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Open Letter to All Retirement Plan Trustees
Dear Trustee, I feel your pain. Like you, I am a retirement plan trustee. This is a difficult time for us. Many trustees are being sued over breach of fiduciary duty; Congress is examining 401(k) expenses; and the stock market is volatile. What is a retirement plan trustee to do? There are approximately $3 trillion dollars in 401(k) plans, and hundreds of billions more in defined benefit plans. All plans have two key objectives: 1. Deliver excellent benefits to participants (at an acceptable cost); and 2. Reduce liability to plan trustees. Unfortunately, most plans (probably including your plan) have excessive costs, vastly underperform the market, and impose unnecessary liability on trustees. Hidden fees can reduce your plan assets by 50% or more! This article will explain why and how. Whether your plan has a $100 million balance or is a small company 401(k), all plans and trustees can benefit from understanding — and then avoiding — these 7 Deadly Sins. I invite you to meet with a Tribeca advisor to learn more about the hidden fees and performance in your 401(k) or defined benefit plan. Sincerely, Karl N. Huish, Esq., CFPŽ President & CEO Tribeca Advisors, LLC
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7 Deadly Sins of Retirement Investments
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Sin 1: Trusting Wall Street over Markets
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f the 20,000 existing mutual funds, which should you use in your retirement plan? Our advice: none of them. Instead of funds, what should you use? Fully diversified, low-cost investment portfolios.
Before we can explore that answer, we need to understand that most mutual funds are “active” funds. Active funds attempt to outperform the stock market rate of return (which is the rate you would receive from an index fund). Active funds frequently buy and sell stocks, and engage in market timing — guessing when to be in and out of the market. Active funds charge high annual fees, and incur heavy trading costs. On the other hand, a structured portfolio of index funds will invest in all stocks in the market, with the assumption that the prices in the market are efficient, and the extra costs of active funds aren’t worth it. So, can active funds beat the stock market return? There have been hundreds and hundreds of studies on this issue, all reaching the same conclusion: The vast majority of active mutual funds actually far underperform the stock market and bond market.
Active Mutual Fund Performance Compared to Market Indices 32 Years (1975 – 2006)
rmeedd uttppeerrffoorm O % 6 . 0 % Ou arket 0.6 theaM rket the M
99.4% 99.4% Underperformed Underperformed the theMarket Market In a rigorous, comprehensive study covering 1975-2006, only 0.6% of all active funds outperformed the stock market indices. That’s only 1 in 160.
Wall Street firms rely heavily on pricey active mutual funds to generate revenue, so be prepared for lots of nervous explanations if you bring up this study with your current retirement plan provider. These empirical questions are decided by data, not slick marketing brochures. And the data — all the data — shows that very few active mutual funds will beat the market.
In a published 2008 research study2 — perhaps the most comprehensive ever Say it five times slowly: Wall performed — Professors Laurent Barras, Street funds don’t beat the marJuly 13, 2008 Olivier Scaillet, and Russ Wermers used ket. Well, a tiny percentage of advanced statistical tests from compuactive funds may outperform “Index funds are the only tational biology and astronomy to drill the market, but very few will do rational alternative for almost down into the performance of active so with any consistency (0.6% all mutual fund investers...” mutual funds. They looked at fund perin the comprehensive 32-year formance over a 32-year period, from study). 1975-2006. The researchers found that after expenses, only 0.6% of active mutual funds outperFor most of your employees, their 401(k) plan will be the formed the market. Let’s repeat that: only 0.6% of all aclargest source of retirement income. You should use structive funds beat the market. This extremely low number (less tured portfolios that have the best opportunity for solid rethan one fund in 160) “can’t eliminate the possibility that the turns, and not hope that your employees can pick the “one few [funds] that did were merely false positives” – just lucky, in a hundred” mutual fund that will actually outperform the in other words, according to Professor Wermers.3 market. Page 2
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7 Deadly Sins of Retirement Investments A d v i s o r s, L l c
They Said It Richest Man in the World: “Most investors, both institutional and individual, will find that the best way to own common stocks is through an index fund that charges minimal fees.” Warren Buffet, as quoted in 1996 letter to Berkshire Hathaway shareholders (substance of quote has been repeated at least 6 times by Mr. Buffet since 1996)
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Nobel Laureate in Economics: Q:
So investors shouldn’t delude themselves about beating the market? They’re just not going to do it. It’s just not going to happen.”
A:
Question posed to Daniel Kahneman, Nobel Laureate in Economics, 2002
g
Greatest Current Institutional Investor: “When you look at the results… over reasonably long periods of time, there’s almost no chance that you end up beating an index fund….The odds ….are 100 to 1.” David Swenson, Yale Endowment Fund Manager (as quoted in: NPR, “Yale Money Whiz Shares Tips on Growing a Nest Egg” (Swenson has the #1 performance track record for all endowment funds over the past 20 years.)
Fiduciary, n. A duty to act for someone else’s benefit, while subordinating one’s personal interests to that of the other person. The highest standard of duty implied by law. - Black’s Law Dictionary
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Sin 2: Fiduciary Liability
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etirement plans are governed by federal law known as ERISA. Under ERISA, retirement plan trustees have personal liability for breaches of fiduciary duty. Yes, this means that you can be sued individually. On February 20, 2008 the Supreme Court ruled unanimously in LaRue v. DeWolff that plan participants can sue plan administrators for breaching their fiduciary duties. As a fiduciary, trustees are required to make decisions that are in the best interests of the plan participants, and are required to follow the Prudent Investor Act (1992).4 What may surprise most trustees is what the Act and its accompanying notes actually state5: “Fiduciaries and investors are confronted with evidence that efforts to ‘beat the market’ ordinarily promise little or no payoff, or even a negative payoff after expenses.” g Regarding active funds: “There will be new expenses of investigation and analysis, increases in general transaction costs, and additional risks such as may result from the judgment calls …They must then be taken into account, both in deciding whether to undertake an active investment strategy and in implementing that strategy.” g “The greater a trustee’s departure from one of the valid passive strategies, the greater is likely to be the burden of justification and also of continuous monitoring.” To sum it up, your burden as trustee is higher if your plan uses active mutual funds. You have the burden to show that you appropriately considered the additional costs of active mutual funds when you placed those in the plan, and that those costs were reasonable for you to impose upon the employees. (After all, the employees ultimately bear the costs of overpriced mutual funds.)
7 Deadly Sins of Retirement Investments A d v i s o r s, L l c
Attorneys will sue where they smell money, and so you will not be surprised to learn that attorneys sense a payday with 401(k) plans. Trustees for most of the largest 401(k) plans in the country have been sued in recent years, for breach of fiduciary duty. By one count there are over 300 current lawsuits and many more are planned. Wal-Mart, the nation’s largest employer, was sued in April 2008. In this suit, the plaintiffs argued that Wal-Mart’s 401(k) plan did not provide index funds or similar low-priced funds, but instead had only high-priced options, costing the employees millions of dollars.
Liability
Your burden as trustee is higher if your plan uses active mutual funds. You have the burden to show that you appropriately considered the additional costs.
So, what can you do as trustee? These three things will significantly, if not completely, eliminate any potential liability you may have as a fiduciary:
3 Keys to Eliminate Fiduciary Liability Risk 1. Use pre-mixed portfolios of low-cost funds. 2. Do not have company stock in the plan (See Enron). 3. Use a Registered Investment Advisor or other cre-
dentialed advisor who can legally render investment advice.
Brokers cannot legally give investment advice, so in plans such as those sponsored by insurance companies, the advice role falls back to the plan trustees, which increases your personal liability. By using a Registered Investment Advisor (RIA) to design and manage diversified portfolios for employees, the RIA becomes an investment fiduciary for those plans. So not only have you significantly reduced your fiduciary liability risk, but you have shifted it to those rendering the investment advice. Doesn’t that sound better?
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Sin 3: Paralyzed Participants
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ost retirement plans provide far too many investment choices for employees. Studies have shown that to increase participation the plan should actually decrease the investment choices.6 The very structure of most plans (dozens of mutual fund choices) leads to four problems:
1. Lack of participation by employees. 2. Contribution restrictions for key employees/owners. 3. Wasted time on the job by participants trying to figure out what to do.
4. Underperformance. You can overcome these problems by reducing your choices to a few complete investment portfolios (we use just six). A portfolio is a carefully constructed group of mutual funds, built to reduce investment risk through proper diversification. The employee spends only two minutes to select his portfolio, and reviews that choice every couple of years. Benefits: Participation rates will increase (leading to fewer or no restrictions for upper management). Wasted time on the job will decrease. And best of all, employees will have a low-cost, fully diversified portfolio of 10,000+ securities, in over 40 countries, in all market asset classes. Noted fiduciaries Jeffrey C. Chang, W. Scott Simon and Gary K. Allen have endorsed this approach: “Yet few 401(k) plans offer portfolios as investment options. Instead, they offer mutual funds or individual stocks. Such options can be likened to the parts that make up a car. The participants are asked, in effect, to assemble all the parts (i.e., stand-alone investment options) on their own in order to manufacture a car (i.e., a portfolio). With a model portfolio, the parts are already assembled for the participants; all he or she needs to do is select the appropriate car from the menu of five or six investment options that comprise the cars sitting on a showroom floor. There is simply no better way to diversify the risk of a portfolio.” 7
7 Deadly Sins of Retirement Investments A d v i s o r s, L l c
Sin 4: Investment Posse
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he story of boxer Mike Tyson is both tragic and fascinating. Tyson earned about $400 million in his career, yet was $27 million in debt when he filed bankruptcy. Tyson had many personal issues, but his financial disasters have at their root, his posse. This group of handlers, managers, trainers, friends and “hangers-on” systematically looted Tyson and separated him from his money. Likewise, many retirement plans have hidden fees and expenses which silently rob your plan, and siphon that money to Wall Street. To understand how this happens we need to review the total cost of a typical retirement plan:
Case Study: Jerry Schneider Jerry was told by his employer, Elcon Associates Inc. that its total 401(k) fees were only 0.10%. After 12 years of questioning, Jerry finally learned from an independent pension expert that he pays at least seven other charges for his John Hancock Financial Services plan, including:
Disclosed Fees: Mutual fund providers: John Hancock Administration: John Hancock Advisory Fee: Commissions to traders:
0.10% 0.50% 1.32% 0.75% 0.76%
Hidden Fee?
P P P P
Jerry’s Total Fees: Over 3.5%
What are your plan’s total fees? Source: Darrell Preston, Bloomberg Markets March 2008
What is the TOTAL Cost of Your Retirement Plan? Hidden Fee? Typical 401k Plan Mutual Fund Fee Trading Charges (SAI)
Advisor Fee
Tribeca
1.62%8
0.35%
1.47%9
0.07%
Varies, often 1.00%
0.75% or less
Varies
ZERO
Varies
0.28% or less
Often 0.5 - 2.0%
ZERO
Record Keeper; Custodian; TPA
Varies
0.35% or less
Total
3-6%
1.50% or less10
Commissions/ Loads Portfolio Mgmt Insurance Wrapper
Once you look at all fees—including those that are typically “hidden” to the plan trustees, the difference between a typical plan and a Tribeca plan becomes staggering, often 1.5% - 3% per year. For those without a financial background, this difference may not seem like much. It is more significant than you think.
Hidden fees of just 1% can reduce a workers’ 401(k) total by 25%. Hidden fees of 2% can reduce the total by over 50%!
A description of the most common type of 401(k) fees can be found in Addendum 2.
With six portfolios, employees have a full range of globally diversified investment porfolios, making retirement investing a cinch.
Equity Aggressive 100/0 Page 5
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Balanced Portfolio 60/40
Moderate Portfolio 40/60
Conservative Portfolio 20/80
Income Portfolio 0/100
7 Deadly Sins of Retirement Investments A d v i s o r s, L l c
What Difference Will 1.5% Make?
From the 2008 Congressional hearings on 401(k) plans: “Two 30-year old workers invest $3,000 annually into their 401(k) programs. Worker #1’s 401(k) program is run according to stringent fiduciary principles and earns 7.5% annually. However, Worker #2’s 401(k) is operated by conflicted, sales driven entities and only earns 6% annually. The table below details the results.”11 Years
Plan #1 - Fiduciary 401(k) Earning 7.5%
Plan #2 – Hidden Fee 401(k) Earning 6%
10
$45,624
$41,915
20
$139,658
$116,978
30
$333,463
$251,405
40
$732,902
$492,143
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$1,244,260
$766,694
Who is going to make up this difference caused by hidden fees? But these excessive fees do something else: they delay retirement. The table below is taken from the April 2008 Congressional Hearings on 401(k) plans. It shows that an excessive fee of 1% will delay retirement by 32 months for the average worker; 2% will cause a 64-month delay — over five years. By having the wrong plan, you can actually be causing your employees to miss out on their best retirement years!
Additional Months Required to work in order to receive the same monthly retirement income 70 60
Additional 64 Months
50 Additional 48 Months
40 30
Additional 32 Months
20 10
Additional 16 Months
0
.5% Excess Fee 1.0% Excess Fee 1.5% Excess Fee 2.0% Excess Fee Page 6
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Sin 5: Paltry Performance
t doesn’t matter which asset class you look at (small stocks, large stocks, domestic stocks, foreign stocks, real estate stocks, bonds, etc.), when you look at the data over typical investment periods (at least five years), index funds outperform the majority of all active funds. As the previously mentioned study shows, only 0.6% of active funds beat the market averages. That is statistically indistinguishable from zero. Unfortunately, retirement investors who pick their own funds far underperform the market averages. Dalbar’s 20-year study12 of performance (see accompanying graph) shows that allowing employees to choose their own funds is a recipe for retirement disaster. Employees are far better off with professionally built portfolios, which provide discipline and diversification.
Average Investors vs. S&P 500 ( 1987 - 2006)
Average Annual Returns S&P 500 Index
Average Equity Fund Investor
Can you improve upon simple index funds and ETFs for your retirement plan? It turns out that you can. Using 80 years of research data, Professors Gene Fama and Ken French have developed the Fama-French Three-Factor Model of investing. This model explains 95% of all stock market returns, and is the basis for the mutual funds provided by Dimensional Funds Advisors (DFA), the #1 rated institutional mutual fund company. Tribeca uses DFA funds to develop state-ofthe-art portfolios for retirement plans. Please contact your Tribeca advisor for information about DFA.
Question: Who is #1? Answer: DFA has been the top-rated
mutual fund company all four times that Dalbar Research has performed its survey of independent investment advisors.13
7 Deadly Sins of Retirement Investments A d v i s o r s, L l c
“Diversification is your buddy” Merton Miller Nobel Laureate in Economics
Another way to improve retirement plan performance is through global diversification. Most active mutual funds consider 50 or 100 stocks sufficient “diversification.” However, with each Tribeca portfolio, the plan participant invests in over 10,000 securities, in over 40 countries, and 15 separate asset classes. All of these different securities and asset classes may help plan participants avoid large losses during stock market drops. “If we could choose only one family of funds for the ideal 401(k) plan, it would be Dimensional Fund Advisors. We believe DFA’s institutional funds are the best, and employees whose plans include them are fortunate.” Paul Merriman
CBS Marketwatch, A world-class menu of 401(k) choices, Jan 16, 2002
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Sin 6: Second-Rate Service ou may have a 401(k) plan that is administered by a brokerage or insurance company. Once the plan was in place, the service stopped. In fact, you aren’t sure if the company is continuing to provide any service at all.
Why? Because your plan involves commissionable products, the broker/agent was interested in your plan only until the commission was earned — right at the start. Once the commission is paid, there is no incentive for additional service. It is axiomatic: how your investment advisor is paid will determine the content and amount of the investment advice provided. To receive service (advice, enrollment, modifications to plan, etc.) you must avoid retirement plans that involve commissions. Instead, opt for a plan that is administered by a Registered Investment Advisor (RIA), who receives an ongoing fee for providing service to the plan. Page 7 |
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Employees don’t need mutual fund choices, they need premixed, globally diversified portfolios, or they will lose the benefits of diversification – lower risk and higher returns. With fully diversified portfolios, retirement investDiversified Portfolio ing is a decision that only needs to be revisited every few years. Life is complicated enough; retirement investing can be simple, when you have the right plan in place.
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Sin 7: Conflicted Advice
he greatest line separating financial professionals is fiduciary obligation. By law, a fiduciary must act solely in the best interest of the client. As such, a fiduciary is obligated to reveal any potential conflict, as well as to fully disclose how they are compensated for their services. Doctors, lawyers, certified public accountants and fee-only Registered Investment Advisors (RIAs) are fiduciaries. Brokers and insurance agents are not fiduciaries. In April 2005, the SEC required brokers to include the following to indicate an absence of fiduciary obligation: “Your account is a brokerage account and not an advisory account. Our interests may not always be the same as yours. Please ask us questions to make sure you understand your rights and our obligations to you, including the extent of our obligations to disclose conflicts of interest and to act in your best interests. We are paid both by you and, sometimes, by people who compensate us based on what you buy.” If you see this disclaimer, you should ask questions, request complete disclosures, and really wonder if this firm seeks to advance your best interests. After all, that’s why you hire a financial advisor in the first place, isn’t it? If your retirement plan is administered by an insurance company, do you know how the funds in your plan are chosen? For many plan administrators, the mutual fund companies pay a fee to the administrator for those funds to be included in the plan. For example: American Funds will pay Principal Group a fee (a percentage of the annual mutual fund fee) so that its funds are in your retirement plan.
7 Deadly Sins of Retirement Investments A d v i s o r s, L l c
Transparency Matters
These “pay to play” arrangements have come under scrutiny, and are part of the onslaught of 401(k) litigation. As a fiduciary, you are responsible for knowing how the funds in your plan were chosen. For thousands of plans in existence today, the funds were chosen not based on objective and independent research, but because those fund companies were willing to pay a kickback to the fund administrator (typically an insurance company) to be included. Sound like a conflict of interest? It is.
Required Broker Disclosure: “Our interests may not always be the same as yours.” Is this who you want managing your retirement plan?
endorsed by
matthew d. hutcheson
On the other hand, when your plan is administered by a RIA, you can be assured that you are receiving independent advice, free from conflict. RIAs are regulated by the state and the SEC, and all fees and expenses are transparent to the plan.
Tribeca’s 401(k) plans have received the endorsement of Matthew D. Hutcheson, Independent Plan Fiduciary. Mr. Hutcheson recently testified before Congress regarding hidden fees in 401(k) plans.
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Edward Jones recently paid $75 million to settle charges related to its “pay to play” arrangements with preferred mutual funds. The mutual fund companies paid a kickback to Edward Jones to include their funds in its retirement plans.
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Making the Change
Chinese proverb says, “The best time to plant a tree was 20 years ago; the second best time is today.” 401(k) and other retirement plans can be changed — you aren’t stuck with bad choices or excessive fees. And making the change isn’t difficult. With a Tribeca advisor, each of these 7 Deadly Sins of your retirement plan can be avoided. If you have an existing plan, it can be changed, usually within 90 days. If you are contemplating a plan startup, you can do it the right way from the beginning. Let’s be clear about the stakes: Excess fees over time can erode 50% of your retirement savings! This is no small matter. As a trustee, you are responsible to act in the best interests of your employees. They deserve an effective plan, without excess costs. We end where we began: the two objectives of retirement plans are to (1) give excellent benefits to the participants, and (2) reduce the fiduciary liability of the trustees. With the assistance of your independent Tribeca advisor, you now can do just that.
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Addendum 2 Fee
Description
Mutual Fund Fee
Annual fee paid to the mutual fund company for operating the fund.
Advisor Fee
Fee paid to the investment advisor for managing the retirement plan, giving investment advice, and working with participants.
Trading Costs
Fees paid to Wall Street brokerage firms for the trading by the mutual funds, including the trading commissions and the “bid-ask” spread. These fees are high for most active funds, and quite low for passive funds.
Group Annuity
With plans administered by insurance companies, the mutual funds are often “wrapped” in a group annuity. This allows the insurance company to distribute their plans through insurance agents (who legally cannot render investment advice and typically aren’t qualified to do so), but adds another layer of cost – hidden of course
Portfolio Advisor
For plans with fully diversified investment portfolios (and not simply mutual funds), there is a cost for this portfolio administration.
Record Keeper; Custodian
The record-keeper tracks the participants in the plan, and their investment balances. The custodian actually “holds” the investments. In some plans, the record-keeper and custodian are the same company.
TPA (Third Party Administrator)
The TPA is an actuarial firm that ensures compliance of the plan with ERISA rules, and determines how much each participant can invest in the plan
End Notes: 1. 2
3. 4. 5. 6. 7.
8. 9. 10. 11. 12. 13.
Address to the National Italian-American Foundation, By Chairman Christopher Cox, New York City, May 31, 2007, www.sec.gov/news/speech/2007/ spch053109cc.htm Barras, Laurent, Scaillet ,Wermers, and Russ, “False Discoveries in Mutual Fund Performance: Measuring Luck in Estimated Alphas” (May 2008). Robert H. Smith School Research Paper No. RHS 06-043 Available at SSRN: http://ssrn.com/abstract=869748 Mark Hulbert, “The Prescient Are Few,” The New York Times (July 13, 2008) As of May 2004, 44 states and the District of Columbia passed the Uniform Prudent Investor Act. The six other states have similar standards. All quotations taken from the notes to the comments from Rule 227 of the Act. Study conducted by Sheena Iyengar, Columbia Business School, as reported in the New York Times, August 31, 2003. Jeffry C. Chang, W. Scott Simon, and Gary K. Allen, “A step Beyond ERISA Section 404(c): Improving on the Participant-Directed 401(k) Investment Model”, Journal of Pension Benefits, Summer 2005, Volume 12 Number 4.5-12 Kasten, Gregory W., “High transaction costs from portfolio turnover negatively affect 401(k) participants and increase plan sponsor fiduciary liability, The Journal of Pension Benefits, 2008. Ibid. This represents the total fees on an average Tribeca 401(k) plan. Smaller plans may have higher fees while larger plans may have lower fees. Witten testimony of Matthew D. Hutcheson, Independent Pension Fidciary, presented to the Committee on Education and Labor, U.S. House of Representatives, March 6, 2007. DALBAR study. Quantitative Analysis of Investor Behavior (QAIB), 12/2006. DALBAR Research Inc.
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Past performance is not a guarantee of future results. Investment return and principal value will fluctuate, and it is possible to lose money by investing. The studies quoted and information used herein are believed to be reliable, but accuracy and completeness cannot be guaranteed. It is for informational purposes only. Data and charts are copyright of their respective owners and reproduced here as supportive research data. Quotes are for illustrative purposes only, and do not imply any endorsements. The Tribeca Advisors investment strategy is based on the principles of the Modern Portfolio Theory and the Fama/French Model for equity investments. Tribeca portfolios are designed to provide substantial global diversification (over 10,000 companies) in order to reduce investment concentration and the resulting increased risk caused by the volatility of individual companies, indexes, or asset classes. Statements in this brochure are the opinions of Tribeca Advisors, LLC and do not imply any guarantee of success or represent conclusions by any government agency or other regulatory body. Tribeca Advisors, LLC is a Registered Investment Advisory firm, with registered investment advisors, including independent advisors. As with any investment strategy, there is a potential for profit as well as the possibility of loss. Tribeca does not guarantee any minimum level of investment performance or the success of any investment strategy. All investments involve risk (the amount of which may vary significantly) and investment recommendations will not always be profitable. This is not a solicitation or an offer to sell securities or investment advisory services except where applicable, in states where Tribeca is registered, or where an exemption for such registration exists.