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Last month, the White House released a report from its Council of Economic Advisers (CEA) that discussed how many investors receive conflicted advice when it comes time to roll over money from a 401(k) into IRAs. Some of the facts and findings cited in the report came from the research of Carroll School of Management Associate Professor of Finance Jonathan Reuter.
Q: It’s not every day that the White House cites one’s research in compiling a report to educate the nation. What was your reaction?
REUTER: I have been studying financial advice in various forms for over a decade. It was reassuring to learn that policymakers have been reading my papers and that they find the analysis convincing!
Q: The White House report focused on what happens to retirement savings when they are the object of conflicted advice. Let’s start there: What is “conflicted advice”?
REUTER: In many cases, the fees that mutual funds collect from investors are used to pay commissions to financial advisers. The White House is concerned that [some] financial advisers are tilting their recommendations toward investments that charge higher fees and pay higher commissions. The conflict arises because the higher fees reduce the returns than investors earn in their retirement accounts. While some financial advisers have a fiduciary duty to their clients, many others do not, allowing them to take commissions into account when making investment recommendations.
Q: How much is being lost in the nation’s retirement accounts because of conflicted advice?
REUTER: The CEA estimates that conflicted advice costs IRA investors approximately $17 billion per year. Because investors can receive conflicted advice outside of IRAs, the total cost of conflicted advice is likely to be much larger.
Q: Some of your research found that fund flows are sensitive to the level of fees. Can you expand on that concept and describe exactly what your research uncovered?
REUTER: The White House report cites two papers that use different types of data. In one paper, we study the retirement portfolios of Oregon investors who choose to invest through a broker. For each fund, we know the level of the annual broker commission paid by the fund. Consistent with the White House’s concerns about conflicted advice, we find that broker clients are more likely to invest in high-commission funds than in low-commission funds with the same investment objective.
Q: The CEA report also cited your research that found that after accounting for adviser fees, actively managed broker-sold mutual funds earn a return that’s 1.12 to 1.32 percent lower than identical accounts that are passively managed, and this reflects an agency conflict between advisers and their clients. Can you elaborate on this?
REUTER: In another paper, we use historical data on mutual fund fees and returns to compare funds sold through financial advisers with funds sold directly to investors. Although it is often claimed that actively managed mutual funds underperform index funds, we only find that this is true when we study the set of funds sold through financial advisers. Among this set, commission-paying actively managed funds earn annual returns that are 1.12 to 1.32 percent lower than commission-paying index funds. Given this large difference in returns, you might expect financial advisers to steer their clients away from actively managed funds and toward index funds. But that is not what we find. Only about 2 percent of the dollars invested in equity funds through financial advisers are invested in index funds.
Q: Do you think advisers are intentionally directing clients into funds that will pay more fees to the adviser, or is it more of a subconscious directing of clients to those funds? In other words, are fund advisers out for themselves or the clients they are paid to be helping?
REUTER: The fact that those financial advisers who receive commissions from mutual funds continue recommending actively managed funds over index funds certainly calls into question the quality of the advice that they are offering to their clients. The most extreme interpretation is that advisers are “pushing” actively managed funds solely because they pay higher commissions. We found some evidence of this in the Oregon study.
A less extreme interpretation is that financial advisers avoid recommending index funds because they are concerned about being compensated for their time and effort. If a financial adviser recommends a portfolio based on high-cost, commission-paying index funds, the client could take the recommendations to a low-cost provider like Vanguard, thereby depriving the adviser of any compensation. In this second case, the advisers are still “out for themselves,” but in a way in seems less nefarious. When financial advisers are compensated directly by investors, this concern is reduced.
Q: As much as potential investors are bombarded with marketing campaigns from investment firms, do you think, given your research and the potential conflicts at hand, that investors are better off without actively managed retirement funds? Are they better off opting for a Vanguard approach where you make your own choices and pay minimal fees?
REUTER: There is a lot of academic research showing that investors are better off investing in low-cost index funds than in high-cost actively managed funds. This is how my retirement dollars are invested. But I recognize that not everyone is comfortable managing his or her own retirement portfolio.
One reasonable approach is to invest in a target date fund. There are different target date funds available for people who expect to retire in different years. These funds start out investing primarily in stocks but automatically switch into less risky investments like bonds as the target retirement year draws near. My preference would be one of the low-cost target date funds that invests in a small number of index funds. They typically had the word “index” in their name.
Another reasonable approach is to hire a financial adviser who has a fiduciary duty to you. These advisers are typically paid directly by investors rather than through commissions paid by mutual funds. While it may seem more expensive to write a separate check to your adviser, they are likely to put you into lower-cost, higher quality mutual funds, which will pay off over time.
Q: What’s the one piece of advice you would give someone looking to park his or her money in a retirement account?
REUTER: If you have money invested in a low-cost 401(k) plan, it is often better to leave it there than to roll it over into an IRA, which offers fewer legal protections.
Q: Any final thoughts?
REUTER: I worry that one of the reasons that financial advisers recommend high-cost, actively managed funds is that their clients think the advisers will be able to put their money in funds that beat the market. According to the academic literature, this is unlikely to happen. Clients would be better off investing in index funds that charge high enough fees to pay commissions.