– James Saft is a Reuters columnist. The opinions expressed are his own –

That 8 percent annual return on investment you and your pension fund manager were banking on is now looking almost as optimistic as Madoff’s magic 12 percent, as deleveraging and deflation bite.

With extremely low or negative interest rates and everyone from consumers to banks trying to shed debt and assets at the same time, what seemed like reasonable projections for a mixed portfolio of stocks, bonds and other assets are now substantially too high.

The implications are a potentially huge hit to corporate earnings and the economy. Companies will be forced to pony up more to keep their pension funds adequately funded while even consumers not encumbered by lots of debt will be likely to raise their savings rate to compensate for lower returns, thus acting as a drag on consumption.

And, while higher savings rates are ultimately what the economy needs, most U.S. company pension plans that promise a payoff based on workers’ final salaries assume an overall return on assets of about 8 percent a year. Individuals and their investment counselors are often even more optimistic, penciling in 9 or 10 percent a year and often maximizing exposure to riskier assets to try and get there.

“The available return from markets has been for some time a lot lower than people have understood,” said Gary Dugan, chief investment officer at Merrill Lynch’s wealth management arm in London.

Returns have been flattered by debt; both that employed in investment strategies to magnify returns and that taken out by consumers and partly recycled into corporate profits. And remember too, if you are an investor who doesn’t leverage you are still affected, as those who did inflated valuations and will remain sellers.

“The challenge is to increase savings to pension plans or long-term savings — a very substantial increase — because long-term returns are negligible,” Dugan said. He estimates equity market returns of between 4 and 7 percent over the next few years.

It may not seem like a lot to assume a 6 or 7 percent annual return rather than 8 or 9, but a rule of thumb is that every 1 percent less in performance requires an extra 10 percent in annual funding to counteract.

ASSUMPTIONS ARE ALL

David Zion at Credit Suisse in New York estimates that the pension funds of the S&P 500 companies could be $362 billion underfunded, a drop of $420 billion in the year. This is far worse than back in 2002 after the last stock market slump and leaves 70 of the 500 with underfundings equivalent to more than 10 percent of their market cap.

This can easily translate to hits to earnings if companies decide to up their contributions, which ironically if done en masse will further depress stock markets and the value of the pension fund. Rinse and repeat.

For final salary pension plans, last year was doubly awful; losses were extremely deep and the interest rates they use to value their future liabilities to pensioners moved in the wrong direction, down.

Funds use a discount rate, in the United States usually one tied to the yield on corporate debt, as a tool to determine their future obligations to pensioners; the lower the rate the bigger the obligation now.

That makes very low inflation or even deflation a real bear for pensions. The Mercer U.S. pension Index Rate, a benchmark for these valuations, fell by almost 1.50 percentage points to 6.11 percent in December, as government rates fell.

Expect this all to be an emerging trend in the next year, and not just in the United States. Of course it is possible that companies and their regulators move to a fudge, not lowering return expectations and even giving companies a break on how they value their obligations, arguing no doubt that current low interest rates are exceptional. Investors who buy shares in these companies, and whose future stream of earnings may be hit by pension costs, may not be so forgiving.

Individuals saving for their own retirements also have to make assumptions about what their investments will command and how much they need to save to reach their goals. It’s very likely that those rates of savings need to rise and the assumptions fall. It will also be interesting to see if equities as an asset class remains as popular.

Finally there is one group that will find itself very vulnerable if we face an extended period of very low inflation and investment returns: investment managers and advisers.

It is one thing to pay out 1 percent a year to a mutual fund manager if you think you can make 9 percent a year, quite another if it’s only six. As for hedge funds charging 2 percent of assets under management plus 20 percent of gains, well, the math is even worse.

– At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. For previous columns by James Saft, click here. –

– Mark T. Williams, a finance professor at the Boston University School of Management, is a risk-management expert and former Federal Reserve Bank examiner. The views expressed are his own. –

With Congress now probing the Bernard Madoff case, some claim the SEC missed the risk because of under staffing. Even if that’s an issue, one SEC enforcement officer using basic risk-management skills, asking probing questions, searching for clear answers, and exercising timely follow up could have helped in detecting this fraud before it grew to such a staggering size.

The central flaw at the SEC is that its current oversight approach is not sufficiently risk focused. Moreover, any changes in approach have tended to be in response to a specific event instead of incorporating an overall risk-based approach across all areas under their regulatory purview.

The SEC is responsible for overseeing registered broker-dealers, transfer agents, clearing agencies, investment companies and investment advisers, yet there is not a consistent risk approach used in all of these examinations. For example, in 2003, after widespread unlawful trading practices surfaced in the mutual fund industry, the SEC took steps to take a more risk-based approach.

Yet these higher examination standards were not viewed important enough to be applied to investment advisers such as Bernard Madoff. The weakness in the SEC’s existing examination approach can be best highlighted by the fact that, in the last 16 years, while Madoff’s firm was investigated 8 times, no fraudulent activities were ever uncovered.

As part of their broad regulatory mandate, the SEC is responsible for overseeing over 10,000 investment advisers. This agency needs to adopt a “where there is smoke there is fire” approach. The SEC must become risk focused in the scope and frequency of its monitoring and surveillance operations. Given the significant number of investment advisers, even if we assume that 99 percent are low risk, that still leaves 100 that need to be closely monitored and scrutinized.

The SEC should keep a detailed list of the top risky investment advisers and use it to prioritize and set review frequency. Currently, there is no clear indication that the SEC links review frequency or scope of exam with level of perceived riskiness. Former SEC Chairman Arthur Levitt recently indicated that only 10 percent of investment advisers are examined every three years. A wealth of new fraud can be dreamed up, hatched, and perpetrated at such firms in the interim.

Instead, the SEC must develop a stronger risk filter that will quickly flag investment advisers which exhibit higher risk characteristics. Such red flags should center on corporate governance issues such as level of independence and checks and balances. For example, does the investment adviser clear its own trades or do they use an independent third-party? Who is this third-party? Are they well known and do they have a good reputation? Who is the accountant for the investment adviser and what is their reputation and size?

Other warning indicators can come in the form of formal as well as informal complaints. What is the nature and frequency of such complaints and is a particular firm being consistently implicated?

Importantly, the SEC needs to develop a better “whistleblower” framework so it can quickly identify and respond to such complaints. If managed properly, the thousands of e-mails the SEC gets annually can be a powerful risk management tool to identify and respond to potential risk.

The SEC maintains a website to collect complaints and tips. However, the fact that whistleblower tips about Mr. Madoff’s firm were received as far back as 1999 and yet they were never fully vetted speaks to the weakness in the SEC’s risk filtering and response system. The SEC must be able to quickly sort through creditable allegations. Once such allegations have been identified, they must be prioritized, investigated and resolution reached in a timely manner.

Internally, the SEC should revise policy and include a clear action plan, process, and timeframe to address whistleblower complaints and tips. This would establish immediate accountability. To further encourage SEC investigators to comply with new response policy, standards must be directly linked to annual employee performance reviews.

In 1920, long before the SEC was established, Charles Ponzi was able to keep his scam running and undetected for only eight months. Fortunately, this fraud quickly unraveled when local media began to raise and followed up on some basic risk-related questions. The Madoff case and the failure of early detections is a further indication that the SEC should move to a more risk-focused approach.

Doing so, when coupled with timely follow up and consistent risk-based examination practices will help restore market confidence that the SEC can and will protect us against investment fraud.

– Prof. James Post, an authority on corporate governance, teaches “Strategies for Nonprofits” at the Boston University School of Management. The views expressed are his own. –

I am inclined to think the Bernard Madoff affair has blown the lid off the financial madness of this decade.  We have been living in an age of fraud, and now must rethink the way we do business.  As John Kennedy once appealed to the nation’s better angels to call us into public service, Barack Obama’s inaugural address should instruct us on our obligation to serve the greater good.  It’s not just a moral concept; it’s good business.  I offer a corollary as well: Without good business, how far will a moral concept take you?

The management cliché about nonprofits goes something like this: What they lack in business savvy or operating budgets they make up for in passion and vision.  This notion was especially apt in an age of decreased governmental support.  And there’s a private-industry parallel declaring that firms may have a wealth of professionally trained managers but run in the red when it comes to inspiration.  Few organizations have it all, so private and public industry must continue to collaborate to serve the community.

If Obama can keep the lives of real Americans in his sights, despite the overwhelming urge to obsess over Wall Street and Baghdad, he can have a profound effect on reversing the destruction wrought by the age of fraud.  He can strengthen the bond between public industry and the private sector in ways that benefit all of the stakeholders.  In many ways, the time is ripe for nonprofits to set a new example, one that marries sound management and ethics, and proves they can stay together for the long haul.

How do nonprofits rise to that challenge?

For starters, Obama’s Social Entrepreneurship Agency for Nonprofits and Social Investment Fund Network purportedly will “build the capacity and effectiveness of the nonprofit sector.”  Not exactly a trillion dollar cash infusion, but a seat at the policy table.  That means better lobbying access, governmental R&D/capacity-building support, a streamlined grant-making process, more explicit encouragement of civic involvement, and greater accountability.  More attention will be paid to the energy, education, and training sectors, meaning added incentive for people to get involved in these areas.

Nonprofits, you need to dust off your gym bags.  If you’re finally going to have that equal playing field in the competition for governmental attention and support, you need to hone your skills and get your team into shape for the upcoming season.  Whether a senior manager looking to move up the professional ladder or a new executive director seeking more effective ways to guide and manage your organization, you need to strengthen your skill set, increase your confidence to lead, and join a focused network of people who share a vision of management excellence.

For instance, when was the last time you stepped away from the day-to-day tactical management of your underfunded, overburdened organization to think about long-term strategic planning, more efficient project management practices, or funding innovation?  How often do you network with your peers in other organizations and report best practices?  What steps have you taken to insulate yourself from the consequences of our unhealthy economy?

Most importantly, you must avoid scandal (or the appearance of scandal) by having unquestionable ethics and demanding the same from your team.  You must engage in new and innovative partnerships — with other nonprofits and with corporations; think like an entrepreneur — creatively, resourcefully, relentlessly.  And you must improve your accounting and assessment practices.  These are just non-negotiable, and if I have to explain why, you’re more out of shape than you thought.

In short, nonprofits are not exempt from Obama’s call to change.  Reject low standards.  Raise your sights.  Find new ways to be heard and taken seriously in a communications landscape that seems to have the bandwidth for only two to three stories a week.  Most importantly, get the training you need to run your organization efficiently.  You can’t capitalize on any of these opportunities if you’re out of breath before you even warm up.