Jason Furman of the CEA, with his boss.

Photographer: Andrew Harrer/Bloomberg.

White House Is Not Fond of Backdoor Retirement Payments

Matt Levine is a Bloomberg View columnist. He was an editor of Dealbreaker, an investment banker at Goldman Sachs, a mergers and acquisitions lawyer at Wachtell, Lipton, Rosen & Katz and a clerk for the U.S. Court of Appeals for the Third Circuit.
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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.  

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. 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. 

Source: White House

This math looks a little familiar. The Vanguard Group will cheerfully compare expense ratios of its funds against other funds, because Vanguard largely markets itself as the popularizer of low-cost index funds.  Here for instance is a little thing from Vanguard's description of its Total Stock Market Index Fund:

Source: Vanguard Group

I highlighted the 1.08 percent average expense ratio of "similar funds," which is 1.03 percentage points higher than Vanguard's advertised expense ratio.  The Investment Company Institute finds an average expense ratio of 0.89 percent for actively managed equity funds, versus 0.12 percent for equity index funds, or a 0.77 percentage point difference. 

Also the actively managed funds tend to underperform the passive funds even before taking out fees, though that is a sensitive topic.  

So you might conclude that somewhere between three-quarters and all of the costs of "conflicted investment advice" are really just costs of actively managed mutual funds. In other words, all the stuff about "backdoor payments" and "hidden fees" and "fiduciary duties" is a non-load-bearing distraction. Most or all of the work in the CEA paper is done by the difference in costs between actively managed mutual funds and passive indexing. The conflicts of interest boil down to: It is in the financial industry's interest to steer investors into high-fee active funds rather than low-fee passive funds.

I don't really know what to make of that. It would be weird if the White House put out a fact sheet called "Strengthening Retirement Security by Cracking Down on Active Investing." And obviously that's not quite what it's going for with this paper. But it's close. The world view underlying this report seems to be that a lot of what the financial industry does is extract unproductive fees for itself from ignorant consumers, and that you can crack down on the fees -- and save consumers money -- without reducing the incentives for any socially productive activity. This, it goes without saying, is a hugely popular theory. I feel like it is generically wrong, but there may be many, many places where it is specifically correct.

In my more dictatorial moods I think people should get to choose one of two options for their retirement investing:

  1. You can invest only in a list of pre-approved, low-cost, fee-capped, diversified, probably mostly passive portfolios run by reputable managers, and if you lose money everyone will nod sympathetically and tell you it's not your fault.
  2. You can sign the omnibus liability waiver and invest in whatever you want, just go nuts, but if you lose all your money it's a felony to complain.

But that is not the system we have now. It's almost the reverse: The people with the least money and expertise, who really want and ought to have simple low-cost generic retirement savings, are at high risk of being steered into weird expensive stuff. It seems reasonable enough to try to nudge them back toward simplicity.

  1. The White House fact sheet has some general (and tendentious) description of the new rules. Here is Bloomberg News, the Wall Street Journal, InvestmentNews, a Vox explainer. Here is Sifma expressing unhappiness, and more from Sifma on the topic. Here is a memo from Debevoise & Plimpton for the Financial Services Roundtable, also opposing the rule. Here is an FAQ from the Labor Department, and here are all the comment letters on the fiduciary-duty rule that the Labor Department proposed in 2010 and then withdrew because it was too drastic.

    Since I have you here, two generic things that I think about fiduciary standards are:

    1. It is impossible to make all broker-dealers fiduciaries, and trying to do so is a category mistake: Dealers are principals, and if you are selling someone something that you own, you can't be asked to put her interests above your own. You would prefer a high price, she would prefer a low price, and making you give it to her for free because you are her fiduciary makes no sense at all. 
    2. There is an argument of the form, "If we couldn't scam people quietly, we couldn't afford to provide them the services that they need." This argument is distasteful, but that doesn't make it wrong. There are probably places where it is right. Arguably being sold on an expensive bad retirement plan is better than not being sold on any retirement plan and forgetting to save for retirement.

    That said, I weakly think that neither of these things apply to retirement-plan brokers. They're not acting as principal, so there's no category-mistake problem in making them fiduciaries. And if you've got a retirement plan anyway -- the new rules seem to be mostly about recommending rollovers and changes in allocations in existing 401(k)s and IRAs -- then being sold a bad plan is probably not going to improve your situation. In that vein, the CEA report describes one mystery-shopper study:

    The study finds that advisers recommend a change to the current investment strategy in about 60 percent of cases when the client had a return-chasing portfolio and in about 85 percent of cases in which the client had a diversified low-fee portfolio. The authors conclude that advisers “seem to support strategies that result in more transactions and higher management fees,” even when clients appear to hold the optimal portfolio.

    Yeah that doesn't seem like an improvement. (Try the Debevoise memo for a persuasive case the other way; Question 8 in the Labor Department FAQ is a good rebuttal.)

  2. The fact sheet characterizes this as "$17 billion of losses every year for working and middle class families," which is just plainly not true. The $17 billion number is for all "load mutual funds and annuities in IRAs," or individual retirement accounts, as you can tell from page 19 of the report. Presumably a lot of IRAs are held by people who are not "working and middle class." Mitt Romney has a notably large IRA, though I guess it's not invested in load mutual funds.

    Incidentally the report notes that "more than 40 million American families have savings of more than $7 trillion in IRAs," meaning that that $17 billion comes to about $425 per year, per family with an IRA.

  3. The stylized version is different from the actual version, which cites academic studies finding a wide range of underperformance. The report hangs its hat mostly on one study finding 113 basis points of underperformance.

  4. As I've disclosed before, a lot of my money is in Vanguard funds (mostly though not all index funds), and I am personally a fan of their work.

  5. Vanguard's footnote cites to Morningstar for that average. 

  6. Also an interesting one. Here is a good post from Josh Brown, which we've discussed previously. Some amount of active underperformance is driven by specific market circumstances: For instance, active managers tend to favor certain factors that underperformed in 2014. Some of it is arithmetic: Everyone can't be above average, and if everyone in the equity markets is a professional (not true, but becoming more true), then most professionals can't be above average either.

  7. Is this one? Well, what is "this"? It seems obvious to me that some amount of active allocation of equity capital to businesses is socially desirable, so rules that strongly disincentivize active management would be bad. But you don't need rules to disincentivize it: Active management is more expensive than passive management, so the market should more or less discourage people from paying for it. The question is how to subsidize it, if it's socially desirable. (I mean, not really, but something like this; we've discussed this topic recently.)

    It is less obvious to me that the things the White House is explicitly objecting to -- conflicted payments for investment advice, basically -- are socially desirable, though again there is an opposing argument (see footnote 1). Also note that these conflicted arrangements might be one way to subsidize active management, although actively allocating capital on behalf of bamboozled principals doesn't seem socially optimal either.

This column does not necessarily reflect the opinion of Bloomberg View's editorial board or Bloomberg LP, its owners and investors.

To contact the author on this story:
Matt Levine at mlevine51@bloomberg.net

To contact the editor on this story:
Zara Kessler at zkessler@bloomberg.net