Over the past 40 years, the process of saving for retirement has changed drastically.
For much of the 20th century, workers outsourced retirement planning to their employers, who relied on pension managers and advisors to create “defined benefit” retirement plans for their employees. In other words, employees didn’t have to think about it too much. They knew that when they retired, their pension would provide most of their income. Today, the equation has flipped. People are more frequently making their own retirement investments, either through employer-sponsored funds like a 401(k), or by investing in mutual funds, index funds and other appreciating assets. This means that individuals need to be much savvier and more sophisticated about financial decisions to ensure they have enough money to draw from when they stop getting a paycheck from their employer.
As with most complex decisions requiring specialized knowledge, people saving for retirement often seek out advice from an expert: their financial advisor. According to the 2013 Survey of Consumer Finances, almost 40 million American households received advice from a financial planner or securities broker. This advice comes at a cost that’s more significant than you might think. Financial advisors take a fee that’s roughly one percent of the value of their client’s retirement fund per year. With the mathematics of compounding interest, that amount can balloon into 15 to 20 percent of a person’s retirement wealth after 30 years of saving.
The high cost of financial advice has come under scrutiny by policy makers around the world. Some critics of the industry claim that financial advisors are reaping high fees because they are acting out of a conflict of interest. Some economists argue that, because many advisors are paid directly by mutual funds, they may have an incentive to steer clients towards the most expensive “actively managed” funds that don’t necessarily produce the best returns—in effect, putting their own financial gain ahead of their clients’ wealth.
Some critics of the industry claim that financial advisors are reaping high fees because they are acting out of a conflict of interest.
Two Tuck professors wanted to test whether that charge might be true. In a working paper titled “The Misguided Beliefs of Financial Advisors,” professors Brian Melzer and Juhani Linnainmaa—along with Alessandro Previtero of Indiana University—devised a novel way to determine if financial advisors behave out of a conflict of interest: they compared the advisors’ personal investment decisions to those of their clients. Using data provided by two large Canadian financial institutions, Melzer and Linnainmaa were able to analyze trading and portfolio information on more than 4,000 advisors and almost 500,000 clients between 1999 and 2013. “How do you test whether advisors are doing what they think is right?” Melzer said. “One of the clearest ways is to look at how they behave on their own behalf, when they are the principal instead of the agent.”
The co-authors begin their analysis by characterizing trading patterns of clients and advisors. “We focus on trading behaviors that may hurt risk-adjusted performance: high turnover, preference for funds with active management or high expense ratios, return chasing, and underdiversification,” they write. One attribute all of these categories have in common is that they usually result in higher fees for advisors. Simple index funds pay the lowest commissions, so if advisors are acting out of conflict of interest, they will choose active management funds. Some individual investors like to chase returns—i.e., invest in the funds that recently performed well—even if that strategy doesn’t always work, especially when trading fees are factored in. Advisors who cater to that desire may do so because they know it leads to more trading, and thus more commissions.
There’s just no evidence that active management is adding value and that you can go and find the best performing mutual funds.
But when Melzer and Linnainmaa dug into the data, they found something a bit surprising. First, the good news. The trading characteristics of clients aligned with those of the advisors themselves. The advisors were investing similarly to their clients, indicating that they weren’t conflicted. The bad news was that the portfolios on both sides were quite expensive. There was a high share of active management, high turnover, and high rates of return chasing. This resulted in poor net returns: on average, the annual returns were three percent less than the market as a whole (the alpha). Oft-cited research by Ken French, the Roth Family Distinguished Professor of Finance at Tuck, could have predicted this. In the 2009 paper “Luck Versus Skill in the Cross Section of Mutual Fund Returns,” French and co-author Eugene Fama found that few actively managed funds produce enough gains to offset their costs. “There’s just no evidence that active management is adding value and that you can go and find the best performing mutual funds,” Melzer explained.
These findings suggest that conflict of interest is not driving the high cost of financial advice. Instead, the costs are driven by the advisors themselves being uninformed. Given this reality, Melzer said, households should consider ways to avoid active management. One option is to invest in a lifecycle fund that adjusts over time for retirement at a certain date. These funds have low costs and track the trends of the market as a whole.
For people hesitant to invest without guidance, Melzer offers another option. “Find an investment advisor who will work on an hourly basis,” he said. “Work with that person to choose a lifecycle fund, and stick with it. It looks expensive up front—maybe $1,000. But that’s a lot less than 15 percent of your retirement assets.”