will no doubt be accompanied by incentives, more than likely squeezed out of the very companies they invest in. And the employees, as human nature often does, will follow what they perceive as a good deal. In many cases, the short term growth in such investments will create an increase incentive to buy even more.

Without the company taking better responsibility how their employee’s invest, these types of offerings will increase. And this in the long-term will disappoint a great many investors who are counting on their retirement to be what they estimate it will be.

To find more info about Paul Petillo, visit his site: Target2025.com