The Retirement Gamble: Why Low-Cost Indexing Reduces your Risk

The wife was working a night shift on Saturday, so I had an opportunity to do what all married personal finance bloggers dream about doing on a Saturday night – watch a PBS documentary on a personal finance topic.

Frontline’s 52-minute documentary, The Retirement Gamble has been getting a lot of press lately – at least in personal finance circles – so it was on my to-do list to watch, learn, and critique.

I appreciate a mainstream media effort to raise awareness about the fact that pensions are extinct, 401K’s are a crappy replacement, and average retirement savings are putrid – but most of the 52 minutes of the documentary was not groundbreaking material. Good, just not mind-blowing news.

I don’t see that there’s any way to avoid a U.S. retirement crisis (quite possibly leading to a zombie apocalypse of seniors roaming the streets for meds). This documentary re-affirmed how imminent that possibility is, with many of the same points I’ve highlighted previously:

• Pensions were the perfect retirement system for everyone, but employers wanted to shift risk from company to employee.
• 401K’s started as a tax loophole for high income employees, but became a means for employers to shift retirement responsibility risk.
• For a while, 401K’s as the go-to was fine. Stocks boomed through the 80’s and 90’s. Everyone was watching their balances explode. Things were great. Then the dot-com bubble hit. And then the housing bubble. And most still have not recovered.
• One-half of Americans say they don’t have enough money to save for retirement.
• One-third have no retirement savings at all.
• For those who do have retirement savings, most of those savings are being eaten up by 401K fees and expense ratios from actively managed mutual funds.

There were, however, a few new interesting take-aways that I discovered for the first time and thought were important enough to to share with you:

Fiduciary Responsibility

Fiduciaries are required by law to act in their clients best interest. A fiduciary is a person in a position of authority whom the law obligates to act solely on behalf of the person he or she represents and in good faith. Fiduciaries may not seek personal benefit from their transactions with those they represent.

Here’s where it gets interesting for most of you – 85% of “financial advisers” are not fiduciaries.

The term “financial adviser” doesn’t really mean anything. Advisers are not obligated to act in your best interests – most are just sales brokers selling the most profitable financial products – and they get handsome kickbacks for doing so.

Outside of finding financial planners with these characteristics and taking these steps to limit conflict of interest, ask them to sign a legally binding agreement that they are willing to act in your best interests as a fiduciary 100% of the time, under ERISA. If they won’t – know that they are a glorified sales rep. who probably will not act in your best interests.

If you’re interested, this PBS companion article has more on this – definitely worth a read.

All this being said, there is an even easier way to avoid financial adviser conflict of interest and the high costs of actively managed funds…

Low-Cost Retirement Investing Really Matters, when Compounded Over Time

I know that low-cost investing is important, but just how important? Leave it to an interview with Jack Bogle, founder and retired CEO of Vanguard, to drive home that point.

75% of the best content from The Retirement Gamble came from the Bogle sit-down. In fact, your time might be better spent reading the full Jack Bogle interview (which was not aired in its entirety in The Retirement Gamble) than watching the documentary. At age 84, Mr. Bogle is still razor-sharp, and his low-cost ETF and index fund approach to investing is iron-clad solid.

A couple of really poignant points from Mr. Bogle:

The Impact of High Fees: 7% return with 2% fees (net 5%), would result in two-thirds of your final balance being depleted, after compounding.

“If you compound a 7 percent and the 5 percent return over, say, 50 years, let’s call that an investment lifetime — well, in fact the investment lifetime is longer than that — something like 70 percent of the market return goes to the purveyors of the services, Wall Street if you will, and 30 percent goes to the fund owners… What happens in the fund business is the magic of compound returns is overwhelmed by the tyranny of compounding cost. It’s a mathematical fact.”

On top of this, most actively managed mutual funds do not beat indexes, especially over longer periods of time.

So what is an investor like you and I to do? Passive index investing through low-cost index funds and commission-free ETF’s.

Expected Investment Returns: I also thought this exchange between Bogle and interviewer, Martin Smith, was very interesting – and wanted to share it in full:

Smith: If [you have] 2 percent earnings growth over time, then you have about a 2 percent dividend.

Bogle: That’s another big thing that changed. We started off the ’80s, at least in the late ’70s, the dividend yield was almost 6 percent. By the end of the ’80s, it was almost 3 percent, and by the end of the ’90s, it was 1 percent.

Smith: Because we had all these dot-com stocks that didn’t pay any dividends.

Bogle: Yeah, and also people were bidding up prices generally. …

Smith: So what’s this business about?

Bogle: First of all, the long-term return on stocks is 9 percent, OK? That’s the historical return, because it averages 4.5 percent of dividend yield averages over 100 years and 4.5 percent of earnings growth. That’s the 9. …

Smith: But your prediction for the future is lower than that.

Bogle: It’s lower than that in part to give you the simple part. The original returns I just told you [were] based on a 4.5 percent opening dividend yield, and now we have a 2 percent dividend yield.

Smith: So going forward, … it seems like by your scenario, there’s very, very little money to be made.

Bogle: … Look at it this way. If the dividend yield is 2 percent lower than the long-term return of 9 percent, we’ll drop to 7. It’s a deadweight loss, that dividend. So 7 percent is a pretty good return in this day and age, because bonds are yielding maybe 2, maybe 3 percent depending on your portfolio. So stocks are really a pretty good investment for the next 10 years. Should be.

Smith: … But once you subtract your fees, you adjust for inflation, and you subtract tax costs, you’re down into pretty paltry return, 1 or 2 percent.

Bogle: We don’t tell people that, you see, in this business.

Smith: You’d be a very bad marketer. …

Bogle… I’m not selling managed mutual funds. I created the first index mutual fund. So instead of taking out, say, 2 percent a year from the market’s return, I’m going take five basis points, less than 0.1 of 1 percent out of that market return. So if we get a 7 percent return, I’m going to give you 6.95 in the index fund because it only costs 0.5 of 1 percent to run.

So I take out the management cost, I take out the portfolio turnover cost, I take out almost all the tax cost, because we’re not trading all the time and realizing capital gains. I don’t mean to be commercial about this, but it is simply mathematically a proposition that cannot be dis-proven. …

That, my friends, is why low-cost investing truly matters, for your retirement.

The Retirement Gamble Discussion:

• Did you watch The Retirement Gamble? What stood out to you? What was new?
• Do you invest in actively managed funds or index investing, or both? And why?
• Did you know about the fiduciary standard and have you asked your adviser if they would sign a fiduciary agreement?