Let’s get straight to the point – teachers at all levels have gotten, and continue to get, inequitable treatment when it comes to options to allow them to become “retirement ready.” My sister-in-law was an assistant principal in a local education system. First thing I told her – NO VARIABLE ANNUITIES! Variable annuities are one of the leading reasons for customer complaints to regulators every year, and for good reason. They are one of the most oversold, least understood and most abused investment products sold to the public. The high costs and generally poor investment options forced on variable annuity owners are one of the main reasons for a popular saying among investment professionals – annuities are sold, not purchased.
Investment fees and other costs matter. Each additional 1 percent in fees and other costs reduce an investor’s end-return by approximately 17 percent over a twenty year period. Given the fact that variable annuities often charge annual cumulative fees of between 2-3 percent, a variable annuity could reduce a variable annuity owner’s end return by 33-51 percent. And guess who gets that money? Right the variable annuity company that sold you the horrible investment in the first place. For a more comprehensive analysis of the issues involved with variable annuities, click here.
But it’s not just variable annuities that have been unfairly forced on teachers. The retirement business in connection with educators has essentially been controlled by a small group of investment companies, TIAA-CREF, Valic and Fidelity investments. TIAA-CREF has been the proverbial 600-lb gorilla in the college/university sector, with Valic being the dominant entity at the elementary/high school level.
The main product that both companies have traditionally tried to peddle has been variable annuities. Why? They pay some of highest commissions of any investment product, sometimes as much as 7 percent compared to the 4-5 percent paid by many actively managed mutual funds.
TIAA-CREF, Valic and Fidelity also offer teachers a variety of mutual funds. However, overall, the funds offered by these companies fail to pass a simple prudence analysis due to the combination of poor performance and high fees and costs.
Studies have shown that the proper way to analyze actively managed mutual funds, the most common type of funds offered by teachers’ retirement plans, is to compare the incremental, or additional, costs they charge to the incremental, or additional return they provide compared to less expensive, passively managed, or index funds. Other studies have shown that the two best predictors of a mutual fund’s performance is a mutual fund’s annual expense ratio and trading costs, as both directly impact a fund’s bottom line and an investor’s end-return.
Based on those two facts, I created a simple cost/benefit metric, the Active Management Value Ratio™ 2.0 (AMVR), that incorporates those elements to determine the cost efficiency of an actively managed mutual fund. In short, approximately 80-85 percent of actively managed mutual funds are not cost efficient when compared to comparable passively managed mutual funds. In some cases the actively managed funds are significantly cost inefficient, with costs 1-2 percent higher, in some cases even higher. Again, 1-2 percent in additional investment costs translates to a 17-34 percent reduction in end-return. For more information about the AMVR, click here.
The last issue about teachers’ retirement abuse has to do with the management of one’s retirement account. Some “financial advisors” will advise teachers to establish an investment portfolio and never make any changes in the portfolio except perhaps to periodically re-balance the investments in the portfolio to restore the portfolio’s original allocation percentages.
Those same “financial advisers” will often attempt to justify such advice with statements such as “market timing does not work. What they often fail to disclose is that they often receive an annual payment from a fund company, generally referred to as 12b-1 fee, for each year you continue to own one of the fund company’s funds. So much for being a “trusted adviser.”
History has shown that true market timing does not work due to the difficulty in successfully predicting the stock market and the costs with making investment trades. However, the key is determining exactly what constitutes “market timing.” Classical “market timing” involves trying to predict the stock market and employing ans “all in” approach to investing, positioning one’s investments 100 percent in the stock market or 100 percent in cash, with no other options.
Such an approach is clearly imprudent from both a cost and risk standpoint. However, the “re-balance only,” also known as the “buy, forget and regret” approach is also imprudent and ignores the fact that history clearly shows that the stock market is cyclical. Given that fact, one should heed the wise words of the Chines philosopher Lao Tzu, who said that “the best way to manage anything is by making use of its nature.”
Since the market has proven to be cyclical, Lao Tzu would suggest that the best approach to managing one’s investment portfolio is to adopt a more proactive, yet prudent, approach to managing one’s retirement accounts. Noted investment icon, Charles D. Ellis would concur with this approach to investment management, as he has warned investors that investing “is, and always should be, a defensive process” and “the secret to successful investing is to avoid significant investment losses.”
This defensive approach makes even more sense for managing investment accounts. Advocates of the “buy-and-hold” approach often try to justify their position to pointing to the trading costs and potential tax problems that can result from making changes in an investment portfolio. However, retirement accounts are tax-deferred accounts, so changes can be made in a retirement account without any tax consequences.
The buy-and-hold” advocates second argument is also without merit. The goal in adopting a proactive, defensive approach is not to perfectly time the stock market and does not need to be in order to provide an investor with significant benefits. When an investor suffers an investment loss, that constitutes an opportunity cost for an investor, who must then use the eventual market to simply restore their retirement account to its original value. As I people. “you will never get ahead if you have to spend all your time catching up>
Many investors underestimate the opportunity cost created by significant investment losses. When I speak to groups I often ask them this simple question – If I suffer a 50 percent loss in my portfolio in year 1, then earn a 50 percent gain in year 2, what is the value of my portfolio?
Most people say that my portfolio is back to its original value. But the correct answer is that my portfolio is still 25 lower than it original value since the 50 percent return in year 2 was on the reduced value of my portfolio as a result of loss in year 1. To fully recover from the year 1 loss, my portfolio has to eventually earn a 100 percent return on the value of my portfolio after the year 1 loss.
During the bear market of 2008, many investors suffered losses of 40 percent or more. An investor would have to earn a return of 67 percent just to recover from the original 40 percent loss. The investor also suffers an opportunity cost, as the return required for recovery does not go to growing his account even larger than its original value.
In suggesting that teachers and other investors adopt a proactive, yet defensive and prudent approach to managing their retirement accounts, I am not suggesting the use of some complicated mathematical formula. For instance, prior to the 2008 bear market, the market’s price/earnings ratio was at historical levels, suggesting that the level was unsustainable and ripe for a market correction or worse. By taking a profit and re-allocating the assets in their retirement account to whatever level they felt comfortable with, teachers and other investors could have minimized their exposure to the significant loss that was to follow, again with no additional tax and probably minimal, if any, trade costs, as many fund companies allow retirement account owners to make a certain number of free trades annually.
Teachers provide a valuable service to society. Yet their pay rarely reflects the value of their contributions. Even worse, they have been saddled for years with an inequitable retirement system that primarily serves the companies that peddle their inferior investment products rather than the teachers and other plan participants. This point can be easily proven by using the Morningstar web site (morningstar.com) and the Active Management Value Ratio™ 2.0 to analyze the mutual funds offered within their 403(b) or other retirement plan.
Don’t even take the time to evaluate the variable annuities these companies peddle, as their high fees disqualify the overwhelming majority from any serious consideration. The various investment subaccounts, or mini-mutual funds, that a variable annuity owner is given to choose from generally suffer from similar high fees and a history of under-performance relative to less expensive passively managed, or index, funds.
403(b) and 457(b) plans at private collages and universities have recently become the target of litigation, as they are subject to the strong fiduciary requirements of ERISA. Unfortunately, state-run schools are not subject to ERISA, so there has not been similar litigation against such schools, despite the obvious inequities in the current system used by such schools. However, teachers in state-run schools may soon get the much-needed relief they deserve, as state-run schools may soon face the same litigation private schools are now facing using state laws and regulations to provide teachers with the relief that they desperately need and deserve.
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This article is for informational purposes only, and is not designed or intended to provide legal, investment, or other professional advice since such advice always requires consideration of individual circumstances. If legal, investment, or other professional assistance is needed, the services of an attorney or other professional adviser should be sought