Conflicted financial advice costs Americans $17 billion a year
By Buttonwood
NEVER ask your barber if you need a haircut, Warren Buffett has quipped. But even supposed dispassionate advisers turn out to have conflicts of interest. A new report from the US Department of Labor focuses on the financial advice given to American workers with pension plans and concludes on the basis of examining the academic research, that it may cost $17 billion a year.
This is a problem that the British financial system grappled with for decades. Some providers paid commission to those who sold their products; others did not. This creates a natural conflict of interest. The only answer was to abolish commission but it was not until 2013 that this was achieved. In America, the conflict still exists. It is not true for all advisers; some charge a fee and can be truly impartial. But others take payment from providers in a variety of ways; revenue-sharing agreements (12b-1 fees); front-end or back-end loads (fees when a product is bought or sold); and commissions based on the volume of products sold.
The report focuses on individual retirement accounts or IRAs. Workers are often persuaded to roll their 401(k) plans into IRAs when they switch jobs or retire. This is not always a bad deal. But it may well be a bad deal if the IRA imposes much higher fees than the workers' original portfolio. How do these costs add up? The biggest impact comes from the tendency to recommend higher-charging mutual funds with higher trading costs. This seems to happen a lot; one study sent "mystery shoppers" who already had portfolios to visit advisers who received conflicted payments. Some of those shoppers had a diversified pool of low-cost index funds, as academics would recommend; incredibly 85% of such people were advised to switch into higher-charging funds. Another study found that a 50 basis point increase in fund fees led to a 17.2 percentage point increase in portfolio allocations by advisers.
Perhaps the advisers are recommending better funds? Alas, the evidence does not suggest they can; largecap funds, for example, have outperformed the market on only five years out of the last 20; the average underperformance has been 1.6% a year. Picking the "best" funds is not easy either; top quintile funds are more likely to be bottom quintile in future than they are to repeat their success. Studies have estimated that the funds chosen by conflicted advisers underperform by more than a percentage point a year. The studies also show that such advisers encourage clients to trade more frequently, another drag on returns. (This may be for the innocent reason that advisers are overconfident about their ability to deliver returns; a study of finance professionals found that 74% believed their performance was above average.)
The report concludes conservatively that the effect on performance may be around one percentage point a year, which on a total of $1.7 trillion of IRA assets equates to a $17 billion cost for savers. Looked at another way, a retiree who rolls over into an IRA may lose 12% of their savings (and so will lose 12% of their annual income); relative to a low-cost approach, they will run out of their money 5 years earlier.
The kneejerk disclosure may be to insist that such conflicts of interest are disclosed and rely on caveat emptor. But the report argues convincingly that this is inadequate; disclosures often appear in fine print, in the contest of documents that are thousands of words long. Investors rarely read them. If the disclosure is presented at the point of sale, that may be too late; the client may be emotionally committed to the decision by that stage. The only answer is to get rid of the conflicts by changing the payment system.
