The Float

BrightScope and Vanguard

Two weeks ago, Vanguard's Steve Utkus posted a thoughtful, if not quite fully informed, take on the work of our friends at BrightScope.*

We encourage you to read Steve's original post here.

Then take a look at Ryan Alfred's response at BrightScope's blog.

We're pleased to see these types of exchanges. They should help everyone who cares about the future of retirement security in this country understand what is being done well and what can be done more efficiently and effectively.

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* Full disclosure: Interlake has believed in BrightScope's basic approach from the outset and we subscribed to their Advisor Central service in October, 2009. We want them to succeed, we believe they will (more to the point, we see that they are succeeding), and we think their data and related services can help us bring a truly fiduciary approach to retirement plan participants at companies of any size and shape.

New DOL Proposal on Index Funds

We ran across an interesting piece in InvestmentNews on a recent DOL trial balloon concerning passive and active funds in ERISA plans. Here's the essence of the DOL proposal:

Specifically, financial advisers point to a recent proposal in which the Labor Department asked whether computer-based advice models should take into account only the fees and expenses of a mutual fund--and not its historical returns--since they aren't guaranteed. If fees and expenses are the primary factor when recommending funds for 401(k) plans, these advisers contend, index funds will win out over actively managed funds every time.

The next paragraph is classic industry stuff:

"I was absolutely shocked that they were asking questions about whether historical performance should be a factor," said Robert L. Francis, chief operating officer at broker-dealer National Retirement Partners. "It's like saying that you should buy a Volkswagen over a Rolls Royce just because it's cheaper."

It can be difficult to choose one's metaphors on the fly, so I don't want to make too much of this, but please...that Volkswagen can get people where they need to go just fine, thankyouverymuch. The reality is that the vast majority of investors should choose the metaphorical Volkswagen over the Rolls Royce. 

And then there's this deeply strange take:

A bias toward passively managed funds, leading to more 401(k) plan sponsors adding index funds to their lineups, would also have a negative impact on employee engagement in saving for retirement, said Paul R. D'Aiutolo, vice president of investments, advisory and brokerage services at UBS Institutional Consulting.

"The purpose is to keep people engaged in their plans," he said. While index funds may perform well over the long term, it's often the ups and downs of actively managed funds that keep plan participants paying attention, Mr. D'Aiutolo said.

Good grief. What a sad example of non-fiduciary thinking, as if participants' attention levels--as opposed to their future retirement security--were the objective. Engaged participation is fine, but only in the context of a sound portfolio strategy built on a foundation of best-available investment options. 

And this:

[If the agency does set a bias toward passively managed funds, it] could also mean increased costs to plan sponsors because index funds offer less in revenue-sharing dollars than actively managed funds, and thus there is less money to cover record-keeping expenses, [Thomas Clark Jr., vice president of retirement plan services at Lockton Financial Advisors LLC] said.

In the new, still-emerging ERISA world, transparency is a moral and practical imperative, and by definition transparency means less revenue-sharing (preferably none). Sponsors can still pass record-keeping and other administrative expenses along to participants, but not by burying them in the utterly opaque shell game known as revenue-sharing.

In our practice, we use index funds in all asset classes where they're available. On a portfolio-weighted basis, index-based vehicles constitute 8 to 23 percent of our holdings.* For us, the most important objective is to offer fully-/globally-diversified portfolios. Though we would prefer to do that using index-based vehicles only, fund providers haven't quite gotten us there just yet.

The point of which is that we're sympathetic to the DOL's implicit instincts here, but the real world is sufficiently complex and imperfect that it's difficult to write sweeping rules that don't create a few unintended consequences. So we'd like to see the DOL tread carefully here. But the old-school, non-fiduciary thinking on display in this InvestmentNews piece reminds us that there's still enormous room for improvement in the retirement plan marketplace. 

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* The asset classes in which we do not use--because we do not have access to--index-based vehicles are: non-U.S. REITs, non-U.S. fixed income (developed and emerging markets), and diversified commodities. Roughly a year ago, we replaced an actively-managed T. Rowe Price fund with a new Vanguard index-based option in the non-U.S. small-cap equity category.

Source

Jessica Toonkel Marquez, "DOL's 401(k) pitch strikes fear among financial advisers," InvestmentNews, March 28, 2010

The WSJ on ETFs in 401(k) Plans

This morning's Wall Street Journal includes an Ian Salisbury story on two of The Float's favorite subjects: exchange-traded funds and defined-contribution retirement plans. By our lights, Salisbury doesn't break much new ground, but he does a nice job of describing ETFs' small-but-growing share of the 401(k) market and the trade-offs involved in including ETFs in a plan's investment lineup. Here are a couple highlights:

According to estimates from BlackRock Inc., the largest sponsor of ETFs, investors hold at least $2 billion worth of its iShares ETFs in 401(k) plans after buying about $500 million in fund shares last year.

Since iShares controls about half the ETF market, the figure suggests that in total there may be something like $4 billion of ETF assets in 401(k)s.

That's just a tiny sliver of the more than $1 trillion in 401(k) assets invested in mutual funds, but it represents significant growth from several years ago, when ETFs were almost entirely absent from these plans.

...

Unlike other 401(k) options, ETFs don't accommodate "revenue-sharing," or using a portion of the fees investors pay to funds to support administrative costs of retirement plans.

Many financial advisers and consumer advocates think that's good news since it makes it easier to keep tabs on what investors are actually paying for.

That last point is especially important. We're no fans of revenue-sharing because of its inherent opacity. But there's another element in a plan's true-and-total cost structure that Salisbury doesn't mention: Bid-ask spreads paid in the trading of ETFs. Of course open-end mutual funds incur spread costs to trade positions in their portfolios as well, but that's exactly the point: The "trading costs" question doesn't resolve so clearly in favor of ETFs after all. When trading is frequent, as it is in the vast majority of 401(k) plans, spread costs add up, even when trades are aggregated within and across plans.

Salisbury mentions the ETF-based plans sponsored by BlackRock's iShares unit. We've looked into those options, and they might make sense for some plans. But we have to be honest: We have other programs at our disposal that impose lower total costs on sponsors and participants and provide easy access to complete portfolios that replicate (almost exactly) the best available ETF-based solutions.

We like ETFs. We use them extensively in our private client practice. We think they may well have a future in the defined-contribution world. But we haven't seen sufficient advantages in ETF-based options to make us abandon our current programs.

Source

Ian Salisbury, "ETFs Make Inroads with 401(k) Investors," Wall Street Journal, January 13, 2010

BusinessWeek on BrightScope

BusinessWeek has an excellent feature story on BrightScope. Here's a highlight:

If BrightScope ratings gain acceptance, they could change the retirement world as dramatically as Morningstar's fund ratings altered the investing landscape. More information could help people better evaluate two job offers or arm current employees with information that lets them campaign for better plans. The ratings could also provide a huge service to corporate plan sponsors, particularly small ones that can't afford to hire high-paid consultants to evaluate and improve their plans.

As longtime readers know, we've believed in this ambitious firm from the outset. As BusinessWeek notes, BrightScope's mission isn't easy. But it's hugely--and increasingly--important. Anyone who's serious about getting retirement savings right needs to understand what this company is doing.

The Independent Fiduciary Experience

In early December, I participated in a trustee meeting presided over by Matthew D. Hutcheson.   Some in the 401(k) industry may wonder exactly what an independent fiduciary like Mr. Hutcheson does. Here's a first-hand report.

The meeting resembled your standard year-end 401(k) meeting, but with some intriguing differences. What struck me was how the executives at this successful Silicon Valley company treated Mr. Hutcheson with absolute deference and respect. As well they should. After all, he's the named fiduciary for their plan. But it was more than just deference and respect. There was a genuine sense of trust and confidence that defined the exchange. The executives of this company knew they were in good hands, and they knew Mr. Hutcheson was taking care of their employees.

During the meeting, we discussed a few of the unique methods he employees with his clients. One of those, of course, is appointing an independent investment fiduciary to assemble and maintain the plan's portfolios. Participants do not choose the underlying funds (at least not without having a spouse or other primary beneficiary sign a waiver). When I asked how many participants had complained or expressed concern about this, the CFO gave the "zero" sign and said "none." I've always wondered how Hutcheson could manage plans with hundreds of thousands of participants without becoming overwhelmed. Now I know; no one complains or expresses concerns about the design or operation of the plan. He has created an environment of such confidence and trust, and has communicated key features of the plan so effectively, that participants know their interests are well-served.

Another important observation: The meeting was absolutely straightforward and efficient. First, Hutcheson asked me pointed questions. After seeking clarification, he turned and explained my answers to the company representative. Knowing what is relevant and what is not, we didn't get bogged down in complexities, jargon, emotional speculation, or financial services sales-talk. He kept the meeting on course, asking questions, reporting information, and covering all important matters pertaining to the management and operation of the sponsor's 401(k) plan. The entire meeting took about an hour.

Because my firm has been appointed by Hutcheson, I report to him, not the company. That arrangement leaves little room for misunderstanding or miscommunication.

I took three things from the meeting.

First, the company that appointed Hutcheson to be the independent named fiduciary sought him out because that is what they wanted. They wanted to sponsor the plan; they didn't want to run it. They now have no day-to-day responsibility for the plan. All of that rests squarely on Hutcheson's shoulders, right where it should be, with a professional fiduciary. Once corporate America figures that out, we may well see an independent fiduciary revolution.

Second, because Hutcheson appointed me to my position as investment fiduciary, my colleagues and I were viewed as professional equals with him. Too often, investment advisors are seen as--and, to be honest, sometimes are--salespeople rather than professionals with valuable expertise.

Third, there was absolute clarity about the plan's objectives, who was responsible for what, and a clear chain of accountability. In total, the experience suggested that companies should focus on what they do best and get out of the retirement plan management business once and for all. It also reinforced my sense that participants appreciate having an independent fiduciary-advocate.

Bottom line: Sponsors who want to do right by their employees, reduce their own legal exposure, and simplify their daily lives should consider hiring an independent fiduciary such as Mr. Hutcheson.  

Target-Date Report from the Senate Special Committee on Aging

Back on Tuesday we mentioned that Herb Kohl's Senate Special Committee on Aging would hold a hearing on target-date funds, with special emphasis on their role in retirement plans. And hold that hearing they did.

The testimony the committee heard was all well and good, but the substantive issues are best captured in this staff report, revealingly subtitled "Lack of Clarity Among Structures and Fees Raises Concerns." If you're into this sort of thing, we recommend that you take a look.  The good stuff starts on page 8.

The Target-Date Debate...

...heads to Capitol Hill tomorrow, as the Senate Special Committee on Aging holds hearings on conflicts-of-interest in target-date vehicles. Here's a four-minute preview of some of the issues from CNBC, featuring Interlake's friend and colleague Mike Alfred of BrightScope:

In addition, Senator Herb Kohl of (the great state of) Wisconsin has just released a Government Accountability Office study of auto-enrollment in 401(k) plans. Here's GAO's overview:

Automatic enrollment appears to significantly increase participation in 401(k) plans according to existing studies, but may not be suitable for all plan sponsors. Some studies found that participation rates can reach as high as 95 percent under automatic enrollment. Available data indicate that the percentage of plans with automatic enrollment policies increased from about 1 percent in 2004 to more than 16 percent in 2009, with higher rates of adoption among larger plan sponsors. In most cases, these plans automatically enroll only new employees, rather than all employees. We also found that automatic enrollment may not be suitable for all plan sponsors, such as those with a high-turnover workforce. Further, some data show that while automatic escalation policies--which automatically increase saving rates over time--are increasingly common, they lag behind adoption of automatic enrollment. In combination with low initial contribution rates, this could depress savings for some workers. Also, the emergence of target-date funds--funds that allocate investments among various asset classes and shift to lower-risk investments as a "target" retirement date approaches--as the typical default investment raises questions in light of the substantial losses such funds experienced in the past year.

More on Time's Recent 401(k) Takedown

Yesterday we offered a few thoughts on Stephen Gandel's furious assault on defined-contribution retirement plans. Today we'll pick up where we left off...

Gandel's core argument is that workers would be better off in traditional defined-benefit pensions than in defined-contribution plans.* In the abstract, we can't argue with that, assuming all such pensions were (and were to remain) fiscally sound. But we know that many, in the private and public sectors alike, aren't fiscally sound. So it strikes us as a little too simple to hold up traditional pensions as the rock-solid, safe-and-sound alternative to the 401(k). That doesn't diminish the problems in the 401(k) world. Not at all. But it does complicate the question of alternatives a little.

Gandel notes the virtue of portability, a clear advantage of DC over DB. (Alas, the accompanying quality of "raidability," the opportunity to pillage one's retirement account during one's working years, has impaired many participants' balances in a big way.) In an economy where people change jobs and careers more frequently than ever, portability will be an indispensable part of any retirement plan regime policymakers might come up with.

Gandel returns repeatedly to the perils of retiring in a down market. "If you retired last year," he writes, "you're toast." Um...no. Not necessarily.

As we've noted in the space time and again, the "retirement moment" isn't the true finish line; instead, it's one's life expectancy. Now, it's absolutely true that taking initial withdrawals from a depressed portfolio does real damage to that's portfolio's likelihood of surviving as long as its owner. But again, the solution for those at or nearing retirement is absolutely obvious and utterly simple: Hold a few years' living expenses in safe, liquid positions. Doing so eliminates the need to tap (or, worse yet, fully annuitize) a beaten-down portfolio of securities.

If an investor (in a 401(k) plan or not) experiences a substantial decline in portfolio value at the retirement moment, he or she shouldn't annuitize that portfolio, and should minimize (or, better yet, fully avoid) tapping any holdings whose prices have fallen precipitously.

The system has the technology to facilitate this approach, one that mitigates (but doesn't eliminate) the single biggest disadvantage of DC plans relative to their DB counterparts: the concentration of longevity and investment risks at the individual level.

Gandel finishes his piece with a discussion of "retirement insurance" proposals. Though we're pretty darn skeptical about a lot of products that mix investments and insurance, we're not remotely "anti-insurance." If our systems of social insurance are inadequate or unreliable, we'll have to supplement them with private/individualized resources.** Getting those systems right is one of the most important problems  policy makers, plan sponsors, service providers, and individual participants will tackle as our population ages.

We aren't thrilled by the status quo in the 401(k) marketplace, but we don't think the system is beyond repair. Indeed, recent legislative and regulatory changes have helped, and more such improvements are on the way. Unless and until the system is overhauled in some fundamental way, the moral and practical imperative is to make defined-contribution plans work as well as they can.

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* "Some said they were happy with their 401(k)," Gandel writes. "But all the people who shared their financials with us would have been better off in a pension." 

** Our view is that they're more inadequate than unreliable. We think Social Security will be around when today's young workers retire, but it'll never be enough, and can't be enough.

Source

Stephen Gandel, "Why It's Time to Retire the 401(k)," Time, October 9^th, 2009

Time Takes a Mighty Swipe at the 401(k)

In a recent issue of Time, Stephen Gandel puts the defined-contribution retirement plan on trial...and convicts it of some pretty serious offenses. Check out Gandel's opening salvo: 

[T]he 401(k) was never meant to replace the employer-guaranteed pension fund, supplemented by Social Security, as the cornerstone of our nation's retirement system. But propelled by a combination of companies looking to cut costs and consumers who wanted control of their retirement destiny, that's exactly what happened.

The ugly truth, though, is that the 401(k) is a lousy idea, a financial flop, a rotten repository for our retirement reserves.

Gandel guides readers through a familiar set of concerns: inadequate savings during participants' working years, ineffective management of individual accounts, and the risk of severe market downturns coinciding with retirement.

We think Gandel is a little too dismissive of the benefits of saving more during one's working years, and it's plenty clear to us--from our own experience and systemic data--that many participants don't manage their accounts prudently or effectively.* It's important for sponsors and fiduciary service providers to implement rules and processes that make these problems less likely and less consequential.

But what about the risk of retiring in the middle of an ugly market? This is indeed a big problem, but we don't think it's quite as insurmountable as Gandel suggests. Here's the core of his argument (emphasis added in bold):

In what must seem like a cruel joke to many, the accounts proved the most dangerous for those closest to retirement. During the market downturn, the 401(k)s of 55-to-65-year-olds lost a quarter more than those of their 35-to-45-year-old colleagues. That's because in your early years, your 401(k)'s growth is driven mostly by contributions. You control your own destiny. But the longer you hold a 401(k), the more market-exposed it becomes. It's a twist that breaks the most basic rule of financial planning.

By definition, Gandel's point about contributions playing a larger role in smaller accounts is exactly right. But there's absolutely nothing about the 401(k) system that requires larger accounts (or accounts of any size held by older participants) to be "more market-exposed." As we see it, there's a very simple solution for (rationally) risk-averse participants for whom volatility in their accumulated assets dwarf the impact of their ongoing contributions: Reduce the risk (i.e., expected volatility) of their accumulated assets while directing their contributions into asset mixes with higher expected long-term returns. 

Such a strategy would impose a capital preservation strategy on a participant's accumulated capital while taking full advantage of dollar-cost-averaging with his or her ongoing contributions.

Practical concerns? Any halfway-decent recordkeeping system should make this type of strategy very simple to implement. We can even envision a world in which a plan's automatic provisions "make inertia work for employees, not against them," as Gandel writes, by defaulting participants into this kind of approach.

We'll offer a few more thoughts on this important story tomorrow.

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* The leading causes of poor account management are (1) risk-taking that's wildly off the mark (which is to say, much too much in some cases and much too little in others) and (2) performance-chasing behavior, piling into what's (temporarily) hot and bailing out of what's (temporarily) not.

Source

Stephen Gandel, "Why It's Time to Retire the 401(k)," Time, October 9^th, 2009

Boise Fiduciary Symposium

Two weeks ago, I was participating in the first morning session of the Boise Fiduciary Symposium, a two-day event sponsored and organized by Matthew D. Hutcheson LLC, with Matt himself as the master of ceremonies and featured speaker.

With 40+ attendees, the event was a clear success. This was a group of professionals coming together to learn from Matt, and from each other, about leading-edge principles and practices in the fiduciary world. Topics included technological developments in recordkeeping, participant advice, and portfolio design; legal developments in and around ERISA; and ways to help plan sponsors and participants understand the differences between the fiduciary approach on the one hand and the product-driven approach on the other. 

I found it very satisfying to see serious, ambitious people tethering their careers to the fiduciary side of the business. There was a palpable sense that we were seeing and shaping the future of defined-contribution retirement plans. Exciting stuff.

Matt is planning to hold more events like this in other parts of the country. Anyone who is interested in what it means to serve as a 3(21) ["full-scope"] or 3(38) ["investment"] fiduciary would be wise to attend. Given the information content and networking opportunities, I think you'd find it time well spent. 

We'll post information on future events as soon as we have it.