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In this article we review the paper, Review of the White House Report Titled “The Effects of Conflicted Investment Advice on Retirement Savings,” by National Economic Research Associates, for Securities Industry and Financial Markets Association, released on March 16, 2015. The NERA paper criticizes the ‘White House Report,’ prepared by the Council of Economic Advisors and released on February 23, 2015, in support of a yet-to-be-released proposal by the Department of Labor on “conflicted advice.” We discussed the CEA report, the President’s speech on this issue, and related fact sheets and FAQs in our recent article Administration support for new conflict of interest rule.
But before we turn to the substance of the NERA paper, we want to begin by framing, for plan sponsors, the issues that may be raised by the new rule.
DOL’s new conflicted advice proposal (which, to repeat, we have not yet seen) is likely to be the most significant retirement plan-related regulatory effort this year. It is expected to target certain practices in the financial services industry – compensation and related practices that create conflicts for persons giving ‘advice’ to sponsors and participants. We put ‘advice’ in quotes because it’s kind of a loaded term – some sorts of advice can make you a fiduciary under current ERISA rules. Hereafter, we are going to drop the quotes, but it should be understood that we’re using the word advice colloquially, not in the technical ERISA sense.
The proposal will be significant for plan sponsors in two respects: First, sponsors are, in effect, consumers of advice. Either directly, when, for instance, a consultant advises them about which funds to put in a fund menu. Or on behalf of participants, when, for instance, they retain persons (educators, investment advisors or (arguably) call center operators) who advise their participants. The new rule may, to some extent, affect that process (sponsor ‘consumption’ of advice) in a ‘good’ way – e.g., by providing greater transparency. Or it may affect it in a ‘bad’ way – e.g., by making advice more costly.
Second, sponsors and sponsor staff may be directly affected by the proposal. The 2010 proposal (withdrawn in 2011 and the predecessor of this new proposal) would have made ERISA ‘fiduciaries’ out of certain sponsor officials who are not fiduciaries under current rules.
On February 23, 2015, the Administration made their argument for the new rule, going so far as to feature that argument in a speech by the President to the American Association of Retired Persons (AARP). The findings in support of the Administration’s argument were described in the CEA report on “The Effects of Conflicted Investment Advice on Retirement Savings.” The NERA paper, which we are going to discuss in this article, is in effect the first financial services industry counter-argument, and it directly confronts the CEA findings.
As we review the arguments and counter-arguments in what is likely to be a very contentious and high profile debate, our focus will be on those two issues of significance to sponsors: How will the proposal affect the availability, quality and cost of the advice that sponsors and participants ‘consume?’ And how will the proposal directly affect sponsor officials?
The financial services industry is itself divided on this regulatory project. Some have business models that would be helped by greater limits/burdens on ‘conflicted advice.’ Others would be hurt. In discussing the arguments and counter-arguments we do not want to take sides. We simply want to make the issues as clear as possible for plan sponsors.
Before we turn to the NERA paper, let’s review what the CEA report purported to establish. That report makes four points:
Conflicted advice significantly reduces returns. Based on a review of the academic literature, the CEA found that “[c]onflicted 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).”
Restricting conflicted advice would impose minimal costs. The CEA asserted that conflicted advice could be restricted without raising the cost of, or reducing access to, advice – particularly for small balance accounts. In this regard, the CEA argued that: (1) “an adviser receiving payment through non-conflicted structures should be able to provide advice at the same cost as an adviser receiving conflicted payments;” (2) if conflicted advice were restricted, “low-cost, high-quality alternatives” would emerge; and (3) “[a] significant motivator for the services provided to low-balance customers today is likely their potential to become higher balance customers in the future.”
The intangible benefits of conflicted advice do not outweigh the cost. The CEA rejected the argument that the underperformance of conflicted advice portfolios can be explained by the intangible benefits that an adviser provides. While it acknowledged that there might be benefits to using a broker, it stated that it is “unlikely that the underperformance [of funds offering conflicted payments vs. those that do not] reflects the fair price of advice.”
Mandated disclosures would not solve the problem. The CEA found that: (1) disclosures are generally too opaque (existing in fine print and in legalese) for participants to understand; (2) even a lucid description of the issues could not do justice to the complexity of the information necessary for the saver’s decision; and (3) disclosures may actually make the problem worse by making advisors more willing to pursue their own interest and advisees overconfident in the honesty of the adviser.
A final issue considered by the CEA but not really disposed of is causation. A major challenge to the CEA’s findings is that the underperformance of the funds of savers receiving conflicted advice may simply be explained by the fact that those savers know much less about investing than ‘do it yourself’ savers do.
The NERA paper makes five significant points.
This objection might apply to the Administration’s and the Department of Labor’s entire February 23, 2015 publicity effort – that it is making a case for a change in rules before the actual proposal has been released. As the NERA paper puts it: “It is a basic tenet of Economics that to conduct a cost-benefit analysis of an alternative public policy one needs to have a well-articulated proposal.”
Instead of providing a thorough cost-benefit analysis, the CEA argues (as described above) that (1) restricting conflicted advice won’t increase costs and (2) a less intrusive disclosure regime won’t solve the problem. NERA argues that the CEA provides no empirical support for these arguments and that they do not make theoretical sense.
With regard to the issue of whether a change might increase the cost of advice and reduce access, NERA cites data from the United Kingdom – which, in 2013, banned commission payments from mutual funds to brokers. According to NERA:
Europe Economics [the firm commissioned to study the effects of the UK rule] finds that just in the first three months of 2014 about 310,000 clients stopped being served by their brokers because their wealth was too small for the broker to advise profitably. An additional 60,000 investors were not accepted as new clients by brokers for the same reason (low-balance) over the same three months. … The study finds that brokers fees have gone up in at least some geographies and for at least some consumers: “The evidence available does imply that adviser charges have increased post-[reform], at least for some consumers.” Europe Economics also finds that the consumers whose (sic) face higher fees tend to be those with smaller savings. Additionally, Europe Economics cites a KPMG study that also “finds that ongoing advice prices are higher post-[reform]”.
The CEA cited the UK commission reform rule as providing a positive alternative to conflicted advice but did not discuss this follow-on data.
NERA argues that the literature (including literature cited by the CEA) indicates that brokers provide valuable services for the compensation they receive. In this regard:
Savers are “more likely to seek broker recommendations when they have lower levels of financial literacy or less investment experience.”
“[B]rokers may help their clients save more than they would otherwise save.” While getting a client to save more may not necessarily improve her return-on-investment, it will improve her retirement outcome.
“[B]rokers may help reduce investors’ tendency to under-diversify by over-investing in local stocks.”
With these facts in view, NERA argues that conflicted advice ‘underperformance’ may simply reflect a selection bias – that investors that use brokers may not be the same kinds of investors that as those that do not. “[T]he Report does not consider the possibility that the benefits received by consumers who choose to use brokerage services may exceed the total of fees and underperformance.” At the risk of repeating the obvious: NERA’s point here seems to be that many who use brokers (and ‘conflicted advice’) may be so uninformed about investment that the total cost of conflicted advice (that is, fees plus underperformance) is justified.
It seems likely that part of this debate is going to involve dueling interpretations of academic studies and challenges (some of them very technical) to the methodologies used in those studies. The NERA paper devotes four of its 16 pages to a study-by-study discussion of the literature cited by the CEA. We are not going to discuss NERA’s criticisms in detail. Here is a very brief summary of NERA’s comments on the major studies the CEA relied on:
Christoffersen et al. (2013). NERA argues that: (1) this study “analyze[s] returns of funds, which is not the same as the performance of an individual investor because investors may trade in and out of the fund (potentially at the suggestion of their broker);” (2) the data used (combining results from 1993-2009) “may not be representative of the current situation;” and (3) the underperformance estimate is only for the first year but is used to support CEA’s estimate of annual losses of 1%.
Bergstresser, et al. (2009). While this study did find that some broker-sold funds (e.g., domestic equity funds) underperformed, others (e.g., value-weighted foreign equity) overperformed significantly. This result raises a causation question: given these ‘discordant results,’ can the underperformance be attributed to conflicted advice? NERA also found methodological issues with this study: The study authors admitted that “characterizing mutual fund distribution channels is complicated.” Moreover, the study relies on Financial Research Corporation (FRC) data, which does not reconcile with Lipper data. Finally, given that direct-sold funds may generate 12b-1 fees, it’s unclear they can be characterized as ‘unconflicted.’
Del Guercio and Reuter (2014). This study did not look at performance as such but rather sought to demonstrate that the mutual fund market is segmented between self-directed investors and investors who use brokerage services. According to NERA, the study authors provide an “extensive discussion … devoted to explaining why investors often rationally choose to use broker-sold funds even if they have higher fees.” This study also presents the FRC vs. Lipper data issue.
Chalmers and Reuter (2014). This paper studied the relative performance under an Oregon University plan in which participants could choose between a low-service or broker-served option. It found that the low-service investors did better. But, NERA notes, those who selected the broker-served option were generally “younger, less educated and have generally lower incomes. … [N]o evidence is provided that financially unsophisticated investors would construct portfolios that perform as well as sophisticated investors, on their own.”
NERA argues that the main support for CEA’s claim “that rollovers of funds from 401(k) to IRA are a channel by which conflicted payments manifest themselves in losses to consumers” is a GAO study based mainly on interviews and is thus, in effect, anecdotal. Moreover, the GAO report focuses solely on costs and does not ‘properly account’ for the benefits IRA investors get.
This may be the most compelling of NERA’s arguments. The academic literature cited by the CEA uses data going back as far as 1990. But both expense ratios and front- and back-end loads have gone down significantly in recent years. The following tables are based on data from the NERA paper, which were in turn based on data from the Investment Company Institute, Lipper, and Strategic Insight Simfund.
Declining average expense ratios (type of fund/basis points)
| Year | Equity | Hybrid | Bond |
| 2000 | 99 | 89 | 76 |
| 2013 | 74 | 80 | 61 |
Declining average front-end sales load that investors actually paid (type of fund/% points)
| Year | Equity | Hybrid | Bond |
| 1990 | 3.9% | 3.8% | 3.5% |
| 2000 | 1.4% | 1.4% | 1.1% |
| 2013 | 1.0% | 1.0% | 0.7% |
Further to this point, data (from ICI) also show that “nearly all net new cash flows in recent years have accrued to no-load mutual funds. Net flows to load mutual funds have been negative for all four years of the most recent data.”
NERA argues that this more recent data calls into question the CEA’s conclusion about ‘underperformance.’
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Notwithstanding that we are still waiting for the proposal to be released, the battle of the advocates and experts has begun on this issue. We will continue to follow it.