The 16 Layers Between You and Your Money and What They Cost You

2016-06-22-1466606789-6398354-ScreenShot20160622at10.45.53AM.pngWhat They Do With Your Money is a thoughtful, meticulously documented, and downright infuriating indictment of the American financial services industry, which not only takes much more in fees from investors than their counterparts in other countries but hides those fees so that people who are relying on employer-sponsored pension funds, 401(k)s, and other investments cannot tell how much of their money is being siphoned off. The subtitle of the book is How the Financial System Fails Us and How to Fix It, and it ends on a hopeful note.

In an interview, authors Stephen Davis, Jon Lukomnik, and David Pitt-Watson explained the 16 layers and 100 different fees that erode the pensions of American workers and the changes in social media and technology that could reroute those returns back to employees and investors.

Why do you say that worker savings have become a "virtual ATM for the financial industry?"

Understandably, we have allowed experts to manage our nest eggs--but the number of agents between us and our investments has grown exponentially and each takes a fee or extracts a cost. Yes, there are money management fees which most of us see, but also marketing fees (12B-1 fees), custodial fees, transfer agent fees, sub-transfer agent fees, sub-custodial fees, audit fees, mutual fund board fees, valuation agent fees, proxy advisory fees, trading costs, broker fees, administration fees... the list goes on and on. It sometimes takes as many as 16 different agents--each extracting fees or adding costs--to shepherd our money from an account to an investment. And while some of those fees are disclosed, many are not, so that the average investor really doesn't appreciate how much the financial industry siphons. Stealth costs can climb enough to knock 50% off the total that a typical worker would have on retirement without those fees and costs.

We have seen a series of post-crash and post-scandal reform efforts over the past 30 years -- what has been effective and what has failed?

The Enron scandal begat the Sarbanes-Oxley Act, and the financial crisis begat the Dodd-Frank Act. In each case reforms from Washington added some constructive safeguards. But they have amounted to Band-Aids rather than comprehensive treatment for market ills. Experts disagree about whether the benefits have been worth the cost when companies have to comply with thousands of pages of new regulations. But one thing is certain: When it comes to fixes, policymakers have had a blind spot about financial agents. The biggest hidden failure in today's financial system is that there is almost no effective oversight of our financial agents. The main law addressing the issue (the Employee Retirement Income Security Act, or ERISA) is 42 years old; it was written for retirement conditions that no longer exist. For instance, we have far fewer workers compared to retirees; people live a lot longer, so they need more money to draw on; and traditional pension plans have given way to 401(k)-style plans with far more risk and higher fees.

Gridlock in Washington has put a brake on efforts to update law and regulation. Recently the US Department of Labor required investment advisors to put client interests ahead of other commercial interests - and the industry is suing to block that rule, and the Congress is trying to overturn it, largely on partisan grounds. That's a shame, because if the partisan gridlock would loosen enough for a rational discussion, much could be accomplished. For example, a reform package could oblige retirement plans to disclose the equivalent of a nutrition statement, so that consumers can learn in plain language whether their agents are configured to act in their best interests, how many agents there are, how they get paid and how much that reduces potential earnings. Legislation could require retirement savings plans to feature skilled, independent boards that police fees, conflicts of interest, and policies of investment funds. Finally, laws could mandate that financial agents abide by fiduciary duties that put the client first.

The interesting thing about that package of reforms is that they are systemic; designed to allow the market to work by adding information, expertise and clear accountability. They are not the type of "do this, don't do that" regulations to which the industry objects and, which, we contend, have unintended consequences and don't work that well in the first place. Consider this: There are now about 100,000 more compliance officers in finance than there were before the financial crisis. They monitor a virtual Hammurabi's code of very specific compliance-type regulation. But few think that the financial sector works better because of this. But if we made the process transparent, made accountability explicit, made fiduciary obligation extend throughout the chain of intermediaries, we could lighten up on the amount of spot regulation.

How has the shift from defined benefit pension plans to defined contribution plans affected retirement benefits? How has it affected shareholder oversight of corporate direction? The overall economy?

Defined contribution plans were conceived as a supplement to pension plans, not a substitute for them. As the principal vehicle for retirement savings, they fall well short of needs. Fees are higher, and returns are lower, than traditional defined benefit or hybrid collective savings plans. Savers shoulder excessive risk, and even those who are supposedly sophisticated are shown to make poor choices. No wonder that the US faces a worsening savings crisis, with the typical American nearing retirement with inadequate income to meet basic living expenses.

But it is even worse than that. The shift to 401(k)s has ballooned the power of mutual funds, and the business model of mutual funds is trading-oriented rather than long-term investment oriented. Studies show they too often act short term - in general they turn over their portfolios every year -- which in turn compels companies to act short term to match their investors' time frame. While some fund families, such as Blackrock, Vanguard, State Street and TIAA, have grown more responsible as owners of shares, some have not. To take one case, in 2012 a large mutual fund spent an estimated $138 million promoting its brand as a champion of clients, but at the same time employed a single person to actually do that advocacy, by managing voting shares at more than 10,000 portfolio companies worldwide. If holders of vast blocks of US stock act in our name in this way, it short-circuits the genius of free enterprise--that owners watch the store. The result is an underpowered type of capitalism in which managers, not owners, make fundamental strategic business decisions.

A number of politicians have recommended a legal standard for boards and executives that is measured by stakeholder benefits. What would that change?

We think this is a distraction. In the real world, managing a company means balancing the demands/risks/opportunities of innumerable groups and time frames. But our legal system makes some of those risks more equal than others. So, for example, financials are audited and filed with the SEC, but companies feel free to omit or segregate into a separate statement the ways in which they address so-called environmental, social and governance, or ESG, factors, when, in today's world, these are fundamental risks and opportunities. Even when there is SEC guidance requiring disclosure of these risks, as there is on climate change, it is honored in the breech, with boilerplate, non-differentiated disclosure. And the SEC has sat by silently while its own guidance is ignored.

So, the first step is for the SEC to start enforcing its own guidance. The second and more important step is for boards, managements, regulators and investors to stop seeing ESG issues as somehow different from other risks and opportunities companies face. Human capital management, climate change, supply chain management, and a host of other ESG issues are now known to have financial consequences. Why would an investor voluntarily assume the risk of ignoring them? Why would a company take on unnecessary risk by omitting them from strategic calculations? Standards should clarify that factors relevant to value, whether conventionally measured or not, should be integrated into statements to allow investors and others to get a more accurate profile of a company. Disclosure of relevant risks is the law. Making it clear that disclosure applies to both short- and long-term risks and opportunities would help investors more accurately assess the danger to, and potential of, portfolio companies.

How many intermediaries are there between an employee and the stock he or she owns in a retirement plan?

As noted above, one study counted 16. That may be low. The Transparency Task Force in the UK has detailed more than 100 fees. While the regulatory regime in the UK and the US are different, we would not be surprised to see such a list here.

What do you think of binding arbitration agreements in contracts between investors and money managers?

Arbitration, like a court proceeding, has its advantages and disadvantages. The great advantage of arbitration is that is flexible, and the parties can agree to the procedure and the arbitrators, customizing the process and tribunal to their specific needs. But that means there needs to be equal knowledge and power in deciding on where, how, and before whom to arbitrate between the parties signing the contract. That may the case for large investing institutions, but it is virtually never the case for consumer investors. Therefore, we believe the courts are better served to protect investor interests. Granted, the sophisticated and monied will always have an advantage, however a court's procedures and a judge's discretion can lessen those advantages.

To deny retail or unsophisticated investors a court hearing based upon a fine print paragraph buried in the back of a multi-page legal document we believe is wrong.

The business community is currently suing to stop a new rule that would require them to put the interests of their customers ahead of their own. Why does that matter?

Investment advisors should put the interests of client investors ahead of their firm's commercial interests. That way individuals seeking investment help can know if the advice they get is truly going to be best for them, or if it is being offered because a broker is being paid on the side. Financial service companies are fighting the measure through Congressional allies and court action, using the argument that the action would curb financial advice. In fact, the new fiduciary duty standard could curb excessive fees going from individuals to those financial companies. And while it might end some types of advice, the chances are that type of advice isn't very good for the investors, since it's being influenced by the promoters of a financial product.

Large institutional investors - the CalPERS and Harvard endowments of the world - usually mandate by contract that their advisors are fiduciaries, which is the legal way of saying that their advisors must put their interests first. Individuals don't have the power to do so. They can fend for themselves and get that contract language. This battle is about some parts of the financial community trying to deny fiduciary protection to small investors who generally do not have the leverage to get fiduciary obligation put into a contract.

Even from the industry point of view, we find the industry's position on this short-sighted. At a time when the financial system is under attack, we need to build up trust. Opposing the fiduciary rule does the opposite. Instead, the industry ought to be proposing a grand bargain: Embrace fiduciary obligation and real transparency so that the market can work the way it's supposed to. In return, let's simplify the exponential amount of "spot" regulation that has created 100,000 new compliance officers since the global finance crisis, and which many think does not work as well as it should.

But the industry today seems to be opposing systemic fixes. Cynics would say that Wall Street has figured out how to pass on the cost of those compliance officers, and has identified the loopholes in the myriad of spot regulations that have been passed. We prefer to think that the industry - our industry - is being short-sighted and will come around to embracing a systemic fix in time.

Why do Americans pay so much more in fees for managing their retirement money than people in other countries like the Netherlands?

The US in the past three decades has migrated away from collective pension savings to individual accounts in which citizens, if they are lucky enough to have a plan at all, shoulder nearly all risks when they save for retirement. In effect, we are sold financial products, instead of buying retirement plans. Studies show that the 401(k)-style system comes at a high cost compared to the type of collective plans available in the Netherlands. Plus, thanks to better governance of savings arrangements there, plans feature fewer intermediaries between the saver and the investment and fewer distortions caused by conflicts of interest.

One other thing that generally flies under the radar. After you retire, the Dutch system features simple, low-cost annuities, compared to the type of very complicated, high-cost annuities you can buy here. So, while a typical retiree in the Netherlands will retire with 50% more in assets than will a similarly-situated retiree here, if the Dutch and the American buy annuities to provide income in retirement, the Dutch retiree will be able to live on 79% more than the American retiree.

You have some intriguing ideas about the use of social media and technology to provide more transparency and oversight for investors. What do you think is most promising?

Take the example of Buycott, a free app launched in 2013, which aims to help consumers align their values with their purchasing. The first question it asks is: "Have you ever wondered whether the money you spend ends up funding causes you oppose?" You can scan a product at a store to see if the company that produced it is involved in any ethical campaign you support.

Now, let's imagine a smartphone tool that asks a parallel question: "Have you ever wondered whether the money you save ends up funding causes you oppose?" It could compare pension or 401(k) plans, providing you with a picture of how accountable each is, how fees compare, and how well or poorly they align with what you believe. That's a gap just waiting to be filled.

FinTech approaches hold other promise. Today, those with a 401(k) plan can easily summon an online page filled with latest data on holdings, transactions, and stock prices. But what's conspicuously missing are real-time updates on how funds you own have voted in your name at portfolio companies on key issues such as CEO pay, or engaged in your name with boards on climate change. Funds don't offer a ready description of how they are governed, or precisely how much in fees is subtracted. It isn't technically difficult to do. They just need pressure from their savers to do it.

In many ways, San Francisco is attacking New York, by which we mean that technology firms are trying to disrupt the financial system. There are payment systems - think PayPal and Apple pay - and there is now retirement advice from the so-called "robo-advisors". They have reduced the cost of portfolio construction advice materially, sometimes to zero. So, technology has the potential to reduce costs and improve services. On the other hand, the history of technology in finance is that it either gets regulated, co-opted or bought by the existing financial services firms. But perhaps this time is different. We don't know. It should be fascinating to watch it play out.