Charles Ellis: How We Fix the Most Important Financial Challenge the U.S Has Ever Faced

by Tom Allen and Mark Hebner - Thursday, 08 October, 2015

Charles Ellis is a prominent and successful authority in the investment world. Most known for his book, Winning the Loser’s Game, which is now in its 6th edition, as well as his infamous article published in the Financial Analyst Journal titled “The Loser’s Game.” Charles Ellis was one of the earliest proponents of index funds when index funds were not available to most investors. While most of his life’s work has been dedicated to convincing investors to abandon active investing, he has recently voiced his concerns with a much bigger issue that many Americans are facing today: retirement.

Addressing the audience at a recent ETF Conference put on by Morningstar, Mr. Ellis went straight to the heart of the issue surrounding Americans and retirement. The title of his presentation was “Falling Short: The Looming Problem with 401(k)s and How to Solve It,” and he stated specifically that 401(k)s represent “the most important investment challenge” the United States has ever faced. Citing recent statistics, Mr. Ellis highlighted the undoubtedly grim future that is in store for the many who are looking to retire in the next decade. The median balance for a 65 year-old in 401(k) and IRA assets savings is $110,000[1]. Assuming the industry standard of 4% withdrawal per year of initial balance, this only yields $4,400 per year or $367 per month. Just to make this number slightly more palpable in terms of standard of living (not adjusted for inflation), this is equivalent to working for $2.12 per hour.

This was obviously not the original intent of the 401(k) when Ted Benna, its creator, looked to utilize the tax incentives passed by Congress in 1978. While the original purpose was to help the middle-class save for retirement, Mr. Benna had most recently referred to his creation as “a monster” during an interview with Money Magazine in 2011. So how did we go from an amazing idea to help people to the proverbial “Frankenstein” of the financial services industry?

While many of our parents can remember the days of pensions, in which employers assumed the responsibility for preparing its employees for retirement, things started to change dramatically with the expansion of real wages of workers during the mid to late 1970s when annualized inflation averaged in the 8-10% range. In short, it became extremely expensive for companies to afford the retirement benefits for its employees, which is understandable. In 1978, Congress passed legislation that allowed working Americans to defer taxes on any income that was directed towards future retirement needs. Enter 401(k) plans.

Now connecting the dots or events that followed an amazing idea in 1978 to “a monster” in 2015 can be disputed, but one thing is certain, what we are currently doing is not working for the vast majority. Walking a fine line of product refinement with public policy, Mr. Ellis laid out what he thinks should be the immediate action items taken by both employers and employees.  Combining elements of empirical investment evidence, behavioral finance, and industry “rules of thumb,” Mr. Ellis stated the following for employers to adopt:

  1. Automatic enrollment – All new employees will automatically be placed into the plan at a predefined savings rate.
  2. Automatic match – All new employees will receive a matching contribution from their employer. IFA recently wrote about the benefits of including a match here.
  3. Automatic escalation – All contribution rates will be increased every year up to a specified level. Most industry practitioners and academics agree this rate should be at least 10% per year
  4. Automatic indexing – All assets will be placed into index funds. No dispute with this point.
  5. Automatic target-date – All index funds will be in a target-date format. We have written about the benefits of incorporating a target-date fund into retirement plans here.
  6. Automatic 4% payout rate – Plan participants who are retired will receive 4% withdrawal payouts. This is an industry “rule of thumb” used by many industry practitioners and is based on analyses run by financial planner Bill Bengen in 1993.

Mr. Ellis also mentioned that all employees should have access to a 401(k) plan. While investors who do not have access to a 401(k) plan do have access to other savings vehicles like IRAs, the contribution limits are much higher and much more economically meaningful for 401(k)s. We have written about the benefits of adopting a 401(k) here.

Likewise, the advice Mr. Ellis gives to employees who are close to retirement is the following:

  1. Work until age 70 – this is more of a necessity than a choice
  2. Defer Social Security Benefits until age 70 – raises social security payouts by 76%
  3. Obey the defaults mentioned above - THE END!

IFA also believes there needs to be a major overhaul of the retirement plan space and have taken steps within our own practice to become an industry leader in that reformation. We have written about these before here. Our take on why we now have a Frankenstein starts at the very top. Until we effectively disentangle how financial “advice” is compensated in our industry, there will always be an incentive to sell rather than educate. The reason why the 401(k) has not worked for the vast majority is because the industry has focused on profits for itself rather than end results for individual citizens. If this wasn’t the case, then we would see more of the action items outlined by Mr. Ellis taking effect and many more Americans being ready for retirement. There is too much revenue sharing on the line to take a step back and ask, “What is the right thing to do?” And everyone needs to be held accountable.

We know what it takes in terms of savings rate in order to get to retirement. We know that investors are often confused when it comes to choosing investments. We know that active management has not and will not work for the vast majority of investors over long periods of time (mathematically impossible). We know that the financial media is skewed to provide misleading information to investors since they are sponsored by the biggest financial institutions in the country.

Much of what impedes practitioners from doing what we know we need to do has to do with liability. In other words, they are on the hook if their advice doesn’t work out the way it was originally sold. Why is IFA willing to accept full responsibility for our advice? Because it is the ONLY thing that has consistently worked over time and is supported by academic evidence.

Enough is enough!

[1] Rekenthaler, John. “Charley Ellis Forsees a 401(k) Crisis. October 2, 2015: