On Friday June 9th the much debated Fiduciary Rule will take partial effect. As The Wall Street Journal reported, despite President Trump’s calls for a re-evaluation, his Labor Secretary, Alexander Acosta gave the “heart of the rule- a best interest standard of care required of stewards of retirement savings” the green light although the rule remains open to review. Read the article here (requires WSJ Subscription).
Supporters of the fiduciary rule say that ensuring that financial advisers act as fiduciaries, putting the interests of their clients first and ahead of their own, is essential. They frequently cite a report put out in 2015 by the Council of Economic Advisers under the Obama Administration which estimated that conflicted investment advice costs Americans an estimated $17 billion a year in retirement savings. Since the fiduciary rule is now partially in effect, at least for the time being, we thought it was worth looking at the report again.
Americans’ retirement income is derived from many sources, including Social Security, traditional pensions, employer-based retirement savings plans such as 401(k)s, and Individual Retirement Accounts (IRAs). While this landscape is familiar today, it reflects a dramatic change from the landscape 40 years ago. The share of working Americans covered by traditional pension plans—which offer a guaranteed income stream in retirement—has fallen sharply. Today, most workers participating in a retirement plan at work are covered by a defined contribution plan, such as a 401(k). Importantly, the income available in retirement from a defined contribution plan depends on both the amount initially saved and the return on those savings. The shift from traditional pensions to defined contribution plans raises important policy issues about investment responsibilities and the roles of individual households, employers, and investment advisers in ensuring the retirement security of Americans.
Defined contribution plans and IRAs are intricately linked, as the overwhelming majority of money flowing into IRAs comes from rollovers from an employer-based retirement plan, not direct IRA contributions. Collectively, more than 40 million American families have savings of more than $7 trillion in IRAs. More than 75 million families have an employer-based retirement plan, own an IRA, or both. Rollovers to IRAs exceeded $300 billion in 2012 and are expected to increase steadily in the coming years. The decision whether to roll over one’s assets into an IRA can be confusing and the set of financial products that can be held in an IRA is vast, including savings accounts, money market accounts, mutual funds, exchange-traded funds, individual stocks and bonds, and annuities. Selecting and managing IRA investments can be a challenging and time-consuming task, frequently one of the most complex financial decisions in a person’s life, and many Americans turn to professional advisers for assistance. However, financial advisers are often compensated through fees and commissions that depend on their clients’ actions. Such fee structures generate acute conflicts of interest: the best recommendation for the saver may not be the best recommendation for the adviser’s bottom line.
This report examines the evidence on the cost of conflicted investment advice and its effects on Americans’ retirement savings, focusing on IRAs. Investment losses due to conflicted advice result from the incentives conflicted payments generate for financial advisers to steer savers into products or investment strategies that provide larger payments to the adviser but are not necessarily the best choice for the saver.
CEA’s survey of the literature finds that:
- Conflicted advice leads to lower investment returns. Savers receiving conflicted advice earn returns roughly 1 percentage point lower each year (for example, conflicted advice reduces what would be a 6 percent return to a 5 percent return).
- An estimated $1.7 trillion of IRA assets are invested in products that generally provide payments that generate conflicts of interest. Thus, we estimate the aggregate annual cost of conflicted advice is about $17 billion each year.
- A retiree who receives conflicted advice when rolling over a 401(k) balance to an IRA at retirement will lose an estimated 12 percent of the value of his or her savings if drawn down over 30 years. If a retiree receiving conflicted advice takes withdrawals at the rate possible absent conflicted advice, his or her savings would run out more than 5 years earlier.
- The average IRA rollover for individuals 55 to 64 in 2012 was more than $100,000; losing 12 percent from conflicted advice has the same effect on feasible future withdrawals as if $12,000 was lost in the transfer.
The conclusions of this report are based on a careful review of the relevant academic literature but, as with any such analysis, are subject to uncertainty. However, this uncertainty should not mask the essential finding of this report: conflicted advice leads to large and economically meaningful costs for Americans’ retirement savings. Even a far more conservative estimate of the investment losses due to conflicted advice, such as half of a percentage point, would indicate annual losses of more than $8 billion. On the other hand, if conflicted advice affects a larger portion of IRA assets than the $1.7 trillion considered here—or if the estimate were extended to other forms of retirement savings—the total annual cost would exceed $17 billion.
I. The U.S. Retirement System
Americans’ retirement income comes from many sources. Social Security provides a basic foundation for retirement security. Traditional pensions, employer-based retirement savings plans such as 401(k)s, and Individual Retirement Accounts (IRAs) allow workers to set aside additional earnings explicitly designated for retirement in a tax-advantaged way. (Table 1 provides an overview of these forms of savings.) Other savings, whether in a bank account or a home, provide additional resources that can be tapped in retirement. While this landscape is familiar today, it reflects a dramatic change from the landscape 40 years ago. The share of working Americans covered by traditional pension plans—which offer a guaranteed income stream in retirement—has fallen sharply. Today the majority of workers participating in a retirement plan at work are covered by a defined contribution plan, such as a 401(k).
Figure 1 shows the composition of Americans’ tax-preferred retirement savings for the period 1978 to 2013. In 1978, traditional pensions accounted for nearly 70 percent of all retirement assets. Defined contribution plans accounted for less than 20 percent and IRAs accounted for only 2 percent. Annuities accounted for the remainder.2 By the end of 2013, traditional pensions accounted for only 35 percent of retirement assets, a decrease of 32 percentage points; defined contribution plans and IRAs accounted for more than half of all retirement assets.
This widely discussed shift from traditional pensions to defined contribution plans and IRAs raises important policy issues. In a traditional pension, investment decisions are largely handled by professional managers. In an IRA, investment decisions are almost entirely left to the individual saver. Defined contribution plans, such as 401(k)s, reflect a middle ground where employers may automatically enroll workers in particular default products and may provide workers with access to various forms of advice, but may also provide a large menu of options and nearly unrestricted choice of investment products (Vanguard 2014).
This shift in investment responsibility has coincided with an explosion in the investment options