New Regulation Could Actually Reduce Access to Investment Advice

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Study highlights the potential value of professional investment advice—and the cost of curbing access to it.

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A contentious U.S. Department of Labor rule, five years in the making, may be finalized as early as next week.

The so-called fiduciary rule would impose greater obligations on professionals who provide advice in connection with retirement investing. A centerpiece of President Obama’s efforts to bolster the middle class, the Labor Department’s rule is largely aimed at protecting retirees from the threat of unscrupulous investment advisers. But if the results of a recent study that Professor Tess Wilkinson-Ryan, law student Kristin Firth, and I conducted are any indication, some of the intended beneficiaries of this rule may end up with reduced access to the very investment advice that the rule seeks to preserve.

The rule’s development dates back to 2010, when the Labor Department introduced an initial rulemaking proposal aimed at eliminating conflicts of interest. The following year, after the proposed rule drew extensive criticism, the Labor Department withdrew it. Last February, the White House’s Council of Economic Advisers released an analysis reporting that that advice from advisers who have conflicts of interest “costs Americans about $17 billion in foregone retirement earnings each year.”

Backed by this data, President Obama called upon the Labor Department to resurrect its rulemaking proposal, citing the need for retirement advisers to “put the best interests of their clients above their own financial interests.” In response, in April 2015, the Labor Department issued a slightly revised proposal.

The revised proposal would impose heightened regulatory standards on brokers working with retirement accounts. Under the rule, anyone providing individualized advice to a plan sponsor, plan participant, or the owner of an individual retirement account for compensation would be regulated as a fiduciary. That would mean that, in order to continue to receive standard types of compensation for advice, such as commissions and revenue sharing, retirement investment advisers would be required to acknowledge their fiduciary status, commit to recommendations that are in the best interests of their clients, and adopt policies and procedures to mitigate conflicts of interest.

Critics have challenged the Labor Department’s claims of extensive adviser self-dealing as being overstated, and they have warned that the proposal will reduce access by middle-class employees and small businesses to investor education and professional investment advice. Missing from the debate, however, is a meaningful assessment of the value of professional investment advice and the resulting cost to society of reducing this access by regulating advisers. This omission is striking in an era in which a rigorous cost-benefit analysis to establish the justification for proposed regulation has become de rigueur.

To examine the value of professional investment advice, Professor Wilkinson-Ryan, Kristin, and I recently conducted a study of retail investor retirement decision-making. Our study simulated the process by which an ordinary employee selects among the options in a typical 401(k) plan. We asked subjects to allocate a $10,000 investment among ten investment alternatives based on real-world options, with the goal of maximizing the value of that retirement portfolio at the end of thirty years. We then used an algorithm to simulate the performance of the subjects’ portfolios at the end of thirty years. Using subjects from Amazon Mechanical Turk—an online platform that enables researchers to recruit and pay subjects for performing tasks such as responding to questionnaires or surveys—we sought to determine the financial literacy of ordinary retail investors and to ascertain the relationship between financial literacy and investment performance.

Our findings were dramatic. We found that financial literacy was highly correlated with various measures of successful retirement investing and that the financial literacy of ordinary investors was strikingly low. The participants in our study lacked the fundamental knowledge necessary to engage in effective retirement planning: they did not identify which of our ten funds were most suited to meeting their objectives, did not reject inferior funds, and did not calibrate their risk tolerance to a level appropriate for a retirement portfolio.

To understand the significance of these results, we ran the same study with sixty investment professionals employed by FINRA-registered regulated brokerage firms. The purpose of doing so was to explore the extent of the knowledge gap between ordinary investors and professional advisers and to quantify the potential value added by professional investment advice.

Perhaps unsurprisingly, the financial literacy demonstrated by the professional advisers dominated that of the ordinary investors across the board. On our customized nineteen-point financial literacy scale, which we developed to measure financial literacy concepts with specific relevance to the investment context, the average broker score was 16.9, as compared to an average score of 12.3 among the ordinary investors.

Most significantly, the professional advisers, unlike the ordinary investors, recognized that appropriate asset allocation was a key component of retirement investing, and they correctly identified and rejected inferior investment options. The knowledge gap resulted in a substantial and measurable performance difference between groups; the average value of the portfolio selected by the professional adviser, as calculated by our simulation, exceeded the average portfolio selected by the less financially literate ordinary investors by a third. In fact, these results likely understate the full value of professional investment advice; other research has demonstrated that more people participate in retirement plans and contribute more money to those plans when they have access to professional advice.

Our study is limited. Because the professional subjects in our study voluntarily chose to participate, they may be more knowledgeable than the average retail broker. In addition, we do not purport to determine the extent to which conflicts of interest may influence the real-world behavior of investment professionals. Nonetheless, our study has important implications for the Labor Department’s proposal. By documenting the knowledge gap between investment professionals and ordinary investors, we highlight the potential value of professional advice in connection with retirement planning. Our study suggests that too much regulatory focus on eradicating all potential conflicts of interest may reduce access to investment advice to the detriment of retirement plan participants.

Jill E. Fisch

Jill E. Fisch is the Perry Golkin Professor of Law and Co-Director of the Institute for Law and Economics at the University of Pennsylvania Law School. The article reporting the results of the study by Professor Fisch and her co-authors described in this posting is forthcoming in the Duke Law Journal.