By James Kwak
Now that I’m a law professor, people expect me to write law review articles. There are some problems with the genre—not least its absurd citation formatting system and all the fetishism surrounding it—but it’s not a bad way to make arguments about how and why the law should change in ways that might actually help people.
That was my goal in my first law review article, “Improving Retirement Options for Employees, which recently came out in the University of Pennsylvania Journal of Business Law. The general problem is one I’ve touched on several times: many Americans are woefully underprepared for retirement, in part because of a deeply flawed “system” of employment-based retirement plans that shifts risk onto individuals and brings out the worse of everyone’s behavioral irrationalities. The specific problem I address in the article is the fact that most defined-contribution retirement plans (of which the 401(k) is the most prominent example) are stocked with expensive, actively managed mutual funds that, depending on your viewpoint, either (a) logically cannot beat the market on an expected, risk-adjusted basis or (b) overwhelmingly fail to beat the market on a risk-adjusted basis.
People in all fields often say that some outcome is bad—here, plan participants pay a weighted average of 74 basis points in expenses for their domestic stock funds, not counting the extra transaction costs incurred by actively managed funds—and say that someone should change the law. While law professors sometimes say that the solution is for Congress to pass a new statute, there are other ways of accomplishing an objective. In the paper I use a common device in the profession: I argue that including actively managed funds, in asset classes where everyone knows that index funds are cheaper and likely to do better than most active funds, may already be against the law (depending on how carefully those funds are selected). In particular, it violates the existing fiduciary duty of employers and plan trustees to invest participants’ money prudently.
The argument is moderately involved, and involves statutory and regulatory detours into such things as section 404(c) of ERISA and the corresponding safe harbor implemented by Department of Labor regulations. But the ultimate point is that plan participants should be able to sue their plan fiduciaries for breaching their duties, and courts could already rule in their favor. Since the law is admittedly not entirely clear-cut, I recommend that the Department of Labor should clarify its guidelines under ERISA (which could be done without Congressional action) to make it clear that actively managed funds create potential liability for plan fiduciaries. The likely result is that most plans would shift to index funds in order to avoid liability, investor costs would fall by about 80 percent, and, in aggregate, investors would do slightly better than before even on a gross (before fees) basis.
This change would also solve the problem of plan trustees who also happen to be mutual fund companies stuffing retirement plan investment menus with their own funds—particularly their most poor-performing funds—which is the problem I wrote about in my Atlantic column last week.
I should add that I do understand that there probably are some fund managers who can beat the market on an expected, risk-adjusted basis. I’ve seen the papers, and I’m convinced that there are more people who beat the market than can be explained by dumb luck.* (There are also far more people who trail the market than can be explained by dumb luck.) But the fact is that, in aggregate, the pursuit of “alpha” is value-destroying, whether the search is conducted by individual investors or by trustees of employer-sponsored retirement plans. The government should not be subsidizing a vast operation that wastes ordinary people’s money. Index funds would give Americans retirees more money and asset management companies less money. From a public policy perspective, that’s a good thing.
* I took empirical law and economics with Ian Ayres and John Donohue. In one class, Ian asked if any of us could think of a policy issue on which we had changed our position because of an empirical paper. Most people had trouble thinking of one. That is, if you think that the minimum wage increases unemployment, you will not be convinced otherwise by any number of papers, and vice versa. Whether there are people who can beat the market is one big issue on which I have changed my mind. I used to believe that no one could beat the market, essentially for the reasons outlined by Burton Malkiel in A Random Walk Down Wall Street. Now I think there are people who can beat the market, but they are hard to find and for most people it’s not worth trying.
The Baseline Scenario 
No it’s not, because once you eventually do find it, it was really a just mirage in the distance to strive for. A way for the law in general to “trick it’s own mind”, and not in a good way, then become confused as to where the consequences are coming from.
The book Unconventional Success, by David Swenson, is a valuable resource for people wrestling with these retirement difficulties. The book corroborates Mr. Kwak’s arguement.
And there’s a company, Unconventional Investor, that applies Mr Swensen’s principles at a very fair (about 0.25%) fee structure.
I agree that there are people who can beat the market, but are there people who can CONSISTENTLY beat the market? I read some study on this topic (will try to locate it) that said over a decent horizon, there were maybe 3 investors/firms that did accomplish the feat of achieving alpha. I’d appreciate it if James/Simon could bring this up with data/studies – it’s an important topic that does not get the requisite attention (coupled with the EMH and its critically flawed assumption of investors being rational). If managers are unable to consistently beat the market, then luck/randomness would be the critical factor versus ability.
Another problem might be in the risk-adjusted alpha; are the currently utilized risk measures up to the task? I doubt it.
In fairness, there’s a dynamic tension between actively and passively-managed portfolios, leading to the Grossman-Stiglitz Paradox. Mr. Kwak’s suggestion makes all kinds of sense, but the element of information asymmetry is hard to resolve. A broader selection of active and passive funds, together with more education about asset allocation, may be a better way to address these issues.
The area where the fiduciary duty is really breached is that the default funds, if you choose to not actively set it up, are always actively managed. This always seems to be the choice of the company managing the 401k, who happens to also manage the mutual funds with high costs.
If anything, I would think that default funds should be index or passively managed funds of some kind. Then, if the employee chooses an actively managed fund they are doing so by their own choice and no fiduciary responsibility is breached.
Just my two cents!
There are two major problems with the studies purporting to show no evidence of skill:
1) Skill is defined away by including value, momentum and size as “risk factors”. Benjamin Graham and his disciples identified and exploited value ex ante. Analogously, George Soros identified and exploited momentum ex ante. If you believe value and momentum are truly “risks”, then, yes, they were simply clever repackagers of some mysterious risks that no one else identified until decades later.
2) Most studies focus on U.S. equity mutual funds. There are severe agency costs that make any alpha generation very hard. Investors fire mutual fund managers who lag their benchmarks significantly, a strong incentive to closet index, which effectively turns most mutual funds small long-short hedge funds grafted onto big index funds–no wonder so few managers outperform their benchmarks after fees. (Cremers and Petajisto found that “active share” of mutual funds has declined over time.) Mutual funds also don’t pay their managers performance-based fees, either, discouraging truly skilled managers from running them. Warren Buffett would have either quit or been fired were he to run a mutual fund.
Interestingly, the literature on skill doesn’t delve much into fixed income. The few studies I’ve seen actually suggest bond fund outperformance is highly persistent.
As somebody who helps companies implement 401K’s, here’s the economic reality you are not considering. There is no law that says a company has to offer a 401K plan – and in the economic environment in which we find ourselves doesn’t give the employee a great deal of power to demand one. Yes, big companies and multinationals who need to attract great talent may have to provide a plan – but the majority of employers are small to medium sized businesses and they typically only have one or two really key employees who can be compensated in other ways. (non-qualified deferred compensation etc.)
The use of plans with managed funds, or with higher fees allows the management to pass on the costs of operating the plans to the plan participants. Otherwise those same employers would be paying thousands, in some cases, tens of thousands of dollars a year to administer the plans. As it stands the administrators are typically the insurance company or mutual fund firm that also offers the funds, and without those fund expenses there would be little incentive for them to administer the plan for a couple hundred dollars a year. Couple this with the audit cost of plans with over $1 million in plan assets – those costs very often run in excess of $10,000 as it stands – then of course there is the 5500 filing which is typically another $1,500-$2,500 out of the companies pocket – unless that money is coming from somewhere else, the accounts of the plan participants most likely.
Now you mention that an employee sponsored defined contribution plan is a poor way to run a countries retirement system, and I agree. But that is the system we have and it’s better for someone to be putting away money and getting a company match of 3-4% of salary and having to pay a 1% management fee then to have no plan whatsoever. And that’s exactly what will happen if you start to mandate lower cost fees and start suing plan sponsors for violating fiduciary responsibility – you will simply have most employers just stop offering plans.
“….start suing plan sponsors for violating fiduciary responsibility….”
If they violated fiduciary responsibility than the retirement plan doesn’t exist because there is no money in it because it all went to administrative costs. That’s a good reason to sue. Grand larceny.
Or you could do like my ex employer does (i retired) they charge $44/year for each participant, and then use Vanguards low cost funds. that makes the needed costs more clear. Of course if legal website only access will cut costs also.
When the market is going up, these “fee, passive management” vigilantes come out of the woodwork. When the market goes down or is stuck in a trading range, they disappear.
The reality is that a well diversified portfolio will include active and passive styles.
The stupidity of books and articles like this is that the author assumes a zero sum game….one investment strategy is ALWAYS right and the other is ALWAYS wrong. Nothing works like that.
Here’s something to “invest” in:
http://www.huffingtonpost.com/2013/02/23/obamas-brain-activity-map_n_2747159.html
And Obama can show leadership by being the first test subject since everyone is curious about what happens to a President’s brain activity once they are in the White House – maybe toxic mold or lead paint still around in that old dump?
They never do what they said they were going to do so I think having any and all of the Prez’s brains wired to watch for where the neurons misfire is critically important to “homeland security”.
employment based heath insurance and employment based pension plans
two government created and protected economic environments in which people are “captive” sources of continuous fees for finance operators
who do these laws benefit the most? employers?, insurance/finance operators? captive employees?
Never understood why employers have to be in control of investment choices, or be burdened with the administration of them. Why not just increase what people can contribute to their traditional IRAs, and let employers make contributions to those?
respectfully, there is another, big, emerging problem: Employers and Plan sponsers are realizing that by colluding in various ways, the plan can be turned into a profit center for the employer.
(with a wink and a nod, there are many ways this can be done)
My prediction, ten years from now, the big exspose is how large companies are actually making money of their workers 401Ks
re absurd citation formatting
I didn’t read all of the many comments, but it looked like no one touched on the two biggies – legal size paper (wtf ?) and inline citations (double wtf???)
removing those two would help ordinary people a lot;
but, the argumetns about normal people not being able to read abbreviated citations is bogus, and part of hte information fallacy: giving people more information doesn’t help, cause we don’t have enough bandwidth to process it; most normal people don’t have enough time to rad legal papers , even if the abbr were fixed
When a player looses, he looses the chance to replay the game. His money is gone and he is out of the game forever. By contrast, when a player wins he simultaneously wins enough to play another game. Each game makes his winnings larger. Thus winners win large, but losers lose small. Thus for each big winner there are a million small losers.
But how does a winner do it? With insider information. Look! The investment game is the most carefully studied game in history. With so many experts competing the profit margin has been whittled down to a nubbin. Only insiders can manipulate prices, manipulate price-perception, then trade on privileged information available only to those on several corporate boards. Only senators have immunity to cover insider trading. Is there a better way?
The Abé way? Promise inflation but deliver disinflation? With deflation the yen in your pocket buys more each year even though you own no securities, hire no investment advisers, and pay no commissions. The saver makes an investment by doing nothing, makes an investment through the
magic of deflation! Got deflation?
Get it
!
Semi-offtopic, apologies to the hosts
I think we have a few Brooksley Born fans and well-wishers here. Neil Barofsky was kind enough to provide this link on his twitter feed and I thought I would pass it along to the “above the crowd” regulars at BaselineScenario (Enjoy!!):
http://www.ustream.tv/recorded/30825643
Welcome back, and thanks.
Oh man…. And people claim creativity is dying in this world: https://twitter.com/W7VOA/status/319994539752431617/photo/1
OMG, I think I am going to be dying with laughter months later when I think of this. I just want to know if the bastard is drunk in this shot:
For anyone who had ANY DOUBTS that former FINRA cocksuckah Mary Schapiro is a complete, absolute, undiluted piece of crap, here is the news any of us could have written the headline for over 3 years ago:
http://www.washingtonpost.com/business/former-sec-chairman-mary-schapiro-joins-promontory-financial-group/2013/04/02/4d32d89a-9b8d-11e2-9219-51eb8387e8f1_story.html
http://rt.com/shows/the-truthseeker/us-aconomy-exposed-offshore-380/
What Shapiro has done won’t be forgotten. No one rises above anarchy.
http://www.nbcnews.com/id/49263362#51434035
The banks and financial health of USA economy would be “threatened” if TBTF banks can’t protect drug cartel $$$$.
First fraudclosure homes to be sold…? The homes that used to be meth labs….
For once, I don’t think “The Who” song calls it right, “…meet the new boss, same as the old boss…”
Savagery. Was that part of the plan when you knew that there would be no swords coming back home to be beat back into ploughshares?
Republicans keep telling us that if Keystone Pipeline is allowed to go from Canada through multiple Midwestern States and small towns that it will save us at the gas pump. Of course, none of these pipelines EVER makes enough change in supply to change your price at the pump. It is another of many lies Republicans tell which could only be swallowed by illiterate Teabaggers.
But wait….. maybe you can save the trip to your gas station and just grab a bucket/pail and scoop it up from your yard when the oil seeps all over your community and dump the raw oil into the fill spout of your car:
Why didn’t I think of this before??? Of course you know the oil companies will pay for any and all damage to your home, community, children, and water supplies. This and saving the trip to the gas station with your own frontyard oil reservoir. Why didn’t those government loving Democrats think of these benevolent benefits Exxon, BP, and other Oil conglomerates are willing to rain down on your family???
Doesn’t look good for somebody!
Just be glad you don’t live in Japan.
http://uk.reuters.com/article/2013/04/09/uk-tepco-water-leak-idUKBRE93802X20130409
Prof. Kwak, which empirical paper persuaded you there are people who can beat the market?
off topic. sorry
I have made many criticisms of Bernanke in the past. My main complaint being he didn’t push the regulatory functions of the Fed more on TBTFbanks, not doing more to prohibit fees, and not speaking out more on illegal foreclosures. But actually I think if we could search out Bernanke’s heart, he is actually a pretty decent human being. I think he genuinely cares and this can’t be said of all those who have been members of the FOMC, much less the Chair.
One thing is for sure, no Chair before Bernanke has made the institution of the Fed more transparent, see here:
http://www.federalreserve.gov/monetarypolicy/fomcminutes20130320.htm (this was released early due to “error”). And for being more transparent with FOMC minutes Bernanke has gotten no “thank you”, but in fact more criticism.
There is only one other person I can get semi-enthusiastic about as replacement for Bernanke, and the odds of him getting the job are between 5% to ZERO.
http://www.globes.co.il/serveen/globes/docview.asp?did=1000833166
There is a large problem with your proposal from a finance perspective. Index funds are difficult to beat through active management because they are largely efficient, but if everyone is in indexed funds they will lose their efficiency and become horrible investments. This is not a theory, it would happen by definition as any understanding of how index funds actually operate clearly shows. I wonder if I am wasting my time with this post as I am nowhere near the first to point this out…and yet we still have the misconception.
How can I get in touch with “mharvey72”? Can you give him my email address and ask him to contact me? He has articulated a very important point. Many–not all–small business owners will sponsor plans only if they’re told it will cost them nothing to do so… the costs are inevitably shifted to the participant and buried in the fund fees. It’s an old story: privatize the profit and socialize the cost.
kerry.pechter@retirementincomejournal.com
Our old friend Miss Warren is doing what all these congressman should be doing, if they weren’t too busy stuffing American Bankers Association and TBTFbanks dollars in their panties. I guess Republicans like Alabama Senator Dick Shelby and Tennessee Senator Bob Corker need something to absorb the cream they get in their silk panties every time Jamie Dimon speaks.
http://money.cnn.com/2013/04/11/news/economy/warren-foreclosure-hearing/index.html?iid=HP_River
The main incentive for the “choice” of retirement funds is the kickback received by the chooser. That is why the funds are somehow mysteriously worse than average. Payoffs and bad funds to suck up worker money.
Incentives are to the criminal investment industry to take the workers money, no one is watching or they are actively not watching.