Choice of Advisers Impacts Retirement Portfolio Choices and Outcomes

The authors of the study “What is the Impact of Financial Advisors on Retirement Portfolio Choices and Outcomes?” by the National Bureau of Economic Research point out that defined contribution (DC) retirement plans ask individuals with poor financial literacy to make choices that could have far-ranging effects on their finances and retirement. One way to improve the quality of their financial decisions is to invest in educational programs that target financial literacy. Another approach is to rely on default investments, such as target-date retirement funds. In a third method, financial intermediaries provide access to financial advice.

The actual portfolios of participants in the Oregon University System’s DC retirement plan were examined by the authors, John Chalmers, associate professor of finance at the University of Oregon, and Jonathan Reuter, assistant professor of finance at Boston College. In order to benchmark the participants’ portfolios of these self-directed investors, hypothetical portfolios using target-date funds—a popular default investment—were constructed.

They sought to determine whether financial advice is an effective substitute for financial education or for the use of defaults.

Providing financial advice to investors is a multibillion dollar industry, Chalmers and Reuter said, but the volatility of investment returns can make it difficult for investors—even those who are financially literate—to distinguish good advice from bad.

Citing previous studies, they brought up the point that financial service providers can profit from transforming simple financial products into more complex ones that may offer little additional benefit to investors.

Clients of brokers allocate contributions across a larger number of investments than self-directed investors, and they are less likely to remain fully invested in the default option. However, broker clients’ portfolios are significantly riskier than self-directed investors’ portfolios, and they underperform both benchmarks. Exploiting across-fund variation in broker compensation, when broker fees are higher, so are the broker clients’ allocations, the survey found.

Survey responses from plan participants supported the study authors’ contention that the portfolio choices of broker clients reflect their brokers’ recommendations.

The main findings of the study are:

• Significant differences exist between investors who choose to invest through brokers and those who do not. Employees who chose to invest through a broker are younger, less educated and make less money. They are also more likely to state that they chose to meet face to face with a broker, and to state that they relied upon their broker’s recommendations when making investment decisions.
• Portfolio choices show some significant differences. Broker clients pay an average of 0.89% in broker fees each year, which helps explain their underperformance compared with the higher fees paid by self-directed investors, of 1.54%. This corresponds to an annual “tax” of $530. In exchange for these fees, broker clients are moved out of the default fixed annuity and into funds with higher-than-average past returns, higher-than-average exposure to several forms of market risk, and that pay higher-than-average broker fees.
• These findings highlight the agency conflict that can arise when unsophisticated investors seek investment advice from financial intermediaries, the authors stated. They said the findings also highlight the fact that, on average, brokers do not help investors construct portfolios that are “at least as good” as the portfolios constructed by self-directed investors. In this sense, financial literacy dominates financial advice.
• The majority of the broker clients and self-directed investors in the sample would have earned significantly higher annual after-fee returns from being defaulted into target-date funds. The investors most likely to choose to invest through an adviser are also the likeliest to accept the default investment option in the absence of access to financial advice.

The study concludes that the benefit investors receive from face-to-face meetings with financial advisers would need to be substantial to justify the use of agency-conflicted advisers over sensible default investment.

Oregon University introduced its Optional Retirement Plan, a portable DC retirement plan in October 1996 as an alternative to the state’s traditional defined benefit (DB) retirement plan. Participants in Oregon University’s system can choose to invest through a firm that uses brokers to provide personal face-to-face financial services.

Between October 1996 and October 2007, approximately one-third of the university’s participants chose the high-service investment provider. Two-thirds of participants chose to invest through three lower-service investment providers. With assistance from the Oregon University System, the authors matched administrative data on investor characteristics, given the type of investment advice chosen.

An abstract of “What is the Impact of Financial Advisors on Retirement Portfolio Choices and Outcomes?” is available here. The study itself can be accessed for a minimal fee.