On Monday, President Obama lent his support to the campaign to increase the legal standards applicable to financial advisers when providing advice about retirement accounts. This is a good idea, but only a very small step toward ensuring retirement security for ordinary families.
The specific issue requires some explanation if you’re not already a retirement plan junkie. Tax-favored retirement plans come in two flavors: employer-sponsored and individual. Employer-sponsored plans, be they defined benefit pensions or defined contribution 401(k) plans, must have a named plan fiduciary who, in theory, is supposed to look out for the interests of plan participants. Among other things, the fiduciary is responsible for selecting the investment options available in a defined contribution plan. (This isn’t actually as good as it sounds, as I’ll discuss below.)
Individual plans — Individual Retirement Accounts or the Roth version thereof — have no such fiduciary. Instead, savers can invest in more or less whatever they want (with a few restrictions); they can do so entirely on their own, or they can get advice from financial advisers. These advisers do not always have a fiduciary duty to do what is in the best interests of the client: some do, some don’t, and some do some of the time but don’t the rest of the time. In other words, the person recommending that you invest your retirement savings in some mutual fund may be getting a (legal) kickback from that mutual fund, and can even (legally) recommend that fund to you precisely because she is getting that kickback. You can see where this is leading.
There is a lot of empirical evidence, helpfully reviewed by the Council of Economic Advisers, that these types of conflicts of interest result in lower investment returns for savers. Therefore, the Department of Labor is beginning the process of issuing a rule that would hold advisers to a fiduciary (best interests) standard when advising clients about retirement accounts.
As I said above, this is a step in the right direction. Conflicts of interest reduce investment returns primarily through increased fees: advisers tend to push clients into mutual funds that charge higher fees with no prospect of better performance. (This shouldn’t be surprising, since, for liquid markets like U.S. stocks, almost everyone should be in low-fee index funds anyway.) The CEA estimates that those excess fees are on the order of $17 billion per year — 1 percent of the roughly $1.7 trillion in IRAs that are subject to conflicts. That’s nothing to sneeze at, although there are a number of hazy guesses built into that estimate.
A fiduciary duty standard is no magic bullet, however.
The CEA report at times makes you think that the problem is IRAs, and 401(k) plans are a model of perfection, and therefore copying the fiduciary duty from the latter to the former would solve everything. See the following illustrative chart, for example.
Anyone who actually believes that is naive. The average expense ratio of a mutual fund in a 401(k) plan is not 20 basis points; it’s more like 74 basis points (see this paper I wrote on the topic of high fees in 401(k) plans). It turns out that there are lots of reasons why people buy high-fee, actively managed mutual funds — even for liquid asset classes in which active management is almost always a waste of money.
One is that human beings are conditioned to believe that you get what you pay for — that a mutual fund that costs more must be better. In fact, the opposite is actually the case: higher fees are associated with lower gross returns — that is, even before you deduct the fees (see Gil-Bazo & Ruiz-Verdú 2009). Another is that mutual fund marketing is focused on past performance, even though (as the fine print always says), past performance is no indicator of future results. So people tend to buy into funds that did well in the past because of sheer dumb luck.
The more surprising reason, however, is that the fiduciary duties of 401(k) plans don’t prohibit exactly the conflicts of interest that the Department of Labor wants to get rid of. Fiduciaries of employer-sponsored plans are allowed to take kickbacks, in the form of lower administrative fees (which the employer often pays), for directing participants into high-fee mutual funds. There is ongoing litigation on the question of whether those kickbacks need to be disclosed. In Braden v. Wal-Mart Stores, Inc., for example, the Eighth Circuit dinged the employer for failing to disclose “revenue sharing” agreements to participants; however, several other courts have said that such kickbacks did not even need to be disclosed.
So, for starters, the proposed Department of Labor rule will have to define financial advisers’ fiduciary duty in a way that prohibits kickbacks altogether. But that still doesn’t mean that most people will put their retirement savings in low-fee index funds like they should.
The more fundamental problem is a retirement “system” that depends on individual choices in the first place.
It sure sounds good in a country that fetishizes individual choice. But we know that people are bad at investing. We know that the investors in mutual funds get lower average returns than the mutual funds themselves, because they buy high (after the fund did well) and sell low (after it did poorly). We know that people do not save enough, withdraw money from their retirement plans too early, and take lump sum distributions when they should annuitize.
Prohibiting kickbacks would eliminate one of the many reasons why people end up with too little money when they want to retire, but not a particularly important one. The most important reason is undoubtedly that many people don’t make enough to begin with, and the second most important reason is that they don’t save enough of what they do make. Of the reasons why people make bad investment choices, conflicted advice is only one: simply bad advice (from friends, family members, colleagues, the Internet, etc.) is probably a bigger problem.
The only retirement plans that are immune from the foibles of participants are traditional defined benefit pensions. And the only defined benefit pension plan that is immune from the risk of bankruptcy is Social Security. (Don’t try to tell me that Social Security will go bankrupt: if Social Security ever stops paying full benefits, that will be a political choice, not a necessity, given the practically unlimited borrowing capacity of the federal government.)
If we want to be serious about ensuring retirement security for the “middle class”—or, more importantly, for the lower class—we need to expand Social Security.
Anything less is at best a very partial solution.