Given the tenuous funding of defined-benefit plans, the widespread failures in the existing defined-contribution plan structure-including both 401(k) plans and IRAs-we ought to carefully consider and then implement changes that move us to a retirement plan system that is simpler, more rational and less expensive. The new system must be one that will be increasingly and inevitably focused on DC plans, albeit those that can to some degree emulate the security of DB plans. (Our Social Security system and, at least for a while, our state and local government systems, would continue to provide the DB backup as a "safety net" for all participating U.S. citizens.) It is time for reform-a reform that serves not fund managers and our greedy financial system, but plan participants and their beneficiaries.
I am hardly alone in my critique of today's retirement system, nor in my struggle to build a better one. Consider the words from the respected pension strategist Keith Ambachtsheer, director of the Rotman International Centre for Pension Management at the University of Toronto. In his remarks, prepared for a FairPensions event at Westminster Hall, Houses of Parliament, London, on November 15, 2011, he provides excellent ideas about how to assure wealth across the generations.
What's To Be Done?
Where there are multiple sins and flaws, as there are in today's retirement system, there are multiple opportunities for improvement. So as we work toward the ideal of "The New Pension Plan" just described- with pension funds helping to shape the future of capitalism-here are five specific recommendations toward that end.
Simplify The DC System
Offer a single DC plan for tax-deferred retirement savings available to all of our citizens (with a maximum annual contribution limit), consolidating today's complex amalgam of traditional DC plans, IRAs, Roth IRAs, 401(k) plans, 403(b) plans and the federal Thrift Savings Plan. I envision the creation of an independent Federal Retirement Board to oversee both the employer sponsors and the plan providers, assuring that the interests of plan participants are given the highest priority. This new system would remain in the private sector (as today), with asset managers and record keepers competing in costs and in services. (Such a board might also create a public sector DC plan for wage earners who are unable to enter the private system or whose initial assets are too modest to be acceptable in that system.)
Get Real About Stock Market Return And Risk
Financial markets, it hardly need be said today, can be volatile and unpredictable. But common stocks remain a perfectly viable-and necessary-investment option for long-term retirement savings. Yet stock returns have been oversold by Wall Street's salesmen and by the mutual fund industry's giant marketing apparatus. In their own financial interests, they ignored the fact that the great bull market we enjoyed during the final 25 years of the 20th century was in large part an illusion, creating what I call "phantom returns" that would not recur. Think about it: From 1926 to 1974, the average annual real (inflation-adjusted) return on stocks was 6.1%. But during the following quarter-century, stock returns soared, an explosion born, not of the return provided by corporations in the form of dividend yields and earnings growth, but of soaring price-to-earnings ratios, what I define as speculative return. By 1999, that long-term rate of real returns had jumped to 12%.
This higher market valuation reflected investor confidence, along with greed, and produced an extra speculative return of 7% annually- resulting in a cumulative increase of 400% in final value for the full 25 years, a staggering accretion without precedent in financial history. This speculative return almost doubled the market's investment return (created by dividend yields and earnings growth), bringing the market's total real return to nearly 12% per year. From these speculative heights, the market had little recourse but to return to normalcy, by providing far lower returns in subsequent years. And in fact, the real return on stocks since the turn of the century in 1999 has been minus 7% per year, composed of a negative investment return of 1% and, as price-earnings multiples retreated to (or below) historical norms, a negative speculative return of another 6%.
The message here is that investors in their ignorance, and financial sector marketers with their heavy incentives to sell, well, "products," failed to make the necessary distinction between the returns earned by business (earnings and dividends) and the returns earned by irrational exuberance and greed. In retrospect, we now realize that much of the value we saw reflected on our quarterly 401(k) statements in 1999 (and again in 2007) was indeed phantom wealth. But as yesteryear's stewards of our investment management firms became modern-day salesmen of investment products, they had every incentive to disregard the fact that this wealth could not be sustained. Our marketers (and our investors) failed to recognize that only fundamental (investment) returns apply as time goes by. As a result, we misled ourselves about the realities that lay ahead, to say nothing of the risks associated with equity investing.
Reduce Participant Flexibility
Both the "open architecture" plan that I described earlier and the near- freedom to withdraw assets from DC plans have ill-served investors. Limiting choices is relatively easy to understand and to achieve. But it will take major reform to reduce the flexibility that plan participants presently enjoy to draw down their cash almost at will (albeit sometimes with tax penalties). If the DC plan is to reach its potential as a retirement savings vehicle, there must be substantial limits-including larger penalties-on cash-outs and loans, no matter how painful in the short term. (Just imagine what would have happened to our Social Security if participants had withdrawal rights!) Importantly, 401(k) plans were originally designed as thrift savings plans. They need to have far more emphasis on their role as thrift retirement plans than we expect them to play today.
A poignant example of the flaws in our 401(k) savings plans, shared by our IRA plans, came from financial writer and The New York Times editorial board member Joe Nocera. In his April 28, 2012, column, entitled, "My Faith-Based Retirement," he identified many of the procedural and human barriers that stand between opening a retirement account and building it into a meaningful asset to fund one's retirement.
Own The Stock Market
Investors seem to largely ignore the close link between lower costs and higher returns-what I have called "The Relentless Rules of Humble Arithmetic." Plan participants and employers also ignore this essential truism: In the aggregate, we investors are all "indexers." That is, all of the equity owners of U.S. stocks together own the entire U.S. stock market. So our collective gross return inevitably equals the return of the stock market itself.
And because providers of financial services are largely smart, ambitious, aggressive, innovative, entrepreneurial, and, at least to some extent, greedy, it is in their own financial interest to have plan sponsors and participants ignore that reality. Our financial system pits one investor against another, buyer versus seller. Each time a share of stock changes hands (and today's daily volume totals some 10 billion shares), one investor is (relatively) enriched; the investor on the other side of the trade is (relatively) impoverished. That diverse collection of 562 equity funds now held in 401(k) plans, combined in the aggregate, in fact owns the stock market itself. In substance, the winning funds' excess returns are offset by the losing funds' shortfalls. The obvious conclusion: We're all indexers now.
But, as noted earlier, this is no zero-sum game. The financial system-the traders, the brokers, the investment bankers, the money managers, the middlemen, "Wall Street," as it were-takes a cut of all this frenzied activity, leaving investors as a group inevitably playing a loser's game. As bets are exchanged back and forth, our attempts to beat the market, and the attempts of our institutional money managers to do so, then, enrich only the croupiers, a clear analogy to our racetracks, our casinos and our state lotteries.
So, if we want to encourage and maximize the retirement savings of our citizens, we must drive the money changers-or at least most of them-out of the temples of finance. If we investors collectively own the markets, but individually compete to beat our fellow market participants, we lose. But if we abandon our inevitably futile attempts to obtain an edge over other market participants and all simply hold our share of the market portfolio, we win. (Please re-read those two sentences!) Truth told, it is as simple as that. So our Federal Retirement Board should not only foster the use of broad-market index funds in the new DC system (and offer them in its own "fallback" system described earlier) but approve only private providers who offer their index funds at minimum costs.
Balance Risk And Return Through Asset Allocation
The balancing of return and risk is the quintessential task of intelligent investing, and that task too would be the province of the Federal Retirement Board. If the wisest, most experienced minds in our investment community and our academic community believe-as they do-that the need for risk aversion increases with age; that market timing is a fool's game (and is obviously not possible for investors as a group); and that predicting stock market returns has a very high margin for error, then something akin to roughly matching the bond index fund percentage with each participant's age with the remainder committed to the stock index fund, is the strategy that is most likely to serve most plan participants with the most effectiveness. Under extenuating-and very limited-circumstances, participants could have the ability to opt out of that allocation.
This allocation pattern is clearly accepted by most fund industry marketers, in the choice of the bond/stock allocations of their increasingly popular "target retirement funds." However, too many of these fund sponsors apparently have found it a competitive necessity to hold stock positions that are significantly higher than the pure age-based equivalents described earlier. I don't believe competitive pressure should be allowed to establish the allocation standard, and would leave those decisions to broad policies set by the new Federal Retirement Board.
I also don't believe that past returns on stocks that include, from time to time, substantial phantom returns-born of swings from fear to greed to hope, back and forth-are a sound basis for establishing appropriate asset allocations for plan participants. Our market strategists, in my view, too often deceive themselves by their slavish reliance on past returns, rather than focusing on what returns may lie ahead, based on the projected discounted future cash flows that, however far from certainty, represent the intrinsic values of U.S. business in the aggregate.
Once we spread the risk of investing to investors as a group, we've accomplished the inevitably worthwhile goal: a low-cost financial system that is based on the wisdom of long-term investing, eschewing the fallacy of the short-term speculation that is so deeply entrenched in our markets today. To do so, we must first eliminate the risk of picking individual stocks, of picking market sectors, and of picking money managers, leaving only market risk, which cannot be avoided. Such a strategy effectively guarantees that all DC-plan participants will garner their fair share of whatever returns our stock and bond markets are generous enough to bestow on us (or, for that matter, mean-spirited enough to inflict on us). Compared to today's loser's game, that would be a signal accomplishment.
Under the present system, some of us will outlive our retirement savings and depend on our families. Others will go to their rewards with large savings barely yet tapped, benefiting their heirs. But like investment risk, longevity risk can be pooled. So as the years left to accumulate assets dwindle down, and as the years of living on the returns from those assets begin, we need to institutionalize, as it were, a planned program of conversion of a portion of our retirement plan assets into annuities. (It could well be integrated with a plan most of us already have, one that includes defined benefits, an inflation hedge, and virtually bulletproof credit standing. It is called "Social Security.")
This evolution will be a gradual process; it could be limited to plan participants with assets above a certain level; and it could be accomplished by the availability of annuities created by private enterprise and offered at minimum cost, again with providers overseen by the proposed Federal Retirement Board (just as the federal Thrift Savings Plan has its own board and management, and operates as a private enterprise).
Focus On Mutuality, Investment Risk And Longevity Risk
The pooling of the savings of retirement plan investors in this new pension fund environment is the only way to maximize the returns of these investors as a group. The pool would feature a widely diversified, all-market strategy, a rational (if inevitably imperfect) asset allocation, and low costs, and be delivered by a private system in which investors automatically and regularly save from their own incomes, aided where possible by matching contributions of their employers, and would prove that an annuity-like mechanism to minimize longevity risks is the optimal system to assure maximum retirement plan security for our nation's families.
There remains the task of bypassing Wall Street's croupiers, an essential part of the necessary reform. Surely our Federal Retirement Board would want to evaluate the need for the providers of DC retirement plan service to be highly cost-efficient, or even to be mutual in structure-management companies that are owned by their fund shareholders and operated on an "at-cost" basis-and annuity providers that are similarly structured. The arithmetic is there, and the sole mutual fund firm that is organized under such a mutual structure has performed with remarkable effectiveness.
Of course that's my view! But this critical analysis of the structure of the mutual fund industry is not mine alone. Hear this from another investor, one who has not only produced one of the most impressive investment records of the modern era but who has an impeccable reputation for character and intellectual integrity, David F. Swensen, chief investment officer of Yale University:
The fundamental market failure in the mutual fund industry involves the interaction between sophisticated, profit-seeking providers of financial services and naïve, return-seeking consumers of investment products. The drive for profits by Wall Street and the mutual fund industry overwhelms the concept of fiduciary responsibility, leading to an all too predictable outcome: ... the powerful financial services industry exploits vulnerable individual investors. ... The ownership structure of a fund management company plays a role in determining the likelihood of investor success....Mutual fund investors face the greatest challenge with investment management companies that provide returns to public shareholders or that funnel profits to a corporate parent- situations that place the conflict between profit generation and fiduciary responsibility in high relief. When a fund's management subsidiary reports to a multi-line financial services company, the scope for abuse of investor capital broadens dramatically.
Investors fare best with funds managed by not-for-profit organizations, because the management firm focuses exclusively on serving investor interests. No profit motive conflicts with the manager's fiduciary responsibility. No profit margin interferes with investor returns. No outside corporate interest clashes with portfolio management choices. Not-for-profit firms place investor interests front and center. Ultimately, a passive index fund managed by a not-for-profit investment management organization represents the combination most likely to satisfy investor aspirations.
What Would An Ideal Retirement Plan System Look Like?
However difficult to implement, it is easy to summarize the five elements of an ideal system for retirement savings that I've presented.
1. Social Security would essentially remain in its present form, offering basic retirement security for our citizens at minimum investment risk. (However, policymakers must promptly deal with its longer-run deficits.)
2. For those who have the financial ability to save for retirement, there would be a single DC structure, dominated by low-cost-even mutual-providers, inevitably focused on all-market index funds investing for the long term, and overseen by a newly created Federal Retirement Board that would establish sound principles of asset allocation and diversification in order to ensure appropriate investment risk for plan participants, as well as stringent limits on participant flexibility.
3. Retirement savings would continue to be tax-deferred, but with a dollar limitation on aggregate annual contributions by any individual, and a similar limit on the amount that is tax-deductible.
4. Longevity risk would be mitigated by creating simple low-cost annuities as a mandatory offering in these plans, with some portion of each participant's balance going into this option upon retirement. (Participants should have the ability to opt out of this alternative.)
5. We should extend the existing Erisa requirement that plan sponsors meet a standard of fiduciary duty to encompass plan providers as well as the corporations themselves. (As noted earlier, I also believe that a federal standard of fiduciary duty for all money managers should be enacted.)
The system I'd like to see may not be-indeed, it is not-a system free of flaws. But it is a radical improvement, born of common sense and elemental arithmetic, over the present system, which is driven by the interests of Wall Street rather than Main Street. With the creation of an independent Federal Retirement Board, we have the flexibility to correct flaws that may develop over time, and assure that the interests of workers and their retirement security remain paramount. But the central principle remains: minimize the impact of all of the various forms of speculation that plague our complex present-day national retirement plan system, vastly simplify it, slash the costs of it, assure its fairness to society, and maximize its focus on long-term investment.
Excerpted with permission of the publisher, Wiley, from The Clash of the Cultures: Investment vs. Speculation by John C. Bogle. Copyright © 2012 by John C. Bogle. This book is available at all bookstores and online booksellers.