Tag Archives: retirement savings

Why Is Connecticut Giving Its Employees’ Money to the Asset Management Industry?

By James Kwak

In general, the State of Connecticut offers pretty good defined contribution retirement plans to its employees. Most importantly, it offers several low-cost index funds in institutional share classes. For example, you can invest in the Vanguard Institutional Index Fund Institutional Plus Shares, which tracks the S&P 500 for just 2 basis points, or the TIAA-CREF Small-Cap Blend Index Institutional Class, which tracks the Russell 2000 for just 7 basis points. Administrative fees are unbundled, and are only 5 basis points. For no good reason I can discern, however, you can also invest in actively managed stock funds like the JPMorgan Mid Cap Value Fund, which costs 80 basis points.

As I’ve previously said, I have mixed feelings about target date funds. In principle, they do the reallocation and rebalancing for you, so they could be appropriate for people who want to make one choice and then forget about their investments (which, in many ways, is a good strategy). The hitch is that a target date fund is only as good as the funds inside it. Fidelity, for example, puts twenty-five different funds inside one of its target date funds, including thirteen U.S. stock funds, eleven of which appear to be actively managed. This is just a clever way to sneak expensive active management back in through the back door.

The Connecticut retirement plans do have target date funds, but luckily they use Vanguard’s versions, which are made up of index funds and only charge 14–16 bp (as opposed to 77 bp for the Fidelity Freedom 2040 fund) … until now. As of February, the Connecticut defined contribution plans are switching away from Vanguard to something called “GoalMaker,” which takes your money and spreads it out among the various funds offered by the plan—including those expensive, actively managed funds. For example, if you say you have a moderate risk tolerance and want to retire in 2034, it puts your money in fourteen different funds—including six U.S. stock funds, three of which are actively managed.

This is just fake diversification. On one level, it may seem more prudent to have money in both the Vanguard S&P index fund and the Fidelity VIP Contrafund Portfolio (wow, “VIP,” that must be special!). But mutual funds are already diversified—particularly index funds. If you have some reason for thinking that the VIP Contrafund Portfolio will beat the index, then you might choose to invest in it—but, in fact, it’s trailed the S&P 500 over 1, 3, 5, and 10 years.

Most likely, the people who are currently invested in Vanguard target date funds will get shifted into GoalMaker portfolios. They will pay several times as much in fees for basically the same thing, except with a little additional risk due to managers’ attempts to beat the market. It’s hard to see how this makes anyone better off—except the asset managers themselves.

Connecticut Public Retirement Plan Passes, More or Less

By James Kwak

A couple of weeks go I wrote an op-ed about a proposal in Connecticut to create a new tax-preferred retirement plan that would, by default, include almost all workers who don’t currently have access to an employment-based plan (like a 401(k)). That proposal took some major steps forward when it was included in an end-of-session bill that was passed by the Connecticut legislature. As it stands, the bill authorizes a feasibility study and implementation plan for the new retirement option, which must contain a number of features (default enrollment, portability, default annuitization at retirement, a guaranteed return to be specified at the beginning of each year, etc.).

As I said in the op-ed, this is a decent step forward that will increase the amount of retirement saving by low- and middle-income workers, put those savings in a relatively low-cost, low-risk investment option, and spread some of the benefits of the retirement tax break to those workers (although you do have to pay income tax to benefit from the deduction). One of the claims made by the plan’s opponents is that it cannot be managed for less than the 1 percent of assets mandated by the bill, but that seems laughable to me: the State of Connecticut’s current retirement plans for its employees have administrative costs of 10 basis points, plus investment expense ratios as low as 2 basis points (for index funds from Vanguard). This is a slightly different animal, since the idea is to invest in low-risk securities and buy downside insurance, but still it doesn’t follow that you have to pay more than 1 percent for asset management is.

Connecticut is one of several states, most famously California, that are in the process of implementing these public retirement plans to cover people who are left out by the current “system,” which favors people who work for large companies.   They can solve several of the common problems with 401(k) plans: nonexistence (at many employers), low participation rates, investment risk, pre-retirement withdrawals, lump-sum distributions at retirement, to name a few.

But they can’t solve the underlying problem, which is that many people just don’t make enough for saving 3 percent of their salary each year to make much of a difference. A big constraint is that the Connecticut plan was designed to not cost taxpayers any money: administrative fees will come out of plan balances, and the insurance is there to limit the chance that the state will have to bail out the plan in the future. If we really want to protect people against retirement risk, we need to actually spread risk by making either the funding mechanism or the benefit formula progressive, which means we can’t regard the idea of the untouchable individual account as sacrosanct. (See my recent paper for more on this topic.) That’s what Social Security does, and it’s vastly popular. But in today’s political environment of me me me me me, and so we’re stuck with treating symptoms.

Retirement Accounts for Everyone

By James Kwak

The Connecticut legislature is considering a bill that create a publicly administered retirement plan that would be open to anyone who works at a company with more than five employees. Employees would, by default, be enrolled in the plan (at a contribution rate to be determined), but could choose to opt out. The money would be pooled in a trust, but each participant would have an individual account in that trust, and the rate of return on that account would be specified each December for the following year. Upon retirement, the account balance would by default be converted into an inflation-indexed annuity, although participants could request a lump-sum deferral.

The legislative session ends in less than two weeks, and while the bill has passed through committees, I believe it’s not certain whether it will be put to a floor vote. On Friday I wrote on op-ed for The Connecticut Mirror about the bill.

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“Retirement Security in an Aging Society,” or the Lack Thereof

By James Kwak

James Poterba wrote up a very useful overview of the retirement security challenge in a new NBER white paper. (I think it’s not paywalled, but I’m not sure.) He provides overviews of much of the recent research and data on life expectancies, macroeconomic implications of a changing age structure, income and assets of people at or near retirement, and shifts in types of retirement assets.

In the past, I’ve used the Federal Reserve’s Survey of Consumer Finances as my source for data about the inadequacy of many households’ retirement savings. Poterba has a new, perhaps even more stark snapshot:

Screen shot 2014-03-04 at 2.20.32 PM

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The Costs of Bad 401(k) Plans

By James Kwak

Mixed in with blogging about this, that, and the other thing, it’s nice to occasionally write on a topic I actually know something about. 401(k) plans and the law surrounding them were the subject of my first law review article (blog post). They have also been in the crosshairs of Ian Ayres (who simultaneously works on something like nineteen different topics) and Quinn Curtis, who have written two papers based on their empirical analysis of 401(k) plan investment choices. The first, which I discussed here, analyzed the losses that 401(k) plans—or, rather, their administrators and managers—impose on plan participants by inflicting high-cost mutual funds on them. The second, “Beyond Diversification: The Pervasive Problem of Excessive Fees and ‘Dominated Funds’ in 401(k) Plans,” discusses what we should do about this problem. To recap, the empirical results are eye-opening. Screen shot 2014-02-25 at 3.21.48 PM This table shows that 401(k) plan participants lose about 1.56 percentage points in risk-adjusted annual returns relative to the after-fee performance available from low-cost, well-diversified plans. The first line indicates that participants only lost 6 basis points because their employers failed to allow them to diversify their investments sufficiently. The big losses are in the other three categories:

  • Employers forcing participants to invest in high-cost funds by not making low-cost alternatives available
  • Investors failing to diversify their investments, even when the plan makes it possible
  • Investors choosing high-cost funds when lower-cost alternatives are available

Now you could say that the latter two sources of losses are the fault of individual plan participants, but that is cutting the employers (and the plan administrators they hire) too much slack. In particular, administrators should know that, if you offer both an S&P 500 index fund and an actively managed fund that closet-indexes the S&P 500 for 120 basis points more, some people will put their money in the latter. Continue reading

Rich People Save; Poor People Don’t

By James Kwak

It seems obvious. Yet it’s often lost, both by the scolds who lecture Americans for not saving enough and by the self-appointed personal finance gurus who claim that anyone can become rich simply ye saving more (and following their dodgy investment advice). Saving is sometimes seen as some kind of moral virtue, but from another perspective it’s just the ultimate consumption good: saving now buys you a sense of security, insurance against misfortune, and free time in the future, which are all things that ordinary people don’t have enough of.

Real Time Economics (WSJ) links to a new survey being pushed by America Saves (which appears to be a marketing campaign run by the Consumer Federation of America, which seems not to be evil*). According to the survey, there are significant differences in savings rates and accumulated savings between lower-middle- and middle-income households. And that’s treating all households in the same income bracket as being alike, leaving aside differences in family structure, cost of living, etc.

I’m all for living within your means and saving for retirement and all that. But it’s a myth to say, as America Saves does on its home page, “Once you start saving, it gets easier and easier and before you know it, you’re on your way to making your dreams a reality.” The underlying problems are stagnant real incomes for most people, rising costs (in real terms) for education and health care, increasing financial risk due to the withdrawal of the safety net, and increased longevity (good in some ways, but bad if incomes aren’t rising and you want to retire at 65). That’s why households are showing up at age 64 with less in retirement savings than they had just last decade. And why, if you feel like you’re not saving enough, it’s probably not your fault.

* But America Saves itself is supported by a bunch of financial institutions and trade associations like the Investment Company Institute, which have a vested interest in getting people to entrust more money to them.

Small Steps, but Not Nearly Enough

By James Kwak

Floyd Norris says some sensible things in his column from last week on the retirement savings problem: Defined benefit pensions are dying out, killed by tighter accounting rules and the stock market crashes of the 2000s. Many Americans have no retirement savings plan (other than Social Security). And the plans that they do have tend to be 401(k) plans that impose fees, market risk, and usually a whole host of other risks on participants.

But even his cautious optimism about some new policy proposals is too optimistic. One is the MyRA announced by President Obama a couple of weeks ago. This is basically a government-administered, no-fee Roth IRA that is invested in a basket of Treasury notes and bonds, effectively providing low returns at close to zero risk. The other is a proposal by Senator Tom Harkin to create privately-managed, multi-employer pension plans that employers could opt into. The multi-employer structure would reduce the risk that employees would lose their pension benefits if their employer went bankrupt.

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