Good news: the Labor Department has finalized a new rule saying that stock brokers can't take pay-offs from mutual funds and other financial companies to give their clients bad advice. The rule stands to substantially increase ordinary Americans' returns on their investments, effectively transferring billions of dollars from Wall Street to ordinary investors.
Naturally, the financial industry fought back, and the Obama administration deserves a lot of credit for defeating them. But Sen. Elizabeth Warren (D-MA) deserves credit too for helping beat back one of the slimier attacks thrown at the rule.
Back in July, the Carter/Clinton administration economist and longtime Brookings Institution scholar Robert Litan and his collaborator Hal Singer co-authored a report attacking the rule. In response, Warren sent Brookings president Strobe Talbott a letter (PDF here) accusing Litan of tilting his findings to please the interests of the Capital Group, a mutual fund manager, which funded the paper.
Moreover, when Litan testified about the research before the Senate Health, Education, Labor, and Pensions Committee, he touted his position at Brookings, in spite of a new rule at the think tank barring nonresident, unpaid fellows from using their Brookings affiliations in congressional testimony; while Litan was a paid staffer at Brookings for years, and in fact ran its economic studies division for a time, he wasn't when he testified before Congress.
The latter violation ultimately led to Litan's departure, with Talbott stating, "He has acknowledged that he made a mistake in not following Brookings regulations designed to uphold the independence of the institution."
Litan, for his part, has expressed frustration that the scandal over his funding eclipsed the work itself, telling the Washington Post's Tom Hamburger, "I think it’s unfortunate that, even when I disclosed the funding, people spent their time discussing who funded my work rather than discussing the merits of it."
The trouble is that the paper's merits were largely non-existent. It was a spectacularly unpersuasive hack-job paid for by one of the predatory financial institutions the Labor Department rule will hurt.
The key issue: Should investment brokers be allowed to snooker clients?
Investment advising is an odd business, in that the only advice anyone really needs fits on a 4-by-6-inch index card.
The basics are really simple. Save 15 to 25 percent of your income (use this calculator to get an estimate for your specific situation); take advantage of tax-preferred savings like 401(k)s and Roth IRAs; buy low-fee index funds rather than picking stocks yourself or hiring an active fund manager to do it for you. If you're really rich, things can get more involved, but for most people, it's not that complicated.
But handing out free index cards is not a lucrative business, so brokers have to figure out other ways to make money. Traditionally, one of those methods has been receiving kickbacks from mutual funds and other investment vehicles for convincing clients to invest.
These kickbacks can take a number of forms. Under "revenue-sharing" arrangements, mutual funds pay advisers annually based on what the advisers' clients choose to invest in, giving the advisers an incentive to favor the funds' products. Mutual funds also sometimes charge fees to investors upon purchase or sale of shares, and then pass the fees on, in whole or part, to the investors' advisers who directed them to buy the funds' products.
If this seems incredibly corrupt and bad for consumers, that's because it is! A report by the White House Council of Economic Advisers from earlier this year reviewed the evidence and found that advice from conflicted advisers reduces investment returns by an average of 1 percent a year.
That adds up over time. For example, if someone earns 5 percent annual returns from age 45 to 65, rather than 6 percent returns, she'll wind up with 17 percent less money at the end. In total, the CEA estimates that conflicted advice costs investors $8 billion to $17 billion in retirement savings every year.
There's a simple fix to this, however, which the Labor Department's new rule embraces: imposing a "fiduciary standard" on investment brokers. Currently, brokers only have to show that the advice they provide to consumers is "suitable," given their clients' age, retirement goals, etc. They don't actually have to provide the best advice available to their clients. But a fiduciary standard would legally require brokers to act in their clients' best interests, and to disclose any conflicts that might bias their advice.
"Registered investment advisers" already have to obey this standard, and generally make money by charging a fee set at a percentage of a client's assets. Hiring a registered adviser is still generally a worse idea than just putting your money in a low-fee index fund, but it's a better idea than getting advice from a conflicted stockbroker. So the Labor Department wants all brokers to follow a fiduciary standard, and end conflicted advice altogether.
The evidence against the Labor Department rule is literally that stock brokerages think stock brokerages are awesome
So why would Robert Litan — the former Brookings affiliate whom Warren targeted — oppose requiring investment advisers to serve their clients' best interests? He and his co-author Hal Singer's argument basically boils down to the claim that the Labor Department rule would make investment advice too expensive for low- and middle-income families, and that loss of access to human investment advisers would wind up reducing retirement savings overall.
The main mechanism cited in Litan and Singer's paper is "market timing," or the tendency of investors to panic and sell when the market is plummeting and buy when it's booming. That results in selling low and buying high, which reduces overall savings compared with doing what you're supposed to and just buying and holding index funds.
Human investment advisers, Litan and Singer claim, are effective at persuading people to buy and hold and not panic during market crashes: "If human advisers persuade just one in seven clients to stay invested through a market downturn, it totally offsets the claimed DOL rule’s ten‐year benefits."
They cite two other major mechanisms by which human advisers allegedly improve retirement portfolio performance: encouraging clients to diversify their stock holdings, and encouraging them to save more and take advantage of savings incentives like employer contribution matches.
Litan and Singer's whole argument, then, rides on whether investment advisers are actually good at preventing market timing, encouraging diversification, and boosting savings. They cite only two organizations to back up these claims: the brokerage Vanguard and LIMRA, a trade association representing the life insurance and financial sectors.
Vanguard is, as brokerages go, pretty damn good; it offers very low-fee target date funds, and I use it for much of my own savings (which technically makes me a Vanguard shareholder, as it's owned by its investors — so, you know, full disclosure). But it's also a stock brokerage with an advisory service. It's not exactly shocking that its own proprietary research would find that its own financial services help customers — and that finding isn't credible absent backing from independent research. Same goes for LIMRA, which Litan and Singer cite as showing that financial advisers encourage more savings. Obviously a trade association would argue that.
Independent evidence shows that conflicted investment advisers don't provide the benefits they claim
The financial sector has produced a number of industry-backed reports trying to muddy the waters, as Litan's erstwhile Brookings colleague Jane Dokko has written. But there are reams of independent research — ably summarized by the White House CEA report — showing that conflicted advice costs consumers mightily,
And this independent evidence demonstrates that Litan and Singer's claims are wrong. They claim that financial advisers avoid market timing, but a 2009 peer-reviewed article in the Review of Financial Studies (ungated copy here) by Harvard Business School's Daniel Bergstresser (now at Brandeis), University of Oregon's John M.R. Chalmers, and Harvard Business School's Peter Tufano (now at Oxford) found that "the aggregate pattern of investment in broker-sold funds does not demonstrate superior market timing advice by brokers" (emphasis mine).
Litan and Singer claim that advisers push for diversification. But an experiment conducted by Harvard economist Sendhil Mullainathan, MIT's Antoinette Schoar, and the University of Hamburg's Markus Noeth found that advisers very rarely advised clients to invest in well-diversified, low-fee portfolios, often instead directing them toward returns-chasing behavior and actively managed funds. Advisers don't encourage good investment practice, as Litan and Singer assert (based on evidence provided by … investment advisers); they encourage bad habits.
Litan and Singer claim that people receiving advice from financial advisers save more as a result. It's true that there's a correlation between hiring advisers and saving more — but the causality issues here are immense. A RAND Corporation report from Jeremy Burke and Angela Hung this year reviewed the evidence and concluded that there isn't strong evidence that the relationship is causal — that advisers are causing their clients to save more, rather than more proactive and retirement-focused people just being more likely to hire financial advisers. They also find that workplace seminars and other interventions can promote savings without wasting savers' money by handing it over to predatory, conflicted advisers.
Investment brokers offer conflicted advice. But so do some think tankers.
So how did Litan — a fellow at Brookings, a former associate director of the Office on Management and Budget, the former research director for Bloomberg Government — get caught writing such an obvious pro-industry hack job?
Well, he was commissioned to write this piece through his position at Economists Inc., a consulting firm that offers economic analysis to business interests and other groups in DC. And he's not the only one on staff there who has (or had, in Litan's case) a prestigious think tank affiliation as well. Singer, Litan's co-author, is a senior fellow at the Progressive Policy Institute, a think tank with close ties to the '90s Clinton White House.
This is a particularly egregious case, but the DC think tank world has long had deep connections with industry, with these kinds of consulting arrangements being only one example. For example, defense contractors have a long track record of backing hawkish think tankers in DC by placing them on boards; retired Gen. Jack Keane, for example, backed military action against Syria in late 2013 and was frequently cited for his position at the Institute for the Study of War, but his membership of the board of contractor General Dynamics drew less notice.
But Warren has demonstrated that policymakers with an interest in these conflicts can call significant amounts of attention to them, and make think tanks reconsider their relationships with scholars who are getting money directly from industry groups with direct stakes in policy. Litan's departure is a genuinely unusual event, in that it arose not out of any ideological dispute with Brookings but out of financial scandal. If Warren keeps it up, Litan's case could wind up being less of an anomaly and more of a bellwether.