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Rekenthaler Report

A Fund Critic's 3 Proposals

Personal licensing, access to the federal savings plan, and a stronger SEC.

The Sun Never Sets
This week, William Birdthistle released his first book, Empire of the Fund. William is one of the few law professors to specialize in fund legislation, which makes him an expert something by default. (The story of my early Morningstar career.) Fortunately, he also knows a great deal--enough so that the book frequently reminds me of incidents that I had forgotten, or informed me of those that I missed. So, he earns his status.

Much of Empire describes the fund industry's gray areas: fund companies' dual responsibility to two sets of shareholders; fees; soft-dollar arrangements; valuation problems; and market-timing. William covers the issues, and provides many, many examples of when fund companies elected not to do right by their investors.

After covering the key developments of the past quarter century--the growth of the 401(k) industry and the invention of target-date funds and exchange-traded funds--William concludes Empire with three prescriptions. They mostly involve 401(k) plans, which, as William correctly notes, have escalated mutual funds to a higher level of responsibility. They are no longer merely supplemental assets for the wealthy. Today, they occupy the heart of the American retirement system.

Personal Investment License
William's first recommendation is the most provocative. He suggests that those who wish to invest in something other than the 401(k) plan's default investment--these days, almost surely target-date funds--be prohibited from doing so until they pass a test of financial literacy. The U.S. does not permit its citizens to court physical danger by driving automobiles or airplanes without a license. Why should it permit them to endanger their financial health?

Yes, he acknowledges, one can argue that "requiring a license to manage one's own money is an impermissible restraint upon--or perhaps even a governmental taking of--a citizen's private property. The right to squander your own money is God-given. Or, at least, your own problem and none of the government's business."

However, William points out, tax-advantaged savings programs aren't exactly a God-given right, either. The "government need not offer a tax boon on the savings in those accounts," nor is anybody "compelled to participate in these plans." There's nothing unconstitutional about setting requirements for the use of government-created, voluntary accounts.

He addresses the libertarian argument that "consulting adults should be free to harm themselves if doing so harms no one else" by arguing that individual mistakes become a broad social problem. "We have good reason to expect that many Americans will do poorly in our defined-contribution system and that large-scale failure will need help from existing government programs." They "may, in a sufficiently dire failure, demand entirely new public bailouts in the future."

His argument, not mine. This subject crosses into the political, which this column attempts to avoid. (Also, I am genuinely agnostic on the issue. I understand the desire to avoid nannyism--but I also appreciate that government-sponsored savings plans are established by rules, and those rules conceivably could govern investment decisions.) Your political beliefs will likely determine your response.

I will say, though, that I don't believe that the danger from poor 401(k) investments is particularly large. If 401(k) plans were structured as they were 20 years back, without default investments and (often) with volatile, specialized funds, then investors could do themselves much damage. (In the late '90s, the single most-popular request by 401(k) participants was that the plan add a technology fund.) In today's marketplace, with most investors defaulting into diversified target-date funds and content to remain there, I don't see how employees can invest themselves into too much trouble.

They can, however, undersave themselves--a huge problem that has only partially been addressed by auto-escalation programs that automatically raise a participant's savings rate each year, unless the participant opts out.

Opening Up the Federal Plan
The federal government, quietly, has assembled quite the defined-contribution plan. Covering 4.6 million participants and holding more than $400 billion in assets, the Thrift Savings Plan (TSP) holds collective investment trusts (not registered mutual funds, but similar) that have an average expense ratio of 0.03% per year. Not 3%, but 3% of 1%--$30 per year for a $100,000 account. The trusts consist of indexes run by BlackRock.

As William states, don't try to get funds for 3 basis points on your own. The only path to such frugality lies with massive buying power, of the sort brought by several hundred billion dollars. (Three basis points on $400 billion means $120 million in annual revenues to BlackRock--admittedly, accompanied by significant operational costs, to track all those shareholders, but the investment outlay for the company is minimal.) Vanguard is doing wonders in bringing cheaper 401(k) plans to the small-company market--but it can't do 0.03%.

William's idea: Open TSP to all working Americans. That way, those who work at companies without 401(k) plans--and tens of millions of American do--or at companies that have expensive plans, because of a lack of scale, would have access to a very low-cost, professionally managed plan with funds that have good long-term records. The work for TSP has already been done. Jump on its back.

That could work. Eventually, perhaps, all those investors in the same index trusts, investing in the same indexes, might lead to the index tail wagging the investment dog. At some point, the markets will behave strangely, if there are no active investors to set its course. But we are far from that moment. There would be no harm done to the market, or TSP's trusts themselves, if they were to receive a lot more money.

Several questions would need to be addressed. One example: Would this effectively gut existing small-company 401(k) plans as employees swapped their current funds for those in TSP? At this stage, the idea is conceptual only.

However, it is decidedly on the right track. The biggest current flaw with 401(k) plans is the high costs that plan providers have of serving small companies, due to heavy sales expenses for connecting buyers with sellers, and to thousands and thousands of reinvented wheels, as the same conversation and the same due-diligence process is repeated, at company after company. William's proposal sweeps away those problems. For that virtue, it deserves further consideration.

Wake Up, SEC
William's final suggestion is his simplest. The SEC should do its job.

He writes, "Our current enforcement efforts come in two dominant strains: misplaced private lawsuits and feeble public ones." The private lawsuits are misplaced because, as is the nature of damage-seeking actions, they attack companies that have the deepest pockets, not those that are the guiltiest.

"Large funds are not the chief perpetrators in charging the highest fees. Rather, small funds with fewer shareholders are among the very worst at charging the most outlandish of fees." Similarly, the companies that are targeted in 401(k) lawsuits are not those with particularly bad plans--indeed, many are quite good--but instead those with massive asset bases. Policing by lawsuit means swatting the fattest cows in the pasture, rather than those that have strayed the furthest.

The SEC, in theory, should be disciplining the worst actors. Doing so is part of the Commission's official mission: "It staffs an entire Division of Enforcement to bring lawsuits that will protect the public interest." However, "until very recently, the SEC has never brought an excessive fee case." In William's view, the Commission should do so with the extreme outliers. Yes, there would be expense in bringing those cases to trial. But the result of "patrolling the upper bounds of fund fees" would be savings that "benefit millions of fund investors," as fund companies change their ways for fear of prosecution.

That also makes sense. The current approach of using private lawsuits to establish the boundaries has been good for transferring wealth from large fund companies and 401(k) plan sponsors to law firms, but ineffective at getting money into the hands of fund investors who have been treated the worst. Reversing that priority surely is sound policy.


John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.