Can You Afford to Retire?

john c. bogle

photo of bogle

He is the founder of Vanguard, one of the world's largest mutual fund organizations, and the author of The Battle for the Soul of Capitalism (2005), which addresses "how the financial system undermined social ideals, damaged trust in the markets, robbed investors of trillions -- and what to do about it." In this interview, Bogle discusses why the entire retirement system is faltering and, in particular, criticizes the mutual fund industry for emphasizing salesmanship over stewardship in pushing 401(k) plans. He also warns 401(k) investors' against mutual funds' costs and fees, which can consume a huge portion returns over the long term. This is an edited transcript of an interview conducted on February 7, 2006.

With regard to defined benefit plans -- lifetime pension plans that give you a certain amount of money as long as you live -- you are saying that the private sector, corporate America, is underfunding its lifetime pension plans?

The whole retirement system, in fact, in the country is in, I think, very poor shape, and it's going to be the next big financial crisis in the country, I honestly believe. ... The private pension plans are underfunded by an estimated $400 billion, and the state and local government plans are underfunded by an estimated $800 billion. That's a $1.2 trillion shortfall between the assets the plans have and the liabilities they will have to the pensioners as they pay out their retirement checks over the rest of their lifetimes.

Editor's Note: Estimates of the underfunding of state and local government pensions plans range from $460 billion to $700 billion.

How do they get away with that? Don't they have to fund them?

No, they don't, because a lot of it is based on assumptions. Our corporations are now assuming that future returns in their pension plan will be about 8.5 percent per year, and that's not going to happen. The future returns in the bond market will be about 4.5 percent, and maybe if we're lucky 7.5 percent on stocks. Call it a 6 percent return -- before you deduct the cost of investing all that money, the turnover cost, the management fees. So maybe a 5 percent return is going to be possible, in my judgment, and they are estimating 8.5 percent.

Why? Because when they do it that way, corporation earnings become greatly overstated, and all the executives get nice, big bonuses. They are using pension plan assumptions as a way to manage corporate earnings and meet the expectations of Wall Street.

So if a company overstates the value of its pension plan assets, it makes the company look better to Wall Street, so there's an incentive to kind of exaggerate, if not cheat.

That is precisely correct. And let me clear on the cheating: It's legal cheating; it's not illegal cheating. In other words, you can change any reasonable set of numbers -- and corporations have done this, have raised the pension assumption from 7 percent to 8.5 percent -- and all of a sudden that corporation will report an earnings gain for the year rather than an earnings loss that they would otherwise have. Simple, legal.

... We have a mutual fund industry that has become a giant marketing system ... to bring in the most money by fair means or foul.

This spring [2006], we have seen IBM freeze its lifetime pension plan, Verizon freeze its plan; Motorola did it before, Hewlett-Packard; [we've seen] other companies freeze them. You see companies like United Airlines or LTV [Steel] and others dumping their pension plans on the government pension agency through bankruptcy. If these lifetime pension plans make the corporate bottom line look good, why are corporations junking them?

I think the reason corporations are junking these plans is because they are so underfunded, they realize they can't keep up. Those estimates which we talked about that were much higher than companies could possibly earn in these pension assets are not coming true, so that's part of it.

The companies want to avoid a day of reckoning.

They want to avoid a day of reckoning. And also, ... we are having a lot of talk about pension reform, in which one of the solutions to the problem is to require companies to include that change in pension plan assets in their profit and loss statement [P&L] in their corporate earnings. ... But companies don't like to show

that kind of volatility to the public.

The Pension Benefit Guaranty Corporation [a federal agency, financed by premiums from corporations, that insures failed pensions plans] is now sitting with $20 billion in deficits, almost all accumulated in the last five years: LTV, $2 billion; United Airlines, $9.8 billion. And employees are saying to us, "They made a promise; we took deferred wages; how can they do that?" And the bankruptcy courts say the companies have to do that in order to reorganize. As a man who's looked at the market for a long time, what is your assessment of that phenomenon?

When a company falls on the kind of hard times that the companies you've indicated have, ... there is not a lot of recourse. ... They really don't have much choice but to throw it over to the Pension Benefit Guaranty Corporation, which is greatly underfunded.

... The economic system is a very, very tough taskmaster. And the companies, in some cases, even if their pension plans are fully funded, they can't go on. The cost of health benefits as well as retirement [benefits] -- and health benefits are going to be even larger -- account for something like $3,000 of the cost of a typical American car.

Editor's Note: GM officials have stated that health care adds $1,500 to the cost of a new car; Ford has put the figure at $1,000 per car.

But we're talking about companies here that are coming in with their benefits grossly underfunded. What is your take on those companies that are doing that, then going bankrupt and leaving everybody in the lurch?

Well, sooner or later we've got to get some sense of reality, and it begins with accounting rules. We have to have much stronger rules on what kind of future rates of return you can assume, how often you have to report the value of your pension plan. Do you realize that in corporate annual reports, they don't even have to report the returns in their pension plan? They don't have to tell you, for example, that we are assuming an 8.5 percent return in our pension plan, but in the last six years we have earned 2 percent a year. That's not a disclosable item. I think we need much better disclosure. On the other hand, ... that's going to make companies very leery of continuing their pension plans simply for, if you will, accounting reasons.

But this is really the thing that's most bothersome of all: All of our retirement system is faltering. We all know that Social Security is faltering. We all know that state and local governments are faltering, not just corporations. And we all know that the corporation pension plans are faltering. We know that 401(k) is faltering. And we know people aren't making nearly adequate use of individual retirement accounts [IRAs]. We have a system that is troubled, and I don't see that our administration or our Congress is giving it the attention that it really has to have. I don't think anybody has a crisis kind of an attitude towards this. And if it's a crisis, I think it would help to have a crisis attitude.

You mentioned before a bailout. And you compared it to Hurricane Katrina. What did you mean?

The perfect storm comes into New Orleans, and the citizens of this country are going to pay something like $100 billion to repair the damage from Katrina. I would say that $100 billion would be cheap to repair the damage to our retirement system. I think it's going to cost more than that.

And the taxpayers are going to foot the bill.

Believe me, the government doesn't pay anything, the taxpayers pay everything.

Are we headed for something like the savings and loan bailout?

I don't think we need a savings and loan-type bailout, because these problems, unlike the real estate problems that engendered the savings and loan bailout, are much more gradual in nature. We have a little time to catch up and to increase contributions to the system.

Are we headed for a bailout that taxpayers are going to have to foot the bill?

That's what the Pension Benefit Guaranty Corporation is, a bailout mechanism. If it doesn't get enough revenues, the president is going to have to propose and the Congress is going to have to approve substantial additions to the Pension Benefit Guaranty funding, because the deficits there are getting bigger and bigger.

In general, are retirees better off with pensions? I'm not talking about wealthy folks. Take the average median salary -- somewhere between probably $45,000 to $47,000. Are they better off with a defined benefit life pension plan if they stick with the company or better off investing for themselves in a 401(k) program?

It's very difficult to say in the abstract, because it depends on how much you put in and how much the company matches and things of that nature.

It looks, on the record, that the pension plan is much more effective because the pension plan, through the corporation, has a discipline. They don't skip payments. They may be making them inadequately, but they don't say, "Well, I'll put this aside and buy a rug this month." That's not an issue over there. It's the lack of discipline in the defined contribution plans [401(k)s] -- people don't make their contributions, don't put money in their IRAs, don't put adequate money in their corporate thrift plans -- that causes them the shortfall.

For companies, are those lifetime pension plans more expensive to fund than a typical employer match in a defined contribution plan -- a dollar-for-dollar match or a 50 percent match?

The pension plan is much more expensive, and therefore the 401(k) plan, the employee savings plan, really is not adequate funding for a retirement. It's supplemental funding. You put away maybe 3 percent of your salary, and the company might match that $1 for $3 or $1 for $2, or dollar for dollar even. But putting away 6 percent, if you get a 3 percent contribution and a 3 percent match, simply isn't going to give you an adequate retirement.

401(k) plans were essentially designed as savings plans to supplement retirement income, so when a corporate defined benefit plan is terminated, the company really has to not just give you a defined contribution savings plan, but an extra defined contribution pension plan. In fact, this is what IBM is doing. Most companies haven't revealed their plans, but they are going to have to give you an extra 5 percent or 6 percent of your salary to make up for that difference.

What do people need to put aside to have a decent retirement that will enable them to live at roughly the same standard of living that they were living at when they were working?

To begin with, it's age-intensive. If you start early, it can be a much smaller portion. If you get to age 40 and haven't started, you probably have to put away 25 percent of your income.

So what do you say to the great mass of people who feel terrific about putting away 6 percent a year, with a 3 percent employer match -- that is, 9 percent a year combined starting at around age 35? What do you say to them?

You'd better step it up if you're putting 9 percent in at age 35, and you'd better also do some other very significant things. One, you'd better keep [the investment] costs down so you aren't overwhelmed by the tyranny of compounding costs, whatever market return you might get.

... Investors should realize [they] don't get the market return. In a 9 percent market, we all share 9 percent before we pay the cost of financial intermediation, and after we pay those costs, which are about 2.5 percent a year, we get 6.5 percent on a 9 percent market.

So if I do your average, what percentage of my net growth is going to fees in a 401(k) plan?

Well, it's awesome. Let me give you a little longer-term example. The example I use in my book is an individual who is 20 years old today starting to accumulate for retirement. That person has about 45 years to go before retirement -- 20 to 65 -- and then, if you believe the actuarial tables, another 20 years to go before death mercifully brings his or her life to a close. So that's 65 years of investing. If you invest $1,000 at the beginning of that time and earn 8 percent, that $1,000 will grow in that 65-year period to around $140,000.

Now, the financial system -- the mutual fund system in this case -- will take about two and a half percentage points out of that return, so you will have a gross return of 8 percent, a net return of 5.5 percent, and your $1,000 will grow to approximately $30,000. One hundred ten thousand dollars goes to the financial system and $30,000 to you, the investor. Think about that. That means the financial system put up zero percent of the capital and took zero percent of the risk and got almost 80 percent of the return, and you, the investor in this long time period, an investment lifetime, put up 100 percent of the capital, took 100 percent of the risk, and got only a little bit over 20 percent of the return. That is a financial system that is failing investors because of those costs of financial advice and brokerage, some hidden, some out in plain sight, that investors face today. So the system has to be fixed.

Editor's Note: For details on this example, see this table.

I've got to unscramble what you just said. You said that in the case of the $1,000 invested for 65 years, the financial system is taking 80 percent of the money. But most of us aren't doing that. In the first place, at 20 we're out spending it; we're not putting it away. But set that aside. We're really talking about people who are probably saving from 35 or 40 or 45 at best for retirement at 55, 60 or 65. and they are plunking the money away into 401(k)s. I'm just asking you, in that system, roughly what chunk of it are people getting back themselves out of their gains, and what chunk of that is going to go to the financial system for managing their money?

Well, in the long run, it's 80 percent to the financial system, 20 percent to you. In a given year, it's about 80 percent to you and 20 percent to the financial system, so if you look at 10 years or 15 years, you're probably talking about 60 percent to you and 40 percent to the financial system maybe over 20 years, something like that. But the longer the period, the greater the impact of that tyranny of compounding costs is.

How do you get costs out of the system? Aren't you stuck? You are in a 401(k), and you've got only 11 options or 28 options from your company, and they are all through Vanguard, Fidelity, T. Rowe Price, somebody else. Can you get the costs out?

Easy. You own [a market index fund]: the entire U.S. stock market or maybe 25 percent international, the entire U.S. bond market, or just simply go to government intermediate-term bonds and don't pay anybody for those services. The costs are going to be about 10 basis points or 15 basis points instead of 2.5 percent a year, that 10 or 15 basis points meaning a tenth of 1 percent or a little bit more. It is all you need to pay to own the market.

And do most company 401(k) plans give you that option, buying a market index, or are you given the portfolio that comes with the mutual fund company that the company has signed up with?

The index fund is an increasingly popular option with corporations, and not all of them, but I think some of them, are kind of expensive. Some are charging half of 1 percent. But even that is better. The regular mutual funds which are selling regular equity funds are charging you, as far as you can tell, somewhere between 1 percent and 1.5 percent a year in costs and have hidden portfolio turnover costs: They are turning over their portfolios at 50, 60, 70, 80, 100 percent a year, and there's a hidden cost that you don't even know about that gets paid to the financial system by all that active management.

So I'm a complete believer in capturing the market return through an index fund rather than taking probably about a 5 percent chance over an investment lifetime of beating the market after all those costs. ...

But one of the ideas behind the 401(k) was, "you can do it!" You own it; you run it. And you've got millions of people out there saying, "I can beat the averages." What do you say to that?

I say, don't kid yourself, pal. Look, it's so simple. We're not like the kids out in Lake Wobegon. As investors, we are all average, and as investors, we all share the stock market's return. It's going to turn out to be 8 percent return, we're all going to share 8 percent return, but only before costs are deducted. We all share the market's return less the cost of the financial system. All those management fees and brokerage commissions and sales loads and God knows what else is thrown in there -- the advertising that you see.

So if investors would just use index funds, and particularly the cheapest ones, they would, by definition, capture the market return, or almost all of it -- 98 percent, 99 percent of it. ...

The evidence is profound that mutual fund investors make terrible errors in terms of timing. They want to pour money into the stock market when it's high, and they want to pull it out when the market is low. They make terrible errors on fund selection. They want to buy funds that have done the best, and then when they do the worst they want to switch out of them and get into something else that is then doing the best. All that shuffling around is a tale told by an idiot, full of sound and fury, signifying nothing but losses for the investor.

... Then another place we have really gone awry is we now offer people basically a nice little shotgun by which they can commit suicide: We have given them brokerage accounts, and you can run a brokerage account in your 401(k) plan. So you can then buy individual stocks and go back and forth and do all the insane things that so many investors do all the time.

So we have taken a system that should be simple -- own the stock market and hold it forever; if you like bonds a little more as you get older, have more in bonds, and hold it forever -- [and] now it's pick and choose and select and move money back and forth, even to the point of where you can pick individual stocks and pick your company's stock, which is a big part of the 401(k) problem, and issue; you can do that, too. It's a system that really needs to be fixed, and badly.

You keep coming back to this idea that buying your own company's stock is a bum idea for people in 401(k)s.

Working for company X and having a substantial portion of your retirement plan in company X is simply exposing yourself to too much risk, because the company is both your employer and the source of your retirement income. So if something goes wrong, you lose both your job and your retirement plan.

Or, since employees seem to have a yen to invest where they know a little bit about the company, limit [that investment]. Ten percent in company stock is not the end of the world. But people got greatly overexposed, partly because companies pushed them into it, and partly because in a wave of enthusiasm -- Enron's stock goes way up, people of their own volition put more in that stock than they had to under the company rules, and the tragedy followed. There are plenty of them out there; it's not just Enron.

Looking at the mutual fund industry as a whole, how important was advertising in getting 401(k)s to be the rage of the country?

Well, the industry did not really advertise 401(k), is my recollection, in any big way. It's just too amorphous or inchoate a market to try and reach all the employees out there when you can target yourself right to the corporation itself and say, "We, Vanguard, or we, Fidelity, or we, Capital Group, are the best choice for you to offer to your employees in your 401(k) plan."

I think a good hunk of the responsibility for what's going wrong here in our 401(k) system is that targeting has basically been to the human resources department of these corporations, not to the financial department. I think the financial vice president might have made much more sophisticated choices about how to go about accumulating money for the long term as compared to the human resource departments.

The corporations should have taken a more important role in disciplining the number of choices that are offered to corporate employees -- maybe 12, 15, 20, 30 choices. How do you pick among 30 choices? I would say they should have given a stock fund and a stock index fund, a bond index fund or perhaps a money market fund for security, and let them change.

Today we're trying to creep up on that system with these target retirement funds, where you target your age, and you have more in stocks when you begin. Say you're going to retire 25 years from now. You might be 80 percent in stocks and 20 percent in bonds, and by the time you are retirement age or it gets 10 years away, you're maybe 90 percent in bonds and 10 percent in stocks. The target fund does that for you. But now people are going to probably choose that as one of half a dozen options when if you put your whole plan in it, it will work fine.

I mentioned before allowing employees to use brokerage accounts in their 401(k) plans. They think they can beat the market. How idle a chance, how idle a threat, how idle an opportunity is trading stocks back and forth and thinking you can win beat the system. You can't do it. Maybe one can out of 1,000, one out of 10,000. Maybe it's only one out of 100,000. The odds are terrible.

How did the mutual fund industry get so complicated? Today you're looking at a family of funds that's got 50, 60, 70 different funds, maybe hundreds of different funds.

That's a long story. Let me just give you a couple of ideas. When I came into this business, there were relatively small privately held companies run by the people that ran the management companies, and these companies were run by investment professionals.

Today that has changed in every single respect. These are giant companies. They are not privately held anymore. They are owned by giant financial conglomerates, whether it's Deutsche Bank or Marsh & McLennan [Companies] or Sun Life of Canada. Basically, the largest portion of mutual fund assets are run by financial conglomerates, and they are in business to earn a return on their capital in the business and the amount they have paid to buy into the business, and not the return on your capital as a fund investor. Corporations demand a return on their capital, and that comes at your expense as a fund shareholder. Of course the money managers are running the funds, but the corporate giants who run them don't have a professional bone in their body.

When I came into it, it was a profession with elements of business. Now it's become a business with elements of profession, and not nearly enough elements of a profession in it. We've become a marketing business, and that's where you get all these choices. If the world wants something -- new toothpaste, new beer, better bread -- we give it to them in our consumer society. That's not the right way to run a business concerned with other people's money. That's a sacred trust; it's not a marketing game.

So when you are talking about the individual investor winding up with 30 percent less of their gains over the short run or 60 percent less of their gains over the long run, the folks who are picking up that 30 percent or 60 percent are these giant financial conglomerates, the JPMorgans of the world?

Well, not necessarily JPMorgan, but any large financial conglomerate that is in this business is responsible for a big portion of that gain. But another big portion is the brokerage business itself, because these mutual funds today trade like they are in an Arabian rug market. It's back and forth with Wall Street turning over their portfolios at 100 percent a year, meaning the average fund holds the average stock for one year of time.

So the big financial conglomerate is both picking up the mutual fund fees and picking up the brokerage fees the mutual fund has generated by trading its stock.

Sure. Merrill Lynch would be a better example than JPMorgan, and any of the other giant brokerage firms are doing it. They're selling their own funds to the public, a little bit to a lesser extent now. But they are also getting a lot of money if, for example, Merrill Lynch sells the Capital Group fund to the public, the Capital Group gives them a lot of their brokerage business, and of course they say it's not a quid pro quo, and who am I to say that it is, but I'm not sure it matters. They get the money when they sell shares of the fund.

When I asked you earlier about the whole retirement system, you used the phrase a "perfect storm." To a certain extent, when you look at the retirement situation in America, are you saying a storm is brewing?

It's a generational storm that is coming in large measure because capitalism has gone astray. We have had what I describe in my book as a pathological mutation from traditional owners of capitalism, where the owners put up the capital and got the lion's share of the rewards, to a new form of managers' capitalism, where the managers, often aided by accountants and the financial system and the marketing system, are putting their own interest in front of the interests of the last-line owners, whether it's the direct owners -- the stockholders of America -- or the indirect owners -- the pension beneficiaries, mutual fund shareholders and the like. They simply aren't getting a fair shake.

Now play it out in terms of the retirement system. How does what you call managerial capitalism affect the defined benefit part of our retirement system, pensions?

... Well, on the corporate side, our CEOs and other highly placed executives in the company are basically getting paid for keeping the stock price rising. And the way you do that, if you can't earn money the hard way -- be more efficient, develop new markets, do a lot of innovation -- you start to manufacture earnings the financial way, changing the financial assumptions. Here, one of the big changes is raising the assumptions on your pension plan beyond reason, which means you make a nice profit that year; you know, you are paid basically on your profitability. But you as an executive are putting that impossibly high return on your pension plan, and those pensioners will eventually have to pay the price, or the corporation will have to.

So to use Lincoln's phrase, you're saying that a system run by and for the managers is going to make pension assumptions that make the corporation look good but also underfund the pension, and employees are going to pay in the end.

That's correct, although it could be at least theoretically possible that the next managers who come along after these CEOs will be in a position to pay that price. They're not going to be able to do it quite so easily. ... They will be a little bit like buying a pig in a poke.

In effect, you are saying the system is set up for this pattern.

But the pattern can't go on forever. Sooner or later, assumptions have to turn into reality --

Turn it over to the Pension Benefit Guaranty Corporation.

Well, you turn [underfunded] pensions over to the PBGC, and then they don't pay you the same retirement that the company had promised you. That system is busted, too, so we don't have a lot of safety valves here.

How does managerial capitalism affect the way the 401(k) system is operating? Is there the same kind of deleterious effect on employees because of the way the managers are running those programs?

Sure there is, because when you get over into the defined contribution system, you are basically using mutual funds, the largest investments in that system, and those managers are taking too big a share of the rewards. They are paid on building a big company on marketing, on creating more total management fees, rather than getting better and better performance from the funds. It's a hard business, because we all try to get good performance for our shareholders. I'm the first one to admit that, but in the long run as a group, we are not all above average; we are all average before costs and below average after costs [are deducted].

If managers were not operating in their own self-interest in setting up retirement plans, how would they behave? What would they do?

If you were to just design the perfect retirement plan, you would own the stock market or you would own the bond market. You would get all the costs or all that you possibly could out of the system. So on an annual basis, if the market went up 8 percent, you would get 7.8 or 7.9 percent.

Or take the federal Thrift [Savings] Plan [TSP]. This is something interesting we might talk about. The federal government has a defined contribution plan, a federal employees' Thrift Plan. And guess what they do? They buy index funds and just a very simple line. You can actually have a government bond account or a U.S. index or an international index. So our legislators and our federal employees get these great benefits through as close to a perfect retirement plan as you can have owning the financial markets and holding them forever. We don't do that for our regular citizenry.

It's quite a contrast, and the federal Thrift Plan is not small -- it's about $150 billion -- and so our federal employees don't have to worry about the problems we are talking about here today. Indeed the Bush administration, to their great credit, when they wanted to put private accounts in Social Security, they proposed a federal Thrift Plan kind of solution.

So it's not just me who is saying index the market, capture the market's return, get costs out of the system, be bored to death and have a comfortable retirement. It's the federal government, and it's even the Bush administration -- which you know certainly likes private enterprise, but here they are turning it over to an unmanaged mutual fund.

Talk to any Nobel laureate who has ever won the economics prize, they are going to tell you [to] index. Paul Samuelson recently described the creation of the first index fund as the equivalent of the wheel and the alphabet. That's pretty strong stuff, by the way; I don't think it's quite that good. But ask college professors in finance what they do and what you should do. They'll tell you [to] index. Then ask them what they do, and they'll say, "I index."

But you can't crank this low return to the financial system, high return to the investor into the mainstream of American investing, because we have dreams of glory. We all think we are above average, and we have a mutual fund industry that has become a giant marketing system [where] the idea is to bring in the most money by fair means or foul.

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posted may 16, 2006

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