Thursday, April 27, 2017

Fiduciary Rule And Alternatives

I'm from the government and I'm here to help you.
Pardon me but this isn't my first rodeo.
Who's Making the Money?
Where's Bogle when we need him?
A different conflict of interest.

The Department of Labor’s fiduciary rule demands that advisors who work with retirement accounts act in the best interests of their clients, and put their clients' interests above their own.  Working with a fiduciary makes sense for many retirement planning activities. However, fiduciary is a higher level of accountability than “suitability,” the standard required of financial salespersons, such as brokers, planners and insurance agents. For most activities related to ongoing management of a retirement account a salesperson is totally appropriate, and in the case of the no-load mutual fund, even a salesman is unnecessary.

Every investor has a right to an opinion about the fiduciary rule, and most investors probably have an opinion. No doubt, that opinion is influenced by the degree to which one wants to take responsibility for making one’s own investment decisions and doing one’s own research. However, some people do not realize that taking responsibility for making one's own decisions and doing one's own research are probably the most important fiduciary rules.

A disclosure is in order. My initial reaction to the fiduciary rule was to wonder whether it was a hoax or a joke. The idea that the government could pass a law that would force others to understand my best interest seemed ludicrous. It also seems apparent that paying someone else to try to understand something that is self-evident to me, my self-interest, was going to get expensive. As Bogle has pointed out on numerous occasions, investment costs are the enemy of successful investing. So, I was skeptical from the start.

On 4/19/2017, the WALL STREET JOURNAL had an article entitled “Wall Street’s Fee Bonanza.” It pointed out that even though the fiduciary rule may not be implemented; firms were already shifting to a fee-based service. The explanation is simple: the firms have found that fees for advice and services could be more lucrative over the longer term compared with commissions.Researcher Morningstar Inc. says fee-based accounts can yield as much as 50% more revenue than commission accounts.”

The fiduciary rule would affect about $3 trillion that brokerage firms oversee in tax-advantaged retirement accounts. Generally, the fee under a fee-based management system is 1% or more. So, the rule would introduce $30 billion of costs into the system. That $30 billion is not all new costs since brokers were previously earning commissions that may be reduced as a result of the fiduciary rule. However, commissions at brokerage firms have been falling without the fiduciary rule, and mutual fund management fees have been shrinking. Introducing this new fee is counter to the trend in the industry.

Theoretically, the fiduciary rule would force the brokers who oversee those accounts to act in the best interest of the clients. Advocates of the fiduciary rule argue that it would address a cost of $17 billion a year in extra expenses that result from conflict of interest. They base that estimate upon the existence of a lower cost “equivalent” investment product. Critics of the rule dispute that estimate, but even if the estimate is right, $17 billion is only about .6% of the $3 trillion in brokers’ tax-advantaged retirement accounts.

It's also worth noting that the $17 billion estimate is not based on the $3 trillion in brokerage accounts. It's based on $6.8 trillion in defined contributions market. Using the $6.8 trillion figure and a 1% wrap fee, the cost could be $68 billion. Finally, even if the $17 billion estimate is correct, there's reason for skepticism about how much of that conflict of interest cost could be eliminated by the fiduciary rule.

As is pointed out in an April 8, 2017 article by Jason Zweig in The Intelligent Investor section of the WALL STREET JOURNAL, conflicts of interest is not so easy to identify, and they are much harder to eliminate than simply passing a rule. The article was entitled “Conflicted And Not So Free Of Friction” and concluded with the statement “the label ‘conflict free’ can lull investors into dangerous complacency.”

He points out that anyone who provides a service including financial advisors has a conflict of interest. “And you should be wary of financial advisers who aggressively market themselves with the label ‘conflict free.’ No matter how sincerely they may believe it, that description is impossible.”

He then goes on to point out some of the “conflict free” claims made by some firms. He gives an example where the claim is made based upon not having proprietary products: “Because the firm has no proprietary products to sell, … advisers can provide truly objective, conflict-free advice and investment recommendations.” However, that language refers to the relationship between the adviser and the company. Yet, people who work for the company may receive special payments for bringing clients with them from their former firms and may earn more when clients invest in one product or service than in another.

The article quotes Brian Hamburger, president of MarketCounsel, a firm that helps advisers comply with investment regulations. He comments: “Conflict free is good marketing. But it is a bad description of financial advice, because it can lull investors into dangerous complacency.” He then gives some examples:

“Some financial advisers charge higher fees to manage stock than bond portfolios: That’s a conflict. Advisers can earn more if you take a rollover from a 401(k) retirement account than if you leave the money where it is: That’s a conflict.”

“Many advisers charge fees on money-market mutual funds but not on a certificate of deposit you hold at a bank. Not surprisingly, they often favor money funds over CDs even though CDs can offer higher yields, and that’s a conflict.”
A conflict of interest can arise from something as simple as which product requires the least paperwork. In the case of the heavily regulated industry like investment advisories, it can arise from the amount of paperwork required to comply with regulations. With the fiduciary rule, the risk of lawsuit undoubtedly would create conflicts of interest between what best serves the client and what minimizes the risk of lawsuit.
The fiduciary rule is not going to relieve investors of the necessity of doing their own due diligence. The investor still needs to know exactly how the adviser is compensated if conflict of interest is a major concern. However, conflict of interest should not be a major concern. The major concern is whether the investment is consistent with the investor’s objectives and competitively priced. An adviser may be selling a product that satisfies the investor's objectives even though the adviser is consciously pursuing his own self-interest.
It just seems inappropriate to potentially introduce $30 billion or maybe $67 billion in cost in order to eliminate what might be as little as a few billion in conflict of interest costs that can be eliminated. So, there has to be some other justification for introducing that cost.
Higher fees may well be justified if they are associated with the higher-level service. Under this fiduciary rule, people managing retirement accounts will have to spend more time trying to understand the client’s full financial situation. It would be unfair to fee-based advisers not to acknowledge that they put considerable effort into understanding the investor’s risk tolerance and personal circumstances. Some advisers are probably very good at it, but others will undoubtedly just be filling out forms in order to check the boxes they need to check in order to protect themselves under the fiduciary rules. However, not all investors need expanded services. So, why make every investor pay for them?
Further, my reaction is colored by the fact that I seriously considered and looked into what is required to get the designation Certified Financial Planner, and I also studied the requirements for a Series 65 license. My conclusion from those experiences was that, rather than improve one's ability to give good financial advice, the regulations introduced a different conflict of interest. That different conflict of interest doesn't preclude giving good financial advice, but it is a conflict of interest between giving advice consistent with regulations versus giving the best advice possible.
Lest all those with a CFP or Series 65 license grabbed their pitchforks and ready the tar and feathers, I want to make it clear that I believe that a fee-based advisory service for financial planning makes sense. So much so, that I invested the time and effort to study the CFP and Series 65 requirements in order to learn more about how to do it. However, using a fee-based advisory service to set up a financial plan is different from ongoing investment advisory services. Many fee-based advisers with the CFP or one of the other designations won't even recommend specific financial products; rather, they'll identify what's needed in generic terms. It's then up to the individual to decide whether those products are appropriate and which products to purchase.
Financial planners provide a tremendous service by showing their customers/clients how to go about setting up a financial plan and helping their clients do it. However, that's quite different from the fiduciary rule that's currently being considered. The fiduciary rule creates the mistaken impression that the financial adviser, because he or she is a fiduciary, can develop as well as implement a financial plan for you. Further, it ignores the issue of whether complying with the fiduciary rule increases the cost of investment management to the point where the fiduciary rule itself conflicts with acting in the best interest of the client by increasing the cost.
Many advisers with the CFP or similar designation pursued the designation out of a desire to provide conflict-free financial advice. That, however, is quite different from a large corporation switching all of its brokers from a commission-based compensation scheme to fiduciaries so that they can have access to large amounts of money for the company to manage. In essence, the fiduciary rule may have shifted the fiduciary designation from a benefit of working with a fiduciary to a marketing program for large brokers.
Some investors undoubtedly need to be protected from their own financial advisor. Others find it far less expensive to just dispense with the financial adviser totally. It would seem to make sense to let the investor select the type of financial adviser that best suits him or her. However, there is the potential for the fiduciary rule to be justified because of an adverse selection process. Those who need the protection of the fiduciary as a financial adviser may also be those who have to have it forced down her throat.
For example, common sense would dictate that one would save and invest for retirement. Yet, one of the greatest benefits of pensions is that they force savings and investment upon individuals who otherwise might not save and invest. Similarly, default 401(k) enrollment and even mandatory 401(k) offerings by employers have many advocates among those who have looked at the issue. So, absent the fiduciary rule, the negative impact might be concentrated among the least financially savvy participants in retirement programs and those least able to avoid the appeal of the sales pitch. However, it would have no impact on those who are so financially unsophisticated that they don't even participate in retirement programs.
However, that raises yet another question and potential objection to the fiduciary rule. If the fiduciary rule benefits primarily the less financially sophisticated, there is an increased potential that acting in the client's best interest would involve forcing them to purchase a product they don't understand. That raises the question whether a fiduciary should sell someone a product that they know the purchaser doesn't understand.
Again, pensions provide an example. Many pension participants understand only that the pension involves a promise to pay. They have no concept of the importance of the ability to pay or the role of the pension fund, and often they haven't the foggiest idea where the pension is investing.
It would seem that the fiduciary rule has the potential to harm a significant number of investors by increasing the cost of investing in a retirement account. Those most likely to be negatively impacted may be sufficiently financially sophisticated to figure out a way to avoid the costs. However, it would seem more reasonable to use the fiduciary rule as a default status while allowing an option to opt out.
Despite the inappropriateness of the fiduciary rule as currently being considered, there is ample room for improving how retirement accounts are run. It is a common complaint that fees associated with 401(k) and other defined-contribution accounts are too high and opaque. However, the high cost and opaqueness are as much a product of the structure of the programs as a conflict of interest. Further, what is true of 401(k) programs isn't true of all retirement accounts.  There's no evidence that self-directed IRAs require a fiduciary broker. A fiduciary is appropriate for some investors and not for others.

Placing the emphasis on providing participants with accurate information on 401(k) programs, especially all costs, may be far more productive than the fiduciary rule. 

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