Why the “F” Word Is a Good Thing for Investors
You can’t open a newspaper or magazine lately without seeing a reference to the Department of Labor’s(DOL) Fiduciary Rule – which requires advisors to put their clients interest first when providing advice on certain retirement accounts. Proponents of the rule are advisors that are already adhering to a fiduciary standard who argue that the rule levels the playing field for the industry and benefits investors by requiring all advisors to act in the best interest of clients.
Opponents highlight the difficulty of adhering to the rule and that not only will costs to investors increase, but that it will result in lower quality advice provided to the very investors the rule is supposed to help.
As of the writing of this paper, the rule has been postponed for further analysis and evaluation into the rule’s intended and unintended consequences.
I’m not here to defend the Department of Labor and whether they are encroaching on an area that is not within their scope – which is another argument from opponents of the rule. What’s more important here is that the DOL is the first regulator of any kind to move forward with the implementation of the fiduciary rule, which has also been on the SEC focus list for the last several years despite no action being taken. The industry seems to be moving towards more of a fiduciary requirement from anyone deemed a financial advisor and the DOL rule is what could be the first in a series of actions to move the industry in that direction.
Until now, advisors have been able to operate under financial conflicts and not in their client’s best interests. Yes, you read that correctly. Up until now, many ‘advisors’ have been under no obligation or legal requirement to act in the best interest of clients. Whose interest have they been serving? More on that later, but until a fiduciary rule becomes standard across the industry, some advisors will only be required to adhere to a less stringent ‘suitability’ standard and give advice that is NOT in the best interest of their clients.
What the DOL has done is let the cat out of the bag and clients are starting to ask the question about whose interests their advisors are serving. The rest of this paper highlights why the fiduciary standard should be adopted not only by the DOL but by all financial advisors for all investment accounts. As you read through the rest of the paper, please note that the description for investors and clients are used interchangeably and are referring to the same constituents.
There are two general differences that make the fiduciary standard favorable for investors. One is that under the fiduciary standard, the advisor must hold the clients interest first when making recommendations; the second is that the advisor must also continue to monitor the client’s portfolio and identify potential risks to those investments.
Clients interest first – this one is pretty straightforward. A fiduciary must ALWAYS keep his or her client’s best interest first. That means that not only must the advisor thoroughly understand what those interests are, they must be cognizant of the client’s situation on an ongoing basis as well as ensuring continued monitoring of the client’s portfolio and individual positions. By contrast, the suitability standard only requires an advisor to make sure an investment is suitable for a client, even if it’s not in the client’s best interest.
For example, a client is looking to enhance the income their portfolio generates and the advisor determines that a high yield fixed income mutual fund is suitable for this client and the yield on the mutual fund will provide a few extra dollars in the client’s account. The advisor narrows down the client’s choices to three different funds from different fund providers. After carefully evaluating the commission payouts for each fund, the advisor recommends the fund with the highest commission, even though it not only has had the worst performance of the three funds, it is also not positioned well for the current economic environment. Under the suitability standard, this is perfectly OK.
The second major difference is that the fiduciary standard requires an advisor to monitor a client’s situation and investments while also providing advice to make changes when they are deemed to be prudent. The suitability standard on the other hand, only requires the suitability test to be passed at the time of sale. Continuing with our high yield example – fast forward to a point in time when the outlook for high yield deteriorates – perhaps due to the probability of rising default rates on these sub-investment-grade investments. As a fiduciary, the advisor would be required to advise the client to reduce the position in high yield – But the broker under the suitability standard need not do anything. The investment was suitable at the time of sale. Nothing else is required.
Some industry service providers are arguing, quite vehemently I might add, that a fiduciary standard will limit the availability of financial advice to certain investors – or increase the cost of providing that service. They are referring primarily to services provided to retail investors with smaller balances who are typically shunned by advisors that charge fees based on assets under management. Now that this fiduciary rule could potentially go into effect, there is an argument that the rule will make it more difficult and costly for Americans to get the high quality advice needed to reach retirement goals.
First of all, let me add that even before the DOL rule goes into effect, there is no guarantee that anyone would have access to a high quality financial advisor. Is it possible that it could be more expensive to get good advice? Perhaps, but I would argue that advice that is in the best interest of the client would be better advice than if it were NOT in the best interest of the client. If you can’t agree with that statement, you might as well just stop reading – we won’t ever see eye to eye on this issue.
There is also this myth that a fiduciary standard will limit client’s choices for financial advice. This is not a myth but a very real fact. But the fact of the matter is that the standard will limit client’s choices because they will be receiving it only from advisors who are acting in their best interest!! So while there may be fewer choices, the advice will be better – by eliminating the advisors who do not or cannot act in a client’s best interest.
Eddie McBride in an article in the Lubbock Avalanche Journal, argues that many financial advisors will no longer find it profitable to serve small plans or individuals with small account balances. This is short-sighted and assumes that the advice has to be delivered the same way it is currently being delivered. There are already technological disruptions in the industry that will allow ‘smaller’ clients to get cost effective and profitable advice, whether it’s a robo-advisor (whose fiduciary role is still debatable), or some other business model that has yet to be developed.
Some advisors say that the increase in costs are what will prevent them from servicing smaller accounts – If they are already acting in their client’s best interest, they will have to do very little to comply with the new rule. It is those advisors who have not been acting in their client’s best interest that will have to revamp their compliance and regulatory infrastructure – resulting in higher costs.
Part of the confusion among consumers is the myriad of titles and designations used to identify people that are considered to be qualified to give financial advice. Even more confusing is whether those individuals are providing advice under the fiduciary or suitability standard.
There are licenses required for individuals working in certain segments of the industry that allow them to give financial advice. Unfortunately, some of these licenses don’t make you more qualified to provide investment advice – they just allow you to SELL financial products. There is a big difference.
For example, a Financial Advisor could be someone that has passed the Series 7 license regulated by FINRA. The actual title of someone who holds the Series 7 license is a Registered Representative, and the FINRA website describes the license as follows:
“The Series 7 exam – the General Securities Representative Qualification Examination (GS) – assesses the competency of an entry-level registered representative to perform his or her job as a general securities representative. The exam measures the degree to which each candidate possesses the knowledge needed to perform the critical functions of a general securities representative, including sales of corporate securities, municipal securities, investment company securities, variable annuities, direct participation programs, options and government securities.”
The word ‘Advisor’, ‘Advice’, or any reference to experience is nowhere to be found. The main reason to obtain the Series 7 license is to SELL investment products, not advise on them. And you don’t need any experience to do so. – Says it right there. Registered Reps, unless bound by a more strict requirement based on professional certifications or company policy, are NOT beholden to the fiduciary standard and do not have to have a client’s best interest in mind when selling a product. They must adhere to the less stringent suitability standard. The standard that doesn’t require them to look out for a client’s best interest.
There are several professional designations that require those who have earned the designation to be held to a fiduciary standard regardless of whether they have less stringent company policies. Two very prominent designations are the Chartered Financial Analyst (CFA) designation and the Certified Financial Planner (CFP). Both require passing a rigorous set of exams based on a detailed body of knowledge and a certain number of years of experience. They each also have a well-defined code of ethics that among other things, requires holders of the designation to maintain clients’ interest above their own.
Other titles that ‘advisors’ may use include Broker, Investment Advisor, Investment Consultant, Financial Consultant, and Relationship Manager, to name a few. Nothing in the name alone provides any insight on whether the advisor must adhere to the fiduciary or suitability standard. So client beware and make sure you ask plenty of questions.
Interestingly, the National Association of Fixed Annuities is arguing that the DOL rule improperly categorizes insurance agents as fiduciaries. Well, insurance agents aren’t fiduciaries so it’s nice that NAFA is raising their hand to announce this. But this misses the point – that anyone providing financial advice to a consumer should be a fiduciary –more importantly is the potential misrepresentation of many insurance salespeople calling themselves Financial Advisors and potentially confusing consumers who might otherwise assume that because of this title, they must adhere to a particular standard.
Eddie McBride also argues that the new rule drives advisors towards a one-size-fits-all model. I don’t think anything can be further from the truth. The ‘Fiduciary Rule’, whether the DOL’s or SEC, requires advisors to act in their clients’ best interest. To do so, an advisor must learn about the client’s specific investment objectives, risk tolerances, tax situation, special circumstances, liquidity needs, etc, that are unique and specific to that client before providing any advice. I would argue that this requires not a one-size-fits-all approach but the exact opposite – advice that is absolutely and specifically tailored for each client.
The scenario that opponents of the rule cite most often as being detrimental to investors is when a commission based approach would be better than a fee-based approach because of the limited trading activity on an account. There are two issues with this argument. On the one hand, the rule doesn’t prohibit the advisor from charging a lower asset-based fee that is comparable to the average commission fees generated by the account in previous years. For example, if a $100K account generates $200 in annual fees for the broker, the broker can charge 20bps. That’s $200 per year. The difference is that the amount of work the advisor must do to earn that fee is greater – because they can no longer just rely on a point of sale transaction – they must actually advise on an ongoing basis.
A comparison of a commission based compensation structure versus a fee-based structure might result in the commission based approach having a lower cost to the investor for strategies where an investment is held for over 5 years. However, that approach may result in a stale and risky portfolio. In this day and age, it is becoming less and less likely that investors will hold investments for that long without making some kind of tactical allocation change or rebalancing. In fact, because the suitability standard requires that the suitability only need apply at the time of sale, an advisor doesn’t ever have to monitor that investment for the client or inform the client of any potential risks that could make selling the investment a good option. Therefore, the ‘breakeven’ analysis of a commission versus asset-based fee may be irrelevant under certain circumstances.
In cases where a commission-based model has a lower long-term fee, we must also consider that the asset-based fee includes continuous monitoring and advice on current and potential investments. For that ongoing service, it is appropriate for the fee to continue to be charged indefinitely until the service is no longer provided. The commission based fee on the other hand does not require any ongoing monitoring or follow up support. So, if the investment pans out and ends up being a profitable buy and hold investment, that’s great – but in the event the portfolio needs to be rebalanced or otherwise repositioned based on market conditions – the commission based fee model breaks down.
The DOL’s Timothy Hauser was quoted as saying that the biggest concern from advisors thus far is whether their incentive structures are going to change. The answer to advisors: Yes, the incentive will no longer be to maximize your profit at the expense of your client but rather, maximize your client’s benefits – eventually you will be able to maximize yours but not at the client’s expense.
If I were a consumer being approached by an advisor who prefers not to be my fiduciary – I would wonder whether that advisor will give me advice that is beneficial to me – or conversely – beneficial to him/her?
Anyone who says they can’t be a fiduciary to the small investor is someone investors probably shouldn’t trust.
I would suggest to any investor to ask their advisor which standard they must adhere to when giving me financial advice, whether it is a requirement based on credentials, company policy, or a regulatory, it really doesn’t matter. The important thing is to understand whose interest an advisor must consider when rendering advice – because if it’s not the client’s best interest, it is his/her own. My advice in those situations: find another advisor.