Remarks by John C. Bogle
Founder and Former CEO, The Vanguard Group
Before Business Solutions 2002
The Annual Conference of the American Life Insurance Council
San Diego, CA
October 14, 2002
Eight months before the stock market bubble reached
its bursting point in March 2000, I happened to appear on Louis
Rukeyser's Wall Street Week. When one of the panelists asked
me what advice I would give to an investor heavily committed to
technology and internet stocks, the only answer I could think of
was: "I'd advise him to read Extraordinary Popular Delusions
and the Madness of Crowds.
I can only hope that investors who heard my warning
quickly dashed out to their local libraries and read that classic
chronicle of earlier financial booms and bustsTulipmania in
Holland, the South Sea Bubble in Great Britain, and so on. In the
world of investing, the cheapest education is what we learn from
the experience of others. And so today I'll discuss the failure
of corporate governance that was a major contributor to that bubble,
and how two financial intermediariesmutual funds and insurance
companiescan profit from that experience.
When I answered that question, it was obviousnot
only to mebut to many others, from Warren Buffett on downthat
we were in a bubble. We also knew that, sooner or later, all
bubbles burst. But while we may know what is going to
happen, we never know when. And so the stock market continued
its ascent for eight more months before beginning its long, painful
decline, the worst bear market since 1929-1933. The NASDAQ Index
is now down nearly 80% from its peak and the New York Stock Exchange
Index is down 40%.
At the peak of the recent bubble, investors seemed
to decide that an average price-earnings ratio of 35 times and a
dividend yield of 1% were reasonable. (The historical norms are
15 times and 4%.) That there was no problem when the $17 trillion
value of the stock market was equivalent to 190% of the $9 trillion
value of our nation's gross domestic product. (The norm is about
80%.) That a corporation could somehow be worth many times the discounted
value of its future cash flows. (It can't. For, however difficult
to calculate, its value is precisely equal to that sum.) And so
the reckoning came. It has continued to this day, and the market
has reverted toward, if not yet quite to, most of
those threadbare old normsa p/e of 17 times, a dividend yield
of 2%, and a valuation of 85% of GDP.
While each financial bubble is different, most have
been associated with the abandonment of traditional financial standards.
As Edward Chancellor, author of "Devil Take the Hindmost: A
History of Speculation," reminded us, manias bring out the
worst aspects of our system: "Speculative bubbles frequently
occur during periods of financial innovation and deregulation .
. . lax regulation is another common feature . . . there is a
tendency for businesses to be managed for the immediate gratification
of speculators rather than the long-term interests of investors."
What is more, bubbles often take on the attributes of castles built
on sand, as sound business practices erode, integrity and ethics
are compromised, and financial misfeasance creeps into the system.
1. Corporate America's Role in
The first major casualty was Enron, described by The
New York Times when it fell apart as a "catastrophic corporate
implosion . . . that encompassed the company's auditors, lawyers,
and directors . . . regulators, financial analysts, credit rating
agencies, the media, and Congress . . . a massive failure in the
governance system." All of the traditional gatekeepers seem
to have failed, and as we were to learn in the ensuing months, Enron
was but the first evidence of the failure of our corporate system.
Soon other dominoes were falling, including Worldcom, Adelphia,
Global Crossing, and Tyco. Who among us can know which corporation
will be next to fall?
Relative to the 7500 publicly-held corporations in
America, the malefactors we know of so far are relatively few in
number. As a result, we're told that we shouldn't let a few bad
apples spoil the barrel. While I accept the premise, I disagree
with the conclusion. Our corporate system has been permeated
by distortions of sound business practices: Virtually all corporations
focus on its prices of their stocks, present unrealistically high
(and unachievable) projections of earnings growth, and push generally
accepted accounting principles to their limit. When our rule of
conduct becomes, "I can do it because everyone else is doing
it," integrity and ethics go out the window and the whole idea
of capitalism is soured.
There are more than enough villains to go around.
Too many of our corporations have vastly overstated their growth
potential and then have tried to force the fulfillment of their
aggressive earnings guidance by fair means or foul. Off-balance-sheet
special purpose enterprises have been created, largely to conceal
debt; illusory transactions have misled investors; and sham inter-company
transfers have raised reported sales volumes. Assumed future returns
on pension plans were raised even as the prospects for future returns
tumbled. And when the loose envelope of accounting principles could
be pushed no further, criminal manipulation of financial figures
And that's hardly the end of the list of sins: Enormous
compensation from stock options enriched corporate executives who
succeeded in hyping the price of their stocks without
increasing the value of their corporations. They sold
huge amounts of their own shares at bubble-driven prices, but in
the aftermath millions of their employees who held company stocks
in their retirement plans were impoverished. Auditors garnered enormous
fees from their consulting activities, becoming partners of management
rather than independent professional evaluators of management's
financial reporting. Corporate profits, it turns out, were substantially
overstated, and investors came to realize that they had assumed
risks that were far larger than those for which they bargained.
Capital Development and the Casino
Sadly, those problems went almost unnoticed among
investment professionals. In the search for huge investment banking
fees, Wall Street's conflicted sell-side analysts lost their objectivity
and ignored the signs of trouble. Even the buy-side analysts of
our large financial institutions engaged in their own search for
glowing investment performance, put aside the lessons of their training
and experience as well as their skepticism, and joined in the mania.
After all, large performance gains draw in assets to manage, and
large assets generate large fees. So investors themselvesespecially
institutional investorsshare much of the responsibility for
the bubble in stock prices. Aware of it or not, and whether through
naivete or greed, they joined the happy conspiracy of market participants
that reveled in rising stock prices. They forgot that while in the
short run, as Benjamin Graham told us, the stock market is
a voting machine, in the long run it is a weighing
machine. Investors engaged in short-term speculation based on
the hope that the price of a stock will rise, rather than long-term
investment based on the faith that value of a corporation will grow.
It was the triumph of perception over reality. But sooner or later,
perception returns to reality, not the other way around.
Long before this latest bubblein fact shortly
after the 1929 bubble had burst and the Great Depression was upon
us, Lord Keynes warned us of what happens when speculation achieves
predominance over enterprise: "In one of the greatest investment
markets in the world, namely, New York, the influence of speculation
is enormous . . . it is rare for an American to 'invest for income,'
and he will not readily purchase an investment except in the hope
of capital appreciation. This is only another way of saying that
he is attaching his hopes to a favorable change in the conventional
basis of valuation, i.e., that he is a speculator. But the position
is serious when enterprise becomes a mere bubble on a whirlpool
of speculation. When the capital development of a country becomes
a by-product of the activities of a casino, the job is likely to
be ill-done." And so in the recent era, it has been
A Failure of Character
At last we are beginning a wave of reform in corporate
governance and are undertaking the task of turning America's capital
development process away from speculation and toward enterprise.
But there's even more at stake than improving governance practices.
One must also establish a higher set of governance principles.
This nation's founding fathers believed in high moral standards,
in a just society, and in the virtuous conduct of our affairs. Those
beliefs shaped the very character of our nation. If character
countsand I have absolutely no doubt that character does
countthe ethical failings of today's business and financial
model, the financial manipulation of corporate America, the willingness
of those of us in the field of investment management to accept practices
that we know are wrong, the conformity that keeps us silent, the
selfishness that lets greed overwhelm reason, all erode the character
we'll require in the years ahead, more than ever in the wake of
this great bear market and the investor disenchantment it reflects,
and especially in the post-September 11 era. The motivations of
those who seek the rewards earned by engaging in commerce and finance
struck the imagination of no less a man than Adam Smith as "something
grand and beautiful and noble, well worth the toil and anxiety."
I can't imagine that anyone in this room today would use those words
to describe our corporate governance system at the outset of the
So this is a sorry era in Corporate America. Serious
ethical mistakes were made, and innocent people have been hurt,
many of them irreparably. While most of these failings have notI
repeat notfound their way into the financial services
industries such as mutual funds and life insurance, there is much
that we in both of our industries can learn from them. The fundamental
lesson we can learn, I think, is that when management places its
own interests ahead of the interests of long-term shareholders,
trouble lies ahead.
2. The Mutual Fund Industry: Putting
the Shareholder First?
The problems we see in Corporate America have many
implications in my own field of mutual funds. While too many of
our corporate stewards have failed to earn our faith, we institutional
managers have, I fear, gotten the corporate governance that we deserve.
We have focused on short-term speculation at the expense of long-term
investing, and our voices on governance have been conspicuous solely
by their silence. We have failed to recognize that ownership entails
not only rights but responsibilities, and as a result have failed
to act as good corporate citizens. With our 100 largest financial
institutions holding almost 50% of all of corporate shares, we control
corporate America, and we ought to make our voice heard.
If only we take the initiative to stand up and be
counted, we will at last return to an era in which the great creative
energy of American business and finance shifts from its short-term
focus on the price of a stockspeculationto a
long-term focus on the value of the corporationenterprise.
When we do, we will at last get the good governance we deserve,
and our corporate stewards will respond appropriately. That change,
in turn, will well-serve both our investors and our nation.
This process is already beginning. Sir Isaac Newton
was not only right in his third law of motionfor
every action there is an equal and opposite reactionhe
was right about our system of financial markets. The bear market
is the inevitable reaction to the action of the bull market. What
is more, a powerful reaction has already begun to the unacceptable
actions of Wall Street, of the accounting profession, and of those
we trusted to be our corporate stewards. Congress has passed the
Sarbanes-Oxley bill, requiring senior corporate managers to attest
to the validity of their companies' financial statements, providing
for disgorgement of profits by executives who sell stocks and later
restate earnings, and replacing self-regulation of accountants with
a new federal Public Company Accounting Oversight Board, as well
as other salutary provisions.
The New York Stock Exchange has produced a powerful
set of guidelines for corporate governance, including greater director
independence, new standards for audit committees and compensation
committees, and even a "lead director" who is independent
of corporate management. (I believe that we should go further, and
require that the board chairman be an independent director, separating
the powers of governance from the powers of management.)
And the newly-formed Conference Board Blue-Ribbon Commission on
Public Trust and Private Enterprise (on which I'm honored to serve)
has already produced a strong set of best practices on executive
compensation, with best practices on corporate governance and on
accounting standards soon to follow.
The Silence of the Funds
In this beehive of activity, however, the mutual
fund industry remains largely silent. The reasons for the silence
of the funds are clear.
- Inertia: "We've never done
much in the way of shareholder activism. Why should we start
- Investment Strategy: With an average
portfolio turnover at an astonishing 110% per year, the average
fund holds the average stock for an average of 11 months. "We
are traders, not owners, so why should we behave
- Conflict of Interest: "The corporations
whose shares dominate our portfolios are our best clients,
for we manage their pension and thrift plans. Why vote against
management and take the risk of losing their business?"
But our failure of corporate citizenship is only one
of our shortcomings. We have not adequately represented the interests
of our long-term investors. Yet the law requires us to do just that.
The preamble to the Investment Company Act of 1940 calls on mutual
funds to be "organized, operated, and managed . . . in the
interests of shareholders . . . (rather than) in interest of investment
advisers and underwriters." Despite that high principle, I
fear that placing our shareholders first-fiduciary duty, if you
willis more honored in the breach than in the observance in
the mutual fund industry.
The first evidence of this breach lies in the high
costs of mutual fund ownership. Direct costs of equity mutual funds,
as measured by the ratio of management fees and operating expenses
to fund assets (the "expense ratio"), come to about 1.6%
per year for the average fund, and 1.3% if weighted by fund assets.
(Smaller funds typically have higher fees.) A tiny proportion of
this cost perhaps less than one-tenthis actually spent
on investment management. Much more goes to sales and marketing
and operations. But the largest part of the fees paid by fund investors
is represented by the substantial profits garnered by the management
companies that operate the funds. (Pre-tax profit margins of 40%
to 50% are not uncommon.) And the expense ratio is hardly the only
cost fund shareholders incur. Indeed, when we add in sales charges,
the hidden costs of that 110% turnover, and opportunity cost (funds
are rarely fully invested), the total cost of equity fund ownership
nearly doubles, to at least 2 ½% per year.
Do costs matter? You bet they do! And they matter
most in financial institutions. Why? Because while much of the value
of most consumer goods is measured by immeasurable factors such
as taste and tone and prestige and image, the value of financial
products is measured almost entirely by that most measurable
of all assets, dollars. And costs matter most in those financial
instruments for which costs are (1) easily calculable, (2) directly
related to returns, and (3) compounded over time. It should go without
saying that the mutual fund is the paradigm of that definition.
How Much Do Costs Matter?
How much do costs matter? Let's consider what
costs mean to a long-term investor, and see what toll a 2 ½%
annual cost would take on a 10% stock market return over, say, thirty
years. When compounded over thirty years, $1,000 earning the 10%
stock market return would grow to $17,500. Pretty nice! That same
$1,000 invested in the typical fund, earning 7 ½% after
costs, would grow to $8,750. Not too bad! But only half as much
as the marketa dead-weight loss of $8,750 engendered solely
by reason of the costs of financial intermediation. Put another
way, the intermediaries put up 0% of the capital, took 0% of the
risk, and garnered 50% of the return, the investor put up 100% of
the capital, took 100% of the risk, and received 50% of the return.
Put me squarely in the camp of those who don't think that's good
That simple example reflects both the miracle
of compounding returns and the tyranny of compounding costs.
But the story gets worse. Intermediation costs are paid in current
dollars, while the investor's final capital must be measured in
constant dollars. Let's assume a future inflation rate of
2 ½%. Result: Real annual return for the market, 7.5%;
real return for the fund investor, 5%. The final purchasing
power of each initial $1,000 falls to $8,750 in real terms in the
market, and to only $4,300 in the fund. We're surely a long way
from that $17,500 that appears on a table showing the magic of compounding
If the fund industry doesn't wish to recognize the
need for these changes and reduce its costs, it is only a matter
of time until investors will recognize itand they will vote
with their feet. But my industry's problems transcend these economics.
Investors' faith in their fund trustees has been shaken even more
emphatically by the fact that fund managers have moved away from
being prudent guardians of their shareholders' resources and toward
being imprudent promoters of their own wares. We pander to the public
taste by bringing out new funds to capitalize on each new market
fad, and we magnify the problem by heavily advertising the boxcar
returns earned by our hottest funds.
The result of this powerful marketing is that mutual
fund investors have fared far worse than mutual funds themselves.
They invested infinitely more in equity funds during the period
immediately preceding the peak of the stock market bubble than when
values were at far more reasonable levels, and then invested the
overwhelming portion of their dollars in technology funds and technology-oriented
growth funds (including internet funds!) and took their money out
of value funds which, bless them, both lagged as the bubble inflated
and held steady as it burst.
An Industry Without Scandal?
Early in 2001, an independent study showed that while
the annual return of the stock market itself averaged 16% per year
during the 1984-2000 period, the return of the average mutual
fund averaged 13%, about the differential one would expect,
given that fund costs amounted to about 2 ½% to 3% per year.
But, because of the market timing and adverse selection issues I've
just described, the annual return of the average mutual fund investor
averaged just 5%. Today, the bear market has reduced that cumulative
market return to about 11%, and the return of the average mutual
fund to about 8%. That relationship suggests that the return
of the average fund investor, during this excellent (from point
to point!) period for stocks, was 0%(!). Nothing. It is not a record
of which we should be proud.
As our industry leaders accurately say, "the
mutual fund industry has never had a major scandal," and certainly
nothing like those we've seen among the corporate malefactors whom
I've earlier described. But it's surely arguable that the astonishing
shortfall in return that we've provided to our fund shareholders
is itself scandalous. So we'd best learn from this recent sorry
era in corporate America and put our own house in order.
We must not only reduce the costs our investors incur,
but increase the horizons of our investment strategies. We must
not only focus far less on salesmanship, but far more on stewardship.
And we must commit ourselves to improving corporate governance and
corporate value. If we simply put our clients first, just imagine
how well the mutual fund industry can serve investors in the coming
3. The Life Insurance Industry
My candor about my own industry, I hope, gives me
license to address with equal candor some lessons that the life
insurance industry might learn from the failings of the Corporate
America. As Robert Burns wrote, "Oh that God would give us
the very smallest of gifts to be able to see ourselves as others
see us." And I hope the views of this outsider to your business
will be both constructive and helpful.
While your industry's recent record
has been largely free of corporate and financial scandal, you have
had to face up to some serious charges of improper market conduct
and overly-aggressive sales practices, and have settled them at
huge expense. But the greatest scandal that plagued your industry
actually took place almost a century ago. Then, the Armstrong Investigation
in the New York State Senate called the life insurance companies
on the carpet for "their excessive salaries, nepotism, unethical
and unsound business practices, and fraudulent management . . .
It became clear that mutuals had not dedicated themselves to the
altruistic pursuit of policyholder profits."1
The investigation uncovered "excessive commissions to field
agents, inadequate accounting procedures . . . and company funds
used to support prices of Wall Street securities in which officers
were intimately interested."2
If those phrases could easily have been written about
Corporate America in our newspapers this very morning, so could
the event that precipitated the Armstrong Investigation. It was
a lavish Louis the Fourteenth costume ball, a spectacular party
that unveiled the splendor of Versailles, said to have cost $100,000
(in today's dollars, $2.1 million) given in 1905 by a dashing young
playboy named James Hazen Hyde, a vice president and leading stockholder
of the giant Equitable Life. This "social event of the century,"
as it was described in the press of that day, ignited a highly-publicized
power struggle within the company, and enough dirty laundry popped
into view to alarm the State's senate, which then unveiled a whole
panoply of corrupt industry practices that directly impaired the
interests of policyholders. The attendant publicity infuriated the
public and set the insurance industry back for years before the
beneficial effects of the consequent reform took hold.
"Nothing Succeeds Like Excess"
If that brief anecdote sounds to you like one you
read about just a few weeks ago, you are very observant. As it happens,
it quite resembles the extravagant 40th birthday party thrown in
Sardinia by Tyco International's then-chief-executive L. Dennis
Kozlowski for his wife. No, not Versailles. But a Roman Empire theme,
complete with waiters dressed in togas and wreaths on their heads,
and a large ice sculpture of Michaelagelo's David, surrounded by
shellfish and caviar and, well, exuding Stoli vodka into
the guests' crystal glasses. The costone-half of which was
paid by the Tyco public shareholderswas $2.1 million, precisely
the real cost of the Equitable costume ball of nearly a century
earlier. I'm not sure whether to say, "nothing succeeds like
excess," or "the more things change the more they remain
I'm sure that Corporate America's excesses will be
ultimately mitigated, not only by the egregious example of the Tyco
party but by the response we are already seeing from Congress and
regulatory agencies, and by the public outcry for reform, just as
the insurance industry's excesses of a century ago were finally
subdued. But it took time, and I like to think that change was fostered
not only by New York State Senator Frank Armstrong, who led the
investigation, but by Philander Banister Armstrong, an insurance
industry pioneer who culminated his career by writing, in 1917,
a book entitled A License to Steal: Life Insurance, the Swindle
of Swindles. An industry insider, he catalogued the accounting
peccadillos and political graft that had scandalized some of the
industry's largest companies.
While those old problems of life insurance need not
concern us today, I mention the latter Mr. Armstrong for two reasons.
One, he just happens to be my great-grandfather. Two, like his great-grandson,
he was also a believer in giving policyholders the best possible
financial terms. In an 1875 speech, he said: "Gentlemen, you
must recognize that companies having the smallest expense will have
the ultimate advantage (and) that companies having this advantage
are the most desirous of correcting present abuses. To save our
business from ruin, we must at once undertake a vigorous reform.
The first step must be to reduce expenses." He was a
missionary for your industry, and he had his own way of reforming
it: "Life insurance," he wrote, "has become one of
the necessities of modern civilization, and it should be furnished
at cost." I guess you could say that the apple's apple's apple
didn't fall very far from the tree!
Life Insurance as an Investment
So let's talk about the cost of life insurance. Just
as in mutual funds, the costs incurred in operating, investing,
and selling the product come directly, dollar for dollar, out of
the returns earned on the policyholders' assets. In the case of
insurance, however, the linkage is much less obvious, and in your
field you enjoy the pricing flexibility to make any given product
more attractive, albeit only by making another less so. The product
you are selling, you may argue, provides most of its value in the
form of the face-amount payment that come to survivors when the
insured comes to the end of his or her days.
Nonetheless, most insurance is an investment, and
increasingly so. Today, annuity reserves, not insurance reserves,
have come to dominate your industry's book of business. While your
clients don't (and perhaps can't) calculate an expense ratio in
the manner that a mutual fund investor can, I've perused your Life
Insurers Fact Book and estimated your annual operating expenses.
Including taxes, these costs came to about $72 billion in 2000,
resulting in an expense ratio equal to about 2.3% of your $3.2 trillion
asset totalconsuming fully one-third of the 7.0% rate
of return on your investment assets, leaving two-thirds to be added
to the resources of your policyholders. While I claim no expertise
on the accounting practices of your business, I would observe that,
valuable as it may be as a medium for meeting the needs of families
for income maintenance and death protection, life insurance is an
expensive way to investindeed consuming significantly
more of your policyholders' investment returns than is the
case in the mutual fund industry.
The Tension Between Client Return and Marketing
For both financial service providersmutual
funds and insurance companiesa strong tension exists between
the need to serve policyholders by minimizing costs without jeopardizing
your ability to provide incentives to the field force. It is not
easy to reconcile enhancing the investment return of the policyholder
with providing powerful incentives to sell more policies. Since
life insurance costs are heavily weighted by sales costs (40% of
costs are commissions to agents, the remaining 60% represents home-and
field-office expenses), the major means of reducing costs would
appear to be an increasing emphasis on direct, commission-free,
sales. Unless I miss my guess, a great opportunity awaits any company
that figures out how to reconcile that dilemma.
On the other hand, I'm sure most of you would argue
that "life insurance is sold and not bought," and, for
better or worse, that aphorism seems to remain true today. But as
the knowledge of consumers inevitably grows, as their education
levels rise, and as the Information Age facilitates comparison-shopping,
it's hard to argue that the dynamics will not graduallyalthough
perhaps glaciallyshift from a seller-driven to a buyer-driven
system. Wise insurers cannot afford to ignore such a potentiality,
for increasing policyholder returns could well serve to enhance
public confidence both in your product and in your industry.
You don't need to tell me it's not easy. In
February 1977, shortly after I started Vanguard, we eliminated all
commissions and abandonedovernight!the broker-dealer
network that had distributed shares of our funds for nearly 50 years,
immediately beginning to distribute our funds to investors directly,
without sales loads. As you might guess, new business plummeted.
So even with normal share liquidations we experienced a steady cash
outflow. But the situation reversed within two years, and we've
enjoyed positive cash flow every year since. Indeed, over the past
ten years our nearly $350 billion of cash flow represented the largest
total in our entire industry.
But it is not only our experience as a no-load distributor
that might interest you. We also have a characteristic that makes
us unique in the fund industry: Our mutual structure. Our operating
company is actually owned by our fund shareholders, and we operate
on an "at cost" basis. (Shades of Grandpa Armstrong!)
The net result is that our expense ratio is presently running at
about 0.27% of the combined assets of our stock, bond and money
market funds. Our major rivals, on the other hand, operate at an
expense ratio of about 1.07%. Result: An expense advantage of 0.80%
(80 basis points) which, when applied to our current $520 billion
asset base, will result in annual savings of more than $4 billion
for our investors in 2002 alone. Put another way, assuming a 5%
combined gross return in the stock, bond, and money markets, we
could deliver almost 95% of that return to investors, while our
peers would deliver less than 80%. The fact is that our mutual structure
is the force that shapes not only our investment strategy and our
marketing strategy, but our corporate strategy as well. "Strategy
Public Stockholders vs. Mutuality
With the staggering advantages the mutual structure
has accorded us in our field, I find myself vaguely puzzled
about why mutualitythe traditional hallmark of the largest
companies in the life insurance fieldhas almost vanished.
In 1980, four of the five giant life companies were mutuals; today
none are. Now, if de-mutualization enables you to serve your policyholders
more efficiently and cost-effectively, I can easily relate to that.
And if moving to a traditional corporate structure with public shareholders
in fact enhances your capital base and facilitates your ability
to make acquisitions by giving you the "currency" to do
so, I'll be interested to see who you acquire and how successful
the combinations prove to be. (So far, it looks as though mutuals
that have converted have been less likely to acquire than
to be acquired. And in my industry, I believe that the acquisition
of fund firms by large financial conglomerates have been more likely
to burden mutual fund shareholders than to serve them.)
What is more, publicly-owned insurers face those
very same pressures that have caused such problems in Corporate
America: Pressures to set earnings targets, followed by pressure
to meet them. Public ownership also offers executives and staff
the opportunity for rich stock options, though in the recent bubble,
only the sharpest executivesthose with the intelligence, or
the luck, or the cupidity to sell before the bubble burstrealized
box-car gains. But I seriously wonder whether the potential advantages
of the shift involved in moving from mutual form to stock form might
not be vastly outweighed by the disadvantages, particularly the
extraordinary change in corporate culture and the potential negative
change in public attitudes about life insurance.
Suffice it to say that, whether you are mutual or
stock in form, you enjoy at least one staggering advantage
over your mutual fund rivals (most of which, of course, are not
mutual in structure): The investment income you earn for those you
insure builds up on a tax-free basis, while no such advantage accrues
to our industry. And that's fair enough. But when this inside build-up
goes beyond the ordinary course of your regular business and is
sold to corporations as a tax-arbitrage play, I wonder whether your
industry might not risk jeopardizing one of its largest competitive
advantages. It's worth thinking about.
Today's Challenge: Variable Annuities
This brings me to an area where our industries join
forces. No longer can it be said that, "life insurance is life
insurance and mutual funds are mutual funds, and never the twain
shall meet." For we meet in the field of variable annuities.
And annuities have become the driving force in your business. A
half-century ago, premiums on annuities were one-seventh those on
life insurance. Fifteen years ago they were equal. By 2000, annuity
considerations of $300 billion were more than double life premiums
of $130 billion. And it is variable annuities that now dominate
your annuity business. Only $5 billion of your annuity premiums
(4% of the total) as the 1990s began, variable annuity premiums
of $137 billion in 1999 actually exceeded fixed premiums,
only to fall back sharply during 2001-2002 as the stock market bubble
The variable product field is dominated by insurance
firms using mutual funds operated by traditional fund firms rather
than the insurance companies themselves. Indeed, after TIAA-CREFthe
800-lb. gorilla of the field with $130 billion of variable annuity
assetsthe 11 largest providers are major fund complexes. In
all, insurance companies manage but 13% of the total. This combination
of mutual fund shares with annuity protections makes consummate
economic sense for the providers. But, alas, the same cannot
be said for the investors. Average fund expenses come to
0.9%, and average insurance wrap costs come to 1.3%, for a total
charge of 2.2%. Given that portfolio turnover and other costs doubtless
parallel the 1.2% that I estimated earlier for regular funds, that
would bring the total annual expense drag to 3.4%. And surrender
charges imposed on policyholders who, for whatever reason, fail
to stay the course, can only add to this total drag. Thus, while
the enormous tax-deferred inside build-up advantage of variable
annuities is a powerful benefit to investors, many independent observers
believe it to be totally overwhelmed by the huge hurdle rate imposed
What is more, the investment merits of variable annuities,
just like those of their regular mutual fund cousins, were heavily
exaggerated by the high returns of the stock market before the recent
bubble burst. Some 85% of the $780 billion of variable annuity assets
at the end of 2000 was represented by equity funds, often the most
aggressive in their class. With the asset value of the average fund
now off 50% from their level at the bubble's peak, and the aggressive
funds that were the recipient of most of the cash flows down 65%,
total assets are down to $520 billion. Now, variable annuities are
contending with the depleting affect of both tumbling stock
prices and heavy costs. (While, say, 3 1/3% per year may
not sound all that bad, it consumes nearly 40% of an investment
over 15 years.) In addition, death benefits that guarantee the payment
of the face of policies are sure to impose an additional burden
on the resources of insurance companies, unless and until the market
recoups the lost ground.
Like mutual fund managers, variable annuity issuers
can only watch and wait and hope that investment returns will improve.
But, again like the fund industry, the insurance industry must work
to improve the financial terms on which variable annuities are offered
to clients. It doesn't appear to be impossible: The two programs
with the lowest costs carry all-in expense charges averaging
50 basis points, less than one-quarter of the 2.2% average, and
neither carry sales loads. Any insurance firm that can challenge
them has quite an opportunity before it. What is more, it's hard
to imagine that high-cost annuities that garner distribution by
aggressive sales promotion techniques such as high surrender charges
and purported "bonuses" in which the annuitants are simply
given their own money back, however good for marketing, won't come
back to haunt this product. Please don't forget that in an increasingly
informed investor community, your industry's credibility is a priceless
But it is more than competitive realities that should
motivate financial service firms. Enlightened self-interest suggests
that our services increasingly demand public trust. And in these
difficult financial markets that trust, like our trust in the stewards
of America's corporations, is not only being tested, it is being
found wanting. For both your industry and mine, forewarned is
Back to the Future
Assets of the insurance industry, like those of the
mutual fund industry, have been deeply depleted by the failures
of corporate America that I have discussed today. And it is not
only equity assets that have tumbled in the bear market, but fixed-income
assets that have suffered major credit downgrades and even some
well-publicized bankruptcies. It is too late for those who have
ignored investment quality in either arena (or both) to recoup,
but it is incumbent on both of our industries to take a more aggressive
approach to enhancing corporate value by practicing sound corporate
governance and demanding high credit quality.
I apologize for being the purveyor of a tough message.
But it is a realistic one, especially as we look to the future.
Looking back, we can revel in the bounty of two decades in which
returns on stocks have averaged 11% per year and returns on bonds
have averaged 9% per year. Generous financial market returns are
especially important to our industries for, holding costs constant,
the higher the return, the lower the proportion consumed by our
operating, investment, trading, and marketing expenses. So controlling
investor and policyholder costs must remain a high priority.
Given the present vastly depleted level of stock
prices, together with metrics that suggest we are now in a fair
value range, I believe that reasonable expectations suggest future
annual stock returns in the 7% to 10% range. If we are lucky enough
to hold the annual inflation rate to 2%, future real returns would
be in the 5% to 8% range, or roughly "normal," in that
the long-term real return on stocks has averaged 6 ½%. For
bonds, the current 5% yield would suggest a future return of 3%,
in real terms, about equal to the historical norm.
So in a sense it is "back to the future"
in the financial markets. The old order hath changeth. If
and if we are to maintain the confidence of our clients, we must
get our respective houses in order and ready ourselves for the new
order. It is impossible for me to imagine that each passing
day does not come with an increasingly aware public, and we'd best
not only give those who have entrusted their financial future futures
to us a not only a fair shake, but an honest stake and, an integrity-laden
shake. It is only by doing so that we will affirm to our clients
that we have learned from the painful experience of our cousins
in corporate America that I've described todayexperience that
has directly affected the $9 trillion asset base of our combined
industriesand readied ourselves for a bright future. The concepts
underlying insurance and annuities, and mutual funds too, remain
as sound as they have always been. It is up to us to implement them
in a manner that puts our clients first.
Note: The opinions expressed in this article do not necessarily represent the views of Vanguard's present management.
to Speeches in the Bogle Research Center
©2006 Bogle Financial Center. All Rights Reserved.