MALVERN, Pa. -- Under no circumstances should the mutual fund industry be allowed to invest Social Security assets in the stock market, says John C. Bogle, founder and senior chairman of The Vanguard Group.
This is but one of Mr. Bogle's contrarian opinions on the future shape of the nation's retirement system as the millennium approaches. The pioneer of no-load and indexed mutual funds shared his views with Mike Clowes, editorial director, in a wide-ranging interview in late December, the edited text of which follows.
Mike Clowes: What do you see as the outcome of the debate on reforming Social Security?
John C. Bogle: The handwriting is on the wall, for better or worse. There is a lot of opinion about whether equities should be part of the program. That's clearly a sign of the bull market. In 1987, no one would have recommended equities. But I believe it will happen. I think changing the retirement age will come. Changing the contribution level, I think, will not come. Raising the Social Security wage base will happen, which I think is too bad because it's another form of taxation. I hope it won't be too extreme.
Mr. Clowes: What shape will the investment in equities take?
Mr. Bogle: You probably make an opportunity available to switch 2% to 2.5% a year of the Social Security contribution into your own individual account, and I think that's the way it will come out. Then you get the question, how should it be invested?
The strongest feeling I have on this is: Under no circumstances under the sun should those investments be entrusted to the mutual fund business.
Mr. Clowes: Why not? It seems well positioned to manage the assets.
Mr. Bogle: We know what net return all the investors in aggregate using the new Social Security self-directed option will get -- the market return. However, they are going to get it less cost. And that cost probably will be about 3.5%, because administering these tiny plans is going to be much more expensive than anything this industry has ever done. It could even be five percentage points.
Let's take 3.5% as a sort of modest global number. It's going to take, in a 6% bond market, or 5% government long-bond market, an 8% stock market return down to 5%. The two, stock returns and bond returns, are going to be indifferent, actuarially speaking. Yet one will involve very large risk, and one will not.
What's 3.5% a year? But if the risk premium is 3.5%, which happens to be the long-term average risk premium, you have consumed 100% of the risk premium for equities through distribution costs and management costs. It simply makes no economic sense to entrust that to the fund business.
Mr. Clowes: How would you do it?
Mr. Bogle: I would let you pick a market fund of some kind, a stock fund or a bond fund, or both -- a balanced fund -- overseen by a completely independent federal agency, not even a federal agency -- a federal board, and they could deal with all of the awesome political decisions like, `Should we have tobacco stocks. Let people with reasonable intelligence make the judgments about the technical stuff.
Mr. Clowes: How would you keep costs down?
Mr. Bogle: I wouldn't put on bells and whistles like the fund industry puts on it. I'd just have a little book-entry system. You can confirm to people once a year -- once a year is plenty. This idea of calling up at one o'clock in the morning and saying, `I want to move my money from stocks into bonds,' is lunacy. And this business of turning over fund portfolios at 85% a year -- the average turnover for stock funds -- is deplorable.
I think the federal government could run that at 10 basis points. They have the accounting system right there in Social Security. There is a big difference in having a 10th of 1% taken out of an 8% to 10% long-term return and 31/2%.
Mr. Clowes: Are you at all worried about the Social Security system owning huge slices of American industry?
Mr. Bogle: Not too much. You do get a concentration of voting power. I would just pass through the vote, or have the board make those decisions. If they own the market portfolio maybe they'll own 6% or 7% of a stock. I'd say whatever the other 94% want is OK with us. I'm not sure I'd even legislate that. I think in America we legislate too much.
Mr. Clowes: How soon do you think we'll get this change in the Social Security system?
Mr. Bogle: I think it could even be in 1999. I think it will be gradual. I don't think will start at 2%.
Mr. Clowes: Your 2%, is that 2% of the 6.45% employee contribution?
Mr. Bogle: No, 2% of the 12.4%. Its 1% from the employee and 1% from the employer.
Mr. Clowes: What do you see as the shape of the pension system other than Social Security 15 years from now? We seem to be heading to a mostly defined contribution system. Do you see any alternative to that?
Mr. Bogle: We have a very good system now. Defined contribution, as I understand it, is now $1.5 trillion compared with $1.4 trillion for pension. It's bigger. That trend has been going on for some time, and I think it's going to continue. First of all, everybody's needs are different. The 25-year-old should not be in the same pension plan as a 64-year-old. We have an opportunity to custom-make pension plans, and that makes a heck of a lot of economic sense.
Mr. Clowes: Why do you like the defined contribution system?
Mr. Bogle: There is nothing under the sun that can beat an equity-based plan compounding tax free. And there is no way anyone can beat that return. If you do it through an index fund, it makes consummate sense. The index fund guarantees you 99% of the market return. The average mutual fund in those markets has given you 85% of the market return.
If we compound, say, an 8.5% return against a 10% return over 50 years, you have only 50% of the accumulation. It's the tyranny of compounding. Everybody talks about the magic of compounding. The tyranny is, that cost differential compounds. So if you can capture 99% of the market return, you are talking about double the amount of money at retirement, or maybe $2 million instead of $1 million.
Investors will get that message; there is no stopping it.
Mr. Clowes: Are you concerned about the money flowing into equity options?
Mr. Bogle: One of the problems is, people think common stocks will always do better than bonds in the long run. It must be a simple truism that when that is universally accepted, the best returns in stocks are behind us.
Mr. Clowes: What do you think the reaction of employees in 401(k) plans will be if we have a prolonged bear market?
Mr. Bogle: I think they'll move out of equities. So I don't look at 401(k) plans as a towering source of support for the market under all circumstances.
Mr. Clowes: What do you think Congress will do? What happens to people who retire in that 18-month- to two-year period?
Mr. Bogle: In a 401(k) environment I don't see they have any complaint at all. It's not the company's fault. They had free choice. They had full disclosure. I'm sure they can, and probably will in this world, sue; although I can't imagine they could win.
Mr. Clowes: Might they not go to Congress and say: `This is not fair. I got half what I would have under a defined benefit plan?'
Mr. Bogle: Anything is a political risk, and Congress is not known for its wisdom, to say nothing of its fairness, but I think that would be a pretty hard act to sell. The employers could say: `Look we gave everybody choice. That's what they wanted. They could have put it all in bonds, and they put it all in stocks.' The federal government can't be responsible for that.
Mr. Clowes: Do you think there's any chance of a revival of defined benefit plans?
Mr. Bogle: I don't see what it would be.
Mr. Clowes: What do you think the money management business will look like 15 years from now?
Mr. Bogle: I think the mutual fund companies should be, but are not, in an almost impregnable position. For example, in August when one read in the paper that almost $11 billion was taken out of equity funds, this industry's cash flow was almost $43 billion. Just about what it was in the previous six months. The cash flow doesn't seem to change very much. The distribution of that cash flow between stocks, bonds and cash does change.
Mr. Clowes: You said, "should be impregnable."
Mr. Bogle: We don't have the same kind of a lock on it as the insurance companies had. The industry's problem is that its lock is not the right lock. It's too expensive. It's too expensive to buy stock funds, it's too expensive to buy bond funds, it's too expensive to buy money market funds. And unless this industry eventually steps up to the plate and gives the investor a fair shake -- and that's not just a matter of fairness, it's a matter of business -- people are going to create other investment alternatives.
This industry's problem is that it doesn't give you a fair share of the return on your investment. Marketing costs are terrible. This industry gets around $55 billion in revenue every year. The operating expenses of running a fund -- accounting, reports, telephone calls, controls, legal -- are probably something like 25 basis points, or about $18 billion.
The profit margin after all costs is probably 45%, let's call that 45 basis points, say $22 billion in round numbers. And there's probably $5 billion for investment management and $10 billion for marketing. I have recommended the SEC do a study and give us the answer to that question, and also to have funds be required in their annual reports to report those numbers to shareholders, for the fund and for the complex.
Mr. Clowes: . What is the future of investment counseling firms without mutual funds?
Mr. Bogle: I don't think you can have a big investment counseling firm without a mutual fund in this day and age. I think you can do perfectly well with a small investment counseling firm with the right philosophy. Investment counsel firms have a lot going for them, I believe, although they don't always do it the right way. The accounts that really matter to counselors are the accounts run for taxable investors, because taxable investors have the most money. There are very very wealthy families in this country. The bank trust departments know how to do it and they don't do a lot of trading. They're very tax conscious. Any wealthy individual is very tax conscious. Look at Warren Buffett. He buys General Re(insurance) in part for tax reasons. Counselors can give you, above everything else, a tax-managed account.
Mr. Clowes: How would you do it?
Mr. Bogle: I designed a fund that just bought America's 50 largest growth stocks and held them forever. Not an index fund because you don't sell them, period. If they drop out of the index you don't sell them, you don't care, you don't replace them. You get extraordinary -- maybe a point and a half -- extra tax efficiency that way.
You make the portfolio bullet proof, but now you have to make the investor bullet proof, and you do that maybe by allowing redemptions only once a year or once a quarter. You have a redemption fee.
My fund, you run it for 15 basis points. You have these fees on it. There's one other thing you do. You can redeem in kind. When the shareholders do leave, the fund doesn't realize any capital gains. It's complicated to do, but it could be built into the system.
Mr. Clowes: Are you going to produce this product?
Mr. Bogle: I can't get anybody here interested.
Mr. Clowes: Do you think there will be any kind of a shakeout in the mutual fund industry?
Mr. Bogle: I think that probably a quarter of (existing stock funds), maybe a third of them, will be gone 10 years from now. The industry will keep growing as long as more funds are created than are liquidated. It's no secret that funds that do badly get merged into other funds. I see some fund attrition in a different environment, with fewer funds being created. After all, there are 130 or 140 index funds out there, and the world, as anybody who has thought about it for 30 seconds must know, needs one index fund.
Mr. Clowes: Who is your toughest competitor?
Mr. Bogle: TIAA-CREF is our best competitor by all odds. They do it by driving their costs down as much as they can. They don't quite have our structure, but it's similar. They can't quite get to our cost level. When they do funds, they do it a little bit differently. Instead of having an index fund and managed funds, they have a big fund that is around 75% indexed and 25% managed. They do it at a fair cost. They haven't been able to beat the index, but they will one day. They are good on something this industry is not good at, and that's corporate governance. I think we should be a little stronger on it than we are.