A book investors will read with disquiet
AMERICANS who want a comfortable retirement, and who work in the private sector, have to look after their own interests these days. No longer can most rely on their employer to pay a pension linked to their final salary; such defined-benefit promises are too expensive.
Instead, workers are promised something called a defined-contribution (DC) pension which, truth be told, isn’t a pension at all. It is a savings pot to which employers and employees contribute, with some tax advantages. How big that pot will be, and what kind of income it will provide, is unknown.
Most of those savings will probably be invested in mutual funds. Yet as William Birdthistle, an academic lawyer, writes in an entertaining new book*, small investors need to become better informed about the way mutual funds work.
One might think, for example, that all investors in a fund are treated equally. But Mr Birdthistle cites a set of JPMorgan equity funds which have seven different types of shares, with opaque names such as Class R5. The main difference tends to be the fees that funds charge. Small investors usually pay most, even those in some DC schemes. These fees often seem excessive. The author reproduces a table from a single fund managed by Oppenheimer, which has six classes of shares, with the cost determined by nine sets of separate figures for each class. Total annual fees range from 1.01% to 2.2%.
Fees are normally charged as a proportion of the fund’s assets, and so rise and fall with the overall market. But does it really cost more to run a fund if the market rises by 20%? Not all fund managers share economies of scale with their investors.
One particular fee sticks in the craw. That is the distribution-and-service, or 12b-1, fee, which is used to market the fund to new investors. But why should existing investors pay for this process, which will benefit the fund manager? Studies suggest that existing investors get no benefit at all from an increase in fund size. But the industry mopped up more than $12 billion from 12b-1 funds in 2014.
Remarkably, the fees listed in a mutual-fund prospectus are not the only charges investors face.
Funds also incur expenses, such as brokers’ commissions, when they buy and sell securities. These fees are deducted from investors’ returns.
Fair enough, one might argue. Such charges are an inevitable cost of running a fund, and a mutual-fund manager can deal much more cheaply than retail investors would be able to do on their own. But sometimes the fund manager receives services from the broker in exchange for trading—a system know as “soft dollar”. Some of these services may look benign, such as investment research to help a manager pick the best shares (though isn’t this supposed to be his or her expertise?). But investigations by the Securities Exchange Commission, a regulator, have found more dubious uses for soft dollars, such as paying hotel and mobile-phone bills. Although these arrangements are legal, they represent a potential conflict of interest—and their cost is not disclosed to investors.
Mr Birdthistle also outlines serious abuses that have occurred in the mutual-fund
industry—particularly over late trading and market timing, where privileged clients were able to make profits at the expense of ordinary investors. These cost the fund-management firms concerned billions of dollars in fines.
With luck, the industry has reformed and such scandals are things of the past. Mr Birdthistle accepts that mutual funds play a useful role in giving small investors access to diversified portfolios, sometimes at very low cost. Yet the structure of the industry needs further reform; only 40% of the trustees (the people responsible for looking after investors’ interests) are required to be independent of the fund manager. It would be better if independents were in the majority.
The rise of passive index-tracking funds with ultra-low fees will surely put downward pressure on the fees commanded by the rest of their industry. Some high-charging managers can outperform their index, but there is no reliable way of picking them in advance. Assuming a 6% gross return, an extra percentage point in annual fees over the course of a career can reduce your pension by about 30%.
Investors who bear the responsibility of building their own pension pot need to understand the huge impact that charges can have. Reading Mr Birdthistle’s book would be a very good place to start.