William McNabb: Pain and hope for retirees

william_mcnabb.top.jpg Interview by Geoff Colvin, senior editor at large

FORTUNE -- Just two weeks after Bill McNabb became Vanguard's CEO in 2008, Lehman Brothers failed, AIG tanked, and the financial crisis became truly frightening. It was one of the toughest times ever to be running America's largest mutual fund company, yet it turned out to be a high-stress boon for Vanguard. As terrified investors pulled out of investments that scared them, they poured dollars into firms they trusted -- Vanguard above all. Today the company manages about $1.4 trillion, far more than before the crisis.

McNabb, 53, still faces turbulence as Washington imposes major new financial regulation and many burned investors grow skeptical about the whole concept of traditional investing. Even in this environment, he believes he can grow Vanguard. Though best known for indexing, the firm is offering new actively managed funds plus more exchange-traded funds. Last year it opened an office in London -- where Vanguard's famously low costs pose a new threat to major incumbents. McNabb talked recently with Fortune's Geoff Colvin about the looming retirement crisis, why some people are irrational investors, answering the phones during the financial crisis, and much else. Edited excerpts:

Today the S&P 500 stands almost exactly where it was 12 years ago. Why should investors, especially young people, believe that stocks and stock funds are where they ought to put their retirement money?

Only a few times in history have we had a set of 10-year numbers where the equity market returns are actually negative. I flip it around and say it's been an extraordinary period, and if there's any kind of reversion to the mean, it's more likely going forward that we'll see better markets.

But more fundamentally, you step back and ask yourself, long term, do you believe that we still have a robust economy and we're going to be productive, and the markets are going to reflect that? Despite all the negativity we've experienced the past couple of years, I see no reason to be pessimistic over a 10-year period.

Still, we're looking at decades. We often hear that stocks are the best investment in the long run, but a lot of investors now wonder if the long run is too long for real people.

A very fair question. Stocks should be a component, and if you're younger, a larger component. For somebody 22 years old with a 60- or 70-year time horizon, you should be balanced across stocks, across bonds; you should have some money in cash. Today cash yields almost nothing, but you still need to have your broad asset classes covered. I also think it's very important to be diversified. While I'm optimistic about the U.S. market, there's so much going on in the rest of the world, you need to be diversified there as well.

A retirement crisis seems inevitable. Almost a third of U.S. households have no retirement savings, and most of the rest don't have enough. Social Security and Medicare are unsustainable. We've known all this for a long time. At what point does the crisis become acute?

Social Security, with a few changes, I actually do believe could be sustained, and it covers a pretty broad group of people. The median income in America is about $50,000 per family, and if you look at the bottom half of earners, Social Security will do a reasonable job covering a pretty high percentage of what they need in retirement. That's not to say there shouldn't be strong supplementation from savings. But it's the upper middle class that I think is where the most acute need is going to arise.

It's really important that we get a message out that the savings rate just has to change. We get a chance to look at 4 million or so investors every day. On average, our 401(k) clientele is setting aside between 9% and 10% of income. It's not bad. We think the number needs to be closer to 15%. The more aggressively we can get that message out, the sooner we can get people moving to that number. I think we at least stand a chance of mitigating that issue.

Even 9% to 10% is well above the national average. Is there evidence that the recession we've just gone through has changed people's attitudes in a good way?

There are a couple of data points, and it will be interesting to see how sustainable they are. Savings rates are up, and what that reflects is people paying down debt. I think it's terrific. We should be encouraging this.

In addition, during the crisis we saw very little curtailment by our 401(k) investors of their contributions. A small percentage of companies suspended their match, but only about 10%. And investors kept putting money into the funds over this period. That was a really, really positive sign that people actually get it.

I gather that when the crisis was really bad, you did some duty answering the phones at Vanguard.

We have this concept that we call the Swiss Army. I don't know how familiar you are with the military history of Switzerland, but it's an all-volunteer army: Everyone volunteers. So when things are really jumping on the phones, we put everybody who is qualified on duty to talk about investments. Now, if somebody calls up and wants me to take them through a required minimum distribution calculation, I'm probably going to ask one of my colleagues to help out. But if we're talking about the funds, I can actually answer those questions.

You must have heard from people who were close to retirement and had seen a lot of wealth disappear. What could you say to them?

Those were the toughest conversations. It got put to me by a plan sponsor. We were holding a session with about 50 plan sponsors of 401(k)s, and a guy raised his hand and said, "I've got this participant, he's 63 years old and was planning on retiring next year. He has done everything right. He's saved as aggressively as we allow him to. He's got a diversified portfolio. He doesn't panic when markets are down. And he's seen his wealth eroded by 30%. What do I tell him?"

Unfortunately there was no easy answer. The only thing you could say was you hoped he had oversaved -- not many Americans have done that -- and if he hadn't, he was going to have to change his lifestyle in retirement or the number of years he was going to work. Those were tough messages.

After what we went through, some people have argued that the 401(k) is an idea that has simply failed and that needs to be replaced by some kind of government-directed retirement plan. Do those people have a point?

I don't think so. A lot of what was being written was at the absolute bottom of the market. As we've come through this, I think the power of the 401(k) plan as a positive force has actually been underscored. I do think things could be done to improve 401(k) plans. We're working hard to make sure that every disclosure is as clear and transparent as possible. There've been congressional hearings around fees, and I think the clearer we can be as an industry about what it costs people to invest and what the risks are, the better off the investor is going to be.

McKinsey research shows that of the people who changed their portfolios during the crisis, the most common change by far was moving into more conservative investments. Was that classic herd behavior -- people doing the wrong thing?

People who did that probably got the worst of the experience. Our data were a little different. Among our 401(k) investors, 85% did nothing. That's about average. On a net basis, the move to more conservative vs. the move into equities was about a wash.

What we did see, and this is where our data are very similar to McKinsey's, we saw people's future contributions go into more conservative options.

There seems to be a strong consensus that interest rates are going up long term, after 30 years of coming down. Do you think that's correct?

We're very concerned about the level of the deficits. Eventually these large deficits are unsustainable, and you're going to have a crowding-out effect. Anticipation of long-term rates has already been built into the bond markets, so what you're more likely to see is a rise in short-term rates. When that occurs is anybody's guess, but it feels to us that that is inevitable.

Does that further suggest that investors may have made a mistake if they moved heavily into bond funds, as many of them did last year?

The single biggest tactical investment issue I'm worried about is that we as an industry saw $400 billion flow into bond funds. Some of that came out of money funds and some out of equity funds, though not as much as you would think. Quite a bit was new money, coming in from checking accounts or CDs. We hope investors remember that if interest rates go up, bond prices go down. We've tried to be very aggressive in education about that.

Taxes on dividends may increase quite sharply next year, which is obviously very bad news for retirees. How should they respond now?

I'm concerned about it. There's no easy answer. People will have to accept lower dividend yields from their equity portfolios and perhaps have to substitute bonds to offset the income loss.

The other thing that's going to sunset unless there's a change is the low capital gains tax. A low capital gains rate has been a very good thing for encouraging long-term savings. One of the interesting discussions we've had with people in Washington has been the concept of a graduated capital gains tax, where you push out what's long term even further. Maybe "long term" is something held more than five years, and that gets the preferential rate. If you want to encourage long-term savings and a more stable economy, that might be a way to go.

As the largest fund company, Vanguard has a huge ability to influence corporate governance through the way it votes all the shares it holds. Data from Proxy Democracy show that about 85% of fund families vote their shares against management proposals more often than Vanguard does. Is Vanguard being as activist on behalf of its investors as it should be?

We think so. We've taken a different tack than many other companies. We've prepared a set of principles by which we live from a governance standpoint. We put them on our website and make sure everybody can review them. I sent out letters to 900 public corporations earlier in the year restating all our positions on governance; we had done this several years prior. What we want to do is establish a dialogue with the companies.

About six or seven years ago -- before we sent these letters -- we voted against something like 70% of management proposals on executive compensation. That number is down, and you'd say that's counterintuitive given what we've just gone through. But we've seen people change their comp structures, and we think we had some influence there.

This is a different approach than some of the activist shareholders take. Many of the activist shareholders want, in a sense, to try the case in public. We think having a good dialogue with a company is really an effective way to get our point across.

In other words, the proposal that you might vote against may never appear.

You may have that occur, or you may have it modified. Occasionally, somebody actually may have a good reason. In one case a company had a director who did not meet our attendance requirements, so we told the company we're voting against this director. This director was a non-U.S. citizen, and there'd been some travel issues, and the company was passionate that this individual was going to help them open up new markets. They laid out a game plan for the next 18 months, what the attendance expectations were going to be, and if the expectations weren't met, then they would ask the director to leave the board. It was one of those clear cases where we think we were incredibly effective, and we changed our vote as a result.

You've said that the biggest management decision you made during the crisis was that you would not have any layoffs, though many of your competitors did have them. What was the thinking?

We thought if our crew were distracted by "Do I have a job or do I not have a job?" there was no way they were going to serve clients well. The cost savings we would have gained were fairly minimal, and we thought it was incredibly important to send a positive message to our people: Focus on the client, focus only on the client. We're going to be fine as an organization.

We've all been given smart investing advice our whole adult lives. Research shows that most people don't follow it. Bottom line, why are people irrational investors?

On the one hand there's this desire for a shortcut, like winning the lottery -- you pick the right fund or the right sector and you get to where you want to be fast and easy. The other side of it is fear, and emotion overtakes your decision-making process. It's how we're wired as people, and part of our job, and it's really difficult, is to try to keep people as rational as possible.

What's your investing advice to the typical employed 55-year-old?

One, continue to save more than you think you need to save, and take every advantage of your retirement plan -- the match, the catchup contributions, and so forth. Two, diversification is critical. For somebody who's 55, you probably still need to be 50% in equities, and on the equity side I would encourage people to have 20% to 30% allocated to non-U.S. On the fixed-income side, at 55 you probably want to look like the broad market, but you might begin to add TIPS [Treasury Inflation-Protected Securities] to that portfolio.

What about the typical employed 25-year-old?

Pick a target date fund that's as far out as you can imagine yourself working, and contribute aggressively to it. We always tell kids when they get their first raise, don't spend it, save it. It's basic stuff, but if you could get everybody to do it, we'd be in a better place. To top of page

The C-Suite Series: This is the latest interview with top executives by Fortune senior editor-at-large Geoff Colvin. See video excerpts of this interview at fortune.com/csuite -- plus find other Colvin interviews, including those with Charles Schwab, the team of Jeff Immelt (General Electric) and A.G. Lafley (Procter & Gamble), Chevron chief executive David O'Reilly, New York City school chancellor Joel Klein, Pimco's Mohamed El-Erian, and many more.
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