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!