Let’s say you’ve finally decided it’s time to get serious about planning for retirement. You stop in at the local office of a bank or brokerage firm. Perhaps you call an investment or mutual fund company you saw advertising on tv. The person you’re talking to calls himself a “financial adviser” – but most likely, that’s just a fancy title for a salesman.
The adviser has a sales quote for certain investment products he needs to move this month. He’s free to recommend those products to you so long as they are “suitable” – but not necessarily the best choice for you – his recommendations could come with high fees and low performance.
Whose interest should come first – his or yours? That’s the question at the heart of a Washington debate over the unsexy-sounding term “fiduciary standard.” Simply put, it’s a legal responsibility requiring an advisor to put the best interest of a client ahead of all else.
The issue has been kicking around Washington ever since the financial crisis, and it took a dramatic turn on Monday when President Obama gave a very public embrace to an expanded set of fiduciary rules. In a speech at AARP – flanked by Wall Street reformer-in-chief Elizabeth Warren (D-Mass.) – the President endorsed rules proposed by the Department of Labor (DOL) that would require everyone giving retirement investment advice to adhere to a fiduciary standard. The rules are under review at the Office of Management and Budget, and are expected to be published within a few months.
Today, financial planning advice comes in two flavors. Registered investment advisors (RIAs) are required to meet a fiduciary standard; stockbrokers, broker-dealer representatives, and people who sell financial products for banks or insurance companies adhere to the weaker suitability standard. The difference between “best interest” and “suitability” can be huge – and most retirement investors don’t know the difference between these two types of “advice.” A fiduciary planner usually is compensated through fees, not commissions – they have no vested interest in recommending any particular financial product. But advisors who work on commission at big brokerage firms often have marching orders to sell proprietary in-house products, such as mutual funds or shares of initial public offerings that they manage. These products often come with much higher fees and other costs than could be obtained outside the firm. A product like that might be “suitable” for you without necessarily being the best solution available in the marketplace.
The difference can be huge for your retirement outcome. A report issued this month by the President’s Council of Economic Advisors (CEA) found that retirementsavers receiving conflicted advice earn about one percentage point less in returns, with an aggregate loss of $17 billion annually.
Financial industry lobbyists were quick to jump all over the CEA report, but they’re spitting into the wind. It’s just the latest contribution to a mountain of solid research showing that too many retirement savers are getting a raw deal on what they’ve managed to save due to conflicts of interest.
The industry makes the Orwellian argument that a fiduciary standard will create a gap in advisory services for middle class households – that is, insisting that real planning help be provided will make it impossible for the industry from offering any cost-effective assistance. But that argument ignores the innovations in technology and business practices that already are shaking up the industry with low-cost advice options.
“The argument is nonsense,” says Chris Jones, chief investment officer of Financial Engines, a large RIA firm that provides fiduciary financial advice to workers in 401(k) plans.. “It’s a fig leaf for outmoded business practices and models.”
Jones adds: “The world has changed significantly over the last 15 years. The availability of the Internet and other technology has made process of providing high-quality advice much less costly. It used to be that a highly expert person would need to sit down and manually create a plan. Now you can effectively serve investors with much more modest balances. We manage $100 billion for 850,000 individuals with median balances of $55,000.”
The idea that the financial services industry would walk away from an opportunity the size of the IRA rollovers is absurd. Nine of 10 new IRA accounts are rollovers, according to the Investment Company Institute (ICI). The CEA report estimates that $300 billion is rolled over annually, and the figures are accelerating along with baby boom generation retirements. What’s more, similar reform programs in other countries have led to positive results for the industry. My colleague David Armstrong wrote recently at WealthManagement.com about the Retail Distribution Review (RDR) implemented two years ago in the U.K., which banned commissions for advisors. Those reforms have hardly been a disaster for the industry:
The report from the Financial Conduct Authority found that the sales of funds that paid the highest commissions prior to RDR declined, and that “product prices have fallen by at least the amounts paid in commission pre-RDR.”
Advisors have also increased their fees for some consumers, the report found. So consumers are, post RDR, better able to compare the “true cost” of advice, since compensation is no longer hidden in fund management charges.
That has actually benefited advisors. According to a survey conducted by Investec Wealth & Investment, the change has forced advisors to improve their business models and find more ways to “add value.” The firm found 61 percent of advisors said their business has grown in the past two years; 13 percent said it has grown “significantly.”
In the U.S., problems exist in the 401(k) market – especially small plans. But the huge IRA rollover market also is rife with abuse – often starting with the advice to roll over in the first place. Participants in well-constructed, low-fee 401(k)s most often would do better leaving their money where it is at retirement; IRA expenses run 25 to 30 basis points higher than 401(k)s, according to the U.S. Government Accountability Office. Yet the big mutual fund companies blitz savers with cash come-ons to rollover, and, as I wrote recently, very few of their “advisers” ask customers the basic questions that would determine whether a rollover is in order.
All in, Obama’s decision to embrace and elevate fiduciary reform into a major policy move is huge. As I explain in my Reuters column today, the only bigger move he could make to restore the retirement security of middle class households would be an expansion of Social Security benefits advocated by progressives. But he hasn’t expressed enthusiasm for the idea and the GOP-dominated Congress would shoot it down, anyway.