How much do investors lose from conflicted advice?

Introduction

Investors worldwide turn to financial advisors when making key decisions such as whether or how they should convert an employer-based retirement account (such as a “401(k)” account in the U.S., an “RRSP” in Canada, “Super” in Australia) to an individually-directed retirement account (such as an individual retirement account or “IRA” in the U.S.). However, such financial advisors are typically compensated, directly or indirectly, in the form of fees and/or commissions from funds and other investment products. Not surprisingly, their recommendations are not always in the individual customer’s best interest.

A U.S. government report, released 19 February 2015 by the White House, summarizes in well-documented detail the toll taken on investors’ savings from this conflicted system of advice. We paraphrase here some of the findings of this report, as well as some related information from other sources.

Background

In the U.S., more than 75,000,000 households have individual retirement accounts (IRAs), which collectively total over USD$7 trillion. Each year, more than $300 billion is transferred from employer accounts to IRAs, and this figure is projected to increase steadily for the foreseeable future.

For most investors, the time when they consider how to transfer their employer account to an individual account is the only time that they confront the full range of investment products available, and thus it is not surprising that they turn to advisors for guidance to sort through the morass of available options. What’s more, at least one study has found that older investors are somewhat less informed (and thus more vulnerable) in this regard than younger investors.

The fees and commissions paid to advisors can take several forms:

1. Ongoing payments to advisors from mutual funds (often known as “12b-1 fees”).
2. Front-end (fees when an investor buys shares) or back-end (when he/she sells shares) sales loads.
3. Payouts for meeting certain sales targets.
4. Variable commissions paid when the advisor sells certain individual stocks, insurance products or other instruments.

Individuals may obtain financial advice from a variety of sources, ranging from registered investment advisors (who have a sworn fiduciary obligation to their clients), to brokers or dealers (who typically do not), bankers, insurance agents, accountants and lawyers. Individual advisors can (and often do) switch back and forth between offering “holistic” advice and “incidental advice,” a practice known as “dual hatting.” Thus a consumer might not know which legal regime applies to the advice he/she receives.

How much does this conflicted advice cost individual investors?

So what is the toll of this conflicted advice? The U.S. government report documents in detail the losses suffered from this conflicted advice, including studies conducted in the U.S. and elsewhere. Here are some international findings:

1. Chalmers and Reuter (2014) found that investors in a university-sponsored retirement plan, who received conflicted advice, under-performed a self-directed plan by 1.25% per year.
2. Christofferson, Evans and Musto (2013) found that among mutual funds with loads, higher payments to advisors lead to higher inflows, suggesting that the advisors’ recommendations are affected by the payments they receive.
3. Del Guercio and Reuter (2014) found that actively managed broker-sold mutual funds earned 1.12% to 1.32% per year lower than passively managed broker-sold funds, after accounting for fees.
4. Foerster, Linnainmaa, Melzer and Previtero (2014) found, in a study of Canadian investors, portfolios crafted by conflicted advisors typically involved greater risk-taking, but the gains in returns are offset by higher fees, leaving the investor with lower risk-adjusted performance than with, say, a passive index fund.
5. Hackethal, Inderst and Meyer (2012) found that investors receiving conflicted advice from a German retail bank between 2005 and 2007 traded more often and were more likely to purchase funds with higher loads, compared with non-conflicted advisors, after holding investor characteristics (such as financial sophistication) constant.
6. Mullainathan, Noeth and Schoar (2012) found, by using a “mystery shopper” study approach, that most financial advisors recommended investment strategies in line with the advisor’s financial interest — away from low-fee, passively managed portfolios and towards higher-fee products.

All in all, the U.S. government report’s authors (the President’s Council of Economic Advisers) found that conflicted advice produces roughly one percentage point lower yields — i.e., a 6% annual return is typically reduced to 5%. In total, the aggregate cost (in terms of reduced performance) of conflicted advice, just in the U.S., is some USD$17 billion per year. Another way of looking at these results is that a retiree will lose roughly 12% of his/her savings due to conflicted advice.

Policy changes around the world

In the wake of these findings, the Obama Administration is proposing new regulations covering financial advice. These new regulations would require that investment professionals act in their customers’ best interests (i.e., their “fiduciary duty” would be to their customers). But the proposal’s fate is uncertain in a Congress controlled by the opposing political party. Moreover, attempts to regulate can fail by being too weak, too stringent, or (as with high frequency trading) just lead to unintended new loopholes.

When considering such issues, it is important to keep in mind that the U.S. is not the only nation to face the problem of conflicted investment advice to its savers and retirees. Here is a summary, taken from the U.S. government report, of some recent policy changes that have been enacted in various other nations:

1. Australia has banned payments from investment product providers, and created a statutory “duty” for advisors to act in the best interest of their clients.
2. Canada has enacted new regulations, which began to take effect in 2014, which require significantly greater transparency about both the direct and indirect costs to the client for each account, as well as additional details on the advisor’s compensation.
3. India has banned all front-load fees for mutual fund products, and tightened fee disclosure requirements.
4. Germany has increased the required disclosures about the cost of advice and whether advisors are compensated solely through client fees or indirectly in payments from providers.
5. The Netherlands has banned all payments by a product provider to an advisor. The regulations apply to investment, insurance, mortgage and annuity products.
6. The United Kingdom has banned conflicted payments, has increased advisor credential requirements and required advisors to disclose whether they make recommendations from a limited menu or across all products.

So the U.S. (or any other nation contemplating regulations in this arena) need not act in a vacuum — numerous other nations have already faced this problem, and there is much to learn from their experience.

Additional details are available in the U.S. government report, a New York Times article, and an Economist column.