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.