Broker Check

Pigeons, Rat Tails, and TIAA

October 24, 2017
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(Featured image: B.F. Skinner’s Pigeon Experiments 1950, Getty Images)

Incentives are the most powerful driver of behavior for most, if not all, living things.

Countless experiments have demonstrated that, given the right incentives, animals will go to great lengths and learn to perform complex tasks.

Some of the most famous of these behavioral experiments were conducted in the 1950s by B.F. Skinner who successfully trained pigeons to do many things, including play ping-pong.

Bad Incentives and Rat Tails

Incentives are just as powerful for us humans. Right incentives will propel people to incredible achievements.

An important corollary, however, is that poorly designed incentives will be just as effective at driving behavior, but fail to achieve the desired outcome, often in a spectacular fashion.

An interesting example of this corollary is the “Great Hanoi Rat Massacre of 1902.”

Faced with a rat infestation, Hanoi authorities enlisted city residents to help reduce the rat population. To motivate people they offered a bounty for each submitted rat tail, assumed as the definitive proof of a vermin’s demise.

Enterprising bounty hunters soon realized they could just cut off a rat’s tail, set it free, and still claim their reward. Freed tailless rats would continue to procreate and ensure future supply of tails and rewards.

Contrary to expectations, the rat tail reward system actually resulted in an increase in the Hanoi rat population.

Advisor Incentives Gone Awry

Given their unparalleled ability to drive behavior, it is not surprising that the business world relies heavily on incentives. After all, how else can a corporation maximize productivity of its salespeople or factory workers?

The New York Times recently published an article (“The Finger-Pointing at the Finance Firm TIAA“) about the current troubles at the Teachers Insurance and Annuity Association (also known as TIAA; formerly known as TIAA-CREF).

TIAA long enjoyed a reputation as a non-profit, integrity provider of insurance and investment services. It was revered by many of its customers–mostly teachers, nurses, and government employees–and perceived as “a different animal from its Wall Street counterparts.”

The article implies that TIAA’s descent down the slippery slope may have begun after the Congress revoked its nonprofit status in 1997. Forced to pay taxes, the company needed to find ways to increase revenue. Shortly thereafter, the company became more aggressive with its sales practices.

In 2004, TIAA set up a registered investment advisory firm to provide asset management services to its clients for a fee.

There is nothing wrong with offering asset management services as millions of investors need and benefit from them. The trouble was with TIAA’s incentive system for its advisors.

The following are several quotes from the article that illustrate the issue:

  • “TIAA management assigned outsize sales quotas to its representatives and directed them to meet the quotas by playing up customers’ fears of not having enough money in retirement and other “pain points.””
  • “Advisers were pushed to sell proprietary mutual funds to clients as well, the complaint says. The more complex a product, the more an employee earned selling it.”
  • “[A TIAA executive] urged advisers to put more of their clients into in-house mutual funds. “Where do you think you get your bonuses?” the executive asked the crowd, according to the lawsuit.”
    Even though TIAA’s investment advisors were legally in a fiduciary relationship with their clients, the incentive system created a powerful motivation to act against it.

The legal system is now working to determine how many advisors did just that as TIAA is involved in a number of ongoing and pending lawsuits.

Not surprisingly, TIAA also faces a loss of clients and its reputation for integrity. As one former client quoted in the article aptly put it: “TIAA doesn’t have the values I thought it did.”

Your Incentive

Unfortunately, the above story is not rare in the financial services industry.

Asset management firms often act as an investment product manufacturer/distributor as well as a registered investment advisor to clients.

There is nothing illegal or unethical about this dual arrangement, unless advisors are compensated based on sales of in-house investment products.

This type of incentive puts any advisor, regardless of how experienced or ethical, in a very challenging position: pursuing the strong incentive to maximize the firm’s revenue (and advisor’s own paycheck) will absolutely conflict with the obligation to always act in clients’ best interest.

In our opinion the generally accepted remedy of simply disclosing the conflict of interest to clients is not sufficient. The purpose of the disclosure is to inform the client and thereby legally shield the firm and conflicted advisor, but it does nothing to eliminate the actual conflict.

If you are looking for help with your investments, you have every incentive to go beyond just understanding a prospective advisor’s qualifications, process, or investment strategy. You must also understand the incentive system.

Therefore, and to reiterate what we often say, the most important question you must ask every prospective advisor is: “How do you get paid?”

PLEASE NOTE: ABSOLUTELY NOTHING IN THIS ARTICLE SHOULD BE CONSIDERED AS INVESTMENT ADVICE OR RECOMMENDATION REGARDING THE SUITABILITY OF ANY INVESTMENT. FOR MORE INFORMATION PLEASE REFER TO DISCLOSURES.