By Pamela Yellen and Dean Rotbart
SANTA FE, NM – Officially, neither the U.S. government nor the retirement planning industry keeps count of how many American employees entrust others to decide for them how and where to invest their hard-earned retirement savings.
Nonetheless, there is evidence that the number of these so-called ‘zombie investors’ – those who shuffle forward without using their brains – may already exceed 15 million individuals and is on a sharp upward trajectory.
The march has been fueled by a Greek chorus of government regulators, Wall Street executives, financial planners and media commentators who regularly opine that only by delegating the task of retirement investment to others can individuals assure the optimal long-term preservation and appreciation of their nest eggs.
“Effective management of a retirement portfolio can be a challenging task, requiring significant knowledge and commitment of time,” cautions the Securities and Exchange Commission.
Thus the SEC and the Department of Labor have instructed employers to offer their workers a variety of defined contribution retirement plans, most commonly 401(k)s, “designed to make it easier for investors” to avoid the headaches and inherent risks of managing their own retirement monies.
Easier, indeed! But wiser and less risky? Often not
Such full-faith reliance on administrators and funds managers is propagating gargantuan portfolio losses that could billow to hundreds of billions of dollars during the lifetimes of the current generation of U.S. workers.
Already many Americans believe that by the time they retire the Social Security system will be bankrupt.
But what wage-earners have yet to comprehend is that many of the personal retirement accounts they are paying into annually at work will – regardless of how the markets perform over the
coming decades – stealthfully bleed each employee of tens of thousands, even hundreds of thousands of dollars that could remain theirs
The $64,000 Question
Consider the financial fate of an unaware 30-year-old worker who has relegated the choice of which investments should be selected for his or her present-day 401(k) plan balance of $25,000. Simply by allowing the plan administrator to choose a fund with annual fees of 1.5 percent rather than 0.5 percent – a mere 100 basis points difference – the employee stands to forfeit $64,000 or more in realized savings by age 65.
In fact, the $64,000 bite is a very conservative projection because it assumes the employee never contributes another dime to a 401(k) and also assumes the initial 401(k) does not suffer a significant loss of principal, such as the pruning that virtually all 401(k)s experienced in 2008.
If that same 30-year-old employee continues to add funds decade after decade until retirement – a fairly typical scenario – then the choice to assign the selection of 401(k) plan investments to his or her employer might easily deprive that 65-year-old retiree of $500,000 or more in late-life savings.
The 15 million or so employees who have already unthinkingly given over the selection and responsibility for their retirement portfolio to others likely have little or no clear knowledge of whose hands they have invited into their wallets or how dexterous these trustees are.
Those making the decision of where an employee’s money should be funneled could be well-qualified and specially trained financial planners. Or, because there are no prescribed standards for who is permitted to make these judgments, employees may be entrusting the most important financial decision of their lifetime to their boss’s dunderhead brother-in-law.
Does this process and the associated losses snowballing into the hundreds of billions of dollars seem scandalous? Does it seem like the government ought to step in and act?
Well it has. In 2006, as part of the Pension Protection Act, Congress approved legislation that shields companies and their 401(k) administrators – including the employer’s idiot brother-in-law – from liability should some of these millions of zombie investors one day awaken to realize just how efficiently their financial flesh has been ripped from them and consumed.
Despite the ghoulish financial consequences, most zombie investors don’t realize – and may never realize – just how lavishly their passivity is priced.
Invest It and Forget It
Government and industry statistics reveal that about 50 million Americans participate in employer-sponsored defined contribution retirement plans.
On the face of it, 401(k)s have it all – matching employer contributions, tax deferments, professional administration and fund management. In other words: invest it and forget it.
Why wrestle with the onerous, time-consuming, risk-prone task of managing one’s own retirement financial planning when it is possible to simply push the “autopilot” button and check back again in two or three decades to see how large your financial stockpile has grown?
The 401(k) industry has made the process such a no-brainer that employees need not bother to even select the type of 401(k) fund where their money will be invested. Rather, increasingly employees are automatically enrolled in one of three types of funds – technically dubbed QDIA or qualified default investment alternative – that the Department of Labor deems suitable for capital preservation and/or long-term capital appreciation.
According to Towers Watson, a global risk and financial management consultancy, 90% of all new hires and 80% of those doing a reenrollment of investment elections let their 401(k) plan administrator choose for them where their money will be staked.
Of those who opt for the no-brainer – i.e. “zombie” – method of retirement planning, roughly 70% end up invested in so-called Target Date Funds (TDFs), the most popular by far of the three QDIA types.
Since their inception in 1993, TDFs have grown exponentially and now account for about $270 billion, or roughly 10%, of all 401(k) assets. The funds attracted $43 billion in net new cash flow in 2009 alone and by some estimates may reach the $1 trillion level in 2014.
Individual investors and 401(k) plan administrators alike are drawn to the theoretical simplicity of TDFs. The concept: select the target date of one’s retirement, say 2025, and match it to a fund designed to grow increasingly conservative as the fund approaches its eponymous calendar year.
If TDFs work according to plan, their fund managers invest in stocks, bonds, cash and cash equivalents in proportions that are rebalanced over time in order to preserve invested capital and gains as the funds approach and pass the target date. A young employee’s TDF, with a target date 30 or 40 years out, would start off disproportionately favoring stocks, for example, and then five or ten years before retirement reallocate the mix of holdings more heavily toward credit-worthy bonds and cash or cash equivalents.
But contrary to their billing, TDFs proved highly unreliable in 2008, when funds with a fast approaching target date of 2010 suffered losses averaging almost 25%. At least one of 31 theoretically “safe” 2010 target date funds plunged 41%.
The fact that TDFs failed to prevent the portfolios of expectant retirees from evaporating so rapidly caused the SEC, Department of Labor and Congress to make quite a fuss, holding hearings and earlier this year proposing new SEC rules aimed at providing investors a better understanding of the risks associated with TDFs.
But for all the Sturm und Drang, Congress and the regulators have yet to propose modifying the rules that permit anyone whatsoever to serve as an employer’s 401(k) plan fiduciary. And astonishingly, no government body is promulgating new rules aimed at capping the wide-ranging fees charged by administrators and fund managers – fees that actually are the most risk-laden aspect of TDFs and all 401(k) funds.
Catatonic Investors and Double-Barreled Illusions
At least when investors opened their 401(k) statements in 2008 and 2009, they knew they had been sucker punched and hence had the choice to rethink the wisdom of TDFs – and for that matter, 401(k) plans in general.
But TDF and 401(k) fee creep is covert. Disclosure seldom reveals the true, compounded costs of higher fees paid out over decades. Nor do most disclosure statements break out the entirety of fees, including those paid to plan administrators, to fund managers and, in echoing fashion, to the funds that those managers reinvest in.
The visible and hidden fees ripple along until the charges, paired with taxes and loss of buying power due to inflation all but consume a retiree’s full capital appreciation.
Here is the reasoning. If the complete buffet of TDF costs and fees total an average of 2% annually (which most likely is a conservative number) and inflation averages 3% annually over the decades a 401(k) plan is in place, then a plan participant has to generate a 5% average annual return just to preserve his or her invested principal.
But even 5% doesn’t clear the hurdle. Why? Because taxes on 401(k) principal, matching funds, interest, dividends and gains are deferred – not eliminated. Factor in future taxes, which could be assessed at rates higher than they are now, and TDFs might well have to deliver average annual returns of as much as 8% to 10% – or more – just to break even.
TDFs, it turns out, are the elite of the zombie 401(k) guard, leeching payments from catatonic investors with a lethalness and efficiency that even horror filmmaker George A. Romero, director of the 1968 cult classic Night of the Living Dead, never conjured.
In his book, Common Sense on Mutual Funds, John Bogle, founder and retired CEO of The Vanguard Mutual Fund Group, writes: “The largest target-date funds include only the costs of their underlying funds in their expense ratio, the range of those costs runs from .18 to .86 percent. Shockingly, however, more than half of the target-date funds carry their own hefty expense ratios – in addition to the expense ratios of the underlying funds, usually in the range of .70 to 1.30 percent. Together these costs can reach almost two percentage points, paid year after year.”
Because payroll withholdings invested in a TDF are compounded, as are appreciation, dividends and interest on the principal, even small 401(k) contributions can grow impressively large with the passage of decades.
Such compounding creates two costly illusions for unsophisticated 401(k) plan participants.
First, even a modest amount of appreciation on principal can seem like quantum growth when amplified by time and compounding. In our original example above, which is taken from a Department of Labor illustration, $25,000 untouched for 35 years in an employee’s 401(k) account will grow to $227,000 at retirement, assuming an average annual return on investment of 7 percent and fees and expenses of 0.5 percent.
Seems pretty nifty on first inspection. Twenty-five thousand dollars transmutes into more than 10 times that amount, no brains required.
The second illusion pertains to fees and expenses, which also balloon courtesy of time and compounding. To an investor who has passively watched his or her $25,000 multiply by a factor of ten or more, the imposition of a tiny 0.5% (half-of-one-percent) charge for fees and expenses often seems like a drop in the bucket.
But turn up the lights and what is revealed is a tsunami of funds, accumulated over a lifetime of labor by an employee, being summarily washed away due to dimwitted administrators and rapacious fund managers.
Even assuming that our 30-year-old employee had no better savings options in return for his or her 35-year net gain of $202,000 – an unduly generous assumption – the unsuspecting wage-earner will have paid a stunning $39,915 in fees and expenses.
That “tiny” 0.5% charge actually dispossesses our 30-year-old TDF investor of 19.76 percent of his or her entire retirement nest egg.
Worse, many TDFs charge fees and expenses in the 1.5% to 2.0% range – all, recall, with the blessings of the Department of Labor and sanctuary from liability.
Rerun the numbers and when the fees and expenses amount to 1.5% instead of 0.5%, the total sweep of the retiree’s savings cascades to $103,914 or 38.93 percent of his or her retirement nest egg.
This calculation bears repeating: annual fees amounting to only 1.5% will flush away nearly 39% of an investor’s entire life-long 401(k) savings.
That is quite the disappearing act, but no illusion.
The No. 1 Fallacy of Investing
The answer for zombie investors, and those who want to avoid the designation, is not to assume sole responsibility for their retirement savings – but to assume at least some responsibility.
Redemption lies in knowing in as much detail as possible what retirement plan options are available and what fees they entail. No one should automatically decide for a 401(k) participant where to invest. Seemingly safe and well-performing retirement funds, such as TDFs, may be neither safe nor efficient.
Before making their own choice, employees should investigate alternative retirement savings vehicles with the realization that funds such as TDFs that are a la mode and come highly recommended may favor the retirement planning industry more than retirees.
Because of compounding, keeping fees in check will likely have greater influence on how much money individuals have to spend in retirement than the underlying performance of the funds they invested in – assuming they invest in any of the government-approved QDIA funds, or like alternatives.
Remember, the number one fallacy of retirement planning is that it is safe to entrust your ultimate success to anyone but yourself.
Note: The references and sources used for this article, along with additional resources, are available here.
October 1, 2010
About the Authors:
New York Times bestselling author Pamela Yellen is the originator of the life-changing Bank on Yourself system and related personal finance strategies. Pamela has worked as a consultant to successful financial advisors for more than two decades.
Pulitzer Prize-nominated investigative reporter Dean Rotbart has reported on business and financial topics since 1979. His editorial and research clients include numerous Fortune 500 companies and leading communications agencies.
© 2010 Hayward-Yellen 100 Ltd Partnership