New Columbia Business School research quantifies the hidden costs of traditional, tax-deferred retirement accounts.
The U.S. government’s stake in these accounts amounts to a $3.8 trillion investment portfolio — one that incurs over $23 billion annually in asset management fees. The findings raise new questions about retirement policy, investment efficiency, and the potential benefits of a Roth-only system.
Key Takeaways:
- Traditional and Roth retirement accounts may seem similar to the average investor, but there’s a crucial difference: Under traditional tax-deferred retirement accounts, the US government effectively owns about 20 percent of the account balance (corresponding to future tax revenue) — and pays management fees on those assets.
- The government’s implicit portfolio totals approximately $3.8 trillion, resulting in $23.4 billion in annual asset management fees that would not exist under an all-Roth system.
- A switch from traditional to Roth accounts could potentially allow the government to offer a roughly 6 percent match on retirement contributions while keeping tax rates unchanged.
The Research:
Traditional tax-deferred 401(k)s and IRAs might seem similar to Roth accounts — both are designed to grow tax free and help Americans save for retirement — until you consider a surprising fact: With the traditional account, the government indirectly pays billions of dollars in investment management fees.
“If you have $100 sitting in a traditional retirement account with a 20 percent tax rate at withdrawal, it’s really equivalent to having $80 in a Roth account, plus $20 in an implicit account owned by the government,” explains Stephen P. Zeldes, the Frank R. Lautenberg Professor of Economics and Public Policy at Columbia Business School. “And just as you’re paying asset management fees on your $80, the government is paying fees on its $20 share.”
This insight led Zeldes and Mattia Landoni, PhD ’14, a senior financial economist at the Federal Reserve Bank of Boston, to investigate a previously unexplored question: Just how much is the government paying to manage its stake in tax-deferred retirement accounts?
The Government’s Hidden Portfolio — and Its Cost
To answer that question, the researchers quantified the cost to taxpayers associated with the government’s implicit portfolio in traditional retirement accounts. With tax-deferred assets in defined contribution plans and IRAs totaling $18.9 trillion, they found that, assuming a 20 percent average tax rate on future withdrawals, the government effectively owns about $3.8 trillion of these assets.
To calculate the government’s fee burden, Zeldes and Landoni estimated an average annual fee rate of 0.77 percent on tax-deferred retirement assets. They arrived at that figure through an asset-weighted analysis that included both explicit costs (e.g., mutual fund expense ratios and advisory fees) and implicit costs (e.g., trading expenses).
Multiplying the government’s $3.8 trillion portfolio by the 0.77 percent fee rate and accounting for corporate taxes, the researchers estimated the government indirectly pays around $23.4 billion annually. “That’s similar to the budget of NASA,” says Landoni.
Beyond the cost implications, the researchers found that roughly two-thirds of the government’s implicit portfolio — about $2.6 trillion — is invested in equities, mirroring individuals’ retirement allocations. This means that, without explicit policy guidance, the government has significant indirect exposure to the risk and return of the stock market.
Further, if the government does want to invest in equities, this is unlikely to be the most cost-effective way to do so. The government could instead switch to a Roth system and invest the added up-front taxes those accounts collect in a low-cost index fund or even a sovereign wealth fund.
How Much Are We Paying in Hidden Management Fees?
The researchers also sought to understand why fees on traditional accounts remain high despite the economies of scale from the added government assets. One would expect competition to drive fees down as assets grow, but that isn’t the case. Instead, asset management firms charge similar percentage fees for traditional and Roth accounts, even though traditional accounts involve larger balances.
This phenomenon happens because neither investors nor the government are sensitive to the fees charged on the government's assets. Then, since firms have market power, they are able to capitalize on economies of scale without passing the savings along to investors.
“As assets grow, firms can charge the same percentage fees, which makes them more profitable,” says Landoni. “Over time, these added profits could lead new firms to enter the market. This means that even with economies of scale, the asset management sector grows along with the assets and becomes inefficiently large.”
Policy Implications: Is Roth the Right Path?
Ultimately, the research suggests that a shift from traditional to Roth accounts could yield substantial savings for the government. What's more, by eliminating latent fees, the government could afford to offer a 6 percent match on Roth contributions without changing tax rates.
Zeldes points out that the research isn't about whether individuals should contribute to traditional or Roth accounts given the choice — they’re paying the same total fees either way. “That decision depends on your tax rate when you’re young and your projected rates in retirement,” he says. “But for society as a whole, our model implies we’d be better off if we had only Roth accounts.”
That said, further exploration of the topic is needed before any sweeping policy recommendations can be made, the researchers say. The complexity of tax systems, distributional effects, and overarching economic impacts mean that policymakers would need to carefully evaluate how various groups would be impacted by a Roth-only system.
As a next step, Zeldes and Landoni plan to investigate why percent management fees stay fairly constant even when assets under management balloon — a trend that seems consistent across financial products beyond retirement accounts.
“You would think that percent fees would drop when assets under management grow if there are economies of scale, but costs and fees just don't seem to be that tightly linked,” says Zeldes. “The model we've developed can help explain this more general phenomenon: With greater assets, people feel richer and aren’t willing to devote as much time and energy searching for lower fees, so the market power of asset managers increases.”
Adapted from “Should the Government Be Paying Investment Fees on $3 Trillion of Tax-Deferred Retirement Assets?” by Mattia Landoni, senior financial economist at the Federal Reserve Bank of Boston, and Stephen P. Zeldes, the Frank R. Lautenberg Professor of Economics and Public Policy at Columbia Business School. The article is forthcoming in the Review of Financial Studies. The views expressed by Landoni in this interview do not necessarily represent those of the Federal Reserve Bank of Boston or the Federal Reserve System.
