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Morning Feature – Pound Foolish, Part II: Risk and Reward, Yours and Theirs

January 4, 2013

Morning Feature

Morning Feature – Pound Foolish, Part II: Risk and Reward, Yours and Theirs

There’s no such thing as a free lunch, or a free dinner, if it’s hosted by someone trying to sell you a financial product you wouldn’t otherwise buy … and probably shouldn’t…. (More)

Pound Foolish, Part II: Risk and Reward, Yours and Theirs

This week Morning Feature considers Helaine Olen’s new book Pound Foolish: Exposing the Dark Side of the Personal Finance Industry. Yesterday we considered the history of personal financial advisors, and how their advice is too often worthwhile only for them. Today we see how the demise of pensions and the rise of the 401(k) created a profitable and powerful industry that resists even basic consumer protections. Saturday we’ll conclude with why education and self-discipline are not enough to ensure financial security.

Helaine Olen is a journalist who wrote and later edited the “Money Makeover” series at the Los Angeles Times. She writes the “Where Life Meets Money” blog at Forbes, and her work has been published in the New York Times, Wall Street Journal, Washington Post, The Atlantic, BusinessWeek, and several online news sites.

“The twenty-first century caught up with her”

When Carol Friery can’t sleep, she gets up in the middle of the night to check her 401(k) with an online retirement calculator. How long will it last if inflation averages 2.5% per year? How long if inflation averages 3%? Will she have enough if she or her husband gets sick again?

Until the 2008 collapse, Friery thought she’d done everything right. She’d kept the same job for almost 20 years, putting 10% of her salary in a 401(k) and another 10% in personal savings. She had no credit card debt. She didn’t buy lattes at Starbucks. “Then,” Olen writes, “the twenty-first century caught up with her.”

The company closed the warehouse where she worked. They offered her a job in Memphis, but her husband’s job and their children were in Massachusetts. Their house was almost paid off. She’d look for work locally, and by 2012 all she’d found were a 12-hour-a-week job delivering food for Meals on Wheels at $8 per hour and a temporary, part-time job as a grocery check-out clerk. Friery plans to apply for Social Security benefits on her 62nd birthday, knowing that will permanently reduce her monthly check. She fears she has little other choice.

That fear is not singular. Olen cites a study finding that only 15% of employee benefit plan sponsors thought their employees were saving enough money for retirement. Their fear – and Friery’s – is in Olen’s words “a byproduct of the do-it-yourself retirement trend that has taken hold in the last thirty years.”

“The most dangerous woman in America”

The trend was, predictably, pushed as a boon for business, and it was. Defined benefit pensions put the market risk on the employer. If the market return was insufficient to pay what pensioned retirees were owned, the business had to make up the shortfall. The 401(k) put that risk on the employee. If an employee didn’t save enough, or the market didn’t return enough on that investment, the shortfall would come from the employee’s benefits. The changeover from pensions to 401(k)s also shifted administration costs. A employer potentially at risk for a market shortfall had to hire someone to monitor and manage the pension fund. The cost of managing 401(k)s fell on individual employees … and often without their knowing what those costs were.

Not surprisingly, employers hopped on the 401(k) bandwagon. But employees didn’t hop, or at least not enough. In 1994 the Senate held hearings on why only one-third of workers were saving enough for retirement. Labor Secretary Robert Reich was optimistic, saying workers could be coached to “make their own way in the economy.” Behavioral economics research (and Nudge co-author) Richard Thaler believed more Americans would start saving more, though he didn’t specify why.

“Then Cassandra sat down to testify,” Olen writes.

Her real name was Teresa Ghilarducci, the assistant director of employee benefits for the AFL-CIO and a professor of labor economics at Notre Dame. Ghilarducci warned that:

Shifting responsibility to workers and bullying them from the pulpit to save like professional money managers … will encourage the high income, not the low, to save in individualistic ways, grow up a whole industry of vendors, and divert human activity toward tending to asset allocation and mutual fund performance.

Her prophecy was chillingly accurate. A massive industry grew around telling people to save for retirement, without telling them how much that savings would cost. Until the 2010 Dodd-Frank Wall Street Reform Act, 401(k) providers were not required to list their annual fees or commission rates. Glowing TV ads emphasized sailing into the sunset, with disclaimers about past performance not predicting future results delivered in rapid-fire prattle near the end. Employees were told a fund had earned 7% per year for the past 10 years, but not that the fund charged almost 3% in total fees, for a net return that was barely higher than the rate of inflation.

By 2008 the retirement industry had, in Olen’s words, “grown into a marketing behemoth.” The latest and greatest fad was so-called “target-date funds” that promised “automatic re-balancing” of investments between risk and stability as workers aged. These were, Olen writes, “a money machine” … for the fund managers who claimed commissions on every transaction involved in that “re-balancing.” These funds averaged almost twice the annual fees of other funds, a price fund managers defended as the cost of “monitoring the glide path” for cohorts of workers. The phrase “target-date” made workers think their retirement plans were guaranteed, but in late 2008 that “glide path” looked more like a nosedive.

The 2008 collapse could not have come at a worse time for Baby Boomers. Financial planner Michael Kitces compared several investment strategies and found that – no matter what strategy you used, or whether you mixed strategies over your working life – your retirement income was largely determined during your last working decade. That’s when most people earn their highest incomes, contribute the most to their 401(k)s, and see their life savings double … unless the market tanks.

Most economists failed to predict the meltdown in the last decade, yet our new economic system expected ordinary workers to see it coming and make preparations on their own. Shifting such risks onto individuals makes no sense and, in the fall of 2008, Teresa Ghilarducci wrote an op-ed for the New York Times proposing that 401(k)s should be scrapped in favor of institutional plans, such as letting private employees buy into state employee pension funds.

For that heresy, US News & World Report dubbed her “the most dangerous woman in America.” Investment firm lobbyists went on the attack, saying Ghilarducci wanted to take away “your control over your retirement savings.” Ah yes … control.

“Willing to make the client effectively worse off”

Few ordinary investors know the difference between the “fiduciary” and “suitability” standards for those who manage their money, yet which standard applies to your money manager can mean the difference between retiring somewhat comfortably and finding your account all but empty. Financial advisors are held to the fiduciary standard and must act in the client’s best interests. Brokers are treated as salesmen and need only show that the investments they recommend are generally suitable. Brokers don’t have to tell you that other investments might offer equal or better returns at lower cost or lower risk. Indeed they don’t even have to tell you that they earn a commission if you buy the products they’re selling.

Olen relates the story of David and Linda, who knew they were spending more than their annual income and went to someone they thought would help them sort out their finances. Instead, they told Olen:

He recommended some very unusual things like options trading, an annuity from a company I’d never heard of, and a very expensive life insurance product that would help our daughter pay our estate taxes. When I asked him why, given our inability to make ends meet, he was recommending a life insurance policy costing a thousand dollars a month, his only answer was “you don’t have to do it.”

Well of course they didn’t. Their net worth would never reach the minimum threshold for the federal estate tax. Yet a broker tried to sell them a $1600/month insurance policy … to pay a tax they would not owe.

When Sendhil Mullainathan, then a Harvard professor and now assistant director for research at the Consumer Financial Protection Bureau, sent actors out to impersonate potential customers at several commission-based banks and brokerage houses, he found the industry ripe with malfeasance:

Brokers did almost everything wrong, from refusing to correct client investment biases to pushing high-cost active management over lower-cost and more efficient index funds, likely out of a desire to increase their own bottom line. Moreover, they almost always recommended massive portfolio changes, even if none was called for. “They were willing to make the client effectively worse off,” the paper bluntly stated of the brokers their surveyed.

“Worse than used car salespeople”

Worse, Mullainathan’s actors – like the consumers they were impersonating – believed they had received good advice; 70% were willing to return to the broker they had seen, with their own money in hand.

The reason, simply, is that the financial industry knows behavioral economics far better than the average investor. Indeed they fund much of that research, and use it to devise better sales pitches. Financial giant Edward Jones tells potential recruits that “excelling here doesn’t require a finance degree or a financial background.” Their job is not to understand your resources and market trends to help you set a course toward a secure retirement. Their job is to sell you products, for a commission the recruiting packet describes as “unlimited earning potential” with “incentive travel opportunities (Hawaii, Africa, the Caribbean, China, and more).”

As Olen writes:

Brokers oppose having the fiduciary standard as it is currently written apply to them because it would significantly cut into their ability to sell products based on the most attractive commission.
Think about this for a moment. If the financial services industry is forced to take the time to find out what their customers’ best interests are and then act on them, the industry doesn’t have a viable business model.

The result is an array of products so complex that “There is almost no investor capable of making an informed choice about this,” according to Barbara Roper, the director of investor protection for the Consumer Federation of America.

“It’s a terrible market,” says behavioral economist Dan Ariely, “worse than used car salespeople.”

“They want you to feel like you have to give something back in return”

Yet that market thrives, driven in part by hucksters who invite middle-aged and older couples to free dinners at nice-but-not-quite-posh restaurants. Nice, so the huckster doesn’t look cheap. Not quite posh, so the couples don’t feel too out of place. And a restaurant, because that feels more like a public social gathering, a party. The salad is served quickly, because research shows we’re more receptive to new information right after we eat. But the entree will be late, so the huckster doesn’t have to talk over the clank of dinnerware.

The huckster will pitch fear, telling you that Social Security may collapse. He may offer to review your past three years’ taxes and refile if you’re entitled to any new returns. You’re not likely to bring 1099s to a dinner party, after all, so to get that advice you’ll need to make an appointment for a private consultation. There he will review your portfolio and point out at least one investment mistake, because even the savviest investor will have made at least one. He might even talk about behavioral economics and why people routinely make bad financial choices … not to teach you to make better choices, but to convince you that only he can make those choices for you.

These and other strategies come from research briefs with titles like “Why Don’t People Choose Annuities? A Framing Explanation,” which Olen says should be better titled “How to Sell a Product Your Customers Don’t Want.”

And all of it is carefully designed to play on common human weaknesses, as marketing expert Robert Cialdini revealed in his book Influence and an interview with the Washington Post:

From our earliest years, we are taught that if you get something you have to give something back. The people putting on these free-lunch seminars know this. They want you to feel guilty. They want you to feel like you have to give something back in return.

Yet our modern retirement model says you’re supposed to be immune to all of that, and have “control over your retirement savings.” The basics are simple enough, you’re told. It’s all about risk and reward.

Your risk.

Their reward.


Happy Friday!

  • winterbanyan

    This is appalling. I’ve long suspected it, though. “Churning” entered my vocabulary a while back, but I have to admit I didn’t realize how pervasive this was. I’m glad I never got into “the markets.” Would investment have made me rich? I doubt it. When I looked at the fees required just to purchase stock, considered the cost of selling any of it, I didn’t even get to the point of thinking I might come out ahead.

    I saw a member of my family, who inherited a small portfolio, get “churned” by his broker, one from a respectable firm. Then when he complained that he had not approved the sales and purchases, the broker shut him down, refusing to give him the papers he needed on his portfolio, the information on the churn, or any other information. He needed to go to a broker for the same firm states away just to get his client records. And while he was assured that should never have happened, that it was wrong, it was a situation he couldn’t correct once it was done.

    I can only imagine what happens with large portfolios, such as those belonging to pension funds. There is such an opportunity to steal.

    Another gripe of mine is Healthcare Savings accounts. When you look at what you put in, compared to the “maintenance fee” charged for maintaining it, you’re better off with a low-interest savings account. Period.

    Thanks for this wake-up call. I’m going to be recommending this book to family members.

    • NCrissieB

      Actually the reason Teresa Ghilarducci recommends shifting from individual to institutional funds is precisely because most institutional funds are monitored by professionals who know the financial industry’s gimmicks. Institutions also have the market clout to demand and get more detailed disclosure of fees and costs, offer employees a clearer menu of choices, and keep “money machine” products off that menu.

      Put most simply, for all but a handful of people, having “control over your retirement savings” translates to dealing with sophisticated hucksters for whom individual workers are mere sheep to be fleeced.

      Good morning! ::hugggggs::

      • winterbanyan

        Institutional funds make more sense, I agree. Unfortunately, most of us can’t get into them. So I’m looking at what most of us can get into.

  • addisnana

    I’m not convinced that we have a well defined problem that we are trying to solve. We are talking about who should manage money and how they should be regulated. I’m not sure that is the right problem. The real problem may be what is money for and how do we take care of each other.

    In several areas we have an aging population in the boomers who have or will have different needs as they age. Where to live? How to get around when they can no longer drive. How to deliver health care and how to not spend such a huge chunk of our health care dollars on the last months of life…How to make sure old people or young people who are disabled or young people who are out of work can have enough to live on with more dignity than that afforded by abject poverty.

    If people were paid living wages, perhaps ‘saving’ might be possible. If saving was part of the big nudge, perhaps people would have enough money for old age. If, If, If…..

    We treat money as so many conflicting values that talking about our real needs, individually and collectively gets colored green…We treat money as a scorecard, a zero sum game, a tool, a bargaining chip, a fiscal cliff, etc, etc.

    I am sure that individuals are incapable of making sound decisions the way that the rules have been written. I am less sure that the equivalent of a financial union doing better than just keeping us from being screwed.

    Sorry about this philosophical detour.

    • NCrissieB

      I agree, addisnana. It’s worth noting that the focus of Olen’s book is the personal finance industry, and that industry is mostly about how we fund retirement. As she writes and we’ll discuss tomorrow this is a comparatively recent societal problem.

      Two hundred years ago, almost no one “retired” in the sense we mean today. You worked until you died, often very young by today’s standards … unless family members could and would support you in old age, usually in exchange for babysitting and other light domestic work in a multi-generational household.

      Industrialization, urbanization, and better diets and health care combined to create our modern notion of “retirement.” More of us live longer and fewer of us want to support our parents or live with our children in retirement. As a result of those two trends, we need a way to support independent seniors whose monthly earnings no longer meet their monthly expenses.

      The original solutions – in Bismark’s Germany and FDR’s America – were government pension plans set up so relatively few people would use them. The life expectancy for Germans was 62 when Bismark set the state pension age at 65, and only 63 when FDR set the Social Security eligibility age at 65. In other words, most people would work their entire lives, while paying taxes to support a pension system whose benefits they would not live long enough to receive.

      Both Bismark’s pension system and Social Security were intended to be only supplemental plans. Most of your retirement income would come from your employee pension fund, a defined benefit plan that put your employer on the hook for any fund shortfall. That combination, plus Baby Boomers working and paying into the system, gave the Boomers’ parents (retired in the 1960s-80s) greater security than any generation before them.

      The central problem Olen addresses is whether and how the Boomers and later generations can have that same security. I agree that is one part of a larger problem – which you discuss – but Olen focuses on that one part.

      Good morning! ::hugggggs::