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David Roodman's Microfinance Open Book Blog


I wrote about how, since all Wall Street stock pickers are smart, it is hard for any one of them to consistently out-smart the rest---and even harder for you, the small investor, to pick such a winner in advance. In the old post, I emphasized the upshot for your finances: trying to beat the market is a loser's game, so your best bet is to buy mutual funds that track markets as cheaply as possible, such as index funds. I did beat the market during the tech bubble downdraft, but that may have been a lucky one-off. A broker who tries to sell you a mutual fund whose expense ratio (the % of your money the fund manager takes each year) exceeds a rock-bottom 0.2--0.5% is ripping you off, probably knowingly and possibly in exchange for a legal kick-back from the fund manager. An extra, say, 1%/year of expenses might seem trivial, especially if it is written in fine print and obscured by wide year-to-year swings in investment performance. But it adds up: multiply 1%/year by 40 years of saving for retirement. In short, go to Vanguard, the leaders in low-expense investing.

Here, I will write an implication of this idea for social policy. A higher savings rate, after all, is an explicit government goal in many places.

Though you wouldn't know it from our historically abysmal savings rate, government in the United States provides copious tax incentives for people to put aside money, mainly for college and retirement. These incentives work by shielding investment gains from annual taxation, so that the earnings can compound faster. In some cases, including 401(k)'s and traditional Individual Retirement Accounts (IRAs), you pay no tax until you take the money out (at retirement). In other cases, such as the 529 college savings plans, you pass through the tax gate just before the money goes in, and never again.

As an aside, tax breaks don't do you much good if you are too poor to pay taxes, which is what led the Commission on Thrift to eloquently decry the bifurcation of American society along the dimension of financial services: people who earn little have access to payday lenders and lotteries, which discourage thrift; people like me, who earn more, can access to "concierge services" such as retirement funds, along with a legion of investment advisors eager to serve.

Of course---to return to the main thread---those investment advisors are also eager to keep some of my money for themselves.

'Tis the season to ponder these matters. With the year coming to a close, I am about to contribute to my sons' 529 college savings plans, just in time to lower my 2009 taxes. Congress, in its wisdom, fabricated 529 plans out of federal tax code provisions but delegated the job of running them to the states, who in turn contract with private companies. This is not your parents' social security. So each state and the District of Columbia (DC) has its plan. Most of these are open to out-of-state people, giving each American about 50 choices. DC law allows me, a resident, to put money into any such plan and avoid DC as well as federal tax on the earnings. In addition, DC law lets me deduct up to $4,000 of contributions per kid per year from my taxable income if I save in the DC government's plan. In sum, that money will avoid federal taxation when it goes out and avoid DC taxation both when it goes in and when it comes out ( some date that is unimaginably distant because my little boys will never grow up).

Even better, the DC government employs a local company, the Calvert Group, to manage my money. Calvert is a pioneer in socially responsible investing. So I can save for my boys' education without financing, say, oil drilling in Nigeria.

Good deal, right?

Well no, or I wouldn't be writing this. And I've already hinted at why. For a typical investment option (a fund for kids aged 6--10, like mine), Calvert and the DC government extract 1.30% of the saver's money, plus a $15 account maintenance fee, each year. Nationally, according to this list, the cheapest state plan open to non-residents is Ohio's which charges 0.24% for a similar portfolio, one that is managed by---you guessed it---Vanguard. Meanwhile, I occupy the DC goverment's top income tax bracket, whose rate is 8.5%. So my local government is offering me this deal: save 8.5% once by putting up to $4,000 into our plan; then pay about 1%/year extra until your kids go to college. Not such a good deal. This spreadsheet compares Calvert/DC and Vanguard/Ohio more carefully by simulating a case in which I put in $4,000/year and the market goes up 5%/year. After 18 years, Vanguard/Ohio earns $42,697 while Calvert/DC earns just $33,424, for a difference of $9,273. At the current tuition inflation rate, this will let me buy my younger son lunch at the campus cafeteria during at least one parental visit.

Seriously, this is not chump change. Now, if I invested through Vanguard/Ohio, I'd lose that 8.5% DC tax deduction. We can factor in this loss by reducing the Vanguard/Ohio gain figure above by 8.5%, from $42,697 to $39,068. This still exceeds the Calvert/DC gain by $5,644. In other words, despite the DC tax incentive, I would lose money by investing through Calvert/DC. Calvert/DC's high expenses not only consume the entire DC tax break; they also dip into my pocket.

Think about it: In the name of expanding access to college, that great ladder into the middle class, the DC college savings program subsidizes a mutual fund company while making the citizens who participate poorer (compared to saving through Vanguard/Ohio). Why can't DC offer a plan as cheap as Ohio's?

Shed not a tear for me if I fall for this scheme. But worry about those of more modest means, the people to whom the DC government markets this savings program. DC is majority black, and is home to many people for whom children-in-college is truly an aspiration, not an assumption. Not surprisingly, the marketing materials include the motto "I see college in your future" and feature children mostly of color. (Just to avoid some American political mines here: I am only implying that race and income are correlated in DC on average, with thousands of exceptions in the form of comfortable blacks and poor whites.) For people on the lower end of the DC middle class, who live in the 6% or 4% tax bracket, the expenses per dollar invested are about the same as I have just computed, but the tax savings are substantially lower---thus the net cost higher. Tax deductions are worth less to those who pay lower taxes in the first place. So the subsidy for Calvert is partially funded by a regressive tax on DC families.

This is socially responsible?

I do not mean to suggest Calvert or the DC government constructed this program with ill intent. Yet they cannot use ignorance as a defense, for Brookings Senior Fellow Henry Aaron wrote about the high cost of the DC plan in the Washington Post in 2003.

Nor do I dismiss the original source of Calvert's claim to social responsibility. In general, I think it is good for people to take an interest in whether their clothes are made in inhumane sweatshops, where their charitable dollars actually go, and what their savings finance. I know that deciding which firms are socially responsible enough to deserve my capital is a dubious proposition at the margin; and that capital is fungible, so that if I shift my investment from ExxonMobil to Evergreen Solar, some hedge fund may do the opposite. Withal, I hope that this kind of investing ultimately reduces the cost of capital for the good guys.

But I do not think that excuses what seems to be a rip-off of families of modest means. In fact, Vanguard runs a socially filtered fund that costs just 0.31%/year. Those who want that socially responsible cake should be able to have it and eat it too.

So what have I decided to do? I am about to borrow a trick from Henry Aaron. Section §47-4509(c) of the DC code allows residents to transfer ("roll over") funds from DC program accounts that are at least two years old to plans of other states without jeopardizing past DC tax deductions. For me, the two-year anniversary is tomorrow. Ohio, here I come.

But the important point is that most people will not use this trick, and should not have to. Clearly I am among Bill Bernstein's 1 percent, the rare investor with the mathematical bent and the propensity to squeeze the most from the system. The halo of social responsibility should not be allowed to obscure, nor shield from criticism, what is being done with people's money. That goes for all U.S. states with 529 programs that overcharge citizens in the name of thrift and educational opportunity. It goes doubly for the District of Columbia, which has added the goal of social responsibility in the allocation of its capital. And it goes for much, much else in philanthropic capitalism and philanthropy.

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CGD blog posts reflect the views of the authors, drawing on prior research and experience in their areas of expertise. CGD is a nonpartisan, independent organization and does not take institutional positions.