60 Minutes – The 401(k) Recession

Sunday’s 60 Minutes piece on 401(k) retirement plans was rather shallow, and not at all what you would hope (and expect) from CBS’s popular, long-running show. The template for this type of exposé is generally that there is a problem/scandal and some party has been physically hurt or financially injured, and some other party has to bear the blame.

According to the 60 Minutes portrayal (sadly, all true, by the way), people have lost jobs, their portfolios were destroyed and retirement dreams must now be deferred. Steve Kroft interviewed discouraged job seekers at a job fair, which, if nothing else, provided sympathy and some activity to televise. It’s curious (and quite a coincidence!) how the interviewees just happened to have their 401(k) statements with them.

Naturally, he only interviewed older people, and that’s fine; after all, it’s the older folk who are more severely impacted. In my opinion, younger investors will be fine, as long as they continue to contribute to their own 401(k) plans and invest in stocks. In fairness to 60 Minutes, they did spend about a dozen words on this distinction.

According to my analysis of the 60 Minutes template, we must find victims and we must identify villains. Indeed, they found a very sympathetic woman who not only lost a lot of money in her retirement account, but lost her job as well. She cried on camera. And 60 Minutes made a veteran industry spokesman appear unabashedly unsympathetic, though that may have been the result of heavy editing of his comments.

Actually, the 13 minute piece combined two things: (1) people have lost money, and (2) fees are hidden in 401(k) plans and may be excessive. What they downplayed is that more consumer education is needed. Surely, they could have spared a few more sentences than the paltry few they uttered on that particular, very important, issue.

What can we actually learn from the 60 Minutes segment?

People Lost Money

Well, yes. But, what wasn’t said is that that has been true of other investment accounts as well, not just 401(k) plans. Small business owners have also suffered, as have people who have lost their jobs. Why only claim that 401(k)s have let down participants?

Fees

Yes, high fees can hurt investment performance, so 60 Minutes got it right that high (and hidden) fees can be a big problem in retirement plans. But they chose merely to list the types of fees, not quantify them or put them in a useful context. In my experience, some 401(k) plans are quite good. Some are too expensive. On the other hand, many 403(b) plans have very high fees, yet no one is examining them.

Risk

Defined Benefit Plans (pensions) have been in decline for some time. The old pensions were much better for average Americans, because loyal employees knew (more or less) what they would get, and they didn’t have to worry about making investment decisions. But employers were happy to get rid of traditional pensions to help reduce future costs and to reduce the business risk of achieving adequate market returns. Accordingly, employers have emphasized Defined Contribution Plans and largely dropped pensions.

In essence, investment management and investment risk were transferred to employees, and they were not prepared to make wise choices. In a bull market this was not so noticeable.

The Solution

The nature of defined contribution retirement accounts, such as a 401(k) or 403(b) plan, is that, while they provide a tax-deferred avenue to save for retirement, they need to be managed. Someone has to determine an appropriate asset allocation, based on a number of factors. Moreover, if you have other investments, it is ideal to treat all of your investments as one portfolio. And your allocations should probably change over time. As you get closer to retirement age, you generally will need to be somewhat more conservative in your investments.

The fundamental problem is that people thought that they could simply invest in the 401(k) plan without putting too much consideration into the asset allocation. Or it could be that they chose hot funds based entirely on past performance. The show did not go into any details as to why the participants had done so poorly, only that they had.

Clearly, more consumer education is needed. Fortunately, there are efforts currently under way to provide independent, unbiased support that will assist more employees to make informed decisions about their retirement plans.

Suggestion for 60 Minutes

The producers could have done a much better job. Next time, they should compare and contrast two people. One individual who had read a couple of personal finance/investment books or had consulted a financial planner who explained risk and return, asset allocation and the need to become more conservative as one approached retirement. The second individual would be one who did not understand any of these issues and pretty much just winged it with what amounts to a large part of her net worth.

While this comparison would have been useful and very telling, it would, of course, have made for pretty boring TV.

Rolling over to an IRA account

If you have a defined contribution account – 401(k) or 403(b) – from a former employer you can do a tax-deferred transfer to an IRA account. This would give you more control and more choices, but it should be done carefully. To that end, I recommend that you consult a fee-only financial planner. Otherwise, you may end up paying even higher fees than what you are now paying! You might even, heaven forbid, be sold a variable annuity to put in your new IRA.

To be continued.

Avoiding Financial Fraud

Ron Lieber’s New York Times column Even Vigilant Investors May Fall Victim to Fraud was quite disturbing and not a little worrying. It recounts how Matthew Weitzman, a founder and principal at AFW Wealth Advisors, a Registered Investment Advisor, and a fee-only firm, is no longer with AFW. The firm informed its clients of “certain irregularities in a limited number of client accounts.”

You can read Lieber’s article for the details. What is not clear, though, is how much money was involved nor how quickly the irregularities were discovered. Though, from my point of view, they are not the most worrying aspects. What concerns me most is that Mr. Weitzman was a member of the National Association of Personal Financial Advisors (NAPFA).

When a member of the advisory community violates the trust that clients place in him, all clients and advisors suffer. What this country does not need right now is any further deterioration in what little confidence we have left in the banking system, the federal government or our financial advisors.

I have been a fee-only planner since 2003, and whenever possible, I recommend that investors seek out financial planners who are compensated directly by their clients, rather than by commissions. In this way, you will avoid obvious conflicts of interest.

Members of NAPFA all practice a fee-only method of compensation and sign a Fiduciary Oath, which means that they swear to act only in their clients’ best interest. So it is with great discomfort that I heard that not one, but two, former members of NAPFA have been accused of bilking their clients.

What to do? As Ronald Reagan once said, “Trust but verify.” And of course, you should never write checks directly to your advisor, but only to an independent custodian. It is the independent custodian who should be providing you with confirmations of all transactions and trades, and a monthly statement. These are sensible precautions in the age of Madoff.

As Lieber says, “Open your mail. Confirm the accuracy of your trades and fund transfers. Read your account statements. Every month. Every number. Every single word.” I am not sure about reading every number, every word, but I get his drift.

Lieber further recommends that you handle all of your stock transactions yourself. I believe most investors will find this “solution” impracticable, inconvenient and unnecessary. I believe a better solution is for you to sign a limited power of attorney, allowing your advisor to enter transactions on your behalf, but which does not allow him to withdraw your funds. Only you should have the ability to withdraw funds from your account. I am not an attorney, but I believe that this provides adequate protection. (Attorneys, please weigh in.)

My mother always said “A promise is a promise.” Unfortunately, there are always people who will promise one thing and do another. It’s disappointing to have your expectations dashed.

I don’t know about you, but I expect firefighters to be brave, judges to be moral and rabbis and priests to comfort the troubled. Yet, there have been judges who, instead of upholding the law, bend it out of shape for personal gain. And there have been priests and rabbis who have preyed upon our young and betrayed our trust.

Lieber says, “I’ve always believed that advisers in the (NAPFA) association were plenty smart and morally upright, but it’s hard to recommend them now without at least including an asterisk.”

In my experience, NAPFA members have the highest standards in the profession. But like every profession, there may be individuals who choose to violate the trust of clients they serve.

It’s not easy to protect yourself against out and out theft, but you can take some small comfort from the fact that if financial advisors break the law, they are subject to prosecution by the regulatory authorities.

In my opinion, a great majority of investors will lose countless dollars because of the continuance of “Standard Operating Procedures” at Wall Street investment firms. Every day these firms peddle ill-conceived, hard-to-understand, expensive investments, because it is profitable for them to do so. Investors will lose more money in the ordinary course of business than they will ever lose due to outright fraud.

Unfortunately, what is legal on Wall Street is bad enough.

And so, I will continue to heartily recommend NAPFA members, because the fiduciary standard is the right way to do business.

And yes, monitor your accounts. Remember, “Trust but verify.”

What Should Investors Do Now?

“No one knows anything.”

“There is a science to investing.”

Given the market volatility and the steep declines of the last year or so, which quote would you agree with?

My answer is that I agree with both statements.  Here’s why.

Absolutely no one can successfully predict the short term direction of the stock market, the value of the dollar or gold, the movement in interest rates, etc., etc. When it comes to investing, there is no magic formula. There are no gurus who can foretell the future and help you “beat the market.”

On the other hand, there are approaches that work very well in the long term. For example, there is a fundamental relationship between risk and (expected) return. Ignore it at your own peril.

And you can learn from the past; you can devise a sensible strategy. Most of all, by following a long term buy-and-hold approach with a diversified portfolio that is matched to your risk tolerance, you can avoid the big mistakes of being too optimistic or too pessimistic.

For a thorough presentation on the intellectual underpinnings of a buy-and-hold approach and what investors should consider as they move forward, I highly recommend the video, What Should Investors Do Now? by Weston J. Wellington of Dimensional Fund Advisors.

This multi-part presentation includes “an examination of capital markets, the effects of recession and government policy on stock prices, how the current market stacks up to previous downturns, and the reasons why our core beliefs have not changed in light of these events.”

If you hold an MBA in Finance, you’ll find this video to be a valuable review of capital markets and portfolio management. If, like most people, you’re merely an ordinary investor, one just trying to figure things out, this will be an extremely useful introduction to the evidence that supports a sensible  long- term approach to investing.

So, grab a cup of coffee or tea, then sit back and enjoy the show. It is over an hour long, but you can view it in segments.

Watch it here.

Questions to Ask When Picking a Financial Adviser

An article in the April 13, 2009 edition of the Wall Street Journal entitled Seven Questions to Ask When Picking a Financial Adviser largely misses the boat. Granted, it is a challenge to find a “reliable” financial advisor; however, the article did a poor job of advising you on how to go about it. Reading it may leave you with the conclusion that it is impossible to find a financial planner you can trust. There can be nothing further from the truth.

I take exception with the emphasis of the article and several of its points.

How does the adviser get paid?

Mentioning that there are different methods of compensation, as the article does, is not sufficient.

As I’ve said in previous posts, the key issue in choosing a financial advisor is finding one who will act in your interests. To determine that, you must know exactly how and who compensates your chosen advisor. If an advisor is fee-only, you’re off to a good start.

Remember that a stockbroker must act in the employer’s best interests, and that you are not his employer. A Registered Investment Advisor, on the other hand, must act in a fiduciary capacity, i.e. in the clients’ best interests.

Stockbrokers are subject only to a “suitability” standard. They are regulated by FINRA, which (despite their rhetoric) is dedicated to protecting stockbrokers and their employers, not necessarily investors.

What do the adviser’s clients say?

This may or may not be relevant or helpful.

Registered Investment Advisors are governed by the 1940 Investment Advisor Act, which expressly prohibits providing “testimonials,” which client references would fall under. Of course, a client recommendation or testimonial could easily be concocted anyway.

What’s the adviser’s track record?

The WSJ article didn’t even come close to getting this issue right. Choosing an advisor based on his/her supposed investing track record is the wrong approach on several counts!

Even if you did find an advisor with a “superior” track record, we know that it is meaningless, because, as has been stated before, “Past Performance is No Guarantee of Future Results.” If you’ll recall, Bernard Madoff had a superior track record, many testimonials and lots of personal references and endorsements. And we all know what he did.

Key Financial Solutions does not try to “beat the market.” We are not active managers, because studies show that the added costs offset any possible gains of active trading.  Market timing and stock selection do not work.

Since we are not mutual fund managers, we do not have one uniform documented track record. Real financial planners take into account their client’s needs, financial objectives and tax situation before investing their money.

Because our clients have different risk tolerances and time horizons, they naturally have different portfolios and, therefore, different investment performance.

Financial Planning versus Investment Performance

Understand that beating an index is not a financial plan. What a good financial planner will do is give clients the best chance to achieve their goals.  Because the financial plan sets the parameters of the portfolio, a portfolio is simply a tool to realize clients’ goals.

Don’t get me wrong, we are quite proud of our portfolio design, because we use low cost, tax-efficient mutual funds to build globally diversified portfolios.  I am personally fascinated by asset allocation and portfolio strategy.  I use automated reports and individual spreadsheets to monitor a portfolio and to make changes, when appropriate.  Certainly all of these necessary tasks contribute something to investment performance, but not as much as having a plan and sticking to it.

Real Life Returns

Since investor behavior is a very large component of investment returns, we act as coaches so that clients do not make big mistakes.  For example, we manage how clients respond to the euphoria near market tops and to the panic and despair around market bottoms.

Behavioral advice – coaching clients to continue to do the right thing and to avoid doing wrong things – will have a greater impact on investment returns than attempting to choose next year’s hot sector or mutual fund.

Believing in full disclosure and transparency, we report results quarterly so that a client can see exactly how well his or her portfolio is doing. This report is net of all fees, which are clearly stated, rather than being hidden. But I do not recommend giving quarterly results much importance.

Conclusion

When considering whether to retain an adviser for a long-term relationship, avoiding conflicts of interest should be the first consideration. A strict fee-only method of compensation is the best approach for most people. Members of the National Association of Personal Financial Advisors are strictly fee-only planners who sign a Fiduciary Oath.

NAPFA has always maintained that an advisor who is compensated solely through commissions faces immense conflicts of interest. This type of advisor is not paid unless a client buys (or sells) a financial product. A commission-based advisor earns money on each transaction—and thus has a great incentive to encourage transactions that might not be in the interest of the client. Indeed, many commission-based advisors are well-trained and well-intentioned. But the inherent potential conflict is great.

Dow Jones Music Video

Is it possible to be as proud of a friend’s child as you would be of one of your own?

Adam Baff, whom I have known for 30 years, is the son of close friends. Adam has many talents, and recently he wrote the music and lyrics for the Dow Jones Music Video.

I think it is very well done and effectively uses humor, irony, and great visuals to express the many moods we’ve all experienced. No doubt, for many of us, the last few months have been “trying” (to say the least), but Adam’s tongue-in-cheek view of life in these United States gives us something to smile about. Adam’s band Downsize performed the music, and the video features Nicole O’Connell an aspiring model/actress.

The link to the YouTube video is here.

The song is available for purchase at Amazon.com and also through iTunes.

So, I ask again, is it possible to be as proud of a friend’s child as you would be of one of your own? Absolutely! Way to go, Adam.

Greed and Stupidity

Last week, I had lunch with an old friend who told me that he was very upset because he had lost so much money on his investments. He said that he was of two minds about the people who caused his pain. On the one hand, he wanted to forgive them, but on the other hand, he wanted to get even. Both, perfectly natural feelings. Of course, the problem with the revenge approach is the he did not know exactly whom to blame. Like many people, he really didn’t understand how we got into this economic mess in the first place.

Well, as previous posts have discussed, it’s a complicated tale in that there are a lot of culprits and more than enough blame to go around, including lax government regulation, unscrupulous mortgage brokers and mortgage lenders, overoptimistic rating agencies and everyone who thought real estate prices could only go up. But focusing on the banking system tells a large part of the story.

Recently, David Brooks wrote a column, Greed and Stupidity, which references some very good articles and contrasts the two theories of why and how bankers screwed up. Here are some relevant quotes regarding the two explanations – greed and stupidity.

What happened to the global economy? We seemed to be chugging along, enjoying moderate business cycles and unprecedented global growth. All of a sudden, all hell broke loose.

There are many theories about what happened, but two general narratives seem to be gaining prominence, which we will call the greed narrative and the stupidity narrative. The two overlap, but they lead to different ways of thinking about where we go from here.

The best single encapsulation of the greed narrative is an essay called “The Quiet Coup,” by Simon Johnson in The Atlantic.

Johnson begins with a trend. Between 1973 and 1985, the U.S. financial sector accounted for about 16 percent of domestic corporate profits. In the 1990s, it ranged from 21 percent to 30 percent. This decade, it soared to 41 percent.

In other words, Wall Street got huge. As it got huge, its prestige grew. Its compensation packages grew. Its political power grew as well. Wall Street and Washington merged as a flow of investment bankers went down to the White House and the Treasury Department.

The result was a string of legislation designed to further enhance the freedom and power of finance. Regulations separating commercial and investment banking were repealed. There were major increases in the amount of leverage allowed to investment banks.

The second and, to me, more persuasive theory revolves around ignorance and uncertainty. The primary problem is not the greed of a giant oligarchy. It’s that overconfident bankers didn’t know what they were doing.

Many writers have described elements of this intellectual hubris. Amar Bhidé has described the fallacy of diversification. Bankers thought that if they bundled slices of many assets into giant packages then they didn’t have to perform due diligence on each one.

Benoit Mandelbrot and Nassim Taleb have explained why extreme events are much more likely to disrupt financial markets than most bankers understood.

To me, the most interesting factor is the way instant communications lead to unconscious conformity. …Global communications seem to have led people in the financial subculture to adopt homogenous viewpoints. They made the same one-way bets at the same time.

Jerry Z. Muller wrote an indispensable version of the stupidity narrative in an essay called “Our Epistemological Depression” in The American magazine. … Banks got too big to manage. Instruments got too complex to understand. Too many people were good at math but ignorant of history.

The Remedies

The greed narrative leads to the conclusion that government should aggressively restructure the financial sector. The stupidity narrative is suspicious of that sort of radicalism. We’d just be trading the hubris of Wall Street for the hubris of Washington. The stupidity narrative suggests we should preserve the essential market structures, but make them more transparent, straightforward and comprehensible. Instead of rushing off to nationalize the banks, we should nurture and recapitalize what’s left of functioning markets.

Both schools agree on one thing, however. Both believe that banks are too big. Both narratives suggest we should return to the day when banks were focused institutions — when savings banks, insurance companies, brokerages and investment banks lived separate lives.

We can agree on that reform. Still, one has to choose a guiding theory. To my mind, we didn’t get into this crisis because inbred oligarchs grabbed power. We got into it because arrogant traders around the world were playing a high-stakes game they didn’t understand.

Conclusion

I agree with Brooks’ belief that the main cause of our economic meltdown was stupidity – not understanding the real risks in using “outsized” leverage to buy risky assets. On the other hand, investment bank managers were receiving “outsized” bonuses based on short-term results, and the long term risks and ramifications was someone else’s problem.

Who says we have to choose between greed and stupidity?

Actively Mismanaged Funds

“Active managers can and often do outperform for short bursts of time. But once you extend the time horizon, the probability of that outperformance continuing significantly diminishes.” – Srikant Dash, Standard & Poor’s.

A previous post sought to debunk the notion that anyone can consistently outperform the market by superior stock selection and/or stock trading, better known as active management. It’s worth continuing an examination of this approach, because so many investors, through their investment advisers, are essentially chasing a chimera. They are trying to beat everyone else by choosing mutual funds that have done well. This approach has been shown, time after time, to fail.

I concluded with this statement: “It would be wonderful if we could find really good stock pickers, the ones who consistently beat the average, but that is impossible.”

Actively Mismanaged Funds by Scott Woolley in the April 13, 2009 Forbes Magazine reinforces my conclusion.

Here are the relevant quotes:

For years William Miller’s name appeared atop lists of the world’s most successful stock pickers. His Legg Mason Value Trust outperformed the S&P 500 every single year for a decade and a half through 2005, an astonishing streak regularly cited as evidence that a smart fund manager can consistently beat the market. Customers flocked to this hot hand. Assets in the fund climbed to $12 billion, representing $200 million a year in management fees for Legg Mason. (Emphasis added.)

That’s when the gravy train came screeching to a halt. Value Trust’s 6% gain in 2006 was only half as good as the market’s. The fund has lost money ever since, including a 6.7% decline in 2007, 55% in 2008 and 20% through February of 2009. Each of those numbers was worse than the broader market’s return.

Another way to look at Value Trust: Investors paid Miller and his underlings $2 billion in management fees to destroy wealth.

Value Trust is an exceptional case of outsize gains followed by outsize losses, but the phenomenon of active managers creating wealth only for themselves is no fluke. What makes this especially searing to investors these days is the implication by many active funds that they’re worth a premium because they’ll rescue you from nasty bear markets while “dumb” index funds abandon you to a mauling.

The facts indicate otherwise. Last year, during the worst stock market drubbing since 1931, the average active stock fund lost 40.5%, versus a 37% loss for the market-tracking Vanguard S&P 500 Index, according to Morningstar. Stretch out the time frame and active management looks no better. According to Standard & Poor’s, 69% of actively run large-company funds, 76% of funds buying midsize companies and 79% of funds buying small companies underperformed their indexes in the five years through last June.

Especially humiliating lately is the performance of the largest funds, including Fidelity Magellan, in Peter Lynch’s day the grand master of actively managed vehicles. The fund lost 52% in the past year.

While Magellan has been a disappointment to investors, it has done very well for its manager, Fidelity Investments (in which the family of billionaire Edward Johnson owns a large stake). The fund’s 0.73% annual expense ratio on $41 billion in average assets added up to $295 million in fees last year. Investors could have stuck their money in Fidelity’s Spartan 500 Index at one-seventh the cost and earned more over the past one-, three-, five- and ten-year periods.

Humans, …are hardwired optimists. To our detriment as investors, we tend to overestimate our ability to pick winning stocks and stock pickers, like Bill Miller. (Emphasis added.)

The other problem is that funds are often sold rather than bought. The sellers are in it for commissions. Those are easiest to skim off actively managed funds that charge fat fees in exchange for the prospect (but not the probability) of knocking out the lights or the protection offered by “professional management” in troubled times.

Franklin Templeton’s ads boast that its flagship Growth Target Fund has “weathered the ups and downs of the market for over 50 years.” That included some rough sailing in 2008, when Growth Target, a supposedly conservative mix of stocks and bonds, lost 31% of its value and lagged its index by six percentage points, according to Morningstar.

American Century enlisted pedaler Lance Armstrong to evoke his successful battle against cancer as a template to “provide for a secure financial future.” Ultra, American Century’s largest fund, lost 41.7% last year, lagging the S&P 500.

Investors are learning

The crash is making investors rethink their faith in funds that try to beat the market. Last year they yanked out $222 billion while adding $18 billion to their index holdings, according to Lipper. That left $3.2 trillion with active managers at year’s end, compared with $672 billion in passive mutual funds and exchange-traded funds.

That shift from actively managed funds to passively managed mutual funds and exchange-traded funds is definitely a move in the right direction.