The way that a lot of retirement investing advice goes is that you go to your broker and ask him what you should invest in, and he says, “Oh Fund XYZ is great, put all your money in Fund XYZ,” and the reason he does that is not that he loves Fund XYZ in his heart of hearts, but rather that Fund XYZ writes him a big check for steering you its way. I’m sorry, but that is the way it works. I mean maybe he also loves it in his heart of hearts, but that is not observable; the check is. As is Fund XYZ’s subsequent underperformance versus its benchmark.
A lot of people think that that is a bad system, and how could you blame them really? When I put it like that it just sounds terrible. U.S. President Barack Obama’s administration, in particular, seems not to like this system, and today the White House released this fact sheet (“Middle Class Economics: Strengthening Retirement Security by Cracking Down on Backdoor Payments and Hidden Fees”), and this report from the Council of Economic Advisers (“The Effects of Conflicted Investment Advice on Retirement Savings”), explaining how bad some retirement advising is. (Some: The administration also has high praise for the “hardworking men and women” who work as fee-only investment advisers.) New Labor Department rules are coming that would, if not quite outlaw these practices, at least make them more awkward, and part of the point of today’s releases is to justify those rules.
We don’t have the rules yet, though there is already a rather enormous literature on what they will or should or won’t or shouldn’t say. But we do have the Council of Economic Advisers report, and it is pretty interesting! The main conclusion is that “conflicted investment advice” costs Americans about $17 billion a year.2
The math here is:
— There’s about $1.7 trillion in individual retirement accounts invested in funds that pay brokers to recommend them.
— The people who invest in those funds could improve their performance by about 1 percentage point a year by switching to other funds that don’t pay brokers.
Pages 17-18 of the report walk through the second point in some (stylized) detail.3 The report assumes an employee who invests in a low-cost index fund through her employer’s 401(k) plan. The expected gross return on the index fund is 6.5 percent, but the employee pays trading and administrative costs of 0.5 percentage points, for a net return of 6 percent. But then she quits her job, and an unscrupulous adviser recommends that she roll over her retirement fund into a new individual retirement account — and that she invest the IRA in a fund with a similar expected return, but with 1.5 percentage points of costs. She gets a net return of 5 percent, and the adviser and the mutual fund split the extra fees among themselves.