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TIAA-CREF's Version of Democracy Gives Investors Raw Deal

These fund shareholders have learned a lesson in civics they didn't get in school.

Christopher Davis, 03/07/2006

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What if voters came out in droves for the challenger, but the incumbent decided to remain in office? If all you knew about democracy was what you learned as a TIAA-CREF mutual fund shareholder, you might think this implausible scenario was a real possibility.

In July, TIAA-CREF asked shareholders of its actively managed institutional funds to approve plans to more than quadruple management fees. Shareholders voted against the hikes in all but a handful of instances. But then TIAA-CREF took the rare step of scheduling another vote. It got its way in the January revote, with shareholders approving the fee hikes. But even if shareholders hadn't approved the fee increases, the game would have remained rigged in TIAA-CREF's favor: The firm had plans to fold its low-cost institutional funds into a higher-expense lineup of funds that it would have created if shareholders had voted down the fee hikes in January. To avoid that fate, shareholders would have had to vote--yet again--to prevent the mergers. (None of the votes or expense increases affect TIAA-CREF flagship annuity offerings, such as CREF Stock, or its non-institutional mutual funds such as TIAA-CREF Growth & Income TIGIX and TIAA-CREF Bond Plus TIPBX.)

It's ironic that a highly regarded champion of democracy in corporate boardrooms would show such blatant disregard for the will of its own fund shareholders. Had TIAA-CREF-style democracy been in place for the 2004 election, Kerry supporters would have had to go to the polls three times to get their man in the White House.

This isn't the TIAA-CREF longtime observers of the firm know and respect. Vanguard founder Jack Bogle, no admirer of most investment managers, once labeled TIAA-CREF as one of the few he held in high esteem. Its decades-long service to educators and other not-for-profit workers (Albert Einstein was once a shareholder) and its low-cost, investor-first ethic rightfully earned it a squeaky-clean reputation. When it launched its first mutual funds in 1997, it succeeded in bringing its shareholder-friendly culture to a wider audience. While we once regarded that culture as one of the fund industry's best, that's no longer the case.

What Went Wrong?

When current TIAA-CREF CEO Herb Allison came aboard in November 2002, shareholders and fund-industry watchers feared he would take the venerable firm in the wrong direction. TIAA-CREF's core constituency of professors and other educators highlighted Allison's lavish compensation package, which included an eye-popping $24 million severance agreement. And given Allison's experience at traditional brokerage firm Merrill Lynch MER, where he was president until 1999, critics pointed to the potential for a culture clash.

Those worries seemed a bit far-fetched. After all, TIAA-CREF--as a pure investment manager rather than a financial conglomerate--wouldn't face the sorts of conflicts Allison faced at Merrill. In 1998, for instance, Allison called Enron chairman Ken Lay after the energy trading firm purposefully excluded Merrill from participation in an April 1998 stock offering because its Enron analyst gave the company a "neutral" rating, which in Wall Street parlance means "sell." Merrill ultimately got in on the deal, and the analyst resigned four months later, replaced by an analyst who gave Enron a "buy" rating. (For its part, Merrill denied any wrongdoing and noted the analyst who left gave Enron a "buy" rating at his new job a few months later.)

TIAA-CREF's not-for-profit status would also appear to shield it from some of the short-term profit pressures facing a publicly traded giant like Merrill. (It's worth noting, though, that CREF, the advisor to the funds, isn't organized as a not-for-profit.) But as Allison's tenure demonstrates, even not-for-profit investment managers can go astray. In addition to pushing through the management-fee hikes earlier this year, TIAA-CREF implemented 12b-1 marketing fees in 2005. The firm's retail share classes of its institutional fund lineup have an annual 0.25% 12b-1 charge used to pay for marketing expenses to promote the offerings.

If the marketing efforts those fees pay for are successful, the advisor will have more assets to manage, but it will have only done so because it took money out of current shareholders' pockets first. (The retail share class is one of three classes of TIAA-CREF's institutional fund lineup. Confusingly, the institutional funds also have institutional and retirement share classes, though those won't levy 12b-1 fees.) How that serves the greater good of investors, which TIAA-CREF proclaims is its mission, is unclear to us.

Once the 12b-1 fees are put into place in 2007, TIAA-CREF's retail investors won't be getting a bargain any longer. For instance, the annual expense ratio of the retail share class of TIAA-CREF Institutional Large-Cap Value TILVX will weigh in at about 1.05% annually once the 12b-1 fee is folded in, about average for a no-load large-cap fund. With plenty of cheaper, superior alternatives like T. Rowe Price Equity-Income PRFDX or Vanguard U.S. Value VUVLX, why would anyone choose the TIAA-CREF fund? With sharply higher expenses, TIAA-CREF will cede its most powerful advantage over the competition.

Board Shares Blame

TIAA-CREF has defended its recent actions, noting that the funds' all-independent board of directors signed off on the management-fee hikes and the new 12b-1 fees. However, having independence clearly isn't the same thing as asserting it.

By law, fund boards are charged with acting in shareholders' best interests. By acquiescing to TIAA-CREF's request for huge management-fee increases and new fees to market its funds, we don't see how TIAA-CREF's fund board was doing so. TIAA-CREF argued for higher fees on the grounds that the funds weren't covering their costs. Of course, TIAA-CREF shouldn't be required to operate its funds at a loss, but the new management fees are higher than what's needed to pay the bills. In a first for TIAA-CREF, the new fees include a built-in margin designed to allow the funds' CREF advisor to reinvest in its business and grow assets. While we can see why the board wouldn't want the advisor to fold, it's still not obligated to ensure that it's making money to pay for future growth. In fact, the board's duty is to current fund shareholders, not to the advisor. Under the fee scheme the board approved, however, current TIAA-CREF investors give up a portion of their returns to fund the firm's asset growth.

Some Bright Spots

Despite discouraging recent developments, TIAA-CREF still does a lot right. For example, it continues to avoid rolling out trendy, flavor-of-the month offerings that don't serve long-term investors' interests. Its shareholder communications are clear and preach the virtues of diversification and long-term investing. Moreover, TIAA-CREF hasn't abandoned its well-known role as a corporate activist, using its tremendous size to vote against shareholder-unfriendly proposals. And as problematic as we found TIAA-CREF's disregard for shareholders in implementing its higher fees, we agree that the firm shouldn't have to lose money running its mutual funds and acknowledge the funds remain reasonably priced (though that's less true of the marketing-fee-laden retail share class than of its institutional funds).

We're also pleased that the firm is taking steps to improve the performance of laggards such as TIAA-CREF Growth Equity TIGEX. In an acknowledgement of its research shortcomings, especially in growth sectors and also in Asia, TIAA-CREF plans on hiring a raft of new analysts to provide more research in those areas. It will take time for that measure to bear fruit if it does at all, but at least TIAA-CREF's investment culture looks like it's improving.

Despite its admirable attributes, though, TIAA-CREF is headed in the wrong direction.

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