The Float

For Most 401(k) Plans, Less is More

Writing for the CBS News and MoneyWatch, Larry Swedroe shares a few classic findings from a recent study of mutual fund selection and replacement in 401(k) plans. If you're in the business of sponsoring or advising a defined-contribution retirement plan, you should give this a good, hard look (emphasis added): 

As one would expect, when administrators change offerings, they choose funds that did well in the past. After all, who would choose a fund that had performed poorly? Funds that were added to plans had positive alphas for both one- and three-year periods prior to the change. And, unsurprisingly, managers fire poorly performing funds.

Funds that were dropped had negative alphas for both one- and three-year periods before they were dropped. The funds that were added had an alpha above those that were dropped of 2.8 percent per year for three years before the change and 2.3 percent in the year before the change (note the declining alpha). Unfortunately for investors, when a plan deleted a fund and replaced it with a fund with identical objectives, the deleted funds outperformed the ones they replaced by about 2.5 percent per annum over the next three years.

The authors also examined what happened when a plan replaced all of their offerings from one fund family and added funds from a new fund family. Not surprisingly, they found that the past Sharpe Ratios (a measure of return relative to risk) were higher for the portfolio of added funds than for the portfolio of dropped funds. After replacement, the future Sharpe Ratios were higher for the portfolio of dropped funds than for the funds that replaced them. Once again, inaction would have proved better for investors than action.

Swedroe also notes that individual plan participants tend to herd into prior-period top performers...just before those funds reconfirm one of the natural world's most reliable phenomena: reversion to the mean. To summarize, funds that have out-performed recently/relatively tend to underperform in the next period. Recent-period underperformance tends to be a little more durable than outperformance, but many funds that look like stinkers on a plan's typical chart of recent returns turn out to do better in subsequent quarters and years. Thus...mean-reversion for recent winners and recent losers alike. 

Swedroe concludes with this: 

These findings demonstrate that investors would be better served if plan administrators limited their offerings to low-cost index funds and if investors put their portfolios on autopilot--setting the portfolio to rebalance on a regular (e.g., quarterly or annual) basis.

Though we prefer market- rather than calendar-driven rebalancing, this is the general approach we take to our role as 3(38) fiduciaries. And it's the approach we recommend to everyone, everywhere. Why? Because we're all engaged in a probability-maximizing process, and chasing performance at the plan or individual level makes it less likely that participants and their beneficiaries enjoy the best outcomes possible under a given set of market conditions. 

SOURCE

Larry Swedroe, "401(k) honchos could do better by doing less," CBS News MoneyWatch, August 29, 2013

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

Hussman on Cicularity

John Hussman's most recent weekly comment contains the following insights, with which we happen to agree wholeheartedly:

In recent weeks, the dominant view of investors and analysts has shifted clearly to the expectation that the U.S. economy is in recovery. Appearing to seal the deal for some analysts was the third consecutive increase in the index of leading economic indicators. For that index, interest rate spreads and the S&P 500 Index have been the strongest contributors in recent months, as 10-year yields have shot higher from near 2% at the beginning of the year to about 4% before retreating a bit, and stocks have similarly rebounded from deeply oversold levels. Unfortunately, as I've noted before, there is little information content in mean reversion following extreme moves, and that's what the LEI is picking up here–-to a much greater extent than has typically been the case at the end of recessions. Put another way, the case for an economic recovery is based largely on mean reversion from the early 2009 extremes (not on improvements in jobless claims or other measures to a level that is on par with prior recoveries).

...

Taking the rally in stocks as an indicator of economic recovery (which the LEI largely does), and then taking the presumption of an economic recovery as a reason to buy stocks, all strikes me as circular reasoning.

Assets, Liabilities, and Retirement Plan Management

In a recent issue of InvestmentNews, Fiduciary360 president Blaine Aiken opens his "Fiduciary Corner" column with this:

An investment fiduciary's duty of loyalty demands that the investor's best interests guide the decision-making process.

Moreover, close attention must be paid to the consequences of decisions, and corrective action must be taken if those decisions are not serving the investor's interests. Sometimes limited fine-tuning is all that is needed; at other times, no amount of tinkering seems to achieve the desired results, and a complete reassessment of the approach is required.

It appears to me that participant direction of retirement plan assets fits in the latter category.

Aiken goes on to note that even the (overrated, virtually unattainable) rules of section 404(c) "did relatively little to prevent participants from making poor investment selections." As longtime readers know, we too see problems with the conventional model of participant direction (see this and this, for example).

"Because a participant holds a separate account, rather than an interest in a commingled aggregate portfolio," Aiken writes, "the costs of participant-directed plans can be higher than they are for sponsor-directed portfolios." No doubt. But as we'll explain in a moment, the big picture turns on the fact that participants hold separate accounts at the individual level.

Aiken suggests that it might be "time to ask whether the whole concept of participant direction is a losing proposition for investors." That's a timely, important question. Here's Aiken's exploratory answer:

Centrally administered portfolios, like those of foundations, endowments and defined benefit plans, are less complicated. Investment fiduciaries have direct control of the process and are accountable from design to execution. The investment committee or chief investment officer, usually with the support of professional advisers and money managers, makes asset allocation decisions, directs the investments, and can change the portfolio composition as needed.

Plan sponsors and their advisers should consider whether a fundamental change in their approach for 401(k) and other defined contribution plans from participant direction to investment committee or trustee direction of the assets would better serve the best interests of the investors they work for.

Again, all of that sounds perfectly reasonable to us, but for one fact: Centrally administered portfolios would create a disconnect between plan assets (which would be managed at the system level) and participant liabilities (which would remain at the individual level).

Generally, the economic needs (i.e., risk and return objectives) of defined-benefit pension funds are relatively easy to specify, such that central decision-makers can manage assets at the system level (and participants and their beneficiaries can plan the liability side of the ledger with relative certainty as to the future payments they'll receive). The economic needs of individual account-holders, on the other hand, vary widely and unpredictably, such that central control of plan investments could/would create a disconnect between group-level assets and individual-level liabilities.

Put differently, as long as accounts balances remain individually-specified (which, after all, is pretty much the definition of defined-contribution plans), most 401(k) participants will need help with their investment decisions, but they also need the opportunity to tailor their investment programs to their idiosyncratic circumstances.

In our view, the appropriate middle ground looks like this: Participants confront a dramatically simplified choice of five or six globally diversified, risk-adjusted, pension-style portfolios (rather than a long menu of mutual funds written in Wall Street language that might as well be Sanskrit). To work outside those boundaries, they must secure the consent of their primary beneficiary (or beneficiaries), as ERISA requires fiduciaries to protect the interests of beneficiaries as well as participants.

The objectives here are (a) to make the process easy and (b) to reduce the likelihood of big mistakes. Done prudently, it can also produce meaningful reductions in plan expenses. We think this type of program solves most of the problems associated with the traditional model of participant direction while leaving room for participants, beneficiaries, and their advisors to connect assets and liabilities.

There's more individual-level risk in this type of program than in traditional pensions, but the defined-contribution regime is here to stay. The question now is how to make such plans work as well as they can.

Source

Blaine F. Aiken, "It's Time to Rethink Retirement Plans," InvestmentNews, July 12, 2009

"Failure of a Fail-Safe Strategy"

Given the meltdown in so many asset classes over the last two years (remember: it was in the Summer of 2007 that the music first stopped without enough chairs), it has become somewhat fashionable to question the benefits of diversification across asset classes.

We've weighed in on this issue here and here, arguing that diversifying across relatively risky asset classes shouldn't be--and never should have been--seen as a means of reducing risk amid crisis conditions.

On Friday, Tom Lauricella filed another entry in the not-so-sure-about-this-asset-allocation-thing genre. As he so often does, Lauricella handles the material well, noting that correlations among risky asset classes had been rising before the recent meltdown. But the most important point about the last 24 months is that cash-equivalents and treasuries held up remarkably well, providing capital preservation and even some appreciation for investors who held them while risky assets cratered.

Lauricella's story opens with a Raymond James broker saying, AA-style, that he's "a recovering asset-allocationist." Near the end of his piece, Lauricella tells us about this broker's new style: more cash, and more flexible mandates for the active managers he hires for clients. We think this makes pretty good sense. As we've argued repeatedly in this space, asset allocation should be inexpensive and index-based; active management should be nimble and relatively unconstrained. In other words, they should be different, and purchased/pursued under different frameworks (not in the big, expensive mash-up of market- and manager-driven returns offered by most mutual funds).

Lauricella closes with this telling sequence about his example broker:

He says he is convinced there is a way to make diversification work. In fact, after the strains of last year, he says, many investments are behaving more like they did before 2008.

Asset allocation, he says, "might well have been injured....But I don't think it's gone forever."

No doubt. Properly understood and executed, asset allocation remains a perfectly intelligent strategy. To paraphrase Churchill's quip about democracy, asset allocation might be the worst thing out there...except all the others that have been tried.

One more note: Be sure to look at the WSJ's interactive graphic on asset-class correlations over the last 15 years. Good stuff.

Source

Tom Lauricella, "Failure of a Fail-Safe Strategy Sends Investors Scrambling," Wall Street Journal, July 10, 2009

From the Contrarian Files

From time to time a headline strikes us as an especially fraught suggestion that the investing herd is buying or selling en masse, often quite late in whatever the latest game might be. In Monday's Wall Street Journal, Shefali Anand came up with a classic of the genre: "A Taste for Risk--Again." Here's how the story opens:

It's amazing the difference a rally can make in investors' appetite for risk.

A few months ago, mutual-fund investors were yanking money out of stocks and high-quality corporate-bond funds and parking it in safer places, like money-market funds and U.S. Treasurys. Lately, however, as stock and bond markets have rebounded, mutual-fund investors have had a split personality.

They're back to buying relatively safe investments like high-quality corporate bonds. But they're also pouring money into the riskiest investments. They're lukewarm toward U.S. stocks but plunging into high-octane vehicles like emerging-market companies, commodities and junk bonds--making these among the 10 best-selling mutual-fund categories this year.

Unfortunately, the story doesn't deliver enough compelling data to get our contrarian hackles all the way up, but it's one of those things that gives us pause.

And here's another ingredient in our current caution. In the chart below, you'll see how the 20-day moving average of the S&P 500 (the red line) provided support on two key occasions during the rally off the market's March lows (especially on April 20^th/21^st and throughout mid-May). Then on June 15^th the S&P closed right on the 20-day, broke below it on the 16^th, and bumped its head on it at the start of July. In addition, the 20-day has rolled over.

In the relatively short term, we don't make much of moving average crossovers, but we've certainly noticed that the 20-day is now moving lower for the first time since the middle of March.

None of this is to say that the rally can't or won't re-ignite. But the Summer's burden of proof may have shifted from the bears back to the bulls.

Source

Shefali Anand, "A Taste for Risk--Again," Wall Street Journal, July 6, 2009

More From Dalbar

Back in March, we posted a brief overview of Dalbar's most recent edition of its "Quantitative Analysis of Investor Behavior," an authoritative study of the perennial gaps between market returns and fund returns on the one one hand, and fund returns and investor returns on the other. Summary: The numbers get uglier with each step away from market returns--and (stock) market returns haven't been especially thrilling in the first place!

Via Mebane Faber, we found Dalbar's fuller treatment of its 2009 report (which is through year-end 2008). This is good, important stuff. Take a look.

Brett Arends' 12 Rules

Back on May 1^st, the WSJ's Brett Arends spun out "12 Rules for Investing in the Next Bull Market," most of which are insightful and helpful. We generally like Arends' work and this piece is no exception. Though we're quibblers by nature, this is pretty strong stuff and it deserves your consideration. Here are a few of Arends' rules followed by our comments:

2. Avoid big moves.
If you buy or sell heavily in one shot you're taking a needless risk. And waiting for the right moment to make your move is futile. You probably won't catch the bottom or the peak anyway. If a market trend has much further to run, then what's the rush? And if it doesn't...what's the rush?

No quibbles here. This is exactly right. 

6. Be truly diversified.
That means investing across a spread of different asset classes and strategies. As investors discovered last year, "large cap value" and "mid cap blend" funds don't offer diversification. They're just marketing gimmicks.

Though it's true that correlations rose sharply among risky asset classes during the last 20 months, we aren't willing to concede this point. There are ways to slice the market too narrowly, but historically there have been--and, we think, will be again--material differences in the risk/return profiles of various classes of equities. Tilting strategic portfolios in one direction or another by weighting assets classes isn't just a marketing gimmick. Or, to be more precise, it isn't necessarily, or always a marketing gimmick.

10. Be patient.
Investment opportunities are like buses. If you missed one, you don't have to chase it. Relax. If history is any guide, others will be along shortly.

Yes.

11. Don't sit on the sidelines completely until it's too late.
You'll probably end up splurging at the last moment. If you are afraid to invest, do it early, little, and often.

Yes.

12. And above all: Price matters.
After all, an investment is just a claim check on future cash flows, whether it be a company's profits, a bond's coupons or an annuity's income stream. By definition, shares in a solvent company are twice as good at half the price...and vice versa. It's amazing how many people get suckered into thinking it's the other way around.

And yes.

But then there's this morning's Arends column, in which he taps some recent research suggesting that near-term economic prospects have almost nothing to do with stocks' long-term returns, which in turn makes the notion of "price" a little less concrete that most investors--and certainly less concrete than most fundamental analysts--would like to believe. Here's an excerpt:

The stock market jumped 6% last week on growing hopes of an imminent economic recovery. It has risen 39% from the March lows on similar hopes. Of course, it had previously fallen nearly 60% on fears of a slump.

All these moves have one thing in common: Millions of investors have acted on the belief that share values are closely related to what will happen in the economy in the next few months and years. But are they right?

Not according to Ben Inker, director of asset allocation at contrarian fund company Grantham Mayo Van Otterloo & Co. In a recent and fascinating note ("Valuing Equities in an Economic Crisis, or How I Learned to Stop Worrying about the Economy and Love the Stock Market"), Mr. Inker persuasively argues that the next moves in the economy shouldn't actually matter too much to investors at all.

Why? Two reasons.

First, because most of the value of shares really depends on the cash they will generate many years, even decades, ahead. The next few years are only a minuscule part of the equation. "Since stocks do not have an expiration date and dividends grow over time," Mr. Inker argues, "the duration of stocks is extremely long. If we assume that half of the return from stocks in a given year comes from the dividends and half from the growth in dividends, most of the value of stocks comes from cash flows in the distant future."

(The second reason is that short-term deviations from long-term trends in economic growth are typically resolved back toward those long-term trends within a few years.)

"This sort of analysis is a useful antidote to stock market moods," writes Arends. Maybe. But the other way of looking at Inker's research is that all we really have in the short run is "stock market moods." Which means you either trade on the technicals (with some attention to short-term expectations of the fundamentals, as in a Keynesian beauty contest) or, like Joshua in War Games, refuse to play the short-term trading game in the first place.*

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* It's one of the great lines in movie history: The rogue computer program "Joshua," having realized that "global thermonuclear war" produces no winners, declares that "the only winning move is not to play."

Sources

Brett Arends, "12 Rules for Investing in the Next Bull Market," Wall Street Journal, May 1, 2009

Brett Arends, "How to Value Stocks? Ignore Economic News," Wall Street Journal, May 11, 2009

Ben Inker, "Valuing Equities in an Economic Crisis," Grantham Mayo Van Otterloo & Co., April 6, 2009 (registration required)

From the Contrarian Files

We still can't feel as sanguine about our near- and medium-term economic prospects as traders (and the few remaining investors) appear to these days, but there's a powerful logic to "don't fight the tape"--let alone the Fed. Whatever the market's near-term prospects, when one takes a longer, multi-year view, this strikes us as a probabilistically attractive time to acquire equities.*

Two items caught our attention along these lines: Rob Arnott's much-discussed Index Universe piece on the relative performance of stocks and bonds in recent years. (We mentioned Arnott's research earlier this month.) As we argued in March, true bottoms tend to be marked by mass indifference, even revulsion toward stocks. In turn, one would expect that indifference to manifest itself in grinding, low-volume trading. But intelligent, sensible efforts like Arnott's can flash revulsion as well, not of the rash, emotional sort, but a kind of mean-reverting phenomenon in which the data Arnott cites, backward-looking by definition, are unlikely to repeat themselves. Take a look at Brett Arends' excellent coverage of this issue in Tuesday's Wall Street Journal:

"Starting any time we choose from 1979 through 2008," Mr Arnott writes, "the investor in 20-year Treasuries (consistently rolling to the nearest 20-year bond and reinvesting income) beats the S&P 500 investor." He argues the figures are even true going back to the late 1960s.

Mr. Arnott's article has generated quite a stir in the investment world, where he has, in theory, turned a lot of received wisdom on its head.

But American mutual fund investors, responding to last year's turmoil, are already voting this way with their wallets. So far this year they've withdrawn $45 billion from mutual funds that invest in the stock market, and put $68 billion into bond funds, reports the Investment Company Institute.

Should you follow suit? Not so fast.

Obviously bonds, especially Treasurys, held up well during last year's crisis. And they can make an important part of a portfolio, especially at the right price. But anyone hoping for a repeat of the last thirty years is probably dreaming.

The second item that leaped off the screen at us was yesterday's Journal story on financial advisers forsaking traditional buy-and-hold strategies rooted in asset allocation and Modern Portfolio Theory. We manage money in two styles, one traditional and strategic, the other (mildly) alternative and tactical. But we've been doing that since before the crisis, and when we see media coverage of rank-and-file advisors (and, implicitly, their clients) throwing up their hands in disgust at the supposed failure of traditional methods of portfolio construction, we can't help but think that this is a great time to have (or acquire) an inexpensive, diversified portfolio of global asset classes. To return, in other words, to the methods many people (professionals included!) can no longer abide. That's our kind of revulsion.

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* Which, as always, implies no particular guesses about the short-term direction of the market.

Sources

Rob Arnott, "Bonds: Why Bother?" Index Universe, April 27, 2009

Brett Arends, "Bonds' 30-year Hot Streak Begins to Cool," Wall Street Journal, April 28, 2009

Anne Tergesen and Jane J. Kim, "Advisers Ditch 'Buy and Hold' for New Tactics," Wall Street Journal, April 29, 2009