W. Scott Simon
PBS’ Frontline broadcast a 1-hour program entitled “The Retirement Gamble” on April 23. Everyone under the sun in the retirement plan industry has commented on it, so I thought that I’d add my two cents’ worth. There has been a lot of criticism of the program but it has had its defenders as well. I’ll try to keep the criticism and defenses to a minimum, and instead offer some observations.
One of the researchers for the program called to interview me. Usually in such cases, there’s only one call and that’s it; it can be safely ignored, and the caller is not miffed. But in this case, the researcher proved to be relentless. After she contacted Morningstar to try to track me down–perhaps thinking that my failure to return her calls was due to my being on some secret Special Fiduciary Assignment somewhere–I hastened to call her back.
I apologized for my discourtesy in not returning her calls but explained that ordinarily I don’t like to be interviewed. After all, Morningstar has allowed me a great deal of latitude over the years in this monthly column on fiduciary investment issues. As a result, I know with certainty that my own opinions will be conveyed accurately–keeping in mind, of course, that many may disagree with them.
When being interviewed for print or visual media, there’s always the risk that one will be either outright misquoted or be quoted accurately but out of context. That’s sort of how Ohio State’s venerable coach Woody Hayes viewed the forward pass: two of the three results–an incompletion or interception–will be bad. That’s why Hayes usually opted for runs–three yards and a cloud of dust–to power his offense, and that’s why I usually avoid interviews.
But what if I had been interviewed for “The Retirement Gamble”? Even then, that’s no guarantee that I would have actually appeared on the program. Apparently, plenty of folks (including certain industry heavyweights) were interviewed for the program, but after hours of answering questions, only a relative few wound up with any face time on the tube.
In any event, here’s what I would have said–or at least I’d like to think it’s what I would have said.
The Amount of Contributions Made by a Plan Participant Is Paramount
While reductions in costs and risks–both of which are the mainstays of modern prudent fiduciary investing–associated with plan investment options are crucial, their relative importance is lessened if a plan participant cannot or will not save money for retirement. By far the most important factor in how comfortable retirement will be for participants is how much money they salt away in their plan accounts. Even a 70% annual return would be of little consequence if a participant is squirreling away only $3 a year.
Many experts maintain that annual plan contributions should total–between participant and employer–around 15%-20% during the participant’s working years to help ensure a comfortable retirement. This doesn’t mean that participants outside this range on the lower side will be unsuccessful or that those on the upper side will be successful in reaching that goal. It does, however, give guidance to participants to help them save as much as they can as soon as they can. Note in this regard that the mandatory contribution rate for Australia’s superannuation (i.e., retirement) plan will be going up to 12%.
The poster child for plan participants who sock away lots of money in their retirement account has to be Crystal Mendez, the 32-year-old schoolteacher who appeared in the program. She said that she started saving for her retirement in her “early 20s.” Even after a bad experience with an annuity and taking the hit of a 10% surrender charge, she has still managed to save $115,000 (over, at most, 7-8 years) on a salary of $70,000. Compare her to the 31-year-old Robert Hiltonsmith who has managed to save only $8,000 on a salary of $61,000.
When I meet with a plan participant like Mendez, I always know that they “get it” and will have a successful retirement, while someone like Hiltonsmith usually doesn’t get it and will struggle (as some of his comments in the program seemed to indicate that he accepted). It appears that Hiltonsmith was going to school for a number of years while Mendez was (probably) working during that same period, but still, the discrepancy in the size of the two nest eggs is striking.
Note that neither case illustrates whether the concept of the 401(k) retirement plan is good or bad. Both show, rather, that plan participants have the free choice, based on their particular facts and circumstances, to make (within reason) a certain amount of contributions. Voluntary saving rates are all-important, and that is independent of the concept of the 401(k) retirement plan. (Of course, a plan sponsor that contributes a healthy match helps as well!)
Costs Matter
The legendary John Bogle, founder of Vanguard, was featured prominently in the program. His main theme: investment costs matter–and they often matter tremendously. Some criticized his example of taking a 7% return and knocking off 2 percentage points to show that around 63% of a plan participant’s return was eaten up by costs after 50 years of investing. Although the example is a simplified “lump sum” hit on return, Bogle’s illustration showed–correctly–that the magic of compounding returns (reputedly said to be the Eighth Wonder of the World by Albert Einstein) can be swamped by the tyranny of compounding costs (or as I have termed it in my books: the “negative compounding” of investment costs generated against accumulating wealth.)
Of course, any amount of investment costs will always slow down the accumulation of wealth, so the greater the amount of those costs, the greater the drag on investment returns. According to Bogle, though, investment costs need not swamp returns if plan participants invest in low-cost index funds. This is conceptually directly in line with what Nobel laureate William F. Sharpe explained in a simple three-page paper–“The Arithmetic of Active Management”–in the January/February 1991 issue of the Financial Analysts Journal (since expanded on in “The Arithmetic of Investment Expenses” in the volume 69, no. 2 issue of the Financial Analysts Journal). Bogle has characterized the issue even more succinctly elsewhere: “[Indexing] is not E = MC2. It’s A-B = C. It’s not nuclear physics, it’s second grade arithmetic.” In “The Retirement Gamble,” he notes that the superiority of low-cost index funds is a “mathematical certainty,” a “tautology” even.
I couldn’t agree more with Bogle which, in some quarters, makes me a “zealot.” In my book, The Prudent Investor Act: A Guide to Understanding (and in a number of Morningstar columns over the years), I asserted–based on a careful reading of the 300-plus page Restatement (3rd) of Trusts (a multi-volume legal treatise recently completed after 20-plus years of toil by Edward C. Halbach Jr., the Reporter for the Restatement and the Walter Perry Johnson professor of law (emeritus) at the University of California law school)–that low-cost passive investing is the “default standard” of modern prudent fiduciary investing. That conclusion rests in part on the fact that “costs matter.”
Those costs include “explicit costs” (i.e., those that show up clearly such as annual expense ratios) as well as “implicit” costs (i.e., those that don’t show up clearly such as trading costs, which are deducted from the gross returns of mutual funds). Few are aware that the amount of implicit costs can sometimes exceed the amount of explicit costs. And it is far more likely that excessive implicit costs will result from the activities of “active” money managers (i.e., those attempting to beat the market through stock-picking, market-timing, or track record investing) as they seek to outperform through the use of their “new ideas” and greater “nimbleness,” which they profess to possess in order to justify their oftentimes outlandish fees.
Inevitably, though, such ideas are not new but are merely repackaged, and any thoughts of manager superior nimbleness are merely an illusion. Younger, less experienced active money managers are oftentimes ignorant of this while older, more experienced ones are all too well aware of it. Either way, participants invested in retirement plan investment options managed according to this world view can pay a high price.
Risk Matters
My conclusion that low-cost passive investing is the “default standard” of modern prudent fiduciary investing also rests in part on the fact that “risk matters.” This is probably even less well known– much less understood–by investors than the nature of hidden implicit costs that erode the net asset value of a mutual fund.
Risk matters because a broadly and deeply diversified portfolio that reduces risk usually goes down less in value during market downturns and requires less return during market upturns to erase its previous deficit–in comparison to underdiversified portfolios. A participant holding such a portfolio will “get back to even” more quickly to where it was before the reduction in value and will therefore be able to resume more quickly its upward march in the accumulation of wealth. Such portfolios are better diversified than actively managed portfolios because the latter, by definition, are always composed of some subset of the market portfolio, which makes them less well diversified and riskier.
Moreover, reducing as much as possible the (diversifiable) risk of a portfolio through broad and deep diversification can actually increase portfolio return. This phenomenon occurs as the result of a mathematical rule known as “variance drain.” “Variance” is a measure of portfolio risk; reducing the variance in returns of portfolio investments–that is, lowering the magnitude of fluctuations in such returns–increases portfolio compound percentage return and therefore portfolio dollar wealth. I have written on variance drain in more detail in a previous column.
The Fiduciary Standard
“The Retirement Gamble” seemed to give short shrift to discussing the fiduciary standard; it seemed to be merely an add-on at the end of the program. Here is my two cents’ worth about the fiduciary standard and retirement plans.
First, insurance companies, mutual fund companies, broker/dealers, and many others just don’t want to be fiduciaries in any legally meaningful way. The basic reason why is that being a fiduciary would mean that the business model they follow–which must be supported by large fees extracted from plan sponsors and plan participants–would largely fail to work if they had to take into account the “sole interests” of all them pesky plan participants. Indeed, broker/dealers wail about the possibility that if they are forced to actually become fiduciaries, they wouldn’t be able to service plan participants cost efficiently in any rollover business; they would effectively be shut out of that marketplace.
Second, many plan sponsors see a 401(k) plan as just another employee benefit that must be offered to their employees to remain competitive. They have no conception whatever of the fact that they are fiduciaries and the fiduciary duties required of them. This was perfectly illustrated by the show’s host, Martin Smith, who had no bloody idea how all those investment options got into his 401(k) plan.
W. Scott Simon is an expert on the Uniform Prudent Investor Act, Restatement (Third) of Trusts and Title I of ERISA. He provides services as a consultant and expert witness on fiduciary investment issues in depositions, arbitrations and trials as well as in written opinions. Simon is the author of two books including The Prudent Investor Act: A Guide to Understanding. He is a member of the State Bar of California, a Certified Financial Planner® and an Accredited Investment Fiduciary Analyst™. Simon received the 2012 Tamar Frankel Fiduciary of the Year Award for his “contributions to advancing the vital role of the fiduciary standard to investors, capital markets and to society.” The author’s views expressed in this article do not necessarily reflect the views of Morningstar.