The Float

Fiduciary Duty and 401(k) Expenses

We've written repeatedly on the drawbacks of the typical 401(k) plan (for the full Float treatment, click here, here, here, and here).

This morning we received the latest "Report to Plan Sponsors" from Fred Reish, a leading ERISA attorney working out of Los Angeles. Ranked the most important professional in the field by 401kWire.com, Reish understands the defined contribution marketplace as well as anyone in the country; plan sponsors, providers, and participants can (and should) learn a great deal from him and his work.

In his June newsletter, Reish takes up the question of plan sponsors' fiduciary responsibility to understand and manage plan fees and expenses. Reish notes that plan sponsors should collect and retain information on all fees and expenses, including indirect payments and any revenue sharing arrangements. But what to do with the information? And how to think of it in context of the available alternatives? Here's Reish:

Once gathered, the information should be reviewed by the fiduciaries should and compared to (i) the costs for similar services in the competitive marketplace and (ii) the value to the plan (that is, are the investments and services actually benefiting the participants and is that benefit worth the cost?).

And that's really the question, isn't it. Costs matter and we think most plans cost far too much. But the real problem with most plans is that they charge participants too much for things that aren't of value (i.e., actively managed mutual funds) and don't provide what is of value (i.e., high-caliber investment discipline).* Thus the value of the typical plan is actually quite low.

In general, participants pay four types of costs:

1. The stated expenses of the plan's investment options
2. The implicit expenses of the plan's investment options
3. Any underperformance of the plan's investment options
4. The performance penalty of flawed decision-making by participants themselves

Each one of those matters, but the last--the cost of behavioral errors such as poor asset allocation, buying high, and selling low--is massively important and badly under-appreciated.

We've written (here and here, for instance) on the nature and consequences of investors' behavioral breakdowns. And we think the next step in improving 401(k) outcomes, which is what this all about, is minimizing the effect of poor decision-making by combining the flexibility of a defined contribution plan with the pension-caliber investment discipline of a defined benefit plan.

In related news, plan participants suffered a setback Wednesday when a federal judge dismissed Hecker v. Deere, one of several class action suits filed against major corporate retirement plans and service providers. We'll have more to say about this unfortunate decision and its implications next week.

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*In addition, participants with large balances pay significantly more for administration in plans that "bundle" services (i.e., pay for adminsitration and investment management out of bloated mutual fund fees, which most plans do). Charging administrative expenses on a per capita basis would serve two purposes: increase transparency and reduce costs.

Sources

Fred Reish, "Fiduciary Responsibility for 401(k) Fees and Expenses," Report to Plan Sponsors, Reish, Luftman, Reicher, & Cohen, June, 2007

"Judge dismisses lawsuit against Fidelity, Deere," Reuters, June 21, 2007

Friday Reading

It's Blackstone Day on Wall Street. The media coverage feels a little overwrought, but this is an important development in the markets. Today's action in BX won't tell us much in and of itself, but we'll be watching to see how it behaves over the next few weeks.

We have a busy day ahead of us, so here are a few worthwhile items this morning...

• The downside (the dark side, even) of merger mania: Bloomberg's Bob Drummond on next-generation insider trading
• (Almost) twenty years later: Bloomberg's Chet Currier reflects on the Crash of 1987
• Thinking about a reverse mortgage? Be careful, says Andrea Coombes of Marketwatch
• Asset allocation matters, but so does asset location: Money's Walter Updegrave on where to hold which types of investments
• Tax changes coming for private equity firms that go public? Fortune's Katie Benner says that isn't dampening enthusiasm for today's Blackstone IPO or a proposed offering from Kohlberg Kravis Roberts

More on the Re-Pricing Process

Following up on this morning's post on the topic, we see that Barry Ritholtz has a great item on the potential unwinding of subprime-related debt. The entire post is very much worth reading, but here's the excerpt Barry pulls from a Bloomberg story on potential problems in the world of CDOs:

"Merrill Lynch & Co.'s threat to sell $800 million of mortgage securities seized from Bear Stearns Cos. hedge funds is sending shudders across Wall Street.

A sale would give banks, brokerages and investors the one thing they want to avoid: a real price on the bonds in the fund that could serve as a benchmark. The securities are known as collateralized debt obligations, which exceed $1 trillion and comprise the fastest-growing part of the bond market.

Because there is little trading in the securities, prices may not reflect the highest rate of mortgage delinquencies in 13 years. An auction that confirms concerns that CDOs are overvalued may spark a chain reaction of writedowns that causes billions of dollars in losses for everyone from hedge funds to pension funds to foreign banks. Bear Stearns, the second-biggest mortgage bond underwriter, also is the biggest broker to hedge funds."

UPDATE: Here's another piece on the potential spillover of credit problems into the economy and financial markets.      

Source

Mark Pittman, "Bear Stearns Fund Collapse Sends Shock Through CDOs (Update2)," Bloomberg, June 21, 2007

Chris Isidore, "Hedge fund woes could hit Main Street: Upheaval in credit markets could hit consumer, business borrowing--and slow the economy; risk premiums already rising," CNNMoney.com, June 21, 2007

The Insurance Industry Strikes Again

We've done our fair share of complaining about the insurance industry lately (here, here, and here). But with this cynical bunch there's always another complaint just around the corner.

This time, Chuck Jaffe hits it out of the park with his bitter objection to insurers trying to get their "stable-value funds" included as qualified default investment alternatives (QDIAs) for 401(k) plans under the terms of the Pension Protection Act (PPA) of 2006.

Here's the story...

Under the PPA, sponsor-employers are encouraged to enroll employees in the company retirement plan automatically (as opposed to requiring new employees to take affirmative steps to enroll themselves). The key is that to avoid legal exposure for investment losses incurred by automatically enrolled participants, the PPA requires sponsors to assign those participants to investment options that meet certain sensible criteria, most importantly broad diversification within and across asset classes.

In the rule-making process required by the PPA, the Department of Labor decided (sensibly) that stable-value funds didn't fit the criteria for QDIAs...and the insurance industry swung immediately into action. Here's Jaffe:

While they have a role in some portfolios, stable-value funds are too conservative to be the sole investment option of a worker who is not otherwise saving for retirement. The return may indeed be stable, but it doesn't provide sufficient growth over time. They might be a choice for employers fearing lawsuits about losing money, but the idea of including them as a default choice is anachronistic given the Pension Protection Act's goal of helping more workers to save successfully.

Alas, the insurance industry doesn't seem to care. Seeing its primary retirement-plan issue being cut out of the default-choice pool made the big players green with envy (several firms seem to forget that they have mutual fund arms that operate funds suitable for being the no-pick option).

And so, they started lobbying. They hit the legislators hard, getting them to write the Department of Labor. And the insurers wrote in themselves.

Their arguments were silly and specious.*

Truly! And we share Jaffe's hope that "the Department of Labor gets this one right, allows only the smart default options and doesn't allow another generation of Americans to come up short on retirement savings."

This is a real test for Congress, the Department of Labor, and the Bush administration. What's more important, the narrow interests of the insurance industry or the broad interests of the investing public? 

If the insurers win this battle, they'll do so on the basis of raw political power, not the quality of their claims.

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*This is just about the silliest argument we can imagine: "That bugs insurers, who say that stable-value funds not only keep money safe but also help young workers -- who may need the money if they change jobs -- and older close-to-retirement employees avoid the pain of a sharp market drop." They can't be serious. Young workers are the very last people who should invest in stable-value funds. And older workers have plenty of cash-equivalent options available to them through conventional money-market funds or even stable-value funds, which as Jaffe points out can still be included as investment options...just not as defaults under automatic enrollment.

Source

Chuck Jaffe, "Default options: Investment choices for automatic 401(k) savers shouldn't be made political," Marketwatch, June 20, 2007

"Contained or Contagious" Revisited

Two months ago, we asked whether problems in the subprime mortgage market threatened the broader economy and the financial markets. Here's part of what we wrote on April 12th:

The point here is not that subprime contagion will wreck the entire economy. We just think it's inaccurate--or at the very least too soon--to say the problem is small and therefore inconsequential.

Given recent events, that perspective looks more appropriate every day. Interest rates have moved higher and Bear Stearns is winding up a couple subprime-focused hedge funds, one of which was highly leveraged--and thus more subject to the sort of race-for-the-exits crisis we're now seeing.

Now, the demise of a couple hedge funds won't exactly bring the financial system to its knees. But we think something bigger is happening here: The re-pricing of risky debt. This shift could be relatively sudden, or it could unfold more gradually (or both). Regardless, this sort of re-pricing raises the possibility of contagion as subprime problems lead to a breakdown in the broader debt market, which in turn threatens M&A/private equity/share buyback activity, which has been the primary force behind a full year of significant gains in U.S. equities.

Related: Tomorrow's Blackstone IPO. Will it be remembered as the top tick for the current boom in private equity? Or will it offer a great new way for ordinary investors to participate in private equity's impressive returns? We'll be honest: We don't know. But there are two sides to every trade, and when the sellers are as smart and powerful as Steve Schwarzman, Pete Peterson, and their Blackstone colleagues, and when their returns have been so impressive for so long...buyers might wonder why the other side is selling at all.

UPDATE: Walden Siew and Al Yoon of Reuters note the rising fears of contagion in an item posted this afternoon.

Source

Grace Wong, "Deadly ripples threaten subprime funds: Collapse of two Bear Stearns funds could trigger selloff and deepen losses across sector," CNNMoney.com, June 21, 2007

"Blackstone IPO draws high non-U.S. demand: report," Reuters, June 21, 2007

Walden Siew and Al Yoon, "Bear Stearns CDO liquidation sparks contagion fears," Reuters, June 21, 2007

One Size Doesn't Fit All

On Monday, we took a closer look at the question of whether an investor might actually be better off paying a steep surrender charge on a variable annuity in order to benefit from much lower annual expenses for the duration of the period in which the surrender charge would apply. (The answer was a definitive yes. For more, see this).

That was an interesting question, but we're beginning to detect a pattern: Advice delivered to investors through the media (which is to say as delivered by the media) tends to be pretty poor. More to the point, our hypothesis is that the more specific the "advice" gets, the worse it actually is.

Though we agree with Marshall Loeb's basic premise that index funds are a better bet for most investors than actively managed mutual funds,* we're not so sure about the blanket recommendation Loeb makes by channeling a Pennsylvania investment advisor who recommends a 60-40 split between stock and bond index funds for "beginners" (whatever that means).

We want to be clear here: P.J. DiNuzzo surely takes a more nuanced approach in dealing with his clients. Given space constraints, reporters and columnists are always hard-pressed to describe the full complexity of investment decision-making. And that's exactly the point. Investors would do themselves a favor by looking to press accounts for general principles of personal finance...and for good questions to ask (of themselves or their financial professionals), not definitive answers.

But back to those "beginners" Loeb mentions...

How old are they? How much money do they have? How much do they need? How much do they want? What sorts of investments do they have outside their liquid assets? The list of questions goes on and on, and the answers to all of them will shape and reshape the range of appropriate strategies for a given investor.

The principles of prudent money management are straightforward enough. Loeb's commitment to index funds certainly fits with our perspective on inexpensive, high-performance investing. But general principles don't speak to the specific circumstances of any single investor. And glib suggestions that a particular asset allocation is appropriate for nearly any "beginner" don't serve Loeb's readers well at all.

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*We don't think active management is doomed to fail. But we do think it's a very low-probability option when pursued in the framework of a conventional diversified mutual fund. We'll be writing more about this in the coming days and weeks.

Source

Marshall Loeb, "The Case for Index Funds," Marketwatch, June 20, 2007

12b-1 Fees Back in the News

As we wrote approvingly back in April, SEC Chairman Chris Cox wants the Commission to change the way mutual fund companies compute, levy, and/or disclose so-called 12b-1 fees. For a short description of these fees and the problems they create for rank-and-file investors, we recommend our April 5th post on the topic.

Yesterday, the SEC held its first hearing on the topic, an extended session featuring testimony from academics, consumer advocates, and representatives of the financial services industry. Over at Marketwatch, Robert Schroeder has a concise account of the various claims made for and against the status quo...though through no fault of Schroeder's this kind of short-form reporting inevitably strips out some of the complexity of the testimony.

Back in April, we wrote that "we expect to see some serious pushback from the mutual fund and brokerage industries." As expected, here's Schroeder: "Meanwhile, Wall Street isn't letting a review of the fees go down without a fight."

We'll try to follow the funhouse arguments as the regulatory process unfolds over the next few months.

UPDATE: From Reuters, another account of yesterday's testimony.

Source

Robert Schroeder, "Mutual fund fees come into SEC sights at review: Disclosure urged, fees defended but no consensus emerges," Marketwatch, June 19, 2007

Rachelle Younglai, "SEC sees more mutual fund disclosures," Reuters, June 19, 2007

The Absurdity of the "IRA Annuity"

As Money's personal finance columnist, Walter Updegrave comes up with a lot of good stuff. We like his perspective and we appreciate his straightforward style. We're especially impressed with today's column, in which Updegrave dismantles the notion of investing in a variable annuity inside one's IRA.

Just yesterday, we took a hard look at annuity surrender charges...and concluded that annuity expenses are egregiously high that investors may well be better off paying a surrender charge of 7 percent in order to avoid the ongoing damage of super-high costs.

And last Friday, we raised a broader set of concerns with annuity products.

Today, Updegrave responds to a reader whose financial advisor recommended that the reader's wife roll her 401(k) assets into an annuity inside an IRA...a recommendation strange enough to lead us back to this post we did on the sources of bad advice in the financial services industry. Yep...our favorite themes seem to come around again just about every day.

In any case, Updegrave rightly warns his reader against the annuity-in-her-IRA option, pointing to two big problems.

One is if you take the trouble to plow through the hefty prospectus (which can easily run 400 or more pages) that comes with these products, you'll find that they're riddled with restrictions and drawbacks that make them a lot less attractive than the picture the adviser paints. (The fact that they're hideously complicated is another downside in and of itself.)

The other problem is the cost. Variable annuities usually tend toward the blimpish end of the fee spectrum, with annual levies of 2 percent or more of assets hardly uncommon. Throw in the extra charges for these riders and you could be talking an all-in cost of 3 percent or more a year. That's a huge portion of your assets to be giving up year after year. Lack of space and fear of causing a terminal case of boredom prevent me from going into the ugly details of these products here. But I can refer you to what I've written in the past about GMIBs and GMWBs.

Ultimately, though, my position boils down to this: if you've got 401(k) money you're not planning on tapping within a few years or longer, you're much better off rolling it into an IRA rollover invested in a mix of low-cost stock and bond mutual funds that's appropriate for your age and risk tolerance and letting it rack up returns.

Indeed. And we strongly recommend Updegrave's earlier items on GMIBs ("guaranteed minimum income benefits") and GMWBs ("guaranteed minimum withdrawal benefits"). Let's just say Updegrave isn't exactly working from the insurance industry's talking points!

Source

Walter Updegrave, "An IRA by any other name..." Money.com, June 19, 2007

More Real Estate Weakness

Housing starts fell by 2.1 percent in May, with permits rising 3 percent over April. Housing trends take a while to develop (and identify), so what do the longer-term averages say? As Rex Nutting notes at Marketwatch this morning, starts are down 26.5 percent from the same five-month period in 2006. The same comparison for permits: off 25.7 percent.

Though these data indicate continuing weakness in residential real estate, this is actually decent longer-term news as it indicates a move toward a new equilibrium where supply and demand are better aligned. But we aren't there yet, and we don't think we're especially close.

Here's Richard Moody of Mission Residential, describing the situation clearly:

"Simply put, there is too much inventory lingering in the market, and the most recent data suggesting rapid growth in the number of foreclosures mean the inventory overhang will become more severe, particularly with higher mortgage rates taking a bigger bite out of demand."

As we've argued before (here and here, among other places), housing is all about inventories. Supply is enormous (and growing, given rising foreclosure rates) and demand is weak and weakening (speculation is gone, buyers are cautious, mortgage rates are higher, lending standards are tighter).

In his Ahead of the Tape column in today's Journal, Justin Lahart assesses the implications of housing weakness for the stock market:

The housing sector has been like the tree falling alone in the proverbial forest -- if it's making noise, investors aren't hearing it.

...

Some investors might even see soft housing reports as "market friendly," because such reports make it harder for the Federal Reserve to raise short-term interest rates. For stock investors right now, low rates are paramount; cheap debt helps keep alive the corporate buyout boom, which is underpinning stock prices.

Of course, even though the short-term interest rates controlled by the Fed are holding steady, long-term interest rates are rising. That threatens to do even more damage to housing. At some point, that tree in the forest might make some noise that everybody hears.

Exactly right.

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UPDATE: Barry Ritholtz points to a nice collection of data and charts on regional real estate valuations. It's worth a look.

Source

Rex Nutting, "Housing starts fall 2.1% to 1.47 million pace," Marketwatch, June 19, 2007

Justin Lahart, "Investors Give Housing Data Scant Attention," Wall Street Journal, June 19, 2007 (subscription required)

It Pays To Do the Math

We've written before on the problem of bad advice in the financial services industry. This morning, Money posted a piece on one investor's experience grappling with sales-driven (as opposed to fiduciary) advice.

Here's a partial detailing of the damage suffered by Jason McCann:

But McCann's go-anywhere style and six-figure salary have also made him an easy target for fee-hungry financial advisers. His nearly half-million-dollar portfolio is a jumble of 14 accounts, many laden with high commissions and fees.

Case in point: the 2.5 percent annual charge on his $55,000 variable annuity. Or the 10 percent commission he paid to invest $47,000 in private REITs. Or the 2.2 percent yearly fee on the $46,000 privately managed, or wrap, account held by a financial firm in Denver.

That's ugly stuff, all of it...but let's focus on that variable annuity.

As we noted Friday, annuities suffer from egregiously high costs, costs that are difficult to fully understand because the true cost of owning the underlying mutual funds is not transparent to the investor. So we're going to say that McCann's annuity is running him at least three percent per year, and we think that's a low-ball estimate of the product's all-in expenses. But we'll go with it for now.

For some expert guidance in helping McCann improve his investment strategy, reporter Asa Fitch turns to Jennifer Cray, a Menlo Park (CA) financial planner. We like a lot of the advice Cray offers, especially her recommendation of low-cost index funds and ETFs.

But we did a double-take when we read this:

McCann pays an annual 1.4 percent "principal protection" fee on his $55,000 variable annuity, along with another 1.1 percent or so for the funds it invests in. Those costs are essentially wiping out any tax benefit he might get on the investment gains, says Cray.

But right now he'd have to pay a 7 percent surrender charge, or $3,850, to close the account. That fee decreases by 1 percent a year, so in five or six years he can exit without taking a big hit. For the time being Cray suggests he select the fund options that offer the highest possible return. They might be riskier, but he's guaranteed not to lose his principal, and the extra return could help offset those giant fees.

Surrender charges are one of several big problems with variable annuities, but do they necessarily mean investors should stick with their annuities until those charges disappear? Short answer: No. Let's explain using McCann as an example.

We ran the numbers to see if McCann would be better off paying the surrender charge now and incurring lower annual fees for the duration of the surrender period...or avoiding the surrender charge and paying higher annual fees until the surrender period ends.

Our working assumptions:

• Annual fees and expenses of 3 percent until the surrender charge disappears
• Annual fees and expenses of 1 percent after paying the surrender charge and exiting the annuity
• A holding period of six years until the surrender charge disappears
• A surrender charge of 7 percent if paid immediately
• Annual returns gross of fees and expenses of 10 percent (and standard deviation of 8 percent) in both McCann's annuity and his post-annuity investment strategy

So how do the numbers work out? Using a random number generator (which produced annual returns of 5.9, 17.4, 10.1, 6.6, 27.6, and 16.5 percent over the six-year holding period), we've calculated that McCann would end up with $101,597 if he avoided the surrender charge and kept his annuity until that charge disappeared...and $105,218 if he paid the surrender charge immediately in order to enjoy lower annual fees over the following six years.

Let's put it another way: With the annuity, McCann's $55,000 earns a six-year return of 84.7 percent. Without the annuity, McCann's post-surrender-charge $51,150 earns a six-year return of 105.7 percent.

In this case, the logic is clear: Pay the surrender charge and put that annuity contract where it belongs...in the recycling bin. 

Insurance companies love surrender charges in part because it takes them several years of fees to cover the super-generous commissions paid to the salespeople who peddle annuities. Given our calculations, surrender charges will only do their job--i.e., make it irrational for an investor to scrap an annuity early in the contract--if they become even more outrageously expensive.

And ohbytheway: Who exactly recommended a variable annuity to an aggressive-saving 30-something in the first place!?

Source

Asa Fitch, "Money Makeover: Riding a wave of bad advice," Money, June 18, 2007