Keep Wall Street Out of the Retirement Business

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Wired for Mistakes

Now, look at what is happening in the financial markets today. The stock market is down more than 20% since its fall 2007 peak. Investor confidence in the bedrock money market mutual fund industry has been shaken now that a major mutual fund company has broken the never-break-a-buck pledge. The mortgage-backed securities market is in shambles. How is the average employee to cope with this? Is it good public policy for workers to be responsible for their asset allocation strategy during the worst financial crisis since the Great Depression?

A steady stream of scholarly research called behavioral economics and behavioral finance makes a persuasive case that many people aren't wired to invest well. The scholars have cataloged a long list of systemic investing mistakes, such as representativeness, a fancy term for an ingrained tendency to rely on stereotypes; overestimating an ability to predict the future; over-conservatism, because people fear a loss more than they relish a gain; a willingness to hold on to bad bets because we don't like to feel regret; a tendency to follow where the herd is going when it comes to the market. The list goes on.

Wall Street doesn't do well by the average worker. The standard advice that individuals fare best when they turn over their money to professional money managers is wrong. It's a bromide guaranteed to lose individuals money, with much scholarly evidence that actively managed mutual funds systematically underperform passively constructed index funds.

Plus, workers are paying a lot in fees for that underperformance. As Warren Buffett put it in Berkshire Hathaway's (BRKA) 2006 annual report, "Meanwhile, Wall Street's Pied Pipers of Performance will have encouraged the futile hopes of the family…will be assured that they all can achieve above-average investment performance—but only by paying ever-higher fees. Call this promise the adult version of Lake Woebegon."

Individual Investors Lose

Wall Street is rife with conflicts of interest, and the average worker is the loser. Who said that? Consumer firebrand Ralph Nader? No, it was David Swensen, the legendary chief investment officer for Yale University's endowment fund. In his book Unconventional Success: A Fundamental Approach to Personal Investment, Swensen wrote that "Individual investors lose. Mutual fund managers win."

Swensen makes a strong case that profit-maximizing mutual fund managers always choose to line their own pockets at customer expense through high fees, opaque charges, excessive trading, and other financial shenanigans. "When a sophisticated provider of financial services stands toe-to-toe with a naive consumer, the all-too-predictable conclusion resembles the results of a fight between a heavyweight champion and a 98-pound weakling," he writes. "The individual investor loses in the first-round knockout."

In 1940, Fred Schwed Jr. famously captured the essence of Swensen's perspective with one of the most memorable Wall Street book titles ever: Where Are the Customers' Yachts? It's worth repeating the allegory that starts off his book:

Once in the dear dead days beyond recall, an out-of-town visitor was being shown the wonders of the New York financial district. When the party arrived at the Battery, one of his guides indicated some handsome ships riding at anchor.

"Where are the customer yachts?" asked the naive visitor.

Where indeed? What is good for Wall Street isn't always good for Main Street. Swensen called for government to act "in loco parentis" and create powerful incentives for companies to put their employees into passively managed well-diversified portfolios, perhaps similar to the low cost, broad-based, limited-choice offerings of the Federal Thrift Plan. But other ideas are worth pursuing. For instance, why not attach to every Social Security number an account consisting of a 60% equity index fund and a 40% Treasury Inflation Protected Securities portfolio? The retirement savings plan would essentially do as well—or as poorly—as the U.S. economy.

Better yet, a number of academic quant jocks are exploring creating annuity-like products that would guarantee workers a steady, inflation-protected income during their golden years but would be less expensive for companies to offer than the traditional defined-benefit pension fund. The demand then would be on workers to take the responsibility of saving but avoid the burden of investing. These ideas are not only worth exploring—they're an improvement over the status quo.

Right now, the Federal Reserve and U.S. Treasury are trying to shore up a crumbling financial system. Now isn't a time for action on big questions. That will come when the panic subsides and the foundation of the U.S. capital markets is stabilized. Among the issues to explore is whether the great 401(k) experiment has run its course.

Farrell is contributing economics editor for BusinessWeek. You can also hear him on American Public Media's nationally syndicated finance program, Marketplace Money, as well as on public radio's business program Marketplace. His Sound Money column appears on BusinessWeek.com.