A Call for Change

An investment pioneer proposes benefits reforms to save the failing retirement system.

Wednesday, March 22, 2006
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Will your employees be able to look forward to a safe and secure retirement? Will your company have to contribute more to retirement plans and work harder to educate employees to make that happen?

As defined-benefit pension plans slowly disappear and defined-contribution retirement plans falter under inconsistent investment earnings, the retirement future of the baby boomers and subsequent generations remains in doubt.

In this Q&A with HRE benefits columnist Len Strazewski, John C. Bogle, retired founder of The Vanguard Group Inc., the nation's second largest mutual-fund company, discusses the failings of the American retirement system, the problems with mutual-fund investing and how to rescue Social Security.

Specifically, Bogle, now president of the Bogle Financial Markets Research Center in Malvern, Pa., proposes a new model for defined-contribution plans, fueled by greater financial commitments from employers.

Also, in keeping with his reputation as a mutual-fund-industry reformer, he calls for investment companies to reduce their management and operating fees to accelerate retirement-investment earnings and more clearly disclose their trading procedures.

Bogle, 76, founded Vanguard in 1974 and led the organization until his retirement in 2000. Since then, he has aggressively crusaded for investment-industry reform.

In 2004, Time magazine named him one of the 100 most powerful and influential people, and Institutional Investor presented him with a Lifetime Achievement award.

He's the author of five books on investing and the investment industry, including his latest, Battle for the Soul of Capitalism, which addresses the social-responsibility need for intelligent capitalism, appropriate investment strategies for retirement and the problems of Social Security, among other issues.

The Vanguard Group manages 100 mutual funds with total assets of more than $700 billion. The Vanguard Index Fund, largest of the company's products, was founded by Bogle as the nation's first index investment fund.

The first of the baby boomers are beginning to retire and that has garnered a lot of media attention. In your estimation, how do you think Americans are doing in terms of saving and investing for their retirement?

I'd say, alas, that they are not doing nearly well enough, and not nearly enough Americans have taken advantage of saving on their own, using the tax-deferment vehicles that are available to them, notably 401(k) savings plans, corporate thrift plans, and individual retirement accounts (IRAs).

And at the same time, while the defined-contribution side of the business is faltering badly, the defined-benefit pension side of the business is, I think, falling apart. When we see in the course of maybe three weeks, Verizon and IBM -- two of America's finest corporations -- suspend future credits to their defined-benefit pension plans, it's clear we're going down a road that's going to make it even tougher to retire in the future than it is today.

We hear a lot about the collapse of the defined-benefit pension plans. Are the vehicles that are available now, defined-contribution plans, truly adequate to the task or do we need new vehicles and new kinds of investments for successful retirement?

Well, for starters, there are too darn many options. We don't need them all. It's just too confusing. There's a lot of complexity in IRAs, 401(k)s, Roth IRAs, Roth NOW 401(k)s -- and for other tax deferrals, we have 529 college savings plans, which, of course, expire in a few years.

In my new book, I recommend the appointment of a federal commission to see if we can straighten out and simplify the whole basis through which American citizens save for retirement. A lot has to be done on the private side--that is to say, people have to do things for themselves, either through their corporations or by themselves, and we really need a blue-ribbon federal commission to straighten out this system.

I think we must give John Q Investor and Jane Q Investor in America some better options, some much simpler options and probably a whole new way of saving.

Most of the retirement funds are essentially employer-sponsored and they have experienced some serious problems. What role do you think employers should play in trying to generate new options or better manage present retirement plans?

There has to be a whole new way of looking at how these plans get funded and what flexibility these pension managers, both public and private, have.

We've had a period in which the assumed returns on pension plans have gone up from 5 percent to 6 percent to 7 percent to 8 percent and 9 percent, now back to the 8 percent, 8 ½ percent area. Assuming returns at that level, those 8 percent returns -- I can say pretty much unequivocally -- are not going to be achieved. So we need a lot of reformulation of the way we look at the pension plans.

I think corporations ought to continue with a kind of a defined-contribution pension plan and add to that a defined-contribution thrift plan and match employees' contributions at a certain significant level. For example, begin with a basic defined contribution of 5 percent to 10 percent of the employee's salary, whatever it is, and then [offer] a thrift plan, maybe another 3 percent or 4 percent, with maybe 100 percent match for up to, say, $10,000. This would go a long way to solving the problem.

That would give us the structure and the cash flow into savings that are going to be required for future retirement.

How successful has the mutual-fund industry been as the vehicle for these kinds of investments? Have they proved themselves up to the task?

I think the mutual-fund managers and distributors have an awful lot to answer for. The mutual fund has become a vehicle over time that has become laden with costs, sales commissions, management fees, operating expenses and hidden but high portfolio-turnover expenses. Funds are turning over their portfolios something like 100 percent a year, and that means there's about a 1 percent charge against capital that you don't even know about.

No way around the relentless rules of humble arithmetic. Gross return minus costs of investment equals the net return shared by all investors. If investors as a group are lucky enough to get an 8 percent return in the stock market, that's what they share. And if it costs 2 1/2 percent a year to operate the stock market, which is not a bad guess, that means the average investor earns 5 1/2 percent.

Now is that devastating? It may not look so bad, but over an investment lifetime it is. For a young person today, investment lifetime is 65 years. You come into the workforce around the age of 20, you work until around the age of 65, you still got a 20-year life expectancy, so that's 45 working years and 20 years of living off the proceeds of whatever you've accumulated.

I'll give you the numbers. If you invest a thousand dollars at the beginning of a 65-year period and earn an assumed return of 8 percent, it would have a final value of $148,780 dollars. And I call that the magic of compounding returns, $1,000 to $148,780.

However, if the intermediation cost is 2 1/2 percent, as I say, the return would be 5 1/2 percent. That same initial $1,000 would then have, at 5 1/2 percent, a final value of -- I hope you're sitting down, $32,465.

And that's what I call the tyranny of compounding costs. The loss of $116,315 has been consumed in what seems to be small increments year after year by our financial system. Seventy-nine percent of that return on that investment went to intermediaries, 21 percent went to the investors who put up 100 percent of the capital and took 100 percent of the risk.


It doesn't look good for retirees. We always think in terms of the mutual-fund companies as sort of the cornerstone of an investment vehicle, and as you point out, also an expense vehicle. Pension and retirement-plan sponsors also turn to the fund companies for investment tools and education. How do you think they're doing in terms of educating savers about these costs, about making the right investment choices and how these things work together?

Well, first, I think most mutual-fund distributors, mutual-fund sponsors, are kind of all singing from the same hymn book in saying the one thing we all know -- that you've got to save more. I guess we're all in a great big marketing business, so it's not surprising we want you to give us more of your money. The more you invest, the more you're going to have at the end of the trail, other things being equal.

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However, we're all trying to sell our own "product," and that is unhealthy. Honestly, human resource executives should be much more active in the education process, particularly when your employees need to know about costs and the uncertainty of future returns in order to plan their retirement.

The reality is that we in the investment business know a lot that we aren't telling people. We often rely on historical returns to show the results of hypothetical investments when history is not a guide to the future. Instead, we can make a pretty good stab at what future returns will be in the stock and bond markets, but that's usually not disclosed to investors along with the cost factors involved. Investors ought to be very, very wary of costs.

Should there be regulatory changes to enforce better disclosure -- sort of an Employee Retirement Income Security Act for investments?

Yeah, and I'm afraid that, for whatever reason, the previous ERISA regulation has not come up with the kind of right protections for investors and retirement plans. But if we had a system in which fund directors and pension trustees had a fiduciary obligation, a fiduciary duty, to put the interest of fund shareholders and pension beneficiaries first, we wouldn't need a lot of other regulation.

Imagine, for example, what those independent fiduciaries would have thought when they learned that the manager was allowing hedge funds to trade against the interest of the long-term shareholders of the funds, [which was at the heart of] in fact, the [New York Attorney General Eliot] Spitzer [mutual-fund] scandal [and investigation].


How much of the charges levied by Spitzer have been a distraction from the more day-to-day issues that you've just been raising?

The Spitzer efforts sure as heck have been distracting, but distracting in the right way. As a result, we've been required to look inward and see basically the failure of our interest in putting the investor first. It's a microcosm of what's wrong with the mutual-fund industry.


When retirement experts talk about the three legs of the stool for retirement savings, one of those legs is the Social Security system. How do you assess the stability of Social Security and some of these proposals for private investment accounts as part of that system?

Fix the Social Security system first. The system is running large -- indeed, ultimately perilous -- deficits unless we do something about its existing structure. That needs to be fixed. It is not complicated; however, it does require that commodity that is conspicuous by its absence today in Washington--courage. And it involves simple things such as:

* Extending the retirement age a little,

* Bringing in public, state and local retirement plans under Social Security, and

* Increasing contributions or perhaps increasing the amount of income that is taxable under Social Security.

Regarding private investment accounts under Social Security, the Bush administration, I think, did a pretty bold thing saying the interest of the Social Security system beneficiaries is too important to be left to the wiles of the mutual-fund industry.

The Administration proposal called for the creation of an index fund -- similar to the one which has worked extremely well for all our federal government employees and legislators. I believe that's the direction to go because it takes turnover costs and expense ratios and management fees essentially out of the equation.

It's not 2 1/2 percent a year in expenses. It's more like less than half of 1 percent, about 5/100ths of 1 percent of expenses to operate that system. It's not a problem if you get the profits to the investors instead of the managers. So that can be done.

Allow no choices. No borrowing and no withdrawing capital. You're in -- just like you're in Social Security. You're in until the last day and that's the way to prevent mistakes by investors.

It can easily be done.

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