Designing sensible defined-contribution retirement-plan rules is a challenging task since most Americans do not have sufficient financial acumen and self-discipline to manage their own retirement portfolio. In spite of the fact that retirement plans constitute the bulk of their savings, most American families struggle with the management of defined contribution (DC) plans. Consequently their savings are inadequate to meet their retirement needs. According to a recent report, 56 percent of Americans have less than $10,000 in their retirement accounts. One in three Americans reported that they had no retirement savings. Clearly, the current DC plans for retirement savings are not working very well for the typical American. In this paper, we analyze simple and sensible rules that can help every American family get the most out of its DC retirement plan.
Since 1975, a structural change has occurred in our private retirement system away from defined benefit plans (DB) and into defined contribution plans (DC), which include self-directed Keogh and IRAs, and employer-sponsored 401(k) and 403(b) plans. DC plans provide tax-advantaged retirement savings vehicles for individuals and typically represent a large portion of the individual’s savings. In 2015, IRAs alone accounted for $7.6 trillion in assets. This massive shift from DB plans to DC plans has increased the urgency and importance of both transparency and sound investment advice regarding retirement savings.
The most important impediment for adequate savings in DC plans is the poor performance of trillions of dollars of investments in DC plans. The poor performance itself is a consequence of the lack of investor sophistication and discipline, as well as the complexity of the investment instruments and investment concepts. This problem can clearly be mitigated by prudent advice from financial experts. Instead the problem is compounded by current rules that do not require investment advice to be in the best interest of the plan beneficiaries.
To address these serious and growing problems, policy makers have recently targeted the “suitability rule” in providing investment advice. Under the Department of Labor’s (DOL) recently instituted new rule, investment advisers for retirement accounts would be subject to a higher fiduciary standard, and investment advisers must recommend investment products with the “best interest” of the beneficiaries in mind. The new rule is prima facie laudable. However, there are two provisions in the recently instituted standard that undermine its primary intent of ensuring that investors get unbiased investment advice at a reasonable cost. The first allows investment advisers to receive compensation such as commissions from financial institutions whose products they recommend for inclusion in the investor’s retirement portfolio. By allowing advisers to receive compensation from both the buyer (investor) and the seller (financial institutions), this provision creates an obvious conflict of interest between the investor and the adviser.
The second provision of concern allows advisers to include proprietary products in the retirement portfolio. These products suffer from greater informational asymmetry, with the seller holding an informational advantage, and have complex features that are difficult for the average investor to understand and analyze. There is considerable evidence that the average investor is not as financially sophisticated as she needs to be to manage substantial retirement assets. Furthermore, proprietary investment products are also likely to involve higher transaction costs. While either of the two issues of informational asymmetry and complexity is sufficient to put the investor at a significant disadvantage, the combination compounds the problem. Furthermore, the above two provisions in combination exacerbate the concern that investors might not get sound advice: Advisers who receive compensation from institutions have a greater incentive to recommend costly proprietary products that earn them greater commissions. In summary, the provisions that create potential conflicts of interest between advisers and investors are further compounded by allowing proprietary products.
The relevant policy question is how significant these issues are. That is, are these potential conflicts of interest likely to result in significant losses to investors due to poor advice? And does the lack of transparency in proprietary products have adverse consequences to investors? In this paper we provide evidence that the answer is “yes” to both questions.
To answer the first question on the effect of conflict of interest, we choose a unique setting in which a similar potential conflict of interest exists: namely, DB pension funds that were already subject to the fiduciary standard. We analyze the performance of DB pension funds in which the fiduciary is also an executive of the firm that is the employer of the beneficiaries. Such a set-up creates a conflict of interest, with the fiduciary-executive required to serve two principals: the beneficiaries of the DB fund and the shareholders of the firm.
Our evidence indicates that a simple requirement that investment advisers be subject to the fiduciary standard does not by itself address the conflict of interest issue in DB pension funds: In funds with conflict of interest, beneficiaries are short-changed for the benefit of the shareholders. The one-year abnormal underperformance exceeds 10 pecent. Based on this experience of DB pension funds with conflicts of interest, we can conclude that the effect of conflict of interest is real and significant and will very likely be to the detriment of the beneficiaries of the DC plans as well. Therefore, without addressing the conflict of interest issue, the current rules for DC plans are not likely to be successful in addressing the issue of inadequate retirement savings.
To address the second question regarding proprietary products, we consider two representative products that would continue to be allowed as appropriate retirement investments. We simulate the performance of these products and find that, on a risk-adjusted basis, the performance is inferior compared with both the risk-free rate and th S&P 500. Hence our evidence suggests that without also addressing the transparency problem, the fiduciary standard rule for DC plans is not likely to be successful.
The current investment advisory rules are clearly deficient. On the one hand, the current rules require that an investment adviser act in the best interest of a beneficiary, yet they allow the adviser to receive income from third parties. In addition, the rules do not prohibit opaque, proprietary products, which would lead to uninformed and costly investment decisions. In fact, the current rules are likely to lead to continued conflicted investment advice, confusion, and widespread litigation to sort out these internal conflicts. We offer three policy recommendations to remedy these problems.
Based on our empirical evidence, our first policy recommendation addresses the current rule that allows advisers to receive income both from the investor as well as the sponsor of the investment product. Any serious reform in retirement investment area must address the conflict of interest problem caused by this income exemption rule. The key to eliminating conflicts of interest involves insuring that investment advisers serve, and therefore receive income from, only one principal. Unfortunately, the current advisory rules and the associated exemptions simply fail to address the multiple-masters problem.
Second, any serious reform must eliminate the lack of transparency inherent in proprietary investment vehicles. In this paper, we show that without transparency, retirement beneficiaries will be unable to make informed decisions about their choice of retirement vehicles. As we show, these investment vehicles are also likely to provide lower returns, thereby reducing the retirement savings of beneficiaries. Furthermore, we show that by using proprietary products in IRA accounts, certain wealthy taxpayers can avoid paying any taxes on their income. Thus, allowing proprietary products into IRA accounts does not make any sense either from the average beneficiary perspective or a public policy perspective. We recommend a very strict transparency rule in order for any investment to qualify as a retirement asset.
Overall, we conclude that simply requiring a fiduciary standard in itself is not going to solve retirement savings problems. Instead, it is likely to lead to additional problems by creating an inconsistent set of rules. To prevent conflicts of interests and lack of transparency from creeping back into the retirement-advice business, we also recommend a further streamlining of retirement accounts. We recommend that only passive index funds, consisting of broadly diversified portfolios, be allowed the tax exemption as retirement accounts. To this end, we further recommend the creation of standards requiring that certain percentages, based on the a beneficiary’s age, of common stocks and corporate and government bonds be held in defined contribution retirement accounts.
 Elyssa Kirkham, 1 in 3 Americans Have Saved $0 for Retirement, Time (Mar. 14, 2016), http://time.com/money/4258451/retirement-savings-survey/.
 See Nick Thornton, Total Retirement Assets Near $25 Trillion Mark, Benefits Pro (Jun. 30, 2015), http://www.benefitspro.com/2015/06/30/total-retirement-assets-near-25-trillion-mark.
 Under the DOL’s definition, any individual receiving compensation for providing advice that is individualized or specifically directed to a particular plan sponsor (e.g., an employer with a retirement plan), plan participant, or IRA owner for consideration in making a retirement investment decision is a fiduciary. Such decisions can include, but are not limited to, what assets to purchase or sell and whether to rollover from an employer-based plan to an IRA. The fiduciary can be a broker, registered investment adviser, insurance agent, or other type of adviser (together referred to as “advisers” here). Some of these advisers are subject to federal securities laws and some are not. Being a fiduciary simply means that the adviser must provide impartial advice in their client’s best interest and cannot accept any payments creating conflicts of interest unless they qualify for an exemption intended to assure that the customer is adequately protected. DOL’s regulatory impact analysis estimates that the rule and related exemptions would save investors over $40 billion over 10 years, even if one focuses on just one subset of transactions that have been the most studied. The real savings from this new rule are likely much larger as conflicts and their effects are both pervasive and well hidden. See Department of Labor Proposes Rule to Address Conflicts of Interest in Retirement Advice, Saving Middle-Class Families Billions of Dollars Every Year, U.S. Dep’t of Labor, https://www.dol.gov/ebsa/newsroom/fsconflictsofinterest.html.
 The new rules have already created a wave of lawsuits regarding conflicts of interests and opacity in defined contribution plans. See for instance Wall Street Journal, August 6, 2016, “Self-Dealing with 401 (k),” and Wall Street Journal, September 14, 2016, “MIT, NYU, Yale Sued over Retirement-Plan Fes.” Also see, Wall Street Journal, September 7, 2016, “Wall Street Remakes the CD, Hitting Yields.” Furthermore, the U.S. Supreme Court recently ruled in favor of the Plaintiffs in 401(k) plans and rejected a strict six-year statute of limitations to bring a lawsuit. See, http://www.wsj.com/articles/high-court-ruling-adds-protections-for-investors-in-401-k-plans-1431974139.
This post comes to us from S. Burcu Avci, a post-doctoral research scholar at the University of Michigan’s Ross School of Business, and from MP Narayanan and H. Nejat Seyhun, professors at the Ross School of Business. It is based on their recent article, “How Should Defined Contribution Retirement Plans Be Organized?” available here.