Proposed Retirement Investment Regulations Could Backfire on Savers
The Department of Labor is proposing drastic new regulations for retirement funds managed by private companies. In an attempt to raise transparency for investors, these regulations would impede investment through time-consuming measures and burdensome fees. In summary, the costs of these regulations would be greater than the benefits.
Some suggest that incentives between financial advisors and those seeking to plan for retirement are misaligned, leading to faulty investments. That is the impetus behind the proposed regulations.
Currently many investors who open IRA accounts or rollover old 401K retirement savings accounts to consolidate them rely on banks, stockbrokers, or other financial professionals. These advisors require no up-front fee for their services, but are compensated by commissions on the securities they sell to the investor. The commission-based advisors comprise one side of the current market. The other side of the market is comprised of fee-based advisors who charge the client a flat fee for advice, usually a 1 percent or 1.5 percent of the total account, regardless of what securities are chosen.
The proposed regulation would outlaw the commission-based approach for advisor compensation unless the advisor and the investor enter into a special "Best Interests Contract." Specified by the government, this contract would include cumbersome disclosures of commissions, speculative projections of future fees and cost for mutual fund securities, and greater exposure of the advisor to lawsuits by disgruntled investors. The intent of the rule is to "nudge" (to use the favorite phrase of former Federal Regulatory Czar, now Harvard professor Cass Sunstein) investors away from commission-based advisors and into the more protective arms of the other group of advisors, those who charge up-front fees directly to their clients.
The Labor Department is accepting comments on its conflict of interest proposal until July 20. Comments can be submitted here.
The retirement financing landscape has changed since 1978, when defined benefit pension plans accounted for nearly 70% of all retirement assets. These plans provide a guaranteed income stream in retirement for the life of the retiree. The proposed regulation is not primarily directed at these plans.
With defined benefit plans, professional managers handle all investment decisions with varying degrees of success. Some defined benefit plans are in top financial shape. Others, such as multiemployer pension plans, are underfunded. The Labor Department issues regular lists of underfunded pension plans.
Defined benefit plans are particularly advantageous when people spend their entire career at one firm. As workforce patterns changed at the end of the 20th century, and people began to have multiple jobs in one career, the defined benefit model did not provide them with sufficient retirement funds. Unless people stay for a number of years in the same job, they are not "vested," i.e. the employer is not required to pay them any pension. Employees who leave without vesting lose employer contributions, contributions that had been part of their compensation package.
That is why firms have gradually opted for defined contribution plans, where they match a certain amount of employee contributions and let their employees direct their own retirement portfolios, within limits. These so-called defined contribution plans give employees more autonomy and allow them to move around the workforce as opportunities present themselves, keeping their retirement funds. In addition, employees can set up tax-advantaged Individual Retirement Accounts. By the end of 2013, 401(k)s, a common defined contribution plan, and IRAs accounted for more than half of all retirement assets.
As defined contributions accounts have grown in popularity, the last 40 years have witnessed the advent of index mutual funds, discount brokerage, exchange-traded funds, and online trading. These are just some of the myriad of new financial tools that have enhanced investment possibilities. These two trends are not coincidental. For most people, tax-advantaged retirement savings form the majority of their saved assets.
The regulation primarily targets advisers who are compensated by commissions or similar payments from the mutual funds or other securities products they sell. The regulation attempts to tilt the market in favor of the competing advisers who are paid directly by the client regardless of what particular securities are selected to include in the account.
The government wants to discourage the commission based advice approach because it claims that those advisors steer clients into the securities that offer the highest commissions to the advisor -- hence their advice is subject to a conflict of interest. The regulation attempts to achieve this discouragement of the commission-based advice approach by piling extra contractual and reporting requirements on the commission-based advisers.
The Council of Economic Advisers, in a survey of the evidence, suggests that savers receiving conflicting advice earn returns that are roughly one percentage point lower each year. Yet, the conclusions of this report are solely based upon some academic studies, as opposed to concrete data or methodology. The report itself even admits that "such analysis is subject to uncertainty." The Council of Economic Advisers has not itself analyzed the data.
While it is easy to conflate lower returns in retirement portfolios with self-interested financial advisors, such a trend is not always the case. Lower returns could be due to advisers recommending churning of investments, which result in higher fees for the advisor. They could also be due to an advisor's recommendation for a more conservative portfolio, one that places a greater share of the assets in low-performing but less volatile Treasury bills or bonds. Returns are positively correlated with risk and variance, and some people prefer lower returns and less risk, especially as they approach retirement.
Other countries have enacted measures to address potential conflicts between investors and advisors. Britain and Australia, for instance, have entirely banned commissions and other payments by the mutual funds whose securities are sold to the investor. They also are attempting to control the fee paid by client advisors to reflect reasonable cost and compensation for services provided -- which is something not included in the proposed US rule.
Yet these new regulations have been ineffective and somewhat detrimental. A report by the British Financial Conduct Authority states that confusion over market conditions still exists, despite new requirements. In Australia, increased costs have been passed on to investors, due to raised fees for businesses dealing in financial transactions. After all, there is no free lunch, not even for retirees.
In the United States, regulations such as mandated disclosures, put in place in 1964, have been made in order to promote transparency and comprehension in financial transactions. But the efficacy of these disclosure regulations are not clear. The typical investor often agrees to the terms and conditions of a contract, including disclosure practices, without reading it beforehand.
This is a claim that the regulators at EBSA endorse. They claim that simple disclosure does not effectively protect investors and that their regulation is more than disclosure. While disclosures are part of the Best Interests Contract option provided by the proposed rule, the key element is the increased exposure lawsuits by disgruntled clients of the advisers who want to continue in the commission-based model. The intent of the regulation discourages advisers from offering retirement savers services on the commission basis and to bend the market toward the direct client fee model.
There is concern that small savers will not be able to afford the up-front fees that fee-based, non-commission advisers will charge and that the result will be that many of those most in need of advice will go without.
Americans should be able to plan for retirement without onerous paperwork. Increased regulation could have the unintended consequence of reducing the advice available to investors. In the case of fostering financial security for retirees, perhaps less is more.
Diana Furchtgott-Roth is director of Economics21 at the Manhattan Institute and Joseph Mitrani is a contributor for Economics21. Diana is the coauthor of "Disinherited: How Washington Is Betraying America's Young," from Encounter Books. Follow Diana on Twitter here.
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