As you may know, a former employee is suing Intel over its management of the company’s retirement plans. The lawsuit is getting a fair amount of press with the NY Times, Morningstar (free account required), and The Oregonian running the story over the last few weeks.
We had a chance to share our thoughts with Mike Rogoway for his Oregonian article, but declined given the active nature of the lawsuit. Essentially, echoing the sentiment of John Rekenthaler of Morningstar, who said, “I have no comment about the case’s legal merits, as that is for lawyers to discuss. (This is a polite of way of writing that I do not wish to hear from either side’s legal counsel.)”
That said we do want to share a few investment-related thoughts (not legal) on the issues that seem to at the heart of this lawsuit.
Why is Intel Being Sued?
First why is Intel being sued over their management of the 401(k) and Retirement Contribution retirement plans?
From the complaint (emphasis is mine):
The Investment Committee’s decisions were imprudent because: (1) the allocations and investments of the Intel TDPs and the Diversified Fund were unprecedented departures from prevailing standards for the design and allocation of, respectively, target date funds (“TDFs”) and balanced funds; (2) the Investment Committee knew or should have known that the asset allocation models and heavy investments in hedge funds and private equity would expose the Plans to the risk of substantial losses; and (3) the asset allocation models and heavy investments in hedge funds and private equity caused the Plans to incur significant fees and expenses as compared to professionally managed asset allocation funds and exposed the Plans to significant risks without commensurate reward.
The complaint claims that Intel’s internal investment committee mismanaged the plans by setting an investment policy for the TDF’s and Global Diversified Fund that was:
- And, high cost
This article will take a look at each of these three claims, but first we need to understand why Intel is where it is today.
The Yale Model
After the Global Financial crisis, Intel’s investment committee observed how it’s own, and many other balanced funds across the industry didn’t hold up too well through this tumultuous period. It decided to adopt the so call “Yale Model.” Rekenthaler of Morningstar summarizes Yale’s style of investing as follows:
Named after the Yale endowment fund, the Yale Model diverged sharply from the traditional balanced-fund approach of blending U.S. blue-chip stocks with investment-grade bonds. The Yale fund’s chief investment officer, David Swensen, had taken to heart the chief lesson of Modern Portfolio Theory–that seemingly risky assets could reduce the risk of the portfolio through the math of diversification. Yale looked–and looks–nothing like a traditional balanced fund.
As of its most recent report, for example, Yale held a puny 4% of its assets in U.S. stocks and 8.5% in cash/bonds. Its biggest position was in hedge funds, at 21.5%, followed by private-equity funds, international stocks (more than triple the U.S. stock weighting), venture-capital funds, real estate, and natural resources.
And Gretchen Morgenson at the New York Times states it like this:
For the professionals who run public pensions, these kinds of investments [hedge funds, private equity portfolios, and commodities] are ubiquitous. They are far less common in 401(k) plans, which are aimed at individual employees and typically limit investment choices to mutual funds that hold publicly traded stocks and bonds.
So Intel took a highly respected way of investing from the university endowment and public pension world and brought it to its retirement plans. Once it made this decision—and started allocating to hedge funds, private-equity funds, venture-capital funds, real estate, and natural resources—it was going to look much different than many of its balanced fund peers.
The first complaint of the lawsuit is the allocations in the Target Date Funds (TDFs) and the Global Diversified funds are different from the average industry TDF and deviate from “prevailing standards.” And the fact that these funds are different is true. We just saw that the Yale model and Intel’s custom funds look different than other TDF’s due to their allocation to Hedge Funds, Private Equity Funds and other alternative investments.
But, does this allocation deviate from “prevailing standards employed by professional investment managers” as the suit puts it? Obviously not. Again to quote John Rekenthaler, “They are [Intel’s custom funds], in fact, constructed in the spirit of the nation’s most highly regarded professional investment manager.”
The real issue here is not so much that the funds were different—it’s that the difference wasn’t a benefit over the period. It’s highly doubtful this lawsuit would have been filed had Intel’s custom funds outperformed.
However, all investing strategies go through cycles. What works in one period may not work in the next. So what’s important then is sticking with your strategy. As the co-founder of AQR Capital Management, Cliff Asness recently said (emphasis is mine):
“I used to think being great at investing long-term was about genius. Genius is still good, but more and more I think it’s about doing something reasonable, that makes sense, and then sticking to it with incredible fortitude through the tough times.”
The last five years have been a great run for the U.S. equity market and therefore by comparison a ‘tough time’ for investment strategies that diversify away from U.S. equities. This doesn’t necessarily mean these other strategies no longer work, but simply that discipline is required for the benefits of diversification to show up.
The second allegation is that Intel’s allocation to hedge funds and private equity subjected the funds to “the risk of substantial losses.” Well, news flash: so does investing in equities. The S&P 500 dropped 53% from its peak in 2007 to its low in early-2009. And in 2000, the index experienced a 46% loss—clearly, what anyone would call a “substantial loss.”
And how did hedge funds do in 2008? Again to quote Rekenthaler from Morningstar:
They are, after all, called hedge funds. And for all their bad publicity in 2008 for not properly protecting themselves and for disappointing their shareholders, hedge funds on average only lost about half as much as the typical stock fund. They are indeed lower-risk securities, as a whole, during stock bear markets.
As the name “hedge” implies, hedge funds (when used in an intelligent, diversified way) can be used to reduce risk. While there are certainly some risky individual strategies and managers, when used as part of a diversified portfolio hedge funds can reduce the overall level of volatility.
And lastly on the topic of risk, when investing risk is usually a function of the price you pay rather than the name of the investment purchased. As legendary investor Howard Marks said, “There is no asset so good that it can’t become overpriced and thus risky, and few so bad that there’s no price at which they’re a buy (and safe).”
On this point we agree. The high cost of the custom funds in the Intel plan is a large reason we primarily avoid using them for our clients.
We have written before about the importance of fees (articles here and here and our white paper “An Overview of Fees in the Industry”) and that employees should understand the fees they are paying and take action to minimize unrewarded expenses.
But it’s not just the Hedge Funds and Private Equity funds that make the TDFs higher costs. Intel is also using a number of actively managed funds within the stocks and bond allocations. These funds tend to be higher costs, and these tend to be unrewarded costs (meaning they don’t make it up through better performance). See here and here for more.
The Target Date funds have expense ratios around 1.3% annually ($1,300 annually per $100,000 invested) but not all the funds in the Intel 401(k) are high cost. You can build a very low-cost, globally diversified portfolio with the investment options available right now in the Intel plan. For example, the venerable 60% stocks and 40% bond portfolio could be built using five, low-cost funds currently in the Intel plan. These funds give you an allocation to U.S. large, mid and small-cap stocks; international developed-market stocks; emerging market stocks; and U.S. government and corporate bonds. The costs for this globally diversified allocation to more than 22,000 stocks and bonds? A meager 0.05% annually! ($50 per $100k invested)
We don’t think from an investment perspective that the Intel custom funds are imprudent, and high risk as the lawsuit alleges. However, it will be interesting to follow the outcome of this case. Of particular interest—and ultimately what the case may help in deciding—is do hedge funds, private equity and other so-called “alternative investments” belong in retirement accounts or should they be restricted to accredited investors outside of their company retirement accounts.
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Cordant, Inc. is not affiliated or associated with, or endorsed by, Intel.