Your Retirement Account Should Look Like a Nutrition Label
Does your retirement adviser have your back? A recent study by the White House suggests the answer might be no, and that's costing Americans $17 billion a year. Every retirement fund comes with associated fees, taken out by the managing broker in the form of a percentage on the return. It's how the financial adviser who manages your 401(k) makes his money and is supposed to incentivize him to do the same for you.
The trouble is that this creates a conflict of interest between brokers and their clients in the form of high-fee funds and back end incentives. You see, not every investment fund is priced the same. One might cost a simple 0.25 percent on the dollar, while another will claim the potential for far greater returns but charge 1 percent.
Financial advisers are supposed to represent the best interests of their clients in navigating this issue, given the specialized knowledge it generally takes to make a meaningful distinction between what one investment package means versus another. Unfortunately, when the higher priced fund means a lot more money for your broker, even if a more conservative approach could be the wiser course for an investor, incentives get muddled. It gets even worse when third party firms offer explicit commissions for brokers who steer their clients into particular investments.
"These conflicts of interest are costing middle class families and individuals billions of dollars every year," according to the White House's press release.
"Working and middle class families receiving conflicted advice earn returns roughly 1 percentage point lower each year (for example, conflicted advice reduces what would be a 6 percent return to a 5 percent return) ... [I]f a worker has $100,000 in retirement savings at age 45, without conflicted advice it would grow to an estimated $216,000 by age 65 adjusted for inflation, but if she receives conflicted advice it would only grow to $179,000."
Portfolio disclosure forms are supposed to protect investors from this kind of predatory behavior, but the reality is that these are generally of little or no use to the average consumer. Stuffed with dense accounting information, disclosures are difficult or impossible for most people to understand meaningfully beyond whether their account made or lost money recently.
Worst of all, according to David Madland with the Center for American Progress, disclosure forms fail to discuss the single most important part of a broker's fees: compound interest.
"People are being charged significant sums of money in their retirement accounts and they're often unaware," he said. "The existing disclosures for fees and returns are many, many pages long. Fees are listed in different places and in different fonts for different types of accounts, and you would almost have to be a forensic accountant to know what you're paying."
Even when a consumer can find the fee information associated with his retirement account funds, it discloses only annual dollars. So, a 0.5 percent fee account would only report that it costs $5 a year per $1,000 invested. That doesn't sound like a lot ... until you consider what it means over the course of several decades. The difference between a $5 a year account and a $10 a year account can add up through compound interest to tens of thousands of dollars, but disclosures don't have to inform consumers of that.
So Madland did the math himself. In a recent article written with economist Jennifer Erickson, Madland estimated that for a median-income worker investing 5 percent of his salary, the difference between a low and high cost account comes to over $70,000 by retirement age.
"Another way of thinking about it," he said, "is you'd have to work three additional years to save up the same balance for someone with a high fee as opposed to someone with a low one."
In fact, according to the CAP's research, many investors don't even realize when they've been enrolled in high-fee funds.
All of this would be less important if these products actually delivered on their promised returns. Financial advisers price funds and sell them on the basis that more expensive ones promise the ever elusive dream of "beating the market." Unfortunately research has consistently shown that this dream remains just that.
%VIRTUAL-pullquote-For the most part, you're actually getting the opposite of something good when you pay high fees.%In fact, high-fee funds tend to do a little bit worse than average.
"For the most part, you're actually getting the opposite of something good when you pay high fees," Madland said. "Most goods, when you think of paying more, you're going to better value, but with retirement, the research shows that there's actually an inverse relationship with the fee. The return is going to be average or worse."
"You're actually paying additional money to get a lower quality product in most cases," he added.
The consumer choice that's supposed to counterbalance this problem gets lost in the glut of misleading paperwork and industry jargon. Average investors can't push back against bad advice when they can't actually understand what a given fund will actually cost and what they're getting for their money.
Hard to Comprehend
That's where the CAP's proposal comes in: far from the dense envelopes we receive today, retirement account disclosures should look more like something off the back of a cereal box and should be just as easy to fully comprehend.
"Study after study shows that people don't know what they pay for their retirement," Madland said. "I would give people a receipt just like you get with any other purchase that spells out in dollars how much you paid for the year for your 401(k) in fees."
The receipt should also line-item compare an investor's options in broad, easy-to-read language. Madland envisions something like calorie counter charts with well labeled boxes showing how each available fund compares to another in terms of costs and historic returns.
The whole key to breaking this shaky fiduciary responsibility cycle is demystifying the process. Retirement funds are products just like any other, but with costs and benefits are spread over generations, it can be difficult to shop around properly. Giving investors the relevant information up front can make it accessible again and help reinstill the consumer choice that is supposed to push back on improperly motivated advisers.
Ultimately, though, it's most important for consumers to understand how important it is to monitor their own long term savings and retirement regardless of third party reform and to keep in mind the power of compound interest. Individual dollars may not matter much when choosing a cup of coffee or pair of pants, but allowed to grow over decades, $5 here and there can add up to tens of thousands.
It's better not to lose that between someone else's sofa cushions.