Thursday, September 15, 2011

Moral Hazard in Investment Management.

Via Craig: The overlooked failure in pension markets

Moral hazard occurs in pension markets because investment advisers have the incentive to maximize fees, but don't really get rewarded for performance.

Consider a simple example:

You have $100,000 with an adviser.  The annual management fee is 1%.  The annual dollar fee paid is therefore $1,000.  If the adviser works hard and earns you say an extra 2% return, his fee will increase to: 100,000*(1.02)*(0.01) = $1,020.

Alternatively, the adviser could recommend an "new" investment for your portfolio that charges a 1.5% fee.  Total fees in this case would be $1,500.

Given how hard it is to beat the market and earn an abnormal return, the adviser's best bet is to try and push his clients into higher fee products.

I've said it before and I'll say it again.  There are really only two things you can control in saving for retirement.  One is the amount of money you put in your account.  The other is the fees you pay to invest that money.  Your goal is to maximize the first and minimize the second.