Study: SEC Fiduciary Delay Costing Retirement Investors $1 Billion per Month

Two years ago, the SEC’s botched proposal for a uniform fiduciary standard was greeted with a uniform chorus of derision from both Congress and the brokerage industry. The biggest complaint was the alleged “cost” to investors should the SEC hold brokers to the same standard as it holds Registered Investment Advisers under the 1940 Investment Advisers Act. The SEC asked the industry to show evidence of this cost, but, sheltered by the bipartisan boos from the political realm, never seemed to provide the promised smoking gun. It turns out, a much publicized academic research study released last month may have finally supplied the much anticipated evidence of cost – but with a surprising twist.

The paper, “It Pays to Set the Menu: Mutual Fund Investment Options in 401k Plans,” (Pool, Veronika Krepely, Sialm, Clemens and Stefanescu, Irina, January 20, 2013), is the result of work done by researchers from Indiana University and the University of Texas at Austin. Much of the media reporting focused on the study’s confirmation of what many had long suspected: trustees who were allowed to engage in self-dealing transactions often do, and often at the worst possible time. Pool et al concluded trustees with a conflict of interest are more likely than unconflicted trustees to keep and to add poorer performing affiliated funds. Worse, employees continued to invest in these poorer performing options even though they had better alternatives.

This conclusion is similar to that drawn by “Broker Incentives and Mutual Fund Market Segmentation,” (Diane Del Guercio, Jonathan Reuter, Paula A. Tkac, NBER Working Paper No. 16312, August 2010). This paper found investors earned, on average, 1% more per year by buying mutual funds directly instead of through a broker (you can read the full report in our earlier story, “Does New Study Seal the Deal for Fiduciary Standard – or Just Warn Plan Sponsors?” FiduciaryNews.com, January 19, 2011). “Both studies look at agency problems in delegated portfolio management but they focus on very different aspects (brokers vs. 401k trustees),” says Irina Stefanescu, Assistant Professor of Finance at Indiana University’s Kelley School of Business and one of the co-authors of last month’s study.

The new study concentrates only on listed trustees. “We collected the names of the ‘plan trustees’ as they are disclosed in the 11-K,” says Stefanescu. “We have not focused on conflicted advisors.”

That conflicts-of-interest exist in the 401k service provider world isn’t surprising. “Unfortunately, it is quite common for mutual fund companies that also act a ‘non-discretionary’ plan trustee to encourage the use of their own proprietary funds,” Houston-based Robert A. Massa, Chief Investment Officer at Ascende Wealth Advisers, tells FiduciaryNews.com. He continues, “To address this problem, I take a considerable amount of time to educate the plan committee members on delineating the differences between the services provided by the plan recordkeeper, the plan trustee and the investment provider(s). Most committee members have a hard time understanding the difference. If they hire a mutual fund company to handle all plan services on a turn-key basis, it can be difficult for the committee members to fully understand the fees and services provided because of the one-stop shopping approach. But this is the core problem. In these fully-bundled, one-stop-shopping arrangements, employers can usually offer a 401k program with great educational materials and online technology, but if they fail to perform their due diligence, they can end up with a stable of funds that may underperform the market.”

“In an ideal world, all fiduciaries that act for a plan under the auspices of ERISA should operate independently,” says Gabriel Potter, Senior Researcher at Westminster Consulting, LLC in Rochester, New York. Potter adds, “Individual advisors acting as consultants may adopt the title of ‘fiduciary’ without really understanding the legal ramifications of the decision. Investment management firms often take up the fiduciary mantle when acting as a consultant, but may be incapable of separating themselves from the inherent conflict-of-interest. It is the advisors’ responsibility to understand if their duties preclude them from being a fiduciary adviser, but the roles of a fiduciary vs. a non-fiduciary individual advisor are sorely misunderstood, even by professionals.”

Making their conclusions even more dire, the study’s sample does not include conflicts-of-interest resulting from brokerage-based “advice.”  Paula Hendrickson, Director Retirement Plan Consulting at First Western Trust in Denver, Colorado says, “Many plan sponsors join forces with a brokerage firm to develop their investment strategy and the broker has an inherent conflict-of-interest.”

But the study does reveal something that stunned even the researchers. “Perhaps the most surprising result was the future underperformance for the lowest performance decile funds,” says Stefanescu. The study concludes “We estimate that on average they underperform by approximately 3.6% annually on a risk-adjusted basis. This figure is large in and of itself, but its economic significance is magnified in the retirement context by compounding. Our results suggest that the trustee bias we document in this paper has important implications for the employees’ income in retirement.”

Just how economically significant is this result? FiduciaryNews.com asked Stefanescu if the authors came up with a dollar figure, but she told us, “Translating these percentages into dollars depends on various assumptions on holding periods and compounding horizons.” Still, that doesn’t prevent anyone from using published data to come up with a number.

And that’s precisely what we did.

According to the January 24, 2013 entry of January Market Size Blog, U.S. retirement assets (including IRAs, 401k plans and 403b plans) total $10.3 trillion at the end of the third quarter in 2012. The universe of trusteed plans in the “It Pays to Set the Menu” paper indicates 33% of the assets are held by “conflicted” trustees. We’ll assume this number for 403b plans and IRAs as a way of accounting for conflicted brokers. (Please note, the 33% number does not mean only 33% of the plans are advised by conflicted vendors, it only means the actual conflict occurs in only 33% of the assets. In other words, a conflicted adviser is likely to also put assets into unaffiliated funds.) A third of the total U.S. retirement assets is $3.4 trillion. Now, we take 10% of that reflecting the lower performing decile of funds and that’s equal to $340 billion. Finally, we take the average underperformance of 3.6% annually and you get $12.3 billion of lost performance each year.

That’s more than a billion dollars a month, or $24.6 billion since the adoption of a uniform fiduciary standard was first proposed.

That’s the real dollar price tag the SEC’s inaction is costing U.S. retirement investors. Go ahead. Check the math. Refine the assumptions. You’re still talking huge numbers.

Elle Kaplan, CEO & Founding Partner of Lexion Capital Management LLC in New York City explains the true tragedy of this wholly unnecessary delay as she expresses concern the indictment of studies like this might take the bloom off the rose of the 401k plan. She says, “Embedded in the term ‘conflict-of-interest’ is the key word: conflict. The fact these conflicts exist is a major problem and should be extremely troubling to all 401k plan advisers. If we are encouraging people to save for retirement, but then we give them options that are poor investment vehicles with bad returns, we are hurting the very people we are supposed to help. We are letting a few bad apples get in the way of delivering responsible options for retirement planning.”

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