Tag Archives: finance

Fund management fee paid explicitly to nudge consumers to choose better funds

Mutual funds with lower management fees have higher future before-fee returns (Gil-Bazo and Ruiz-Verdu 2009). Nonetheless, the high-fee funds have not gone out of business, so there must exist a sizable number of silly customers who accept low returns without switching to competitors. When asked explicitly, all fund investors prefer more money to less. Their hourly wage is not large enough to explain their non-switching with the time and hassle costs of comparing fund returns and choosing a new one. Similarly, many Estonians keep their retirement savings in badly performing high-fee pension funds despite the availability of dominating options (Tuleva and LHV index tracking funds). This is costing the customers over one percent of their retirement wealth per year.

By contrast, people with chronic or expensive diseases in the US often pick the health insurance plan that maximises their wealth (coverage minus premiums). This dynamic optimisation involves switching to a different plan when their illness changes. People without costly medical conditions tend not to switch their insurance even when cheaper plans with higher coverage are available.

Both the pension and the insurance plan decisions are complex, but matter greatly for wealth. Why do people pay attention to the financial consequences of their insurance choice when sick, but ignore better options among pension funds (and when healthy, also among insurance plans)? One possibility is that insurance is more salient to the sick, and the greater attention leads to better decisions. Specifically, the premiums and out of pocket payments for medical procedures frequently remind patients of the financial consequences of their insurance, but the missing returns on one’s retirement assets are not observed without explicit comparison to the stock market or competing funds. Most people do not compare their pension plan to the market, so even in retirement may not know what their (counterfactual) wealth would have been had they chosen a better fund .

If it is lack of attention that causes the bad choice of mutual and pension funds, then one solution (proposed by my friend Hongyu Zhang) is to make the management fees more salient by requiring their explicit payment. For example, every month the customer has to transfer the amount of the management fee from their bank account to the fund. Financially, this is equivalent to the fee being deducted from the retirement assets like now (assuming these assets are eventually taxed the same as income, otherwise the transferred fee can be adjusted to make it financially equivalent to the deduction). The attention required is however greater for an explicit payment than for doing nothing following a lack of capital gains. Similarly, requiring customers to pay the difference between the return of their fund and the market return into the fund every two weeks would nudge them towards greater attention to their retirement account.

In practice, such a nudge is unfortunately politically infeasible. Not only would the fund industry lobby against it, but voters would irrationally perceive the required explicit payments as increased taxes. This would make the transition to transferring fees to funds from customers’ bank accounts very unpopular. If people understood the equivalence between low returns on their assets and explicit payments required of them, then they would be financially literate enough to choose low-fee, high-return index funds in the first place. Thus the problem of low-performing pension funds would be absent. To sum up, the fool and his money are soon separated, and it is difficult to protect people from their own bad decisions.