An Inflated $17 Billion Talking Point From The DOL

Capital Flows Contributor

Dr. Lewis is a finance professor at Vanderbilt’s Owen School of Business and formerly the SEC’s chief economist.

For the past five years, the Department of Labor (DOL) has pushed to expand the definition of “fiduciary” under ERISA, the 1975 law governing pension plans, to include all financial professionals who provide investment advice to sponsors of and investors in IRAs, including brokers who are paid commissions. This decision could lead to higher fees for investors, and decrease their choice of investment products and competition for their business.

The DOL initially proposed a rulemaking in 2010, which prompted strong bipartisan objections from Congress regarding potential harm to investors. The DOL ultimately withdrew its initial proposal with a promise to conduct additional economic analysis. With time running out on the Administration, the DOL re-proposed a fiduciary duty rulemaking in April of this year and has stated that it plans to finalize the rulemaking in early 2016.

Unreliable claims

To drum up support for the proposal, the White House and the DOL have repeatedly claimed that conflicted advice from brokers costs investors $17 billion a year. This figure, which first appeared in a report prepared for the White House by its Council of Economic Advisers (CEA) early this year, has featured prominently in the administration’s narrative to justify moving forward with the proposal—despite a number of significant concerns about the reliability of the estimate and the results-oriented process that produced it.

To reach its estimate, CEA asserts that several academic studies show that assets subject to broker commissions underperform similar products sold directly to investors (that is, without a broker and without a sales load) by approximately 1%. CEA then states that because there are roughly $1.7 trillion of assets in IRAs that are impacted by conflicted advice from brokers, therefore there is a $17 billion (1% of $1.7 trillion) drag on investment performance for customers who choose to use a broker instead of transacting directly with a fund.

Unfortunately, CEA’s economic analysis leaves a number of critical questions unanswered.

To begin with, none of the research cited by CEA analyzes the performance of mutual funds held in annuities, yet more than one-third ($610 billion) of the above-mentioned $1.7 trillion pool of retirement assets is comprised of mutual funds sold through variable annuities. That discrepancy should be addressed.

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CEA’s conclusions also ignore the fact that, with just one exception, none of the academic studies cited takes into account the asset-weighted performance of broker-sold funds. As a consequence, the report paints an incomplete and misleading picture of fund performance.

For context, a non-asset weighted study examining nine funds each with $1 million invested yielding a 1% percent return and one fund with $10 million invested yielding a 10% percent return would show an average return of 1.8%. But, an asset-weighted study looking at the same 10 funds would show an average return of 5.7%. By ignoring which funds investors actually invest in, the report fails to achieve its stated objective of measuring the market-wide impact of conflicted advice in retirement accounts.

Furthermore, the data comprising most of the studies relied on by CEA is from the late 1990s and early 2000s, when there was little overlap in the marketing and sales of broker-sold funds and no-load funds. The competitive landscape is very different today, with 90% of front-load funds also having no-load classes. Moreover, from 1990 to 2013, front-end sales loads declined by more than 75%.

Recent data suggests a different outcome

Given these changes in the fund markets, it is unsurprising that recent data suggests a very different outcome than the studies relied upon by the CEA. For example, Professor Jonathan Reuter of Boston College, who authored one of the earlier studies cited by CEA, recently issued an updated analysis revisiting mutual fund performance based on more recent data from 2003 to 2012, which concluded that broker-sold funds only underperform no-load funds by an average of 18 basis points—a far cry from the 100 basis point difference touted by CEA in its report.

You don’t have to be an economist to recognize the Administration’s $17 billion talking point significantly overestimates the costs, if any, to investors relying on the “conflicted advice” of brokers. And you don’t have to be a regulator to recognize that an independent and objective economic analysis should be performed during the public comment process, especially when the regulatory agency making the decision is not a subject matter expert. This is particularly true here given the significant impact that the rulemaking will have on tens of millions of investors.