Earlier this year, the California state pension (CalPERS), made a couple of blockbuster decisions that you almost certainly didn’t hear about.
First, CalPERS decided to transition from actively managed to index funds in its defined-contribution plan.
That means in its 401(k)-like 457 plan, investors will only have access to index funds (including passive target-date funds).
The most obvious result of this change: target-date fund investors will see their fees drop by 89%.
Then, in September, CalPERS changed its investment policy statement for its Big Kahuna, the state pension fund itself, suggesting that it will transition over time from active management to a passive investment strategy.
Instead of trying to beat the market, most of the CalPERS portfolio will match the market, at low cost.
The financial crisis, the growing popularity of index funds, and public acceptance of online investing tools has led to a new breed: the financial entrepreneur who won’t try to convince you he can beat the market.
I’m talking about companies like FutureAdvisor, Betterment, Wealthfront, and Rebalance IRA.
The latter was founded by former hedge fund manager Mitch Tuchman, who explained to MintLife why the CalPERS moves are a big deal even if you aren’t a public employee in California.
MintLife: What does CalPERS’s shift toward indexing signify for individual investors?
Tuchman: I think when people begin looking back at this massive retirement crisis baby boomers are facing and that is upon us as Americans, and they look at how people began to fix that or began to turn the tide away from a financial services industry that did way more harm than good, I think they’ll look back and they’ll say, “This was the ringing of the bell.” This was a moment when this shift began to occur.
Vanguard just reached $2 trillion of assets. That’s all pretty much indexed assets. Dimensional Fund Advisors, same kind of thing. They’re hitting record highs.
So I just think that the indexing religion is taking hold, and it’s really hitting that kind of tipping point, and when large institutional investors like CalPERS say, “You know what? We don’t know who the hell’s smarter than who, we’re just going to index,” that’s a big deal.
One of our advisors, Jay Vivian, ran IBM’s pension. That’s the largest American pension in the country. He was responsible for $130 billion.
It’s not CalPERS, but it’s the biggest in America from a private standpoint, and he went to indexing. So we see the revolution is underway. But the way media works today, things like this just kind of get lost in the Twitter flow.
MintLife: What are some of the factors that account for this shift away from active management and toward indexing?
Tuchman: I’ve been in the valley in 32 years and I’ve been an entrepreneur most of those years.
After I had enough liquidity at my various companies that I could figure out what to do to manage my money, and had the time, I began to look at my options, and I have a Harvard MBA background and have always had a big interest in finance, and I could not understand how I could pay the fees that were being asked to be paid. This was back in 2000.
There’s just some very smart institutional best practices to investing that the everyday investor does not hear about, have access to, or know about.
There’s very little money in it, because by definition, an institutional investor is trying to keep more money in their fund than give it to the financial services industry.
So indexing, even today, most of the index funds are bought my institutions.
If you’re a journalist, if you’re Morningstar, if you’re Jim Cramer, if you’re any of that part of the media, you need to keep getting people’s greed and fear glands stoked up to keep getting people to consume your media.
But the reality of all of this, if you cut through all the crap, is that smart institutional investors running retirement funds on behalf of retirees get around an 8% return.
And those who are left to their own devices who have to do this themselves in a 401(k) plan, and even worse yet an IRA plan, are getting 3 to 4% less a year, and it’s killing them when it comes down to what’s going to happen to them in retirement.
MintLife: So how do we introduce individual investors to these ideas?
Tuchman: Here’s how I do it. And this is what we try to teach all of our clients. Of course you need to get fees down.
People do not understand their fees, and the industry is wired to be able to obfuscate their fees, like literally saying, “This doesn’t cost you anything.” That’s what people will be told, many times.
Then there’s the allocations. How do you construct a really well-diversified portfolio? It’s not rocket science, but people really just screw this up 9 out of 10 times.
On the emotional side, here’s the thing. It’s the distinction between investing and speculating. What most people believe deep, deep down, and what gives them all this anxiety, is they sense that most of what they’ve been told to do is speculate.
And Wall Street is all about speculation. Here’s the patter of that.
You’re listening to CNBC. Today they’re saying, “US stocks are up 25%; we’re due for a pullback, so we’re underweighting our US equities and going to cash until the pullback happens.”
Well, that’s speculating. People have been saying that for a year and lost a 25% run. All that crap on TV is pushing speculation.
MintLife: So what’s the right way to think about investing?
The way to get around that is to understand that if you are investing, you’re investing in global economic growth.
If you set the portfolio up like sails on a sailboat, and you know which way the wind’s blowing, eventually it’s going to blow you in the direction you want to go. There may be a bunch of storms along the way, but the directional weather is in your favor.
MintLife: You used the term “retirement crisis,” and I assume you watched the same Frontline episode I did.
Do you think there are structural problems with defined contribution plans like 401(k)s, or is the problem just the way people use them?
Tuchman: Let’s use an analogy like medicine. You’re not a doctor, I’m not a doctor. I don’t think you’re a doctor. Are you?
MintLife: I’m not.
Tuchman: What if Obamacare said, look, the malpractice insurance is too high, and doctors really just don’t want to have any responsibility anymore for your medical care? New medical system, everybody!
I’m going to tell you what your options are, but you have to pick, because I can’t have any respnsibility. And then I’ll just execute whatever you pick.
That would be horrifying beyond belief. I don’t know what I’d do. What would you do?
MintLife: Drop dead, probably.
Tuchman: That’s what’s slowly happened in the last 35 years. It’s just that horrifying.
A whole generation of people that are starting to retire don’t have enough money, don’t know what the hell to do with their retirement accounts, don’t understand how much they’re paying, and they’re screwed.
Younger people have the opportunity to learn how to do this, but the problem is, like my medical example, knowing what to do, knowing how to handle your emotions, it’s as daunting and horrifying as you and I figuring out what to do for our medical care.
This interview has been condensed and edited for clarity.
Matthew Amster-Burton is a personal finance columnist at Mint.com. Find him on Twitter @Mint_Mamster.