We Have a Bridge You Might Want to Buy

Article created by The Century Foundation.

The administration failed last year in its bid to introduce private accounts to replace all or part of Social Security’s guaranteed benefits. But many interested parties, particularly in the financial services industry, are hoping soon to bring privatization back to the front burner.

New research by James Choi of Yale University, David Laibson of Harvard University, and Brigitte Madrian of the University of Pennsylvania highlights why some continue to press for privatization: those who sell financial products stand to make a pile. Choi, Laibson, and Madrian (CLM) conducted an experiment in which bright university students, even MBA students, consistently spent far more on financial services than they should when compiling portfolios of investments.

CLM can be quite certain that their subjects were not buying a better product at a higher price. There is no difference, except branding and marketing, among the four financial products their subjects were allowed to choose from. Yet the vast majority chose high-priced versions of these identical products. Even the MBA students proved susceptible to the sort of irrelevant information used to sell mutual funds.

In the experiment that CLM undertook, students were asked to invest $10,000 in four mutual funds. They stood to receive a real cash payoff based on performance of the funds they chose. All four funds were index funds that aimed to mimic the performance of the S&P 500 index. All of the subjects were given each fund’s prospectus. CLM provided some students with additional information to help them understand fees; and they provided other students with information on returns of each fund since inception (these returns differ only because inception dates differ).

This investment problem has only one right answer. All four funds will perform identically; each will produce the S&P 500 rate of return before fees. The fund with the lowest fees is the best investment. Past performance is completely irrelevant; over any given period, all four funds will perform the same. Since the difference between the fund with the lowest fees and the fund with the highest fees was more than one percentage point a year, the subjects had relatively much to lose.

In the experiment, only five percent of these subjects—who on average had SAT scores above 1450, placing them in the top 2 percent nationally—put all their money in the mutual fund with the lowest fees. After fees were explained, this figure rose to 15 percent. The MBA students did only a little better than the undergraduates. When students were informed about historical returns of the funds, they invested based on these irrelevant numbers.

Consumers have every right to buy brand names they like. They have every right to use tea leaves, or star charts, or glossy brochures to decide how to invest their money. But what this research shows us again is that we cannot afford to trifle with Social Security’s income guarantee for everyone. The fact that even the smartest people make foolish decisions underscores the importance of the safety net, of which Social Security is the anchor.