The Float

Independent Advice

Playing catch-up here with a September 14^th InvestmentNews story on the fate of a Bush-era proposal concerning the delivery of advice to retirement plan participants. Here's Sara Hansard's opening riff:

The Department of Labor is killing a regulatory change issued in the last days of the Bush administration that would have allowed brokers affiliated with mutual funds, brokerage firms and other companies that sell investments to provide investment advice to 401(k) participants.

With legislation pending in the House, and the possibility of similar provisions emerging from the Senate, it's likely that the current Congress will act on the question of independent advice. The immensity of the health care reform effort has pushed other things aside for a while, but even if it happens in 2010, and whether it's a product of Congress or the DOL or both, the rules on advice are going to change.

Meaningful legislation on independent advice would help our firm, but our support for these ideas doesn't follow from our firm's position in the marketplace. Instead it's the other way around: Our support for these ideas explains our firm's position, as we wouldn't be in this business if we couldn't do it with absolute independence. 

This is a story worth following.

Source

Sara Hansard, "Labor Department nixes Bush OK to let brokers advice 401(k) plans," InvestmentNews, September 14^th, 2009

BrightScope in USA Today

We were pleased to see our friends at BrightScope featured in yesterday's USA Today story on the high and hidden fees that plague so many retirement plans. This marketplace is changing, and very much for the better.

Fiduciary service providers, sponsors, and participants need to work hard to ensure that defined-contribution plans give participants and their beneficiaries the best possible chance of a decent standard of living in retirement. 401(k) and other DC plans aren't the only piece of the retirement puzzle, of course, but they're immensely important, and there's no reason we can't effect lots of positive change over the next few years.

"The New American Dream: Renting"

In this space, we've written on the widespread misunderstanding of the investment value of residential real estate. Whether it's short, anomalous bursts of rapid appreciation that warp people's sense of long-term averages, or gross underestimates of the true costs of ownership, many people have made enormous financial mistakes on the premise that owning (to say nothing of "flipping") a home is a sure path to financial security.

So we were delighted to see last Penn professor Thomas Sugrue's piece on rentership and ownership in last Friday's Wall Street Journal. As usual when we make reading recommendations, the whole thing is worth your time. But this struck us as a key passage, in many ways the key to the entire story:

Yet the story of how the dream became a reality is not one of independence, self-sufficiency, and entrepreneurial pluck. It's not the story of the inexorable march of the free market. It's a different kind of American story, of government, financial regulation, and taxation.

We are a nation of homeowners and home-speculators because of Uncle Sam.

...

It's a story riddled with irony--for at the same time that Uncle Sam brought the dream of home ownership to reality--he kept his role mostly hidden, except to the army [of] banking, real-estate and construction lobbyists who rose to protect their industries' newfound gains. Tens of millions of Americans owned their own homes because of government programs, but they had no reason to doubt that their home ownership was a result of their own virtue and hard work, their own grit and determination--not because they were the beneficiaries of one of the grandest government programs ever. The only housing programs prominently associated with Washington's policy makers were underfunded, unpopular public housing projects. Chicago's bleak, soulless Robert Taylor Homes and their ilk--not New York's vast Levittown or California's sprawling Lakewood--became the symbol of big government.

Then there's the other part of the residential real estate story we've returned to repeatedly. The fallout from the housing bubble is (and will continue to be) especially awful because unlike railroads or telecommunications or the Internet, excessive residential real estate--too many homes that are too big and too far-flung--does nothing to promote future economic productivity. Indeed, it impairs future productivity by diverting public and private resources from other, better uses. Your town could benefit from more solar power? From a more efficient grid or better schools? Sorry. They spent the money on that (largely empty) subdivision out in the fields.

Sugrue's closing lines apply to the U.S. as a country as much as to individuals and families:

If there's one lesson from the real-estate bust of the last few years, it might be time to downsize the dream, to make it a little more realistic. James Truslow Adams, the historian who coined the phrase "the American dream," one that he defined as "a better, richer, and happier life for all our citizens of every rank" also offered a prescient commentary in the midst of the Great Depression. "That dream," he wrote in 1933, "has always meant more than the accumulation of material goods." Home should be a place to build a household and a life, a respite from the heartless world, not a pot of gold.

Source

Thomas J. Sugrue, "The New American Dream: Renting," Wall Street Journal, August 14, 2009

BrightScope on 401(k) Legislation

The center of gravity on 401(k) legislation has long been the office of Rep. George Miller (D-CA), who chairs the House Committee on Education and Labor and has taken great interest in issues relating to retirement security in general and defined-contribution plans in particular. 

Miller is the lead sponsor of H.R. 2989, which combines fee disclosure provisions with a requirement that investment professionals providing advice to retirement plan participants be genuinely independent. All of which sounds good to us. And to our friends at BrightScope, where Ryan Alfred has posted a comprehensive assessment of H.R. 2989's investment advice component. Here's Ryan's conclusion:

It should be the intent of the legislation to align the standard of care of financial representatives with the expectations of investors and to strengthen investor protections. If "harmonization" is to occur it needs to be the harmonization of investor expectations with the standard of care of their advisers, regardless of whether that financial firm was heretofore regulated as a broker-dealer or an investment adviser. That means upgrading all providers of investment advice to the existing fiduciary standard for investment advisers, not lowering the fiduciary protection via a new "federal fiduciary" standard. Nowhere is this case more clearly evident than with retirement plans, where a higher percentage of investors are unsophisticated and lack the freedoms they have in non-retirement accounts. These investors deserve to have access to conflict-free advice from fiduciary advisers.

We second that enthusiastically.

ERISA Litigation

We ran across an interesting report in InvestmentNews on a lawsuit against the service providers--investment advisor, recordkeeper, and custodian--to a $2 million 401(k) plan in Kansas. To this point, of course, most 401(k) litigation has focused on the biggest plans. Here's IN's Mark Bruno:

A group of fewer than 30 employees at a small company in Kansas has filed a lawsuit against the investment adviser, record keeper and custodian for its $2 million 401(k) plan, alleging that the trio of plan providers caused participants to pay "secret" and "excessive" fees.

The claim itself is a familiar one, of course, as more than a dozen Fortune 500 companies that boast billions in their 401(k) plans have been hit with similar suits in the past four years.

However, experts said, this latest suit represents the first time that participants have taken aim at such a small plan--and an investment adviser.

They also suggested that this could just be the beginning of a potential wave of litigation in the small-plan market, one that could put a bull's-eye on investment advisers and service providers that typically supply most of these plans.

In the age of LaRue v. DeWolff, sponsors and service providers need to get serious about their fiduciary duties to plans of all sizes and shapes.

Source

Mark Bruno, "Employees name investment adviser in 401(k) suit," InvestmentNews, July 19, 2009

The Slipperiness of "Macroprudential Regulation"

Back on April 1st, we produced an excerpt from Simon Johnson's excellent Atlantic essay "The Quiet Coup." We called our post "Line of the Year," with reference to Johnson's statement that "anything too big to fail is too big to exist."

Yesterday, at The Baseline Scenario, Johnson extended that line of thinking by wondering out loud whether the Fed--or any other "macroprudential regulator"--can "sniff" bubbles before they threaten the financial system.

"Asset bubbles may not be that hard to identify," [New York Fed President William C.] Dudley argues. Fine, but it would help to know exactly the Fed would do this ex ante-–not using the rear view mirror.

Of course, if the Fed can't get better at spotting bubbles, the implication is that no one can. Which means that "macroprudential regulator" is just a slogan-–a nice piece of what Lenin liked to call "agitprop."

And if macroprudentially regulating is an illusion, what does that imply? There will be bubbles and there will be busts. Next time, however, will there be financial institutions (banks, insurance companies, asset managers, you name it) who are-–or are perceived to be–-too big to fail"?

You cannot stop the tide and you cannot prevent financial crises. But you can limit the cost of those crises if your biggest players are small enough to fail.

We think Johnson's exactly right, not just in sensible-capitalist principle, but in practical terms as well. Government has a fighting chance to get antitrust-style stuff right. But identifying bubbles? And doing something about them at the right moments...neither too soon nor too late? We just don't see it.

A Faster Lost Decade?

Is the United States economy headed for a Japan-style lost decade? Evoking our February, 2008, item "Faster Markets," Slate's Daniel Gross suggests that the deep, ongoing recession in the United States may unfold much more quickly than Japan's analogous bubble-bust of the 1990s. This is good stuff:

Why the accelerated pace? It has to do in part with changing global circumstances. Nishimura argues that both crises started because problems in the property and credit markets contributed to an adverse feedback loop between financial distress and economic activity. But information, events, and distress move much more quickly around the globe today than they did in the 1990s. With just-in-time production systems, and with 21^st-century communications technology, bad news travels much more quickly--and farther. In the 1990s, much important exchange of international market information was still done by fax. In addition, traders can now act more quickly on real-time bad news. In the early 1990s, analysts had to wait several months for data. And since the level of financial integration was much less intense in the early 1990s, Japan didn't export its financial problems.

The upshot: In the current crisis, "the velocity of market dysfunction has been much faster and its contagion much more widespread than in Japan's case." And so the damage has been more devastating.

Of course, the duration of the crisis also has something to do with the mentality and action of the first responders. A lesson from both crises, he argues, is that once an adverse feedback loop is established, it's difficult and very expensive to break it and restore confidence. It took a very long time for good news to reach critical mass in Japan in the 1990s, in part due to the slowness of the policy response. But this time, it's different. The Federal Reserve--and, indeed, global central banks and governments--have responded with alacrity. Japan's central banks didn't adopt a zero-percent interest-rate policy until more than eight years after the crisis started; the Fed did so within 20 months. It took Japan nearly eight years to inject funds into troubled banks, compared again with 20 months for the United States to do so. And, Nishimura argues, efforts like the stress tests and TARP exits are bolstering confidence.

Read the whole thing. It's excellent.

Source

Daniel Gross, "A Recession in Dog Years," Slate, June 24, 2009

Fiduciary Delegation Revisited

Scott Simon, firmly ensconced as one of our favorite columnists, has published the third installment in his series on fiduciary delegation, the process by which retirement plan sponsors can outsource all but the legally-required minimum of their fiduciary responsibility for the day-to-day operation of their ERISA plans.

This is a great series. If you care about these issues, we recommend the entire column and its predecessors (see our coverage here, which includes links to the first two installments). Here are a couple highlights (emphasis added in bold):

It's important to note that some in the retirement plan industry have created marketing gimmicks to capitalize on the cache and power of being an ERISA section 3(21) fiduciary. Upon closer examination, though, the "discretion" that's actually accepted for any fiduciary responsibilities in this kind of marketing-driven environment is essentially zero, in my opinion. Such entities create the appearance of fiduciary stature, but in fact they turn out to be fiduciary nothings. One way to recognize such pretenders from a real named independent fiduciary under ERISA section 3(21) that has absolute responsibility to operate a qualified retirement plan through delegation from the plan sponsor is to be on the lookout for the term "co-fiduciary." (My four-part series three years ago documented this.) An honest-to-goodness named independent fiduciary would never use the term "co-fiduciary;" the term has no legal meaning in ERISA. [Here's our take on this pesky issue.]

...

Once a named independent fiduciary has accepted appointment of all the foregoing duties, it then has the right and the power to hire (and fire) all other professionals such as investment advisors, custodians, third party administrators and other service providers to the plan. This, after all, is the entire point of taking the approach set forth in this series. Delegation of these duties to different people or organizations is advantageous for purposes of efficiency and to encourage favorable outcomes for plan participants. Even more important, such delegation transforms a high risk scenario to a low risk one by appointing independent entities with specialized expertise to perform these functions.

Scott always does a nice job of teasing his next column; here's our favorite part of this month's tease:

I'll also explain why very few plan sponsors have [ever] even heard of the kind of significant risk mitigation described in this series--much less understand how they can benefit enormously from it.

We'll guess that the industry's established "model in which...non-fiduciary product pushers are the inmates that run the asylum" will be an important part of that story.

Source

W. Scott Simon, "Delegation for Plan Sponsors (Part 3)," Morningstar.com, June 8, 2009

BrightScope Responds to the ICI

BrightScope's Ryan Alfred has posted the latest entry in the ongoing debate between leaders of the transparency movement (where BrightScope is at the head of the class) and the mutual fund industry's Investment Company Institute. For what it's worth, we've contributed our thoughts here, here, and here.

You should read Ryan's post in its entirety, but we think this is the most important thing he wrote:

The more we listen to both sides on this issue the more we realize that any single number used to describe 401k fees, be it asset-weighted, plan-weighted or participant-weighted is not all that useful in trying to help participants and plan sponsors understand what fees they are paying within their plan.

Exactly right. Though we'll always have a little uncertainty about plans' hidden expenses, it's perfectly straightforward to develop a general sense of which investment vehicles are likely to have higher and lower implicit costs. And it's even more straightforward to understand and disclose the full list of explicit costs facing a plan and its participants.

If we can get individual plans right, in the sense of both transparency and modest expenses, the average/aggregate numbers will take care of themselves. Those aggregate numbers are important, but only to the extent that they reflect the actual experiences of actual participants. And there's still so much variance across plans and participants that there's no substitute for calculating, disclosing, and, where necessary, reducing expenses at the level of individual plans.

Our Response to ICI's Response to BrightScope's Response to ICI's 401(k) Survey

Over the last two weeks, we've participated (marginally) in a discussion of the Investment Company Institute's recent survey of costs borne by 401(k) plans and participants. Elements of that discussion--including our initial post on the topic--have focused not just on the findings of the survey, but on ICI's descriptions thereof.

Writing at BrightScope's blog, Ryan Alfred advanced the debate by examining the ICI survey's sample. That sample leaned heavily on large plans, which tend to be less expensive than small plans, though there's enormous variance even among the biggest ones.

Yesterday, the ICI posted a comment on Ryan's response at BrightScope's blog and a longer response at its own website. We're pleased to see this discussion continue. It's important. And judging by the progress we've already made, it should help sponsors, participants, service providers, policy-makers, and reporters better understand the 401(k) marketplace.

Here are a few thoughts on the ICI's response to BrightScope...

Sampling. Here's ICI on this key factor:

The survey used a sampling technique known as nonproportional quotas. Knowing that the universe of 401(k) plans includes more than 450,000 plans, and that smaller plans are harder to find, the survey was specifically targeted across the spectrum of asset sizes and stayed in the field until specific quotas for plans of different sizes were filled. This survey design ensures that all segments of the population are included and resulted in the extensive, comprehensive data presented.

This is a perfectly reasonable approach. As we noted in our initial item on this topic, the biggest problem isn't with the sample per se; it's with the ICI's description of the report's findings. About those adjectives: We'll grant ICI "extensive," but we won't quite go for "comprehensive," and we certainly wouldn't grant them the most important descriptor (which they don't use)...representative.

What ICI Has Said About the Survey. ICI notes that in his description of the report's findings, ICI Chairman John Murphy said this (emphasis added in bold by ICI):

"The median all-in fee for these plans was 72 basis points. Less than three-quarters of 1 percent--quite a bargain compared to the 3 percent that some critics cite."

In fact, however, ICI's estimate isn't an "all-in" fee, at least if you consider "fee" and "expense" practical synonyms in this context. By excluding trading costs (more on that in a moment), ICI compares its incomplete picture of what participants pay with others' claims about plans' and participants' true and total costs. In addition, for all the reasons we cited back on May 8^th, ICI's "0.72%" excludes more than just implicit fund expenses. Bottom line: We need to get everyone on the same page, talking about the same elements of plan expenses in the same terms.

What Do 401(k) Participants Pay? The most important point made in ICI's response is that while most plans are small, most people participate in large plans. Weighting aggregate, system-wide estimates of expenses by assets or participants is fine. But it can't obscure the fact that, as an anonymous ICI employee posted at BrightScope's blog, "small and tiny plans" need help. And it shouldn't obscure the fact that a lot of non-small, non-tiny plans need help too.

Trading Costs. In a short summary of its response to BrightScope, posted at BrightScope's blog, ICI calls trading costs "a complicated issue." Indeed. But it's not so complicated that we can't get serious about understanding it and--just as important--including it in all discussions of plans' and participants' true and total costs. Here's what we know:

• Trading costs are, as ICI rightly points out, unavoidable.They can also be very substantial indeed.
  
• All else equal, they tend to be higher for funds in relatively illiquid asset classes (due to larger bid-ask spreads).
• All else equal, they tend to be higher for funds with more assets under management (due to larger market impact).
• All else equal, they tend to be higher for high-turnover funds (due to trading commissions and the fact that high turnover raises spread and impact costs).

To the extent that plan participants and fiduciaries care about implicit costs, as they should, they can compare investment options on the basis of asset class liquidity, fund size, and turnover. The point here isn't that big, high-turnover funds in less-liquid asset classes are always and everywhere bad choices. It's that sponsors and participants, guided by fiduciary service providers, should understand the nature and impact of these costs, and, armed with that knowledge, make prudent decisions about their investment options.

Big Ideas. The ongoing debate about expenses is important. The sooner we can establish a shared framework for comparing plans' and participants' true and total costs, the sooner we can agree on a new regulatory framework and industry standards to match. But we shouldn't let this talk about expenses and transparency distract us from the fundamental objective: to give participants and their beneficiaries a better shot at a decent retirement. Simply put, it's all about outcomes.

We care about expenses because, all else equal, lower expenses will produce better outcomes. We care about transparency because we think more and better information will help sponsors and participants correct the informational asymmetry that continues to plague the 401(k) marketplace. And we care about the 401(k) marketplace because it has profound implications for participants' economic outcomes.

So let's get disclosure right. Let's eliminate unnecessary expenses and shrink the rest. Let's replace the industry's selling machine with a thoroughly fiduciary model. Let's do all those things. But let's also remember that for the vast majority of participants, long-term outcomes are more a function of their investment programs--their original formulation, their ongoing maintenance, their periodic changes--than of the costs they pay to participate in these plans.

As we've noted in this space, a true fiduciary plan features low expenses and good decision-making. Unfortunately, the current model--in which participants (even those in the least expensive plans) are presented with a menu (which is often incomplete) of mutual funds (which are often mediocre) and left to fend for themselves--tends to produce all sorts of dysfunctional behavior and sub-optimal outcomes.*

So above all, let's organize the entire defined-contribution model around the inherently fiduciary concept of improving participants' long-term outcomes. That means modest expenses, full transparency, and easy access to superb, portfolio-centered (as opposed to fund-driven) investment programs.

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* See this post from late 2007, "Real Participants, Real Problems," for our take on The Uncertain 1/n Hedger, The Shameless Performance-Chaser, and other categories of participants behaving badly.