Saving Retirement: Government Subsidy to Investment Industry Shortchanges Savers, Taxpayers

by Mattia Landoni|

As policymakers around the globe continue to debate options to incentivize retirement savings, new research uncovers some game-changing facts. The two main competing options for savings vehicles like 401(k)s and IRAs consist of traditional tax-deferred accounts, in which savers contribute pretax money and pay tax on withdrawals, and Roth-type plans, whereby savers pay taxes first and withdraw funds tax-free upon retirement. Which type of scheme is better depends on which side of the table one sits. In their paper, SMU Cox Finance Professor Mattia Landoni and co-author Stephen Zeldes discover that under a Roth-type regimen, government fares better, largely because of the investment fees that government implicitly pays in traditional tax-deferred accounts.

The authors start with a well-known benchmark: when comparing the two systems in a world without investment fees, both savers and government are indifferent. Savers achieve the same level of consumption during both working life and retirement. Government achieves the same tax revenue, at least in present value. (A difference does show up in the timing of tax revenues, with Roths yielding more upfront cash to the government.)

It's the fees
When the authors add investment management fees into the mix, things change. Assuming fees are fixed as a percent of assets under management, they show that individuals are still indifferent to the timing of taxation but the government is not. Under traditional back-loaded taxation plans, the government implicitly owns a share of all retirement accounts, $2.9 trillion of the $15.3 trillion currently in plans; it is effectively paying investment fees on this share, something avoided under front-loaded taxation. They estimate this cost to the government at $15 billion per year. If state and local government and defined corporate benefit plans of $7.1 trillion were included, another $1.4 trillion would be added to the government's virtual share.

Landoni was surprised about cost to the government, which is a de facto subsidy to the financial services sector. About the $15 billion-dollar number, Landoni says, "It's about the same as the whole budget of NASA." The authors find that [traditional] back-loaded taxation is more expensive for the government and it produces a larger asset-management industry.

The U.S. has the greatest amount of tax-deferred retirement assets vis-à-vis other countries. Including defined benefit plans, U.S. savers have amassed $22.4 trillion to the U.K.'s $2.86 trillion and Canada's $2.53 trillion; these governments are also leaving money on the table based on the subsidizing of investment fees.

Running retirement plans and managing assets requires record keepers, asset managers, and financial advisors. The fees for this service are typically charged as a percentage of assets under management. The authors also posit: "It is not clear that individuals who pay higher fees on retirement accounts receive any additional benefits as a result.” In addition, even if some do receive benefits, many of these benefits cancel out in aggregate for the government, who owns a fraction of every tax-deferred account. According to the renowned academics Fama and French, "The aggregate portfolio of actively managed U.S. equity mutual funds is close to the market portfolio, but the high costs of active management show up intact as lower returns to investors."

"Right now, the government is counting on around 20 percent of outstanding tax-deferred assets," Landoni explains. "In the future, these assets will turn into tax revenue; but now, they are a $2.9 trillion account that belongs to the government." If we were in a Roth-only world, "The government would have already received the money, and paid down Treasury bonds," he notes. "There would literally be fewer assets in circulation. Thus retirement accounts would be smaller, as would the fees being paid."

In the research, the authors suggest that the average fees paid by investors (and government) are about 80 basis points or .80%. In comparison, the federal government's Thrift Savings Plan (TSP) pays average fees of 4 basis points on its indexed funds. "With lower fees, if extra assets were in the TSP, a sovereign wealth fund, or an efficient fund structure, we would not be so concerned," suggests Landoni.

Paying a price
Further, the authors find that this increase in the size of the asset management industry reduces social welfare by producing an excess of funds. “To see what this means, consider S&P 500 index funds,” Landoni explains. “Last time I checked there were 29 of them, without counting ETFs. Worse, some of them charge fees exceeding 1% per year. It is quite possible that some of these funds would already be out of business without the extra $15 billion in government subsidies." Each of these funds (that would not be viable without a government subsidy) employs skilled individuals who could be productively employed somewhere else, he suggests.

Thus, in the authors' model, when presented with a choice between Roth and traditional accounts, savers are indifferent. "However, with traditional accounts, taxpayers are stuck with a higher tax bill and ultimately enjoy fewer goods and services," says Landoni. "Since in our model, taxpayers and savers are the same people, Roth accounts are ultimately better for savers too."

With the estimated fees of 80 basis points, Landoni acknowledges that passive investing offers much lower fees that are both visible and explicit. Part of the cost of actively managed funds "is that they trade a lot," says Landoni, which raises the cost of investing in a more opaque way.

Landoni is not advocating for passive fund investing per se, even though larger volumes of assets are being directed toward passive funds by investors, large and small. "Remember when Microsoft Windows was only game in town, then Linux came along," he explains. "People said, 'It's impossible to have a world of Linux because there is no one to call if a problem arises.'” But then, the competition forced Windows to improve, Landoni suggests." Active funds will continue to become better in order to compete with passive funds."

Landoni and Zeldes conclude that while savers and taxpayers are getting shortchanged, the industry's growth is magnified by government policy.

The paper "Should the government be paying investment fees on $3 trillion of tax deferred retirement assets?" is authored by Mattia Landoni of Southern Methodist University's Cox School of Business and Stephen Zeldes of Columbia University. Landoni recently presented the paper at the Federal Reserve Bank of Boston.

Written by Jennifer Warren.
Mattia Landoni