Bad Advice

By James Kwak

I’m starting teaching at the UConn law school this fall, so I got a folder of information in the mail about my retirement plan. UConn professors have a choice between a defined benefit plan (SERS, in which I would be a Tier III member) and a defined contribution plan called the Alternate Retirement Program, or ARP. (There’s also a Hybrid Plan that seems to be the defined benefit plan plus a cash-out option at retirement.)

I chose the Alternate Retirement Program for reasons that are complicated (I used a spreadsheet) and that I may get into another time. The main benefit of defined benefit plans is that they do a pretty good job of protecting you from investment risk and inflation risk, since the state bears most of it. The main downside is that if you will work either for a short time or a very long time at your employer, they have a lower expected value, even given conservative return assumptions. The other downside is counterparty risk.

Anyway, the ARP is a pretty good plan. The administrative costs are a flat 10 basis points.  It includes a reasonable number of index funds (although there are also actively-managed funds—more on that later). And the plan had the sense to ask for institutional share classes with low fees. For example, the S&P 500 index fund is the Vanguard Institutional Index Fund – Institutional Plus Shares, which has an expense ratio of 2 basis points. Adding the 10 bp of administrative fees, that’s still only 12 bp.* (Contrast this with Wal-Mart, for example, which, despite being the largest private-sector employer in the country, stuck its employees with retail fees in its 401(k) plan.)

But despite that, the plan then goes and encourages people to put money into expensive, actively-managed funds. I got a brochure subtitled “A Guide to Helping You Choose an Investment Portfolio” that was almost certainly written by ING, the plan administrator. It has the usual stuff about the importance of asset allocation and your tolerance for risk, and then provides “model portfolios” for various investor types.

These model portfolios are overwhelmingly composed of actively-managed funds. For example, for an aggressive investor, it recommends 22 percent in “small/mid/specialty” investments. These are split between the JPMorgan Mid Cap Value Fund (expense ratio: 76 bp), the Vanguard Explorer Fund (34 bp), and the DFA Real Estate Securities Portfolio (22 bp)—with nothing in the Vanguard Mid-Cap Index Fund (10 bp) or the Vanguard REIT Index Fund (8 bp).

I should pause here and remind you that, when it comes to domestic equities, actively managed funds are a great way to throw away your money: over almost any time period, the large majority of active funds underperform their relevant indices (even leaving aside the fact that most active funds also take on more risk). So why are ING and the State of Connecticut recommending that people put their retirement savings into them? The most likely explanation is that ING gets higher kickbacks from JPMorgan than it does from Vanguard. (Payments from fund companies to plan administrators who direct money into their funds are legal, or at least they were the last time I checked).

This is a big reason why I’m skeptical that better financial education and advice are the solution to our country’s retirement savings problems. The education and advice come overwhelmingly from the asset management industry itself. And they have no incentive to give you good advice.

* That still seems high to me, since I can get an S&P index fund from Vanguard for just 5 bp with an initial investment of just $10,000. And I don’t see why the administrative costs for a group plan should be higher than for individual accounts.

28 thoughts on “Bad Advice

  1. ‘I chose the Alternate Retirement Program for reasons that are complicated (I used a spreadsheet)…’


    ‘The main benefit of defined benefit plans is that they do a pretty good job of protecting you from investment risk and inflation risk, since the state bears most of it. ‘

    Tell that to the retirees in California.

  2. ‘The education and advice come overwhelmingly from the asset management industry itself. And they have no incentive to give you good advice.’

    You teach, why don’t you and your colleagues do a better job?

  3. I chose a defined contribution plan in a similar situation over 20 years ago. At the time, I didn’t want to lock myself into a job that I might not like. Now that I’ve stayed, it looks like a very bad decision – especially if I compare life annunities from the defined contribution assets assuming the low payout rates on offer today with the traditional pension payouts. Hopefully, the payout rates will improve before I need to annuitize. In our plan, you have to annuitize some of your assets to qualify for retirement health benefits. Overall, the defined benefit vs defined contribution choice was much more complicated than I had anticipated 20+ years ago. I’d never contemplated the possibility of extended periods of low interest rates at retirement and how that would impact the accumulations needed to generate an income stream.

    As to the advice to choose actively managed funds – if the market becomes dominated by passive players, pricing can become so distorted that you don’t really have a market. I used to invest retirement accumulations in passive indexes but finally realized that supplying “dumb” money into the equity markets just contributed to the wealth of the “smart” players. Hard to complain about billionaire financiers when we let index funds hand them our money. You don’t do any better with active funds for the reasons you mention. Guess I’m just unwilling to do the work needed to feel comfortable investing in equities or mutual funds. Equities are incredibly weak claims to be funding base-level retirements. Just look at Japan.

  4. I’m curious as to what you think would be helpful regarding the country’s retirement savings problems if education is not effective? It seems the problem you are pointing out has more to do with an education filter – only certain information is meted out to the public and passed off as being “complete” or “expert”.

  5. ‘I used to invest retirement accumulations in passive indexes but finally realized that supplying “dumb” money into the equity markets just contributed to the wealth of the “smart” players. ‘

    Except that most of the ‘smart’ players underperform the broad indexes.

  6. @ James, let’s be real, retirement assets are tricky, and it’s prolly a “crapshoot”, so to speak, as to which is better. It’s hard making a decent return these days with my defined contribution plan, but I’m hoping with the defined benefit plan fully kicking in after months of the administrator tweaking it, etc., I can nearly re-constitute a healthy percentage of my gross annual income from work, anyway. My IRA took a big blow in the meltdown, as this was Fidelity Mutual Fund(s), and I still have yet to re-cover the significant portion of my loss on deposit. Social Security is a godsend, that’s why I won’t be voting for any stinking republicans.

    I have a feeling I was deliberately ripped off with the Fidelity acct, but, alas, proof of these matters is difficult to come by.

    Good luck in retirement everyone, it’s a whole other world.

  7. I participate in a 401(k) plan and recently received some feedback from JPMC about my asset allocation, saving rate and projected long-term 401(k) value. I couldn’t agree more with bad advice with strong evidence to entice people to use (and buy) their services such as a personalized plan. Their analysis was misleading. Unfortunately most people don’t know any better and take the advice as granted. No easy way out of this problem.

  8. ‘…his blog is one of optimism, and good cheer….’

    Right, like that guy who keeps telling us ‘there will be blood’. Or, Annie; now there’s a sunny disposition.

  9. Just $10,000? That is an unattainable investment amount for a vast majority of Americans, James.

  10. ‘401k’s are nothing but a big slow train wreck. The future isn’t going to be pretty.’

    You’d be doing yourself a service by clicking on the link to the finance course I provided above, Robert.

  11. The author is tragically unaware that over the last 30 years members of the Alternate Retirement Program (essentially a 401k) paid over twice the contributions as members of the defined benefit State Employees Retirement System, yet received less than half the benefits–and the ARP cost the State of Connecticut more in employer contributions than SERS. The financial services industry is the main beneficiary of 401k-like schemes like ARP–not retirees or their employers. For more information, go to

  12. Professor Kwak:
    Thanks for your comments. I would like to fill you in on the State of Connecticut Defined Contribution Plans of which ARP is one of three plans with a common investment menu, fee structure, and administration.

    The investment menu is made up of institutionally priced mutual funds, both active and passive, and the Connecticut Stable Value Fund which has a guaranteed minimum credited rate of 3%. ING is the third party administrator but does not manage any of the mutual funds. They are one of three managers of the Stable Value Fund (PIMCO and Prudential are the other two). As the TPA overseeing all three plans they receive a flat 10 basis points to cover administrative costs. ING is not permitted by our contract to receive anything beyond the 10 basis points except the management fee for their portion of the Stable Value Fund and the insurance wrap for the 3% minimum guarantee. All of the registered representatives supporting our plan are salaries and are not permitted to receive commissions from the plans. In other words, they have no financial incentive to steer individuals to any of the mutual funds, including the actively managed funds.

    However, I do agree with your observation that the current asset allocation models utilized by the plans do, in many periods, show heavier weights toward actively managed plans. The models also tend to underweight the stable value fund. I have spoken to ING and Morningstar, the plan’s advisor on portfolio modeling, and we are working on solutions.

    This problem is really a problem that is common throughout the financial services industry with regard to portfolio construction. First, we have done a pretty good job of selecting active fund managers who frequently outperform their benchmarks. The index funds, if they are doing their job, match the benchmarks. This leads to the overweighting of the actively managed funds in the portfolio recommendations that flow from the asset allocation models utilized by Morningstar and ING).

    Second, portfolio modelers don’t quite know how to model guaranteed fixed accounts of insurance companies or managed stable value funds like ours. These funds usually do not report the market value of their underlying assets and this does not fit into the way they build their models. For this reason, we have asked ING to begin reporting in great detail the underlying assets in the Connecticut Stable Value Fund so Morningstar can construct models for us that adequately include the Stable Value Fund.

    We hope to begin reporting results to plan participants in the next several months. Our goal is to develop eight model portfolios made up of the plans’ investments that they can select and have Morningstar oversee for them. I am also engaging the Department of Risk Management at UConn to assist us in this initiative. Stay tuned.

    Thomas Woodruff, Ph.D.
    Healthcare Policy & Benefit Services Division
    Office of the State Comptroller

  13. Save as much as you can as fast as you can, because you’ll need every penny. Social Security is critically important leg in retirement years for the vast majority of retired Americans.

  14. Thanks for that dose of reality, Bond Man. I hope that James Kwak and Simon Johnson will do their utmost to counter the drumbeat against Social Security, the best social program this country has ever had. As a recent book title mentions, it is “The People’s Pension.” And for millions and millions of Americans, it is the ONLY retirement income they will ever have.

  15. ‘…Social Security, the best social program this country has ever had. ‘

    It was for those who got the benefits early, but for those of us who come later, not so much. Even daily newspapers can’t hide from that fact;

    If you retired in 1960, you could expect to get back seven times more in benefits than you paid in Social Security taxes, and more if you were a low-income worker, as long you made it to age 78 for men and 81 for women.

    As recently as 1985, workers at every income level could retire and expect to get more in benefits than they paid in Social Security taxes, though they didn’t do quite as well as their parents and grandparents.
    Not anymore.

    A married couple retiring last year after both spouses earned average lifetime wages paid about $598,000 in Social Security taxes during their careers. They can expect to collect about $556,000 in benefits, if the man lives to 82 and the woman lives to 85, according to a 2011 study by the Urban Institute, a Washington think tank.

  16. That Urban Institute study is a simplistic, fmisleading analysis. The kind of analysis that misrepresents the value of SS and encourages those most likely to benefit from SS to support politicians who are determined to undermine or detroy the program. According to my local paper, the UI study assumes average life spans, average wages and that taxes paid would have earned 2 percent return in addition to inflation. The average lifespan is lower than the average lifespan of someone who is 65 or 67 yo today; they can expect to live a number of years past the average lifespan.

    I started contributing towards SS INSURANCE PREIUMS in 1977. I am 50 yo. What I have been paying for is an insurance annuity payable beginning when I turn 67, which is a more than long enough wait. My contributions to date adjusted for the average 4% annual inflation between 1977 and 2012 amounts to $212.5k. Paying the maxmium $4,485 per year for the next 16 years & assuming 2% inflation will bring my total SS contributions since 1977 to a present value of $375.3k at age 67. The Urban Inst. says a couple earning average wages, well below the maximum SS tax level, will pay $225k more than I will. They say that because the Urban Inst. assumes the SS tax paid would have otherwise been saved and earned 2% ABOVE inflation each and every year. Right.

    My estimated benefits TODAY are $2400/month at age 67. At age 67, a person on average draws SS for 14 years. If I draw for SS benefits for 14 years I break even, but THAT assume no cost of living adjustments to my benefits estimated TODAY ever occur; which obviously will not be the case. Even with that poor assumption, every year after year 15 is bonus.

    IN ADDITION, if I am disabled today SS INSURANCE reinstates $2400 of monthly income TODAY. If I die, my spouse draws $2400 of income at retirement age. How are those features of SS insurance valued in the Urban Inst analysis? They aren’t to answer my own question.

    The idea that anyone would have earned 2% above inflation on what they have contributed to date to SS is a pipedream, and to calculate the present value of contributions from workers with average salaries based on that pipedream is inexcusable. That money for the average wage earning contributor would have been spent, perhaps never even paid to them by employers.

    SS is insurance which provides income over a lengthy old age to insure subsistence income. It works well & this sort of simplistic analysis is what prompts the who stand to benefit most from SS to vote against their own interest & elect politicians hellbent on either dismantling SS or robbing (so called “privatizing”) SS funds for the benefit of their political supporters on Wall St.

  17. I consider myself lucky to work for a private institution that still provides a hybrid (defined-benefit and defined-contribution) pension plan, plus a decent match on 401(k) contributions. How rare is that?

  18. …..The most likely explanation is that ING gets higher kickbacks…

    Hey Kwak, what are you going to teach? Conspiracy Theory? Fiction Writing?

    As i have said many times before, it is very disheartening to see that people like simon and you are actually responsible for educating the youth of this country.

    For example, your post on “When It Pays To Be Wrong” about “the fundamental reasons why big banks are always screwing up” was wrong and misleading on so many levels.

    Your assertion that “This is clear evidence for the too big to manage hypothesis” is comical and insulting to anyone with an iota of intelligence.

    As you are aware, the following are not “big banks”:
    – Madoff
    – MF Global
    – Peregrine Financial
    – Turkish Bank (like HSBC, also money laundering)
    – Glaxo ($3B fine for fraud)
    – Countrywide (who gave us a good part of shabby mortgages)
    – Knight Trading

    Somehow backfill your hypothesis!

    Your incompetence does not surprise me.

  19. The paradigm of these non-bank corporations was learned and assimilated from the conduct of the big banks.

    It takes an incompetent to know an incompetent.

  20. Mr. Sullivan,

    If it is true SS was good “for those who got the benefits early, but for those of us who come later, not so much,” then why aren’t we talking about increasing the benefits rather than cutting them or raising the eligibility age (same thing)?

  21. I’m totally biased, being a retirement consulting actuary, but I would *totally* take a defined benefit retirement plan if one was offered to me. You literally can’t buy that kind of security right now. Or, rather, you can, but at today’s annuity purchase rates, you’re giving all your money to the insurance company.

    Under the status quo, the defined benefit plan will pay the annuity benefit. Under a non-distress termination, the annuity will be covered through an annuity purchase by the employer. In the worst case, you’ll get a portion of your annuity up to the PBGC guaranteed amount. The plan sponsor can offer a lump sum, but they have to offer an annuity as well. None of those options is currently available to me. (These rules mainly pertain to private pensions; I suppose government plans may not be subject to these ruler.)

    James, does your spreadsheet include life contingencies? I’m interested to see how many real people take mortality into account when planning for their retirement income needs. I certainly don’t think the investment banks do.

  22. Greg Taylor: ‘I chose a defined contribution plan in a similar situation over 20 years ago. At the time, I didn’t want to lock myself into a job that I might not like. Now that I’ve stayed, it looks like a very bad decision…’

    Ditto here — only in the great state of Illinois, they’re exempt from paying Social Security. So you get the worst of both worlds: lousy, crummy ultimately worthless 401k (based on your lousy, crummy salary) — plus almost nothing from Social Security.

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