Nudging, or influencing people toward a particular decision while still allowing them to make a different one, is one of the big popular ideas in behavioral finance. These suggestions are particularly widely used in 401(k) plans, which nudge you through tools like automatic enrollment, default allocations, automatic escalation, menu design, and, of course, marketing material.
But nudges don't exist in a vacuum: They exist in a profit-maximizing industry. What if you're being nudged in the wrong direction?
Conflicts of interest: Still there
"Nudgers," writes Jacob Hale Russell, an academic fellow at Stanford Law School, in a recent working paper, "seem to have forgotten their own lesson: all decisions are subject to subtle influences that can have profound consequences. In particular, the retirement industry has a variety of ways to counter-nudge participants into alternative strategies."
In other words, what started out as a socially beneficial exercise in helping people save more for retirement could very well become a way to extract more profit from unsuspecting nudgees.
Asset allocation and a lack of options
The root source of the problem lies in the decision about asset allocation. Fund managers, as Russell points out, are not compensated by performance, but rather by assets under management.
More assets means more fees -- and more assets in expensive vehicles means even more fees. Unfortunately for you, those funds that are widely accepted as being the best for individual investors -- i.e., low cost index funds -- are the least profitable for money managers.
This is made worse by the fact that 401(k) participants don't have many places to turn.
You're presented with a single menu of options, usually quite constrained, and that's about it. If you don't like what's available, you can essentially quit your 401(k), or quit your job.
This means that customers are "sticky," and it gives a lot more room for managers to exploit nudges for their own means -- like presenting high-fee funds in a more attractive light, or defaulting participants into higher-cost strategies.
Marketing: It's still effective
Add to this extensive marketing efforts touting the benefits of certain types of funds, and many unsuspecting savers wind up paying way more than they should, which diminishes performance and, thus, long-term returns.
Need an example? You can see the influence of industry nudges in the enormous fee divergence among S&P 500 index funds. How is such a thing possible, when all of these funds track the same thing?
Presumably, if the market was correcting for unjustifiably high fees and poor performance, costs would drop and/or equalize.
Neither is in evidence. In fact, in a particularly disturbing example, one study quotes a Morgan Stanley representative's words to a research assistant regarding their S&P 500 fund:
There's no question that Vanguard's fund will outperform ours... Do not buy our S&P 500 index fund... I wouldn't be able to look at myself in the mirror in the morning if I recommended that fund to you.
Getting people to opt-out of a good default
This conflict can also arise in the form of individual influence, most notably by plan brokers who, it should be noted, do not have fiduciary responsibilities. So, for example, you default someone into a 401(k) plan... but then they are influenced by the provider to switch to a high-cost fund. As Russell puts it:
A nudge advocate might object that we just need to make the nudge stronger. We could tell investors, for instance, in big, red type: 'Don't trust the advice you're being given: they're all lying to you, and you need to choose low-fee funds.'
Unfortunately, for the time being, it doesn't work that way.
A study of the University of Oregon's plan found that less-educated and lower-compensated employees were more likely to use the plan's broker... and ended up with worse portfolios as a result.
Target-date funds: Final frontier of confusion
Another popular, and theoretically ingenious, nudge is the target-date fund.
Intended to solve the problem of asset allocation confusion and people remaining in functionally useless money market funds, target-date funds have become a booming business since being introduced.
Unfortunately, offering a target-date fund doesn't change the fact that managers are still trying to maximize profit. The paper cites a Morningstar study of 45 target-date funds. Of these, only six had 90% or more of their allocation in passive (read: cheaper) index funds.
There is also an incredible amount of variety among funds. On the surace, this might seem like a good thing, but it could actually be harming overall decision making.
Some researchers have gone so far as to suggest that the ever-increasing variety is evidence of obfuscation. By competing on vague differentiators rather than cost, and making it difficult to conduct an apples-to-apples comparison between funds, fund managers might be making it harder for savers to accurately assess a given product.
Add to this the fact that target-date funds have every incentive to go with their own internal mutual funds, and the reality that most savers are only provided with one option anyway, and you can see that, what started as a really good idea could quickly devolve into a bad one, undone by high fees, a lack of competitiveness, and an opaque body of information.
So what am I to do?
While there's comfort in thinking that defaults are implicit recommendations, and that your best interests are being kept in mind, it's an unfortunate fact that they aren't.
It's probably annoying for many people to take on the burden of becoming well-informed about finance, investing, and saving, but it's becoming more and more important.
Gone are the days of defined-benefit pension plans pooling our risks and allocating our assets. In this brave new world, knowledge, skepticism, and a keen awareness of cost are the order of the day.
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