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Personal Finance
Vol. 2
Whartonon
Finance
http://executiveeducation.wharton.upenn.edu http://knowledge.wharton.upenn.edu
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When it comes to personal finance matters, many feel its better to make
no decision than to be wrong. In fact, thats how most investors manage their401(k) plans, according to research conducted by Wharton faculty. But in the
face of longer and more expensive retirements, that approach is a recipe for
disaster. Aside from 401(k)s, investors are bombarded with a variety of new
investment vehicles, such as Exchange Traded Funds (ETFs), and conflicting
advice about where to put their money and how to grow it. In the following
Knowledge@Wharton articles, Wharton faculty and other experts discuss some
of the thorny points of personal investing, separating financial fact from fiction.
Personal Finance
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Stale or StickyWhat Motivates Late Trading and Market Timing in Mutual Funds? 4
Three years ago, mutual funds were accused of allowing favored customers to engage in late trading and
market timing that hurt ordinary investors. The scandal has subsided, but questions remain: Is short-term
trading encouraged by the use of out-of-date, or stale, stock prices in valuing fund shares? And, what
remedies will work without penalizing ordinary investors?
Todays Research Question: Why Do Investors Choose High-Fee Mutual Funds 7
Despite the Lower Returns?
With their combination of low fees, tax efficiency, and simple, autopilot investing style, index funds seem to have
captivated American investors. At the same time, however, many investors still hold trillions of dollars in high-fee
funds despite well-publicized evidence that low-fee alternatives offer higher returns over the long run. It struck
us that most people just dont know what mutual fund fees are. So we set out to actually test that, says Brigitte
C. Madrian, professor of business and public policy at Wharton, who coauthored a study on the subject.
Dont Sweat the Inverted Yield Curve: No One Really Knows What It Means 10
Consider the inverted yield curve as the equivalent of an economic bogeyman. Its when the natural order up-ends
and short-term interest rates are higher than long-term ones. The Treasury bond yield curve inverted December
27, 2005, for the first time in 5 years. That gave shudders to those who saw the phenomenon as a harbinger of
recession. What does the inverted yield curve really mean? Wharton professors offer some perspectives.
Exchange Traded Funds: Whats the (Big) Deal? 13
Exchange Traded Funds (ETFs) are on a roll: According to investment research firm Morningstar, 177 ETFs were
listed as of August 31, 2005, with net assets of $255 billion, compared to 97 in 2002, with net assets of $89
billion. Why are ETFs so popular? According to Wharton faculty and industry experts, ETFs provide certain benefits
that their mutual fund cousins do notbut they can have a downside, too, if not used responsibly by investors.
Longer Lives and the Lump-Sum Illusion Are Just Two of the Challenges Retiring 16
Baby-Boomers Face
In the United States alone, an unprecedented 77 million baby-boomers will be living the next 20 to 30
years in retirement. With long lives ahead of themand without adequate planningwhat are the risks
they are facing? Knowledge@Wharton spoke with Olivia Mitchell, Wharton professor of insurance and
risk management, and Christopher Kip Condron, president and CEO of AXA Financial, about the new
challenges facing the rising tide of boomers in the U.S. and around the world.
Hands-Off: Holders of 401(k) Retirement Accounts Are Not Your Typical Investors 21
With $2.5 trillion invested in 401(k) retirement accounts, 60 million Americans control a powerful chunk of
cash. So how much attention do investors pay to this vast pool of savings? Not much. According to a Wharton
analysis of retirement accounts managed by The Vanguard Group in 2003 and 2004, participants in 401(k)plans made little effort to tend their defined-contribution plans once they were set up. Even among those who
did trade regularly, turnover rates were one-third those of professional money managers.
Tax Shelters: Exotic or Just Plain Illegal? 24
In February 2006, German bank HVB Group agreed to pay $29.6 million in fines to avoid indictment for
defrauding the Internal Revenue Service with abusive tax shelters that gave rich clients phony losses to
reduce taxes. The settlement was part of a broadening investigation into shelters that wealthy individuals used
to escape about $2.5 billion in taxes from the mid-1990s through 2003, according to the government. What is
a tax shelter, and more importantly, what is an illegal one?
Contents
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three years ago, the business scandal
spotlight moved to a new industry when
mutual funds were accused of allowing favoredcustomers to engage in late trading and market
timing that hurt ordinary investors. Since then,
fund companies and individuals have paid more
than $4 billion in restitution and fines, and
regulators have been searching for ways to
prevent or discourage short-term fund trades.
But although the scandal has subsided, some
questions about these strategies have gone
unanswered. Is short-term trading encouraged
by the use of out-of-date, or stale, stock
prices in valuing fund shares? Will remediessuch as redemption fees, mandatory holding
periods, and fair-value pricing work? And can
they work without penalizing ordinary investors?
To find out, Wharton Finance Professors
Marshall E. Blume and Donald B. Keim looked
at stock and mutual fund data from 1993
through 2004. The result is their recent paper,
Stale or Sticky Stock Prices? Non-Trading,
Predictability, and Mutual Fund Returns.
What our paper shows is that you need some
device other than fair-value accounting to stopthe potential for market timing, Blume says,
referring to proposals to change the way fund
shares are priced at the end of each trading day.
Anything that works to deter market timing
harms other individuals.
The net asset value, or price, of a mutual fund
share is calculated by the fund company after
the 4 p.m. close of each trading day. The closing
price of each stock in the fund is multiplied
by the number of shares held. The resultthe
total value of the funds holdingsis dividedby the number of fund shares owned by
investors, determining the share price for that
day. Investors who had placed orders to buy or
sell the funds shares during the day have their
orders filled at this price.
However, the stock prices used in this
calculation are often slightly out of date. This
is especially so with foreign-company stocks
traded on exchanges in Europe, Asia, and
elsewhere. Those exchanges close many hours
before the 4 p.m. New York time used in pricing
fund shares. The fund price is therefore based
on stock prices that do not reflect news that
took place after the foreign exchanges closed
making the fund price stale.
In theory, investors can profit from staleness
by, for example, purchasing shares likely to go
up tomorrow when the foreign market reacts to
news that broke late today.
Stale or StickyWhat Motivates Late
Trading and Market Timing in Mutual Funds?
You need some device other than
fair-value accounting to stop the
potential for market timing,Blume says.
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Market timingbets on short-term moves in
fund pricesis legal so long as the fund lets
all shareholders do it. The fund companies that
got into trouble were permitting only favored
investors to make the quick-turnaround trades
this strategy requires. Short-term trading
generates lots of expenses for the fund
expenses borne by all of its shareholders.
In late trading, which is generally illegal, atrader is allowed to buy or sell at that days
price even if he places the order after 4 p.m.,
though a late order is supposed to be filled the
next dayat the next days closing price. This
gives the trader a valuable edge because key
news, such as the quarterly earnings report, is
often released after the market closes. For the
favored investor, the privilege of late trading is
like having a time machine that allows him to
buy at the old price after hearing news that is
sure to drive the price up the next day.
Late traders effectively bought shares at a
discountthe previous days pricewhile
the fund had to pay full price to buy the
stocks needed to create the fund shares the
late traders ordered. In effect, other fund
shareholders made up the difference between
the actual cost of those stocks to the fund and
the price paid by the late traders.
Momentum and Predictability
While the benefits of trading with stale prices
is easy to see with foreign stocks, where prices
can be many hours out of date, Blume and
Keim noticed that many of the funds involved
in the scandals were trading U.S. stocks, where
the staleness was likely to be less extreme.
If you go look at the actual mutual fund cases,
you find that many of them are domestic
funds, Blume said.
The study started by measuring the staleness
in U.S. stock prices. Stocks were divided into 10
groups based on market capitalization or the size
of the companies that issued the shares. Theprofessors found that 99.5 percent of the largest
stocks traded within the last 5 minutes of the
day, meaning their closing prices almost perfectly
reflected the most up-to-date information. A fund
owning such stocks and valued at the 4 p.m.
prices would therefore not be stale.
As stocks got smaller, the percentage traded
in the last 5 minutes fellto 60.6 percent for
those in the middle group and 13.3 percent for
ones in the smallest stock group, for example.
Hence, staleness increased for stocks of
smaller companies. On the other hand, large
stocks represent most of the trading. Thus, 96
percent of all stocks were traded in the last
5 minutes, resulting in little staleness in fund
values. This suggests some factor other than
staleness was attracting short-term traders.
In their next step, Blume and Keim looked at the
predictability of fund prices. That means, if it
goes up today, it goes up tomorrow, Blume says.
Various studies had shown that short-term
predictability exists and can be measured. But
what causes it? Could it be stalenessthe
fund price reacting to news a day late in a
predictable way?
Blume and Keim put together a series of
portfolios ranging from large stocks to small
ones. They eliminated the effect of stalenessby including only stocks that had traded in the
final 5 minutes of the day. They found that
the portfolios still exhibited a high degree of
predictability, indicating that some factor other
than staleness was at workthough staleness
did contribute to predictability of funds holding
smaller stocks.
Predictability, they concluded, was largely
caused by stickiness and momentum
traders tendency to cling to their views of
individual stocks. If traders liked a stock on one
day, and bid up its price, they were likely to dothe same the next day.
The conclusion: There is not much staleness
in mutual funds that own U.S. stocks. Hence,
market timing and late trading were mainly
momentum-based strategies rather than stale-
pricing strategies.
While the benets of trading with
stale prices is easy to see with foreign
stocks, where prices can be many
hours out of date, many of the funds
involved in the scandals were trading
U.S. stocks, where the staleness was
likely to be less extreme.
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Since stale pricing is not the problem, Blume
and Keim say it makes little sense for regulators
to try to stop short-term trading by targeting
staleness in fund pricing, as some reformers
have urged.
One proposal, for example, would adjust each
stocks price at the end of the day by a factor
based on futures trading in the Standard &
Poors 500 Index. The funds share price wouldthus, in theory, reflect what each stock would
have traded for had it traded at the very end of
the day, even if it did not. Using such fair-value
pricing systems to set prices for fund shares
would not deter market timers and late traders,
because funds would still have the price
predictability that attracts those traders, Blume
and Keim argued.
Some reformers have suggested that short-
term trading would be discouraged if traders
were allowed only a limited number of
transactions per year. But this would not fix theproblem either, Blume and Keim say, because
people could still concentrate their trades on
days that short-term gains could be expected.
Another proposed remedy: a redemption fee
charged to investors when they sell fund shares
a fee larger than the profits generally offered by
short-term trades. The best deterrence, Blume
and Keim say, would require a fee charged no
matter how long the investor had owned the
shares, but this would penalize all investors.
As an alternative, the fee could be lifted once
an investor had owned the shares for a given
number of months or years. Unfortunately, thispenalizes investors who are not market timers but
need to redeem before the period ends for some
other, perfectly proper reason.
Whats the ideal solution? There isnt one,
Blume says, as any approach will penalize
ordinary shareholders to some degree. Still, he
adds, a temporary redemption fee seems the
least onerous of the alternatives.
Indeed, investors may soon find more fund
companies imposing them. A rule passed
in 2005 by the Securities and ExchangeCommission made redemption fees easier to
levyand ordered fund companies to address
the issue by mid-October 2006.
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With their combination of loW fees, tax
efficiency, and simple, autopilot investing style,
index funds seem to have captivated Americaninvestors. Indeed, the Vanguard 500 Index Fund
is the third largest of the more than 8,000
funds, with assets exceeding $111 billion. And
investors have plowed money into the newest
indexers, called exchange traded funds. ETF
assets hit $296 billion in 2005, up from just
over $1 billion 10 years earlier.
Clearly, investors have embraced the core
belief that minimizing annual fees boosts long-
term gains.
Or have they? Three researchers at Wharton,
Yale, and Harvard wanted to find out. Why,
they wondered, do investors persist in holding
trillions of dollars in high-fee funds despite
the well-publicized evidence that low-fee
alternatives offer higher returns over the long
run? It struck us that most people just dont
know what mutual fund fees are. So we set out
to actually test that, says Brigitte C. Madrian,
professor of business and public policy at
Wharton. The result is a paper entitled Why
Does the Law of One Price Fail? An Experiment
on Index Mutual Funds, by Madrian, James J.
Choi, professor of finance at Yale, and David
Laibson, economics professor at Harvard.
Their conclusion: Investors appear to have a
poor grasp of the fee issue, failing to minimize
fees even when the benefits are presented in
a clear and incontrovertible disclosure. Most
investors dont understand the importance of
mutual funds fees, Madrian notes.
To zero in on the issue, the researchers asked
test subjects to choose among a variety ofindex-style funds with identical stock holdings
but different fees.
Index funds buy and hold the stocks or bonds
contained in an underlying market gauge, such
as the Standard & Poors 500 Index, composed
of the 500 largest stocks traded on American
exchanges. The index fund simply holds those
securities, providing the investor with returns
matching the indexs, minus the fees. In
contrast, actively managed funds employ teams
of portfolio managers and researchers who huntfor the hottest investments. Much research has
shown that, over long periods, few of these
managers can match index funds performance,
let alone beat it. The chief reason is the higher
fees managed funds charge to pay for the
securities hunt.
A typical managed fund investing in stocks
carries an expense ratio, or annual fee, equal to
about 1.3 percent of each investors holdings,
while the cheapest index funds charge 0.2
percent or less. Over time, this can make a
big difference. If two funds contained identical
portfolios returning an average of 10 percent a
year before fees, an investor putting $10,000
into one with a 1.3-percent expense ratio would
have $53,038 after 20 years. An investor who
chose the fund charging 0.2 percent would end
up with $64,870.
Some investors would nonetheless choose the
high-fee fund in hopes its managers could more
than make up for fees by picking top-performing
securities. Or the high-fee fund might offer
other benefits, such as investment advice from
the brokerage or fund company that sold it.
But with all other factors removed, leaving thetwo funds identical except for fees, it would
seem that sensible investors ought to choose
the low-fee fund. To see if they would, Madrian,
Choi, and Laibson recruited two groups of
students in the summer of 2005MBA
students about to begin their first semester at
Wharton and undergraduates (freshmen through
seniors) at Harvard.
Todays Research Question: Why Do Investors Choose
High-Fee Mutual Funds Despite the Lower Returns?
Investors appear to have a poor
grasp of the fee issue, failing to
minimize fees even when the
benefits are presented in a clear
and incontrovertible disclosure.
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All participants were asked to make
hypothetical investments of $10,000, choosing
from among four S&P 500 index funds. They
could put all their money into one fund or divide
it among two or more. We chose the index
funds because they are all tracking the same
index, and there is no variation in the objective
of the funds, Madrian says. By and large, they
all generate the same performance. So the only
difference in the actual returns you are going toget at the end of the day is generated by fees.
Participants received the prospectuses that fund
companies provide real investors. And, they
were told that at the end of the experiment,
one participant would be randomly selected to
be paid any profit his or her investment choices
had generated from September 1 through
August 30. This gave participants a financial
incentive to pick the fund, or combination of
funds, they thought most promising.
One group of participants also received a fee
sheet that broke out information from the
prospectuses on fees charged by each of the
four funds. It explained that funds charge fees,
and it showed how to figure the impact of fees
and loads, or sales commissions, on investment
returns. The funds annual fees, or expense
ratios, ranged from 0.59 percent to 0.8 percent.
Each fund also charged a front-end load, or
sales commission, ranging from 2.5 percent
to 5.25 percent of the amount invested. The
sheet reported the combined effect of the two
charges on a $10,000 investment over 1 year.
The students, therefore, were shown that the
Allegiant/Armada S&P 500 fund would charge
$309 over one year, the UBS S&P 500 Index fund
$320, the Mason Street Index 500 fund $555,
and the Morgan Stanley S&P 500 fund $589.
Instead of the fee sheet, a second group
received a returns sheet reporting each
funds average annual returns since the fund
was started, net of fees, loads, and other
charges. Since the four funds portfolios wereidentical, returns varied only because the
funds inception dates were different, with the
data covering different time periods when the
markets behavior varied.
The Allegiant/Armada fund had returned 1.28
percent, the UBS fund 2.54 percent, the Mason
Street fund 5.9 percent, and the Morgan
Stanley fund 2.54 percent.
A control group received the prospectuses but
not the fee or returns sheets.
A knowledgeable investor trying to get the
largest possible return in the future would
ignore the past-performance data, since the
different periods covered made any comparison
apples to oranges. Because the four funds held
the same securities in the same portions, their
future performance would be identical beforethe impact of fees was deducted.
Therefore the logical choice was the fund with
the lowest feesthe Allegiant/Armada fund.
We kind of stripped away all of the other
elements that might drive your investment
decisions and boiled it down so that the fees
should be the only thing that should matter,
Madrian says.
But the students overwhelmingly fail to
minimize index fund fees, the researchers
write. When we make fund fees salient andtransparent, subjects portfolios shift towards
lower-fee index funds, but over 80 percent still
do not invest everything in the lowest-fee fund.
In fact, the mean fee paid by the students was
1.22 percentage points above the minimum they
could have paidenough to dramatically reduce
long-term gains. Most students spread their
money among two or more fundsa pointless
move since the funds were the same. They
probably really dont understand what an S&P
500 index fund is, because there is no more
diversification to be gotten from spreading your
money among the funds, Madrian says.
Among the MBA students who received
the fee sheet, the combination of funds
chosen produced a mean annual fee of $366,
compared to the $309 they would have paid by
concentrating in the fund with the lowest fee.
For the undergraduate Harvard students, the
mean fee was $410.
Results were even worse for the students given
the returns sheet instead of the fee sheet,even though all the fee data was still available
to them in the prospectuses. The mean fees
paid were $440 for the MBAs and $486 for the
undergraduate Harvard students. The control
group fell in between, with a mean of $421 for
the MBAs and $431 for the Harvard students.
Since students who received the returns sheet
posted the worst results, it was clear they
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had used this information improperly. When
we make index funds annualized returns
since inception (an irrelevant statistic) salient,
portfolios shift towards index funds with higher
returns since inception, the researchers write.
This was especially damaging because the
researchers, in selecting from among the hun-
dreds of S&P 500 indexing products available,
chose ones in which the higher returns frominception were coupled with high fees.
The experiment did indicate, however, that
students had some sense of the importance of
fees, as they put more money in the lower-fee
funds. Among the MBAs who received the fee
sheet, for example, nearly 20 percent put all
their money in the cheapest fund, paying only
$309. No student in any group put all of his or
her money into the fund with the highest fees,
$589. The bulk of the investments were made
in the two funds with the second- and third-
highest fees.
Because the students who received the fee
sheet did better than the others, what we
draw from this is that disclosure matters,
Madrian says But how information is disclosed
also matters. What our study suggests is that
people do not know how to use information
well. My guess is it has to do with the
general level of financial literacy but also
because the prospectus is so long.
Investors might benefit, she says, if regulators
required fund companies to disclose fee
information, and its importance, in a brief form
providing standards for comparisonsomething
like the nutrition labels on food containers. In
other words, suggests Madrian, Come up with
something that is shorter, more digestible, and
more informative.
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consider the inverted yield curve as the
equivalent of an economic bogeyman. Its when
the natural order up-ends and short-term interest
rates are higher than long-term ones.
The Treasury bond yield curve inverted
December 27, 2005, for the f irst time in 5 years.
That gave shudders to those who see the
phenomenon as a harbinger of recession. And
yet, the U.S. economy is strong, and surveys
show most forecasters think it will stay that
way. So what does the inverted yield curve
really mean?
I think it sometimes portends a recession,sometimes not, says Marshall E. Blume,
finance and management professor at Wharton.
This time, it probably does not, he adds. All
the forecasts are quite favorable. There arent
any real excesses in the economy at the current
time, and you usually think of recession as a
tonic to the economy, to undo excess.
Business inventories are not excessively high,
Blume notes. Recent government data has
shown inflation picking up, which can lead to
recession. But most of that is due to the oil-price jump last year, and oil has leveled off and
doesnt appear likely to rise further. Also, the
economy is less dependent on oil than it was
during the recession-bound 70s, so oil-price
increases are less likely to infect the broader
economy, Blume says.
In fact, its a bit of a stretch to describe todays
yield curve as inverted, suggests Wharton
Finance Professor Robert F. Stambaugh. I
certainly wouldnt describe it as a sharply
inverted yield curve. Its flatish and
downward-sloping in some segments.
The yield curve is a graph with a line tracing
short-term yields on the left and longer-term
yields as it moves to the right. Typically, rates
for 1- and 3-month Treasury bills on the left are
several percentage points lower than those
of 10-, 20-, and 30-year Treasury bonds on the
right, as investors demand higher yields for
tying their money up longer. A year ago, the
3-month yield was just over 2 percent and the
30-year just under 5 percent.
The curve is inverted when short-term yields
are higher than long-term ones. At this time
last year, the 2-year Treasury yielded just over
3 percent and the 10-year about 4.3 percent.
By late December, the 2-year had moved up to
4.347 percent, just edging out the 10-year at
4.343 percent.
Not only was this inversion very slight, it was
confined to just part of the curve, Stambaugh
says. Three-month yields continued to be lowerthan 10, 20, and 30-year yields, though the
difference was far less pronounced than a year
earlier. People were comparing the 2-year to
the 10-year, but thats sort of the worst case.
The curve has flattenedand inverted in this
segmentbecause short-term yields have risen
significantly, while long-term ones have stayed
about the same.
Dont Sweat the Inverted Yield Curve: No One
Really Knows What It Means
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At the short end, the cause is clear: The
Federal Reserve has raised short-term rates 13
times since June 2004, lifting the Fed Funds
rate from 1 percent to 4.25 percent. By raising
rates, the Fed hopes to make it more expensive
for individuals and companies to borrow
money, causing a slow-down in spending. That
translates into a decline in demand that should
discourage prices from rising, averting inflation.
Typically, a rise in short-term yields is followed
by a less pronounced rise in long-term yields.
But the Fed has no direct control over long-term
yields, which are governed by supply and demand
as bonds are traded in the secondary market.
Greenspans Conundrum
The key question today: Why have long-term
rates so stubbornly stayed low despite the Fed
action? Even Fed chairman Alan Greenspan,
often seen as the guru of interest rates, has
described this as a conundrum.
While various factors affect long-term rates,
economists generally see them as an average
of current short-term rates and the short-term
rates traders expect in the future, says Nicholas
S. Souleles, finance professor at Wharton.
Current yields are known, but long-term
yields can only be guessed at. They largely
depend on what the Fed will do with short-
term rates in the future, and that is governed
not just by evolving Fed philosophy but by the
unpredictable factors it will evaluate years
down the road.
Simple arithmetic says that if the Fed lifts
short-term yields, long-term ones will followbut not by as much, since current short-term
yields are only part of what governs long-term
yields, Souleles says. We always see this:
When the Fed raises short-term rates, long-
term rates dont go up as much. Typically, long-
term rates rise about two-fifths as much as
short-term rates do.
But today, long-term rates have not gone up as
much as they would typically, he says, adding
that economists have focused on three general
reasons for this. First, bond traders may be
anticipating low inflation in the future, which
would allow the Fed to keep interest rates low
or to make them even lower. Some economists
and traders believe that globalization will rein
inflation in, as more products and services are
produced by low-cost economies.
Also, he adds, the bond market may be
anticipating an economic slowdown or recession
as well as a Fed rate cut to make more money
available to stimulate the economy.
Second, long-term rates may be staying low
because high demand for Treasuries and other
U.S. debt securities keeps bond prices high,
which keeps yields low. Bonds represent loans
from bond buyers to bond issuers. When
demand is high, issuers like the government can
attract lots of buyers despite offering low yields.
Various factors affect demand for Treasuries,
including their perfect safety record. But
demand has been increasing, Souleles says,
because China, Japan, and some other
countries are selling more products to the U.S.
than they are buying, leaving them with a cash
surplus they are stashing in safe Treasuries.
The Chinese have more income than they are
spending. They are saving those funds, and
some of the savings is going abroad.
The third reason for low long-term yields involves
traders demand for a risk premium, according
to Souleles. Typically, they demand higher yields
to offset risks related to tying money up in long-
term bonds. For example, if interest rates rise
in the future, bonds issued at that time will be
more generous than ones issued today, so there
will be less demand for the older bonds, and
their prices will fall. Similarly, higher inflation
in the future could chew away a good part of a
bonds interest earnings.
These risks are not as pronounced for short-
term bonds, since they will soon automatically
convert to cash that can be reinvested in
whatever way seems most suitable for the
changing conditions. So there is little risk
premium on short-term bonds.
When long-term rates are virtually the same
as short-term ones, it could mean that traders
Simple arithmetic says that if the Fed
lifts short-term yields, long-term ones
will followbut not by as much, since
current short-term yields are only part
of what governs long-term yields.
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dont believe it likely that interest rates and
inflation will move higher, Souleles says. Hence,
they do not demand as high a risk premium as
they did in the past.
Early in January, the Fed released minutes of
its December meeting, indicating that its rate-
raising cycle may soon come to an end. If short-
term rates will not be rising in the future, that
would help keep long-term rates low.
Though most economists agree about the
three groups of factors that influence long-term
rates, it is virtually impossible to determine how
much influence each has at any one time, notes
Souleles. The worlds bond markets are too big
and far-flung, and different traders weigh the key
factors differently.
Upward Pressure on Energy Prices
Given all the factors that can be affecting
todays yield curve, a looming recession canhardly be considered a certainty. But that
cannot be entirely ruled out, either, notes
Francis X. Diebold, professor of economics,
finance, and statistics at Wharton.
In fact, most recessions have been preceded
by inverted yield curves, as traders anticipate
a Fed rate reduction to stimulate the economy,
he points out. Im not going around saying
theres a recession coming. But he notes that
the future is not necessarily rosy, either. The
bond market doesnt seem to be as worried
about inflation as I am, he adds, arguing that
growing demand for oil by China, India, and
other countries will continue to put upward
pressure on energy prices, contributing to
broader inflation.
Interest rates are also likely to rise as the
U.S. deals with the huge federal budgetdeficit, according to Diebold. There are only
three ways to address that problemraising
taxes, borrowing, or printing money. The Bush
administration has ruled out higher taxes, and
the other two remedies both tend to drive
interest rates up.
Hence, he predicts inflation will run 3.5 to
4 percent over the next decade, a half to 1
percentage point above the long-term average.
Investors in 10-year Treasuries will demand a
real return of about 1.5 points above inflation,and they will want a 1-point risk premium. That
would take the 10-year Treasury to 6 or 6.5
percent, well above todays 4.3 percent.
And that would be the end of todays partially
inverted yield curve. Markets are fickle,
Diebold says. So I cant say this with any
certainty, but I wouldnt be surprised to see
the yield curve steepening, with the long bond
going up.
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exchange traded funds (ETFs) are on a
roll: In early June 2005 the American Stock
Exchange (AMEX) announced it had creatednine new industry-based Intellidex Indexes as
foundations for a new family of ETFs.
By the end of that month, Wheaton, IL-based
PowerShares Capital Management had already
launched eight ETFs based on those indexes.
Each index tracks 30 stocks from target industries
based on proprietary research designed to offer
market-beating investment returns.
At the AMEX, 24 funds were introduced in
2005, compared to seven in all of 2003.
According to Morningstar, a Chicago-based
provider of independent investment research,177 ETFs were listed as of August 31, 2005,
with net assets of $255 billion, compared to 143
funds with assets of $174 billion for the same
period the previous year. In 2002, there were
only 97 funds with net assets of $89 billion.
None of us envisioned this kind of growth,
says Jim Ross, co-head of the advisor strategy
group at State Street Global Advisors (SSgA),
a unit of Boston-based processing bank State
Street, one of the big ETF players. ETF growth
is expected to continue, he adds, with assets
predicted to increase about 30 percent over
the next few years. Some in the industry have
predicted that ETFs will grow at 30 percent
annually for the next 5 years, Ross adds. I can
see that happening.
Why are ETFs so popular? Because they
provide certain benefits that their mutual fund
cousins do not. Like index-style mutual funds,
ETFs are baskets of stocks designed to provide
diversification and to mirror the performance
of an underlying stock market index. Whenyou buy a share of an ETF, you are buying
shares in the index. Unlike mutual funds, ETFs
can be traded throughout the day and can be
used in short sales. They also offer some tax
advantages over mutual funds.
And the annual expense ratios for ETFs are
generally lowjust 0.4 percent to 0.5 percent
a year, compared to 1.4 percent for stock
mutual funds, according to Dan Coulton, a
senior analyst with Morningstar. (Investors pay
brokerage commissions on ETF trades, whilethey do not when they deal directly with no-
load mutual fund companies. For active traders,
commissions can eat up ETFs low-expense
advantage, Coulton said.)
ETFs can trade throughout the day because
they use a pricing system quite different from
that of mutual funds, which are priced just once
a day based on the closing prices of the funds
holdings. ETF share prices, in contrast, rise
and fall with supply and demand as they are
traded during the daythe same way ordinary
stock prices are set. That could cause ETF shareprices to diverge from the value of the stocks
owned by the fund. This happens to closed-end
mutual funds, which trade throughout the day
like stocks.
So to keep an ETFs share price in line with the
values of the stocks it owns, market makers
and specialist firms are allowed to create
or redeem large blocks of ETF shares called
creation units. A market maker purchasing a
creation unit, for example, can pay for it with
shares of stock in the unit, or it can sell the unitand get the shares. The unit prices and stock
prices can thus never move very far apart.
One of the most attractive things about ETFs
is the way prices are kept in check by market
makers and arbitrageurs, says Wharton Finance
Professor Jeremy Siegel, who is a director
in Index Development Partners (IXDP), a
company that develops indexes on proprietary
Exchange Traded Funds: Whats the (Big) Deal?
ETFs can trade throughout the day
because they use a pricing system
quite different from that of mutual
funds, which are priced just once a
day based on the closing prices of
the funds holdings.
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methodology and plans to launch an ETF soon.
You can always go back and forth between the
underlying shares and the index, so arbitrageurs
will make sure that the prices of these two
quantit ies are extremely close, he notes.
The ETF pricing system also can benefit
investors at tax time. With a mutual fund,
sales by investors force the fund to sell
shares of stock, and net profits must bepaid out to investors by the end of the year.
That distribution may be taxed as a capital
gain. But because ETF trades do not force
sales of any fund holdings, there are no such
distributionsand no tax bills.
Need for Innovation
AMEX created ETFs 12 years ago as a flexible and
tax-efficient alternative to index-tracking mutual
funds. The first AMEX ETF, issued by SSgA, was
the Standard & Poors Depositary Receipt (SPDR),
which tracked the S&P 500 Index.
Cliff Weber, senior vice president at AMEXs ETF
Marketplace, says there was recognition early
on at AMEX of the need and opportunity for an
exchange to be innovative. The ETF serves both
long-term investors and active traders, he notes.
ETFs have proven to be a popular alternative to
mutual funds. In addition to tracking standard
indexes such as the S&P 500 that use broad
criteria like market capitalization, ETFs now
track many specialized indexes. Some focus on
specific investment styles or market sectors.
Others buy dividend-paying stocks or issues
from certain countries or regions. Some even
track commodities markets.
AMEX alone lists 168 funds, 24 of which werelaunched last year. The latest include three new
dividend achieversETFs by PowerShares,
based on Mergents Dividend Achievers
Index. These started trading on the AMEX on
September 15.
Last month, Barclays Global Investors, the San
Francisco-based unit of Barclays of London,
launched a micro-cap ETFiShares Russell
Microcap Index Fundthat trades on the New
York Stock Exchange. Also in the works is a
fund tracking yet another specialized indexthe
FTSE RAFI US 1000 Indexcomprising stocks
picked up for their fundamentals, such as
cash flow and book value. PowerShares, which
was selected as the sole licensee of this index
on September 9, hopes to launch an ETF based
on it later this year.
Both Barclays micro-cap fund and the dividend
achievers funds embody the latest innovations
in ETFs. Although State Streets SPDR (known
as Spider) is st ill the largest ETF, with assets of
$51.9 billion as of June 30, other issuers such
as Barclays have muscled their way in. Barclays
has more than 100 funds tracking the S&P, Dow
Jones, Russell, and Morningstar equity indexes
as well as Lehman Brothers bond index.
The Vanguard Group, based in Valley Forge, PA,has 23 funds in its VIPER family of ETFs and
manages about $9 billion in ETF assets. Earlier
this month, Vanguard announced that AMEX
has started trading options on 20 VIPER funds.
State Street also has 22 ETFs and plans to
launch nine more.
Hedge Funds Moving In
Investors have grown increasingly sophisticated
with ETFs. Many now use them to hedge or
temporarily change their position in a particular
industry sector or class of investment. Hedge
funds and institutional investors are using
ETFs to bet on market declines with short
salesborrowing ETF shares to sell in hopes of
repaying the loan with cheaper shares bought
later. Siegel notes that being able to short is a
great advantage of investing in ETFs.
Many investors who dont like the high risks of
futures markets like to use ETFs to hedge their
positions. Many ETFs are now linked to options,
which give their owners the right to buy or sell a
block of shares at a set price for a given period.
Ross of SSgA said financial services firms and
brokers increasingly use ETFs to easily change
market sectors emphasized in their portfolios.
According to Wharton Finance Professor
Marshall Blume, ETFs are highly effective if
an investor wants to temporarily change his
position in the market.
Many investors now use ETFs to hedge
or temporarily change their position
in a particular industry sector or class
of investment.
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With ETFs growing in popularity, issuers have
begun to offer funds that track more and more
specialized indexes, such as a fund for socially
responsible investors and a fund tracking gold.
Indeed, Blume believes that ETFs will continue
to gain in popularity, with issuers designing
more and more exotic forms, such as funds
tracking stocks with high or low price-to-
earnings ratios. Siegel agrees. My personal
feeling is that [standardized] index productsare pretty much exhausted; most of them have
been covered.
Siegel believes ETFs could very well cut into
the market share of index mutual funds. And he
expects future ETFs to entail actively managed
funds, rather than just indexers. Although
managed ETFs do not currently have regulatory
approval, AMEXs Weber said several companies
want to offer managed ETFs, and he expects
some to be launched by the end of next year.
Already, niche players like PowerShares areedging in this direction. PowerShares funds
are classified as Intellidex or Dynamic
portfoliothe indexes are regularly adjusted in
hopes of beating the broader market.
PowerShares Dynamic Market Portfolio (PWC),
which evaluates 2,000 stocks in 10 sectors
every 3 months, has produced an average
annual return of 24 percent since June 30,
2003, compared to the S&P 500 Indexs return
of 14.89 percent.
While some consider the proliferation of
specialized funds to be a desirable step, others
sound a note of caution. Coulton of Morningstarsays that while there are plenty of sound,
diversified ETFs, there are an awful lot of
really narrowly defined, undiversified, gimmicky
sorts of funds that are very difficult to use
responsibly and well. He worries that people
are going to use them the wrong way by trying
to time the ups and downs of the marketplace.
History shows that investors do a really poor
job of this.
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in the united states alone, an unprecedented
77 million baby-boomers will be living the
next 20 to 30 years in retirement. With long
lives ahead of themand without adequate
planningwhat are the risks they are facing?
According to Olivia Mitchell, Wharton professor
of insurance and risk management, and
Christopher Kip Condron, president and CEO
of AXA Financial, the worlds largest financial
services firm, the rising tide of boomers in
the U.S. and around the world needs to meet
challenges that previous generations never
faced, including changes to key retirement
institutions, as well as medical-care cost
inflation and the lump-sum illusionthe
tendency to view retirement savings as a
lump sum, as opposed to a prospective
income stream. In the following interview,
Knowledge@Wharton spoke with Mitchell
and Condron about how the financial services
industry is working to meet the needs of this
next wave of retirees.
KnoWledge@Wharton: Olivia, can you give
us a brief understanding of what the baby-boomer market is facing today, particularly
in the financial space of both retirement and
wealth management?
mitchell: The situation facing the baby-
boomers is very different from that facing
their parents. The risks are much greater, and
the uncertainties are terrific. For example,
Social Security and Medicare face tremendous
insolvency problems. The capital markets
are much more globally integrated and more
volatile. And therefore, baby-boomers reallyhave a very great challenge facing them,
one quite distinct from what their precursor
generations confronted.
KnoWledge@Wharton: Kip, although your
business is a global company, what services do
you provide in the United States [alone] for the
baby-boomer market?
condron: Basically, our business is the
business of providing guarantees. We provide
guaranteed income for people at retirement,
and we provide guaranteed death benefits.
You would typically think that what we do [as
an insurance company] is life insurance and
annuities. But what we really do is take the risk
off an individuals personal balance sheet, put
it on ours, pool it with others, and find ways
to hedge it in the marketplace so that we can
provide some comfort to these baby-boomers
as they are approaching retirement.
KnoWledge@Wharton:And how have your
services changed and evolved with the baby-
boomers getting older? Are you finding it requires
a different sales process now to reach them and
to market to them and also to service them?
condron: Absolutely, and I think that theres
a realization that when you think about baby-
boomers today, you say, whats their biggest
fear? Their biggest fear is that they are going
to run out of money. So what we do is provide
guarantees that theyll have a stream of income
for life, regardless of how long they live.
Longer Lives and the Lump-Sum Illusion Are Just
Two of the Challenges Retiring Baby-Boomers Face
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KnoWledge@Wharton: Boomers generally do
have a lot of money. Is that correct?
condron: Well, some do and some dont.
KnoWledge@Wharton: On average, would
you say that its a wealthy population?
condron: I think it is tiered, and Olivia
probably would have some comments on
this. But I think that there are people at oneend of the spectrum who plan for retirement
and worry about running out [of money], but
they have done some good planning. At the
other end of the spectrum, you have people
who have done very little planning and have
accumulated very little and dont know what
they are going to do.
mitchell: The research shows that boomers,
on average, are about at the same position
financially as their previous generations;
however, they face much greater uncertainty.
For example, my parents generation had Social
Security to look forward to. What we know
today is that Social Security is running short
of financing. My parents generation benefited
from a huge run-up in the value of their houses.
What we dont know looking forward is: How
secure is that housing asset?
Health care is much more uncertain going
forward. The good news is we are going to live
much longer. The bad news is its going to be
that more much expensive to take care of our
health care needs. So I identify, along a numberof spectrums, new risks or graver risks that
boomers are facing. And thats where I think
the work that Kip is doing is so important
to talk about protecting against those risks.
KnoWledge@Wharton: What are the
psychological barriers to penetrating the market?
Is there a fear factor there thats underlying
the population? Do they need to be educated
more than with other sales processes?
condron: Well, I think they surely need to be
educated more, and thats the one thing that
we found out about this particular population.
Theyre smart, and theyre better educated than
their parents were about financial issues. But
they want to be smart and make smart personal
decisions. They dont want to be told what to
do, but they want to be educated so that they
can make smart decisions.
The big problem is that the conventional
wisdom is wrong. The conventional wisdom is
that as you get older, you should become more
conservative in your investment portfolio. So, as
I go into my 50s and Im approaching 60lets
say 65 is the magic agethe conventional
wisdom is I should start making my investment
portfolio more and more conservative. Yet
a couple at age 60 today has a 62-percent
probability that one of them will be alive pastage 90. So were not planning for 15 years,
were planning for 30 years or more.
If you go back 30 years ago to 1976, you had an
inflationary environment that was very different.
If you go through the last 30 years, you couldnt
possibly have major investments and fixed-
income securities and have hedged yourself
against inflation.
KnoWledge@Wharton: Today, many
people are as active as can be at age 65
entrepreneurially, education wise; some of
them are going back to school.
condron: Well, the [idea about retirement atage] 65 came about from Benjamin Disraeli, I
think, [over] 100 years ago, because 65 was the
life expectancy at that point and time.
mitchell: In the U.S., weve already started
to push on that retirement age frontier along
a number of fronts. For example, the Social
Security Administration has moved the normal
retirement age for getting full benefits to 67.
So boomers cannot count on the old-fashioned
retirement plan anymore at 65 or younger. It will
probably have to be pushed up even further.
If we go back to when Social Security was
created, age 65 was selected as the life
expectancy. Now we would have to talk about
age 80 as the possible retirement age. Im not
saying that everybody should or could do that.
But I do believeand this is what weve been
pushingthat we have to encourage people to
work longer, because just another 2, 3, 4, or 5
Research shows that baby-boomers,
on average, are in about the same
financial position as previous
generations; however, they face
much greater uncertainty.
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years of work can really alleviate some of the
shortfalls later on in this climate.
KnoWledge@Wharton: Some of the
institutions youve mentionedsuch as Social
Security and Medicareare changing, and I
imagine will impact boomers.
mitchell: The boomers are very much
influencing the solvency of Medicare and Social
Securitytheres no question about that. And
indeed those systems will be running short
of money in the near term. Its not something
thats 50 years away; its going to be starting
in about 10 years. So we do have to focus on
greater risk management and risk prevention
and mitigation. If we can just work a few more
years now, save a little more, invest a little
more wisely, and protect against some of the
bigger risks, were going to be a whole lot
happier when were 85 or 90.
condron: I think that retirement means
different things to different people today. If we
think of our parents generation, they retired
from whatever they did and they didnt work
anymore. Today people retire usually or often
to something, and theyll have a second career
or a second interest in life. So people may not
continue to work in the same places theyve
worked for most of their career, or even in the
same areas of interest. But they will go do
something to make up the short-fall financially.
Also, theyre healthier and theyre living longer,
and they want to keep active. So keeping a
sort of finger in the pie is something a lot of
people care about.
KnoWledge@Wharton: As an international
company, do you see a difference between
United States baby-boomers versus those
in Europe? Is it a different mind set? Is it a
different process there?
condron: There are a lot of similarities, and
there are a lot of differences. The similarities
are that there are boomers everywhere, all
around the worldpost World War II baby-
boomers. And the need for retirement planning
is universal. However, when you look at the
makeup country by country, we probably have
in the U.S. the most sophisticated retirement
systems of almost anywhere in the world.
KnoWledge@Wharton: From a protection
standpoint?
condron: Yes, because of our corporate
structure with corporate pension plans, 401K
plans, 403B plans, and so forth. Our population
has more private sector money put away for
their retirement, whereas in a lot of other
countries, there is a lot of public sector money
supporting people for retirement. But, they
havent put the kinds of incentives and systems
in place that we have. So the challenges,
country by country, are rather different as tohow you solve the needs that individuals have
as they are approaching retirement.
Because we are a global company, we are
taking this in itiative we call At Retirement,
which is a model for advising people about
making smart decisions at retirement. We
are taking this model and rolling it out across
the world, but we are adapting it country by
country, because every countrys needs are
different and every countrys demographics
and social makeup is different. Its a fascinatingchallenge, actually, because weve never done
this inside our company before, and Im not
sure if anyone has ever done it at all. So,
trying to figure out how to take a universal
problem, like satisfying peoples financial
needs at retirement and looking at it from a
global perspective, rather than just a domestic
perspective, takes on a whole lot of other
issues that you have to deal with.
mitchell: If I could just add to thatone of
the things that weve realized, looking around
the world, is that different countries have
different institutional structures. Sometimes
they facilitate retirement planning, retirement
protection, and sometimes they dont. As an
instance of that, in Japan we see that most
older people, like in many countries, have a
house. They have a lot of money invested in
their dwelling, but they dont have many other
assets, so theyre not very diversified. So,
one of the questions might be how to develop
financial markets and new financial products to
help people tap into those assets. An example
in the Japanese case would be to try to develop
a reverse-mortgage market. You can live in the
house and get the services from the house, but
by the same token have some protection from
running out of money.
KnoWledge@Wharton: How does real estate
factor into the retirement situation in the
United States?
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mitchell: Most older Americans do own a
house. Its a very key part of their retirement
portfolio. Past experience has suggested that
people tend to hang onto their house until the
bitter enduntil there is a death in the family or
they have to move into a nursing home. So, one
of the challenges in the U.S. is, again, how to
develop means to let people access that equity,
to finance their retirement while not forcing
them to move until they absolutely have to.
condron: There are a lot of challenges around
that because the concept of reverse mortgages
is wonderful. If I have a million-dollar house
and I borrow $500,000, I can create income for
myself and settle up the debt at the time of my
death, and so forth. But the problems with it are
that on the front end, it tends to be expensive
for the client because there are a lot of mouths
at the trough. There are the mortgage people,
there are the investment peoplethere are a lot
of fees, and thats the challenge.
And secondly, you have the power of compound
interest working against you, and thats a
problem. This debt that keeps growing, if you
want to think of it in those terms, is a real
significant issue. There is a lot of work being
done on reverse mortgages. There are some
in the marketplace today. Its not yet, at least
in the United States, something thats hit the
mainstream very well because I think the
product structure is still a little bit flawed. Its
one thing that were doing a lot of analytical
work on right now to see if there is a design
that can be beneficial to the client, not create an
environment where the heirs are going to feel
like someone took advantage of their parents,
which is always an issue here. So there are a lot
of challenges around it. Its sort of like the Holy
Grailif you can figure out how a retired couple
could continue to live in their house and create
liquidity and have enough income, maybe you
would get the prize for figuring out retirement.
So we are working on it.
KnoWledge@Wharton: On the psychological
side again, theres got to be a group thats very
stubborn, that wants to just defer the whole
thought of retirement. What do you say to
those people? And how do you educate them to
start planning and emphasize that the more you
push it off, the more pain youre going to feel
later on in life?
condron: I think that you have to remind
them that they are going to live for a long
time. And, I think that is the one piece [of
information] that people are shocked at. For
example, people tend to think, If Im 65,
Ive got a 15-year life expectancybecause
life expectancies for children born today are
somewhere around 80 years. But the fact is,
if you [make it] to age 65, your life expectancy
is a lot longer. And then you get into theprobabilities, because what we found isgoing
back to the point I made earlierif youre a
couple that is age 65, there is a 62-percent
probability that one of you is going to live past
age 90. Thats the year 2000 data, the most
current data we have. In the 1970 data, you had
a 40-percent probability that one of you was
going to live past age 90.
KnoWledge@Wharton: Thats quite a shift.
condron: People are living longer. One of the
things that we have to worry about is managing
[something] that people never talked about
before: longevity risk. We have to manage the
risk of guaranteeing income for people who are
going to live longer than we anticipated. And so
those kinds of risk management challenges for
companies like ours are very robust.
KnoWledge@Wharton: Do you see a big
difference in the post-boomers, in the next
generation that is coming up? Is there a different
attitude there with money and retirement?
mitchell: I think that its starting to emerge.
I think that the next generation is seeing their
boomer parents take care of the kids, plus the
elderly in the sandwich group that theyre in.
And so there is some evidence that theyre
beginning to pay more attention. I know as
a teacher and as a parent I certainly try to
educate everyone under the age of 30 about all
these problems. But I think that there is a lot of
education needed; in particular, younger people
tend to think they are immortal, that nothing
will ever befall them.
Once you start getting into your 40s, maybe
50s, you realize health problems become
an issue. You start to hopefully take some
responsibility for retirement planning. But there
is a tremendous amount of illusion around it
still. I call it lump-sum illusion. People think
they have $100,000 in their 401k Plan and
feel rich. And they dont realize that theres a
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reasonable chance that they are going to live
30 years with that sum of money, and its not
going to boil down to very much.
I think a lot of the online retirement calculators
contribute to that because they ask you your
age and your sex. Then they spit out a number
youre going to live for 14 more yearsnever
incorporating the possibility, the very high
probability, that you may live to be 100, or ifyoure a woman, 110. And so these are the areas
where we really do have to educate the populace.
condron: I want to pick up on the lump-sum
illusion, because its a problem in the way
that the financial industry has taught people to
think. You know weve developed retirement
plans and defined contribution plans which
pay off in a lump sum. We sell life insurance
to people in a lump sum. People arent
equipped to really make the calculation and
the conversion from a lump sum to income
because its all about income.
One of the things that weve been doing in
our industry is putting income floors under
lump-sum calculations. For example, one of
the products that our industry delivers to the
market place is called Withdrawal Benefit for
Life. A 65-year-old could put $100,000 into one
of these products and have a guarantee to be
able to withdraw 5 percent of the principal for
life and never run out of money. They have a
balanced investment portfolio, but a significant
percentage of equities which will allow forsome growth. Once a year, if their portfolio
goes up in value, they can reset at a higher
amount the value upon which that 5 percent is
calculated. So if their portfolio went up in the
second year to $110,000, they set it at 5 percent
of $110,000. It will never go lower, and it can
readjust itself, assuming that the price goes up.
Basically, one of the big problems we have
here is: How do I create an inflationary hedge
for myself during retirement? And if I take a
fixed-income solution, Im blocked at whatever
that amount is. And thats the problem of
inflation. The beauty of these products that we
in our industry have worked hard to design is
that they create an environment where people
have an ability to transfer their lump sum into
an income streamnot lock it into a fixed rate,
but rather get an opportunity to get a higher
rate if markets change.
mitchell: I was just going to pick up on the
inflation theme briefly. For one thing, many
people dont understand inflation. They discount
the impact it will have on their well being,
20, 30, maybe 40 years into retirement. The
second factor people dont understand is the
extra hit of medical care cost inflation and the
toll it will take on their well being. So, once
again we should think about the downstream
consequences of needing long-term care,
nursing home care, the downstream costs
of pharmaceutical drugs, and so forth. All
these are concepts that todays boomers just
arent focusing on enough. And so part of the
educational mission is again to get people to
begin to estimate what it will take to maintain
their lifestyle in retirement, even though prices
are going up.
condron: [Thats] a very good point, because
if you look at, say, a 3-percent inflationary
environment and youre going off into
retirement, your inclination is to plan for 3-
percent inflation. But, if medical expenses are
going up 10 percent, thats a bigger share ofyour wallet than it is of the 35-year-olds wallet.
So youre not planning for a 3-percent inflation
rate, youre probably planning for a 6-percent
or 7-percent inflation rate. And thats a whole
different planning process that people have to
be cognizant of.
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007UniversityofPennsylvania WhartonExecutiveEducation Knowledge@Wharton 1
With $2.5 trillion invested in 401(k) retirement
accounts, 60 million Americans control a
powerful chunk of cash. So how much attentiondo investors pay to this vast pool of savings?
Not much.
According to a Wharton analysis of retirement
accounts managed by The Vanguard Group
in 2003 and 2004, participants in 401(k)
plans made little effort to tend their defined-
contribution plans once they were set up: 80
percent of participants made no trades at all
in the time period, while another 10 percent
made only one trade. Even among those who
did trade regularly, turnover rates were one-third
that of professional money managers.
Olivia S. Mitchell, executive director of
Whartons Pension Research Council, Stephen
P. Utkus, principal, Vanguard Center for
Retirement Research, Gary Mottola, a VanguardCenter researcher, and Takeshi Yamaguchi, a
Wharton doctoral student, present their findings
in a paper entitled The Inattentive Participant:
Portfolio Trading Behavior in 401(k) Plans.
When it comes to managing their portfolio on
an ongoing basis, says Utkus, participants are
otherwise occupied. Mitchell, who is also a
professor of insurance and risk management,
says the inertia uncovered by the study
indicates some positive signs about retirement
savings behavior, as well as some concerns.
For example, participants show no inclination
to engage in risky trades based on market
timing or other short-term strategies. To me,
it was comforting to show that most people
dont day-trade in their pension plans, says
Mitchell, adding that studies indicate investors
trading through brokerage accounts tend to
buy high, sell low, and spend a great deal on
commissions. Our finding of low turnover
in pension accounts builds confidence in
the ability of 401(k) participants to invest for
the long run. The paper cites 2000 research
showing that active traders using brokerage
accounts had returns of 11.4 percent, compared
to 16.4 percent for all households and 17.9
percent for the market overall.
At the same time, the authors point to potential
problems with maintaining a totally hands-
off approach to 401(k) investing. Such a no-
involvement attitude can leave portfolios out
of balance if market conditions shift. Inertia
investing might also leave the plan out ofsync with projected retirement age targets.
Inattentive participants could get into trouble
if they fail to rebalance their accounts from
time to time, Mitchell cautions. For example,
during the study period, the Standard & Poors
500 Index rose 43 percent, which would have
shifted portfolio holdings heavily toward equities
if there were no adjustments. That can be good
when the stock market is soaring, but people
close to retirement are typically advised to
concentrate an ever-increasing part of their
portfolio on more stable, lower-risk investments,such as bonds.
The researchers plan to do additional work on
the study and could find problems at both ends
of the trading spectrum. We will probably
show that the portfolio risk of the participant
who didnt trade increased, and the returns
for the traders were lower because they were
fiddling around too much, says Utkus. Both
extremes are a problem. In general, we would
like to see people trade once a year, or every
other year, to keep their portfolio in balance.
Mitchell, who is also executive director of
Whartons Pension Research Council, says the
study, which examined the accounts of 1.2
million participants in 1,500 pension plans, is
the first large-scale look at trading patterns in
401(k) accounts. These defined-contribution
plans now have more assets than traditional
defined-benefit pension plans. Despite the
Hands-Off: Holders of 401(k) Retirement
Accounts Are Not Your Typical Investors
A no-involvement attitude can
leave 401(k) portfolios out of
balance if market conditions shift.
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central importance of the defined-contribution
pension model, there has been remarkably little
microeconomic research on how individuals
make their asset allocation decisions and trade
in their retirement portfolios, says Mitchell.
The average plan participant in their sample
has an account balance of $86,000, is 44 years
old, has been on the job for 8 years, and has an
average household income of just over $88,000,according to the research paper.
The reasons behind the lack of active
participation in 401(k) investing are not obvious.
While it is clear that most participants are
inattentive to their portfolios, it remains to
be seen whether this inactivity is motivated
by rational choice, based on the long-term
nature of pension assets, or whether it signals
inertia, implying that participants would
require additional assistance to manage their
portfolios, according to the paper.
Failing To Learn From Enron
One factor that plays an important role in 401(k)
trading patterns is company stock, the report
noted. The good news for those interested in
retirement security is that most workers tend
to buy and hold their pension portfolios, says
Mitchell. On the other hand, plan sponsors
should realize that certain plan design features,
notably the presence of company stock, can
spur trading, even after controlling for other
factors. Indeed, the paper states, perhaps
the most significant factor influencing trading
is the presence of company stock in the plan
investment menu. The probability that a
participant will trade is more than 10 percent
higher if company stock is offered.
While 15 percent of plans offer employer stock,
those tend to be the larger firms with a bigger
employee base. As a result, 52 percent of
the participants in the database studied have
access to employer stock, and about one-third,
or 32 percent, hold an employers stock in their
401(k) plan.
Prior research by Mitchell and Utkus has
indicated that employees tend to be more
likely to buy and sell their own companys
stock because they feel they have inside
information about the firms prospects. And,
Utkus adds, employees continue to invest
heavily in company stock, despite the danger
of becoming too dependent on their employer
as a source of income and a retirement savings
vehicle. Even after learning how employees atEnron Corp. were financially wiped out after the
company collapsed, many investors still hold
too much company stock, says Utkus.
The study did reveal new information about
the demographic makeup of those who trade
401(k) investments frequently. Active traders
who made more than six transactions in the
2-year period accounted for just 2 percent
of the participants. These participants are
overwhelmingly male, white, older, have more
assets, and have worked a longer time on
their jobs than their counterparts, says Utkus.
The lesson in this data, he notes, is that plan
sponsors with a high number of employees
who fit the active-trader profile may want to
take that into account when designing plans or
developing employee-education materials.
Mitchell says the results of this study line up
with other research that shows women are less
likely to actively manage their investments. That
can often be a sensible strategy, says Mitchell.
Whether its attributable to women being more
risk averse, or having greater understanding oftrading costs, remains to be investigated.
Not Big on Borrowing
The average plan reviewed in the study has 776
active participant accounts with assets of $38.4
million; while it offers more than 17 investment
choices, plan participants use only 3.5 of the
available options. Almost all participants have
access to equity index funds (99 percent) and
international funds (98 percent), but only half
of the workers (53 percent) actually invested
in equity funds, and only one-fifth (20 percent)
chose international options.
The research also indicates that offering more
funds does not increase the level of active
trading, whereas including a brokerage option
does. Offering a brokerage option within the
401(k) plan has a large impact on trading activity
and turnover rates, though the impact in practical
terms is still small since only 3 percent of
The research indicates that offering
more funds does not increase the level
of active trading, whereas including a
brokerage option does.
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participants are currently offered such an option,
the report states. We measure trading only
in the nonbrokerage component of the 401(k)
account. Part of this higher trading may be due
to greater movement among the regular fund
options in the account; another part is likely due
to the movement of money from these regular
fund options to the brokerage feature.
One additional finding that suggests eitherinertia or caution is that, while 85 percent of
participants have access to a 401(k) loan feature,
only 11 percent have a loan outstanding.
The researchers also examined patterns of
Internet use in participant management of their
401(k) plans. Of those plan participants studied,
one-third (37 percent) had registered to access
their accounts on the Internet as of January 2003.
People with web access traded more frequently.
They were three times more likely to trade at all,
and nine times more likely to be active traders.What we could not tell is if the people who go
to the web are traders, or whether the web itself
creates traders, Utkus says.
Mitchell and Utkus plan to continue working
with the Vanguard data to gain additional
insights into the behavior of 401(k) participants.
For now, there are already some implications
for fund managers and others involved in
retirement security. One interpretation is that
the portfolio inertia identified here suggests
that participants may require additional helpmanaging their portfolios, the paper states.
Utkus notes there are tools emerging to
help investors manage their 401(k) holdings
better. One option is lifecycle funds, which
are structured to reallocate assets as the
participant comes closer to retirement. Some
plans also offer automatic rebalancing services,
which reallocate assets to maintain a balance
determined by the participant. A third option is
to create managed accounts, which reallocate
for a fee.
Automatic rebalancing services, lifecycle
funds, and managed accounts can be useful in
ensuring that sensible portfolio management
takes place on a disciplined schedulewhether
in 401(k) plans, public sector defined-
contribution pensions, or even in a reformed
Social Security system with private accounts,
the authors write. Increased use of any of those
tools would raise aggregate turnover rates,
they add, given that the current rate for mostparticipants is zero.
Mitchell also suggests that plan sponsors might
want to consider the cost of active traders on
pension plans as a whole and enact remedial
policies targeted to traders. While only a few
401(k) plan participants actively trade their
accounts, such behavior can raise transaction
costs for all participants, and their activities may
be disruptive to portfolio managers.
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they Were unusual tax shelters that went
by incomprehensible names like BLIPS, OPIS,
BOSS, and FLIPand they boomeranged on thecompanies that sold them.
In February 2006, German bank HVB Group
agreed to pay $29.6 million in fines to avoid
indictment for defrauding the Internal Revenue
Service with abusive tax shelters that gave rich
clients phony losses to reduce taxes.
The settlement was part of a broadening
investigation into exotic shelters that wealthy
individuals used to escape about $2.5 billion
in taxes from the mid-1990s through 2003,
according to the government. Indeed, the IRS
recently announced that a string of law firms,
banks, and accounting firms will be fined
billions of dollars for failing to admit their role in
promoting these improper investments.
In fall 2005, KPMG LLP, the accounting firm that
created and marketed many of the shelters,
agreed to pay $465 million to avoid indictment.
In addition, 17 former KPMG employees and two
other individuals have been charged with criminal
offenses for plotting to defraud the IRS. KPMG
has been sued for hundreds of millions by clientswho got into trouble for using the shelters.
Yet despite government efforts, there is no
silver bullet that can stop promoters from
cooking up new shelters, says William C.
Tyson, professor of legal studies and business
ethics at Wharton. Whenever a new regulation
is imposed, people just start looking for new
ways to get around the tax law. Before 1986,
these shelters were rampant. There are not
nearly as many of them now because the law
has closed up so many of the loopholes. Itsjust that there is still some room to squeak
through. People are really creative.
If its difficult for regulators and tax experts to
tell what constitutes an abusive shelter, its
virtually impossible for a taxpayer to know if
hes buying into a strategy that could come
back to haunt him later. This is an area that
is difficult to define with precision, notes
Stuart E. Lucas, CEO of Integrated Wealth
Management LLC and author of the Wharton
School Publishing book, Wealth: Grow It,
Protect It, Spend It, and Share It. I guess I
come down on the side of using a smell-test
rule. I think the intent of the tax law is fairly
clear, and if you are doing things that fulfill
the intent of the tax law, then you can feel
reasonably safe.
But he suggests that even legitimate tax-
reduction strategies can backfire if they involve
paying big ongoing fees or leave the taxpayer
with his hands tied when conditions change
years down the road. Its especially hazardous,
Tax Shelters: Exotic or Just Plain Illegal?
Despite government efforts, there is no
silver bullet that can stop promotersfrom cooking up new shelters.
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he says, to take on a fixed, long-term obligation,
like a debt to be repaid, and plan to pay it with
an asset that can lose value in the meantime.
The Miracle Workers
Yet despite all the recent news, the U.S. is
not in a heyday of abusive tax shelters. They
were probably more prevalent in the 1970s,
1980s, and 1990s. But the IRS, Congress,
and other regulators are focused on the issue
because a loss of tax revenue is especially
serious when the federal government is running
budget deficits and because promoters have
been standardizing shelters to expand their
market. There is money involved From a
business point of view, why shouldnt [lawyers,
accountants, and bankers] try to make money?
Thats their point of view, says Edward B.
Kostin, an adjunct faculty member in Whartons
Accounting Department.
U.S. tax laws are extremely complex and
offer many legitimate ways to reduce taxes.
Ordinary taxpayers, for example, can deduct
mortgage interest payments and home officeexpenses, and they can use losses on one
investment to offset profits on others, reducing
taxes. Businesses can deduct expenses, claim
depreciation on buildings and equipment, book
their profits in low-tax foreign countries The
list goes on and on.
Typically, according to Lucas, as a person gets
wealthier, a larger share of his or her net worth
and annual income comes from investments
rather than wages. Investments provide all sorts
of options in navigating the tax shoals. While
ordinary income is taxed at rates as high as 35percent, the long-term capital gains tax rate
is only 15 percent. The lower rate also applies
to dividends, while the higher one applies to
interest. Municipal bonds are tax free. Capital
gains tax can be postponed until an investment
is sold. Trusts and gift giving offer additional
layers of tax-minimizing possibilities.
The U.S. government really acts as a silent
partner to any investor, Lucas says. It sets
th