Tuesday, December 31, 2013

IRA Rollovers and 401(k) Problems

FINRA is warning financial advisers in Regulatory Notice 13-45 that they need to remember their fiduciary duties when discussing IRA rollovers with clients.  I have no such fiduciary duties with anyone so I can discuss this subject from all angles.  The regulatory notice reminds advisers that products in a 401(k) may be more appropriate for a client's goals and risk tolerance than products available in an IRA.  I'm reminded of target date funds that automatically adjust portfolios as clients age, and those funds may not be available outside of a 401(k).  Positioning clients to accept comparable arrangements with products in IRAs may harm their best interests if management fees and transaction costs would increase.

FINRA's regulatory workarounds preserve the independence of retirement plan sponsors who offer diverse options within 401(k)s.  The remaining problems for 401(k) investors go beyond the choice of whether to rollover assets into other retirement accounts.  I can think of quite a few problems off the top of my head, based on years of studying finance.

A 401(k) contains a lot of actively managed products.  Actively managed funds carry more fees and tend to underperform passively managed products (i.e., indexed funds).  Even target date funds contain actively managed funds, layering another set of fees on top of the active managers' fees.  This Yale study by Ian Ayres and Quinn Curtis shows how active management and plan fees hurt 401(k) investors.

Multiple 401(k) options confuse investors.  Plan sponsors do not all perform thorough educational roles for their plan participants.  The best education is probably oriented toward construction of simple plans to avoid overwhelming low-information investors with poor choices.  It is unfortunate to see plan sponsors mimic brokerages by stuffing flavor-of-the-year mutual funds into 401(k) choices but that's what they are allowed to do to entice interest from their participating employees.

Investors borrow from 401(k) accounts.  Allowing investors to borrow from their own retirement accounts is IMHO one of the dumbest loopholes in American tax law.  Those loans must be repaid with interest to ensure the investor catches up to where their retirement account balance should be if they had never taken out a loan.  Oh BTW, the interest on a 401(k) loan is NOT entitled to the same tax deductibility as a home mortgage loan, so it's a pretty stupid way to fund a home purchase for people who don't qualify for a mortgage.

I would much prefer that the US scrap its entire tax-advantaged retirement system and start over from scratch.  The replacement regime should be very simple.  It should NOT at all resemble Theresa Ghilarducci's Guaranteed Retirement Account plan.  I've criticized that idea before because it's just another way of funding persistent federal budget deficits.  Investors forced to accept such a plan will eventually be prohibited from investing in anything other than government bonds.  Those bonds will eventually pay below-market interest rates and will lose purchasing power after inflation.

My preferred solution would resemble Australia's superannuation accounts system.  A simple system would be the best system.  Investors would be able to put as much of their income as they like into one tax-advantaged account with exactly one product:  a target date fund.  The fund would be structured like the federal government's Thrift Savings Plan and contain only index funds to minimize fees.  Limiting the number of fund components to a handful would still allow for allocations to equities, fixed income, and hard assets (and I'll include real estate and infrastructure among hard assets).  Investors would be prohibited from taking out loans from their superannuation account.  My plan has exactly zero chance of ever being enacted in America because it's too easy to understand.  The national political climate favors complicated solutions that are amenable to financial sector lobbying.  The plan would also completely replace Social Security because it could not be used as an entitlement program or as an accounting gimmick to mask deficit spending.  That definitely isn't going to fly in Washington, DC.  We'll just have to watch our government's entitlement programs collapse during hyperinflation before we see real reform.

I was a financial adviser years ago, and I was very circumspect when I discussed the characteristics of an IRA rollover with prospective clients.  I outlined the advantages, disadvantages, and consequences for their particular situations.  That's precisely why no one wanted to entrust an IRA rollover to my care.  Sharing my knowledge and concern really turned people off.  Human beings won't listen to detailed descriptions of consequences.  They prefer the excitement of wish fulfillment and will trust liars who promise the moon.  Financial advisers who "succeed" in obtaining business from investors doing rollovers are likely to ignore details and lie about consequences; they are human and they pitch to humans.  They tend to use action words like "must, should, ought" to manipulate a prospect into thinking there is only one choice.  This is why I have contempt for most financial advisers and most individual investors.  I find manipulation to be disgusting and I believe FINRA would agree with me.

Nota bene:  Nothing I wrote here constitutes investment advice.  I need to state that clearly in case a bunch of idiots claim I give financial or investment advice.  I do no such thing.  I don't give advice because I don't give a hoot what other people do with their money.