An article in the New York Times discusses the recent Congressional debate over instituting a fiduciary standard in the brokerage/financial planning world. What is a fiduciary standard? Why should you care? People acting under the fiduciary standard must put the interest of the client, customer, or recipient first, above all others including their own. Usually, lawyers, trustees, and investment advisors who are subject to the Investment Advisors Act of 1940 are held to this standard.
Wall Street has been operating on two competing standards since the Great Depression when the government set out two laws dealing with financial advice. The first, previously mentioned Investment Advisors Act requires that investment advisors registered with the state or Securities and Exchange Commission (SEC) adhere to the fiduciary standard and put their client’s interests first. This is how my firm operates. The second, the Securities Exchange Act of 1934, dictates the behavior of brokers and requires adherence to the “suitability” clause. This means the product being offered to the client does not have to be in the client’s best interest; rather, it just has to be suitable to a client in their circumstance. As you can imagine, the suitability feature leads to inappropriate products for clients and bigger commissions for the brokers. This is how so many variable and equity indexed annuities end up in people’s accounts. These products offer tax deferral so they are suitable for anyone attempting to save for retirement. The differences in these acts also affect other aspects as well. For instance, brokers under the 1934 act do not have to disclose conflicts of interest or their compensation whereas registered investment advisors subject to the 1940 Act must do so.
The reason this is a big issue is most consumers have no idea that different standards exist or how their personal advisor operates. Chances are you are dealing with a broker subject to suitability requirements since the big brokerage houses like Merrill Lynch, Morgan Stanley, Wells Fargo, and Edward Jones operate in this manner. The SEC has only made the situation worse by providing an exemption to brokers in the Investment Advisor Act of 1940. The SEC gave exemptions to registering as an investment advisor to professionals in certain industries where advice is incidental to the professionals normal course of business.
Lawyers, certified public accountants, and financial journalists are exempt since they may give advice, but it is not intended as financial advice. A CPA may give tax advice about selling an investment; a lawyer may discuss purchasing an asset as part of an estate plan; and a journalist may discuss the benefits of a Roth IRA in a published article. I don’t have a problem with these folks getting exemptions, but the SEC extended this exemption to brokers. The SEC figured any advice given was incidental to the selling of financial products. However, customers do not see it this way. If a broker provides a retirement projection or recommends moving assets, the client feels as if this is the right move for them. They see it as advice. The SEC thinks the broker is merely selling a product; this advice is incidental, and the broker should not be held accountable for the advice.
To their credit, the brokerage world has stated they support a fiduciary standard whereas the insurance industry is steadfast against it. This does not surprise me, nor does it shock Mercer Bullard, an associate professor at the University of Mississippi School of Law and a member of the SEC’s Invement Advisor Committe. From the article linked above, Professor Bullard stated the insurance industry is, “apoplectic because if they sell a variable annuity and they are subject to fiduciary duty, that means they will probably have to fully disclose the compensation they are getting.” He then added, “would make clear the excessive incentives they have to mis-sell the variable annuity, which has been the cause of regulatory problems in that area.”
However, I am still suspect of the brokerage world as well. A fiduciary standard would impact their business in a big way. The brokers would face the same compensation issues as the insurance salesmen. Brokers sell a lot of variable annuities and other rotten products. They would also have to disclose conflicts of interest. This would mean telling clients that they are recommending Disney stock because their investment banking arm is raising capital for Disney. Or, it may mean disclosing how a certain mutual fund company provides an extra 1 or 2 percent commission for selling their funds. This won’t sit well with clients. These firms make a lot of money through these avenues. I don’t see them letting these revenue streams dry up.
What I suspect will happen is something that is already taking place at firms like AXA and Ameriprise. It is called “hat switching.” The broker wears the fiduciary hat when crafting and giving financial advice, but the broker switches to the suitability hat when implementing the plan. So the advice is in the client’s best interest, but the execution or products sold do not match the same standard. As an example, the broker may determine the client needs $500,000 of insurance while wearing the fiduciary cap. Then the broker switches hats and puts the client in a $500,000 whole life policy that pays a fat commission when a term insurance policy would have been better for the client. Later, if the client is upset with the insurance product (cannot afford it, not performing as explained, etc.), the client can’t make the case the advisor sold a product that wasn’t in their best interest. Only the amount recommended would be subject to that argument. The clients would have to show the product was not suitable, which would be difficult to show since the client needed $500,000 in insurance and got it.
If you are going to swim upstream to wealth, you need to ensure you are getting good advice. Here are the key questions to ask:
1. Do you act as a fiduciary in all our interactions? The last part “in all our interactions” is critical because the broker or advisor may act as a fiduciary when developing the plan and then switch hats. You don’t want that.
2. Are you a registered investment advisor (RIA)? RIAs are required to adhere to the fiduciary standard. Why would you entrust your finances to someone who has no legal obligation to do what is in your best interest? Saying that you “like” your current broker isn’t enough unless you like conflicted, expensive advice.
3. Will you disclose all of your compensation and any conflicts of interest to me? RIAs must do so. If the broker says no, why would you work with him or her? Would you work with a mechanic, doctor, or lawyer who did this? Why would you put your financial future in the hands of someone who won’t be straight up with you?
This is an issue that is flying under the radar, but it has huge implications to the financial future of millions of Americans, especially as the defined benefit pension plans disappear.