Whether or not the United States faces a retirement crisis is the subject of much academic debate. What is clear, however, is that the inefficiencies inherent to how private retirement accounts are managed benefit financial managers to the detriment of retirees.
The recently vacated “fiduciary rule” would have required financial advisers to make investment advice that is in the “best interest” of the investor, rather than investments that are simply “suitable.” The idea behind the Obama-era rule was to prevent financial managers from making investment decisions that benefit themselves (through higher fees) rather than the investors.
But how self-serving are these managers? Anyone offering prudent investment advice would recommend putting money in low-cost index funds, rather than actively managed accounts. Economic theory (the “efficient market hypothesis”) tells us that, in the long run, active management can’t beat the market. This has been confirmed empirically; a 2009 study found that only the top 10% of hedge fund managers were able to outperform the market enough to cover the added costs to their investors. For further evidence, look to the dismal experience some public sector pension systems have had with their alternative investment portfolios.
In the newest issue of Regulation, Peter Van Doren reviewed a paper discussing the investment decisions of financial managers. The paper found, unsurprisingly, that actively managed funds underperformed the market, with an alpha (returns from active investment relative to a baseline) of negative 3%.
The more interesting finding was that the managers themselves had similar portfolios to their clients and achieved similar subpar returns. From this the authors conclude “many advisors offer well-meaning, but misguided, recommendations rather than self-serving ones” to “trade frequently, prefer expensive, actively managed funds, chase returns, and under-diversify.”
Whether individual investment managers’ failures are due to lack of talent or conflict of interest, taxpayers, not just account holders, also pay for these inefficiencies. As Steven Teles writes,
“IRAs and 401(k)s, for example, do not appear to actually increase personal savings; instead, their main effect is to cause wealthier investors to shift their savings from taxable to untaxed accounts (from which, again, the wealthy gain the greatest savings since their tax rates are highest).”
These tax subsidies are intervention, albeit in a “submerged” form. If government is going to use taxpayer money (in the form of foregoing revenue that must be made up somewhere else) to achieve a policy end, why not do it the smart way?
Sweden is a good example of a partially privatized social insurance scheme. In addition to a more traditional defined benefit pension, employees contribute to a defined contribution account with portfolios of index funds selected by the government. Individuals may choose how they allocate their portfolio, but this measure is designed to avoid the possibility of retirees “day trading” away their retirement savings.
But we don’t even need to leave the U.S. to find a good model for capturing the benefits of the stock market when saving for retirement. The Thrift Savings Plan, the defined contribution retirement plan for federal employees, invests in low-cost index funds that track the performance of the market.
Not investing (at least some) retirement savings in the market is leaving money on the table, but making an actively managed investment is putting money in the pocket of the managers. Recognizing basic economic theory about the inability of investors to beat the market would go a long way to remove the rents present in US retirement policy.
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