Vanguard’s John Bogle never pulls his punches when it comes to assessing the industry he has helped shape for more than 50 years.
This article originally appeared in the August/September 2013 issue of MorningstarAdvisor magazine. To subscribe, please call 1-800-384-4000.
Recent gains in the stock market may be allowing investors to erase some of their memories of huge losses in 2008, but they still face serious problems on the road to retirement. At the 2013 Morningstar Investment Conference, Don Phillips, head of global research with Morningstar, sat down with Vanguard founder John Bogle to discuss the issues that investors and the fund industry must confront in the years to come. In his usual blunt fashion, Bogle didn’t mince his words, tackling money market reform, Social Security, retirement plans, and the legacy of Eliot Spitzer, a decade after the market-timing scandals sent shock waves through the mutual fund industry. Not surprisingly, even the firm Bogle founded doesn’t agree with everything he says these days. But that didn’t stop him from speaking his mind. The conversation, which took place June 13, has been edited for clarity and length.
Don Phillips: Let’s begin with a couple of hot topics in the industry. Money market reforms have been on a lot of people’s minds. What do you think of the solutions that have been suggested and are they the ones that you would advocate?
Jack Bogle: It’s really interesting when we talk about probabilities and risks because the probability of something bad happening in the money market business is tiny. But the consequences when things do go wrong can be fatal.
Congress has decided that no more taxpayer money should bail out the money market fund industry. That seems like a reasonable position to take. Taxpayers are bailing out everything else, but we might as well draw the line for a profit-making business. So the consequences are dire, but the probabilities are tiny. I think we still must act.
What bothers me, and this bothers me a lot, about the industry in which I find myself— it doesn’t seem to like to get right down to the truth. What’s the fact? The fact is that money market funds’ net asset values fluctuate. What’s the industry’s problem? They don’t want to let the world know that money market fund asset values fluctuate. So, I think they’re leaning on kind of a weak reed. Of course, this industry, which is in the technological vanguard of just about everything, apparently can’t deal with a single class of funds that has a floating net asset value. That seems a little crazy to me.
I think the industry has got to stop defending its own financial interests and start thinking about the interests of shareholders and letting them know actually how money market funds work. I don’t like the reserve solutions that have been proposed, having the funds hold a reserve. I wouldn’t even know how to do it from an accounting standpoint. My solution is to have a floating net asset value, say $10. You can hold up to $10 if you really want to be conservative. That’s up to the money market manager. But have that [floating NAV] be the solution.
Now, what the government has decided to do, or the SEC is recommending—it’s not done yet—is to have asset values float for institutional funds, where the largest problem is. That seems to me like a King Solomon-type decision. Cut the baby in half. I don’t think we should compromise. We should be upfront and do the thing that we know is true.
Phillips: Let’s turn to the retirement crisis in the U.S. When I look at 401(k) plans over the last several decades, I see much progress. I see less money in company stock, fewer people in their 20s with 100% in stable value, more money in balanced funds, things like target-date funds, auto-enroll, auto-increase. In other words, I see a lot of progress.
But a recent PBS Frontline special, which you were featured in, was sharply critical of the industry. I’m interested in how you score the progress, how big is the crisis, and what still needs to be done?
Bogle: As I wrote in my most recent book last summer, called The Clash of the Cultures: Investment vs. Speculation, the retirement system in the United States is facing a train wreck. Or, to be more specific, it is facing three train wrecks, all of which have to be fixed.
Social Security—you all know about that. It’s just underfunded. It could be funded with things that people wouldn’t even notice: a change in the cost of living adjustment, which the administration has proposed. They’re simple things that end up being completely controversial. I’m not proposing reducing the payments, but making the payments appropriate to the circumstances. That, along with a little older retirement age and larger minimum Social Security distributions, and the problem would be solved.
The defined benefit plan, which is a vanishing kind of figure in the retirement system, is grotesquely underfunded. The states are a bigger problem than the corporations. They’re using an 8% future return. I will say, unequivocally, they are not going to get an 8% future return. Not with bond interest rates around 2%, depending on what you’re looking at, to 2.5%, and stocks likely to return about 7%, and that’s before costs.
The way these corporations and states look at it is in effect they say—and they’ve said this to me—you know, you’re right about the return, but we’re going to hire good managers. It’s possible for any one of them to do that, but it is impossible for them all to do it.
The third leg of this retirement stool is the defined contribution plan. The problem with it is we’ve taken a thrift plan and turned it into a retirement plan. What does it need to be fixed? We need to be much stricter on withdrawals. If we allow people to say, “I’ve got a sick child and my wife wants a new living room rug and I need to take some money out.” How are you ever going to have a good retirement doing that? Social Security wouldn’t amount to anything if you could take your money out whenever you felt like it. It’s just a system that has too much flexibility.
Of course, I can’t resist saying, as I told Frontline, that [consumers are] investing in the wrong thing. That is, what do we know about all of these thrift plans, 401(k) plans, and mutual fund plans put together? We know they’re indexers, because they own, as a group, the entire market. There’s no way around this. If you look at what they have in all those plans, it looks just like the market. Probably has an R-squared of 99, something like that, maybe even 100.
By owning the market individually, they’re assessed these substantial costs: 1%, say, for the fund; fund turnover cost, 0.5%.; extra charges by the companies, or by advisors, or whatever it is that has replaced brokerage loads. It comes to maybe at least 2% a year total all-in cost. So investors are going to get the market, less 2%.
The math is undeniable, so we need more discipline, we need less ability to take money out, and we need investors to do the right thing in terms of their investment choices. What I have recommended in my book is that we have a federal retirement board that determines eligibility for a firm to get into the retirement plan system. There would be guidelines for a long-term focus and reasonable fees. You’d have to clear muster.
Phillips: You mentioned high costs and the problem of choice. Yet when I look, most of the money today in 401(k) plans is going into target-date funds. The three big providers all have costs substantially lower than what you cite. Is the market, to some degree, taking care of this problem, and what do you think of target-date funds?
Bogle: My first impression about target-date funds is that they follow the philosophy I’ve had as long as I can remember. That is, your fixed-income position should have something to do with your age. Target-date funds are all based on that. I guess this is almost a postscript before I get to the main point, but I’m not sure we don’t have to think a little bit about—does that idea work under all circumstances?
The other thing that worries me is I think target-date funds have too narrow a mandate. Think about it this way. Virtually everybody who is investing has the resources to invest for their future. Probably a third of citizens don’t have those resources and will never have them. They will have to rely totally on Social Security.
But once you’re getting Social Security, think about how that fits into the target-date environment. Example: You can do this a lot of different ways, but let’s suppose that the capitalized value of Social Security at age 65 for most people is, say, $300,000. So you have got a $300,000 fixed-income position and probably the best fixed-income position you will ever have in your life. It’s got a cost of living adjustment. The payouts are as close to certain as things can be in this world. You’re sitting there with that $300,000.
Now, let’s look at you as you’ve accumulated $300,000 in your 401(k) plan. If 100% of that is in equities, you’re 50/50. You should look at that. I’m not saying you should forget the age-based solution. But you should think about what other sources of income you will get during retirement rather than basically treating target-date funds as your entire asset base. Because for probably 90% to 95% of all investors, it isn’t their entire asset base if they would look at Social Security.
If you just look at the stream of income, it would suggest more focus on dividend-paying stocks and less on growth stocks. I know [dividend stocks are] almost a fad these days, and, therefore, they may be overpriced. Over the long run, focus on the dividend stream, focus on the fact your Social Security checks will keep coming in and grow each year as inflation grows, and think about your retirement in terms of when you go out to that little mailbox and pull out two envelopes, your fund envelope and your government envelope, and maybe another pension plan or something, whatever there is. That’s what should matter to you in retirement.
Phillips: I should note that on both money market funds and the retirement crisis, that your views differ rather dramatically from the current Vanguard management team, which wanted the steady $1 NAV and just issued a report yesterday saying that things are much better with the 401(k) system than people recognize. What would you say to people that say, “Gee, Vanguard gets to be on both sides of every issue?”
Bogle: Well, there is a little matter of phraseology here. People will state to me: I understand you disagree with Vanguard on this point. And I say, absolutely not. I would never do that. Vanguard disagrees with me. I’m too old to go out and speak vigorously in favor of a position that I simply don’t fundamentally believe in. So, it gets me in a little bit of trouble. I never know, to be honest with you, what Vanguard’s position is in these things. I probably have an idea. But I have my position. I may take it before Vanguard does. I may take it after.
But you have to stand for what you stand for. The book that I mentioned, The Clash of the Cultures—book plug number two—Vanguard was not particularly happy with that book. If you add together the money managed by the 25 largest firms, it’s probably 50% of all the equity in America. This small handful of corporations, particularly the top five, controls corporate America. Corporate America needs a lot of cleanup, a sweeping out. Executive compensation is a disgrace. Political contributions made by corporations are a disgrace. When you look at the whole picture, we’re the last gatekeeper. Think about that for a minute. The press and the courts have failed us in terms of shareholder rights. The regulators have failed. The security analysts have failed. The money managers have failed. The fund and corporate directors have both failed. We’re now down to the last line, the shareholders who own those companies. If they don’t speak, there’s nobody left.
Industry’s Black Eye
Phillips: Let’s turn to the market-timing scandals in the fund industry, which is sort of a seminal event of the past few decades. Given what we now know about his strongarm tactics, his disregard of due process, the fact that he lost nearly every case he actually took to trial, let alone his personal life, do you still think Eliot Spitzer is a true American hero?
Bogle: Hmm. Just to be unequivocal about it, yes and no. The overreaching on the legal side was not proper. I could see a little bit of this, to be quite blunt about it, when I got to know him decently well, but not well enough to tell him to put the arrogance aside.
So on that, no, but for taking up this crusade on the mutual fund side, I think it was courageous. I think he did it energetically. He over-prosecuted some of the cases. And it probably wasn’t his fault, but he under-prosecuted the mutual fund cases. Only one person went to jail in all that mutual fund fakery—an absolute disgrace, a black eye for our industry.
I looked at it as a conspiracy. That’s my legal theory. I’m not an attorney, which makes me totally competent to comment. I looked at it as a conspiracy of fund insiders and hedge fund managers to defraud the long-term holders of the funds. But alas, I was nobody’s legal advisor, and the courts had a very high standard of proof.
I observed in a speech I gave in Boston very recently, called “Big Money in Boston,” what a failure we’ve made of fiduciary duty. Then I raised a subtle question. Take Fidelity, or for that matter, take Vanguard. We each run a couple hundred funds. I think Fidelity runs 260 or 270, and Vanguard runs, I think, 160. Can our directors be fiduciaries and totally understand the workings of 160 or 260 different mutual funds? How can they be [an effective] fiduciary when they’ve got 160 oversights? I leave that as a question, but the answer is pretty obvious. [The board] needs some help. That’s going to be an evolving part of the industry, where independent directors have an independent staff.
Phillips: The market-timing scandals clearly tainted the industry and what a number of funds did was inexcusable. But is it fair to paint the whole industry with the same brush? When the scandals first broke, when it seemed like every day another fund was being indicted, one of the things that Morningstar said was, that when the dust settles, the majority of fund firms won’t be involved and that many of the big players— and we named names, Vanguard, Fidelity, American Funds, T. Rowe Price, and PIMCO— won’t be involved. We were right about that. To me, it seems that clearly, what happened was terrible, but there were also many examples of people who did the right thing. Almost all of the rewards have gone subsequently to those firms, and the ones that misstepped have been penalized severely. So, it seems to me, in some way, capitalism is working.
Bogle: Well, it sort of worked, sure. I agree with that. There probably were only about 20 mutual fund firms that were able to do this big market timing. So when you get down to 20, and take out the four or five you mentioned, which you’re absolutely correct on, probably 100% of the remainder were in there. Say 16 firms, and they have paid a price in the marketplace.
Phillips: In reading some of your books, it occurred to me that we all do a certain amount of anchoring. When you think back on the fund industry, you remember a golden era of it being treated as more of a profession. I started looking at this industry in the 1980s. When I look back, it seems to me that things have improved dramatically from the ‘80s, when firms like Dean Witter and First Investors walked the earth and were big players. But when you look back you may see deterioration. Do you think there has been progress in the last 25 years?
Bogle: We weren’t angels back then. But the Wellington Fund
That’s changed. Now, 40 of the largest 50 fund firms are owned by financial conglomerates. I think that is a huge negative because [these conglomerates] buy a firm, like any corporation buys a firm, to earn money on their own capital, and they’re also fiduciaries to mutual funds and have a fiduciary duty to earn the maximum return on those shareholders’ capital. Those things conflict at the level of cost. You can see it very clearly.
So they’ve got dual fiduciary duty, and I say in that Boston speech, “When that split is there, you go to good old Matthew 6:24”— always have a Biblical quote. That is, “No man can serve two masters.” Matthew goes on to say, “He will either love the one or hate the other.”
Phillips: When I look at the fund industry today, I see more good, low-cost funds available to investors than ever before. I see more examples of good stewardship. Frankly, the funds that have low cost and good stewardship are the only ones getting assets today. Isn’t that progress?
Bogle: It’s progress, absolutely. Let me say that without any doubt. You’re right about the lower-cost funds—lower cost, not low cost, because there’s only one low-cost firm out there, to be honest with you. Just look at the numbers.
Phillips: That’d be what, Charles Schwab?
Bogle: Yeah. Don’t know what to say about old Chuck. Maybe I should ask Chuck or something. Now, you know I’m reading his ads. It’s a business for Schwab, and they’re doing their best to compete. If it knows it has to lower costs, it’s going to do that. And in a couple of cases, [Schwab’s] costs, I think, are maybe even lower than Vanguard’s. The philosophy comes out if every fund in your complex has low cost. It doesn’t come out when you can pick and choose to meet competition.
I think there’s some progress, but I don’t particularly like the huge concentration of assets in the top five or 10 firms. It’s actually higher than it was in the past. Not hugely higher, but those top 10 firms probably have 50% of the industry’s assets, and that’s where the money flows are.
But I would say, yes, the industry is better. But what’s that all about? We should be getting better and better from where we are, and that’s really my gripe, my lover’s quarrel with the industry. We can’t stand there and say that we’ve done a great job when the record shows that we have not done a great job, A, because of cost, but B, because of the way we attract investors.
Phillips: You regularly champion indexing, obviously, and you tend to have less gracious things to say about active management. But when I look at some of the firms out there, I see more of your DNA in a place like T. Rowe Price or American Funds than I do in some of the upstart, very specialized or leveraged index funds. What would your counsel be to someone: Would you rather have them buy a lower-cost actively managed fund than a high-cost index fund?
Bogle: I guess the answer to that, since I believe that cost is the single most important factor, is absolutely yes, provided the [active fund] had reasonable diversification. I think [Morningstar] had a piece of data the other day that said the average cost— [the average] expense ratio of an index fund—if you take all of them and add them up, and divide by 200 or whatever the number is, is 129 basis points.
Phillips: And the turnover is over 100%. Stunning.
Bogle: Yeah, the turnover over 100%. Forget them.
Phillips: At some point, does it cease to be indexing, if you’re not buying and holding the whole market?
Bogle: You can say you index. You see this all over the place in the ETF market, where there are, I think, 1,500 funds, and I think they track something like 1,100 different socalled indexes, some of which they make up themselves. Indexing, like any good idea, attracts marginal players.
Phillips: This is our 25th anniversary of the conference. When we hold our 50th anniversary, are you optimistic that this industry, at that point, will tilt more toward a profession than a business today, or are you worried that it’ll be the opposite?
Bogle: I’m optimistic that will happen, and I actually expect to be here.
Phillips: It’s a standing invitation.
Bogle: I should say, in 2001, I wrote a book called John Bogle on Investing: The First 50 Years, leaving hanging that the sequel, John Bogle on Investing: The Second 50 Years would be out there. As some of you know, I may, particularly right now, not walk like I’m 44, or even look like I’m 44, but 17 years ago I got a 26-year-old heart, so I’m only actually 43.
Phillips: Truly young at heart.
Bogle: Yeah, so count on seeing me there. It has to happen, because ultimately, and I have a quote again in this Boston speech from Adam Smith. This is the great Adam Smith, 1776, The Wealth of Nations. They call him the first consumer advocate, and he says— it’s so obvious that I’m not even going to try and prove it—that serving the consumer must be the object of every enterprise’s existence. It’s obvious to all of us. It’s obvious to someone selling cars or anything else. But this industry has these two masters, and it doesn’t seem to be obvious. The consumer is not always the object of their existence. The object is getting bigger. It’s gathering assets. So, I can’t disagree with you. The industry has gotten somewhat better. But for heaven’s sake, as I’ve often said, “Success is a journey and not a destination.”
Some people say that Vanguard is a great firm. Of course it’s not. It should be trying to be great, striving forever to be great. But once you think you’re there—that’s not a good idea. Forget it. Keep working for what your duties are, what you’re assigned to do, what your conscience tells you to do. Just be the kind of person you want to be when nobody else is looking.