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8/9/2019 Wharton Finance2

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Personal Finance

Vol. 2

Whartonon

Finance

http://executiveeducation.wharton.upenn.edu http://knowledge.wharton.upenn.edu


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WhartononFinance Personal Finance, Vol.

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trading encouraged by the use of out-of-date, or stale, stock prices in valuing fund shares?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

007UniversityofPennsylvania WhartonExecutiveEducation Knowledge@Wharton


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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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007UniversityofPennsylvania WhartonExecutiveEducation Knowledge@Wharton 7

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.


10/26

10 WhartononFinance Personal Finance, Vol.

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


11/26


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.


12/26


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.


13/26


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.


14/26


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.


15/26


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.


16/26


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


17/26


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.


18/26


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?


19/26


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


20/26


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.


21/26


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.


22/26


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.


23/26


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.


24/26


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.


25/26


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

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