Oct 09, 2015

Why the U.S. Is Headed Toward a Retirement Crisis –- and How to Fix It

Following the worst quarter for U.S. markets in four years, most investors would do well to pause for a moment of silence in memory of their dearly departed dollars.

The S&P, as decent a benchmark for U.S. investments as any, lost 7% in the third quarter and it has recovered to just below the level it was at this time last year. Of course, these are just the averages. The individual results reflected in investors’ account balances are probably far worse.

Why? Even in the best of times, the fees charged by the financial intermediary complex make for stiff headwinds. In a bear market, however, under the terrible effect of reverse compounding, these fees can ravage portfolios.

Still, according to the Hobbesian logic of the financial industry, an investor must always pay the fee, regardless of how expertly – or not — the money manager navigates the storm.

Combine that standard business practice with all the industry’s forms of legal larceny — revenue sharing12b-1 feeshidden trading costs — and their game plan appears straightforward: Heads they win, tails they win.

This is why many of the world’s richest people are money managers, and the investment business has produced a greater number of billionaires than any other industry in the U.S and worldwide.

Though it’s not always easy to mentally connect the dots between yourself and JP Morgan Chase (JPM – Get Report) CEO Jamie Dimon, make no mistake: his $27.7 million pay package for 2014 may have contained a few dollars from your retirement account. After decades of their firms taking fees for managing their investors’ portfolios through mutual funds, 401(k) plans, and, more recently, ETFs, it’s no wonder that Dimon and his colleagues have gotten richer as the U.S. has lumbered toward a momentous generational financial crisis. Large financial institutions are in the business of making money.

Even the casual observer has a sense that the U.S. is on the cusp of a retirement cataclysm. Politicians love to talk about itSerious and not-so-serious media outlets routinely explore the topic. Even the federal government has gotten involved.

So, how did we get here?

Here’s the CliffsNotes version:

In 1875, the American Express Company created the first corporate pension plan. The general idea: Put a portion of workers’ income in a collective account, invest the money, and use the proceeds to provide employees with guaranteed income after retirement. This became known as a defined benefit plan, with a retirement payment — usually a percentage of the worker’s final salary — defined in advance and provided monthly for life.

Driven by tax laws and corporate competition for skilled workers, the popularity of the defined benefit model flourished for decades, bolstered by an unprecedented period of American economic growth. Things got rocky in the 1960s, however, as increased longevity, growing health care costs, and mismanagement revealed the fragility of thousands of companies’ defined benefit plans. Pension bankruptcies became a slow-motion crisis.

The numbers are certainly worthy of attention: The difference between what people have saved for retirement and what they should have is at least $7 trillion. That’s about half our country’s GDP — not something the government is going to come up with by looking between the national couch cushions.


In 1974, President Gerald Ford signed into law the Employee Retirement Income Security Act (ERISA). It dramatically changed the way Americans saved for retirement, codifying the rules for how companies managed retirement obligations, and also paved the way for a new type of savings plan: the individual retirement arrangement (IRA).

Designed to supplement traditional defined benefit plans, IRAs offered tax advantages to encourage workers to put aside even more money for retirement. But in doing so, ERISA opened a can of worms. In fact, it created the beginnings of a lucrative, new market for financial firms: selling retirement products and services directly to middle-class Americans. Within just a few years, that market would metastasize through the 401(k) and lead to a new financial era.

With a wonky moniker befitting its origin in the IRS code, the 401(k) provision was written into the books in 1978. In 1980, a retirement benefits consultant named Ted Benna used it to reduce a client’s tax burden. Originally applicable to highly paid executives only, 401(k) eligibility eventually expanded to all employees. Thus, the defined contribution approach to retirement saving was born.

The financial industry quickly rolled out new products and services targeting this nascent retirement-fund market. Playing on the insecurities of the growing population of Americans working without a defined benefit pension, financial firms marketed products, especially 401(k) plans, in ways that exploited both the fears and the hopes of a new generation of investors increasingly anxious about their capacity to provide for themselves and their families in retirement.


And yet, there was something appealing and quintessentially American in empowering individuals to be the masters of their own financial destinies.

The first few decades of the defined contribution era, from the early 1980s until the end of the twentieth century, seemed to validate this strategy of financial self-determination professionally stewarded by Wall Street. For two decades, it appeared that outsourcing our financial affairs to money managers and financial corporations, through 401(k) plans and mutual funds, was going to deliver on its promise in spectacular fashion.

The economy was in overdrive, bolstered by a thriving technology sector and appreciating housing market. Picking mutual funds, playing the stock market-it was all pretty easy. Year after year, account balances went up and up.

Until, of course, they went way, way down.

Looking back now, we can see that the great returns were largely transient, an illusion enabled by one of the great bull markets of the twentieth century. But the transformation in the infrastructure of retirement saving is permanent: by the end of the 1990s, IRAs and 401(k)s had surpassed defined benefit pensions in number, participants, and total assets.

Financial services corporations have built a colossal industry around defined contribution products, primarily mutual funds (and index funds and ETFs) purchased through 401(k)s and IRAs. Big box financial firms like Fidelity and Vanguard, along with tens of thousands of brokers marketing themselves as “financial advisors,” have now wedged themselves firmly into the mainstream of American investing. Modern investors have handed over trillions of dollars to professional money managers and mutual funds that have delivered inconsistent — if not downright dubious — value while steadily harvesting billions of dollars annually in fees.

Mutual funds, in particular, have become a central mechanism for retirement saving and investing for millions of Americans; as of mid-2014, roughly 43 percent of U.S. households owned them, representing more than 90 million individual mutual fund shareholders.

Despite the mutual fund’s superficial sheen of simplicity, it’s hardly less complicated than the infamous credit default swap. Though less likely to explode spectacularly and bring down global finance, mutual funds have many of the same toxic hallmarks, including extreme complexity and embedded conflicts of interest, as derivatives — the “financial weapons of mass destruction” at the heart of the 2008 financial crisis. In some ways, mutual funds are even more sinister, slowly bleeding investors over decades instead of finishing them off with a cataclysmic extinction event.

Of course, it’s not just mutual funds. Index funds and ETFs may not be the panaceathey once were thought to be. And there are even cracks appearing in the integrity of some registered investment advisors.

Today, roughly 20% of U.S. workers have a traditional, defined-benefit pension — a percentage surely in decline — and half of workers have no retirement plan, at all. About two-thirds of full-time U.S. workers have a defined contribution plan, and about two-thirds of their collective assets are held in 401(k) plans. Half of Americans have less than $10,000 in savings, and 85% report that they are worried about their prospects for retirement.

And they should be.

But there is a better way.

The article was originally published by TheStreet.com on October 17th, 2015.