A standing ovation for a financial innovation

Posted by on August 14, 2009 @ 1:32 pm in Retirement

There’s been lots of talk since late last year about the plusses and minuses of financial engineering, including a debate (see blogs by Felix Salmon and Tyler Cowen) about the overall merits of various modern financial innovations. While it’s easy to pick on stuff like “NINJA” loans (No Income, No Job, No Assets) and various mortgage-backed securities as examples of financial innovations that we’d have been better off without, I think it would be foolish to let these mistakes convince us that we’d be better off going back to the barter system.

Financial innovation can be good for consumers and society generally, and I’d enthusiastically join those nominating the 401(k) as perhaps the most important and welfare-enhancing financial innovation of the last 30 years (if not of the last century; but there’s a good case that index mutual funds would take that prize).

The great benefit of k-plans—namely, allowing middle-class Americans to directly participate in investment markets at low cost—is enormous. One of the biggest unsolved puzzles in financial economics is why well-diversified equity market investments have earned the incredibly generous average returns that they have over time. Allowing individuals to participate to at least some degree in equity markets at low cost, and to share in those risks and returns, almost certainly improves welfare, given any reasonable view of investor goals and objectives—especially in a world in which the government provides a significant retirement income benefit not directly tied to the markets in the form of Social Security. It’s amazing that the unusual and incredibly poor results in financial markets over a period of less than one year are being taken seriously as somehow undermining this basic position.

The typical arguments being made against 401(k) plans fall into two categories:

First, there is a set of ultimately valid but incredibly overblown concerns about “profiteering” in the 401(k) industry. Yes, there are a few providers out there who are able to at least temporarily generate outrageous fees from unwitting or conspiring administrators before they are exposed and replaced. But profiteers, thieves, and charlatans are not a by-product of financial innovation, nor are they a particular issue with 401(k)s. The 401(k) business is in general competitive and tightly regulated, with strong fiduciary standards in place for plan sponsors. Given how many 401(k) plans are managed by top-flight, reputable providers (Vanguard, Fidelity, T. Rowe Price, and others), it’s reasonable to guess that the vast majority of participants out there are getting good value in their plans at very low cost.

A second set of arguments against k-plans are effectively diatribes against the “riskiness” of investing, or against people managing their own portfolios, and are essentially arguments for expanding Social Security. It’s true that some people have no desire or capability to assemble a sensible portfolio of investments appropriate for retirement. But broad-based, low-cost balanced mutual funds—and target-date funds particularly—are additional valuable financial innovations that address this problem directly and may provide a sensible option.

Of course, the risk issue remains. But given that the value created by these plans is to provide exposure to investment risk in order to balance and supplement Social Security and private savings, concern about this seems misplaced. Yes, target-date funds suffered losses in 2008—but as my colleague Steve Utkus points out, the stories written about target-date funds are to some degree disingenuous. The premise of these stories is basically analogous to the classic question “When did you stop beating your spouse?” (“So, when did target-date funds stop offering guaranteed returns?”)

In contrast to this silliness, my guess is that even financially naïve participants basically got it: “The stock market went down 40%, so I probably lost some money in my k-plan.” (Why else would people decide not to look at their plan statements, as is commonly claimed?) Of course, no one enjoys losing money. But given what happened last year, my guess is most aren’t any more “shocked” about what happened than Captain Renault was about the gambling going on at Rick’s. Most participants do understand that they are taking risk in a k-plan, and they are doing so in hopes of earning a return. Target-date funds and balanced funds generally offer a sensible way for them to do just that, but well-diversified risk is part of the deal.

To me, the only debate on k-plans worth spending any time on is whether the tax subsidy to retirement saving is too big or too small relative to other national budget priorities (such as, say, fixing Social Security). Recent events have certainly highlighted the critical role that Social Security plays in providing income that isn’t tied to the investment markets—but it’s not at all clear that reducing the tax incentives for k-plans and IRAs is the best way to fund a fix or to pay for other policy initiatives.

The benefit of k-plans—enhancing the ability of middle-class Americans to directly participate in stock and other investment markets—is enormous. Backward-looking, peak-to-trough analysis of market returns isn’t reality for any investor, it’s just fodder for a headline. (I particularly enjoy stories presenting the peak-to-trough performance numbers to the exact day, which is clearly worthless analysis even as little as three months later.) What I earned on the money I had in my 401(k) as of last year, during the bear market—or even on the money I had in the plan as of 10 years ago—isn’t ultimately relevant.

What’s important is the overall average of what I earn over my full career of work, along with what I will earn before I stop living, breathing—and spending. And it’s my personal belief that, over that horizon, most people participating in 401(k) plans will end up better off for doing so than those who never had the opportunity to benefit from this innovation.

(Note: Investments in target-date funds are subject to the risks of their underlying funds. The year in the fund’s name refers to the approximate year—the target date—when an investor in the fund would retire and leave the work force. The fund will gradually shift its emphasis from more aggressive investments to more conservative ones based on its target date. Investments in target-date funds are subject to the risks of their underlying funds, and an investment in a target-date is not guaranteed at any time, including on or after the target date.)


• All investments are subject to risks. Past performance is no guarantee of future results.

• Links to third-party websites mentioned in this post will open new browser windows. Vanguard accepts no responsibility for content on external sites, including reader comments posted on other blogs.


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