“…back-door payments or hidden fees for steering people into bad retirement investments that have high fees and low returns…”
On February 23, 2015, President Barack Obama threw his support behind a forthcoming (as of the writing of this article, it had not been released) Department of Labor fiduciary standard. According to a White House fact sheet, conflicted advice costs the average investor 1% every year.
The President’s Council of Economic Advisors further clarified what consisted of conflicted advice. It cited four areas:
- Revenue sharing agreements, or 12b-1 fees. Basically, it’s a kickback to the advisor that puts his client in a certain fund.
- Loads. These are commissions paid straight to the advisor who puts a client into these funds. Read more: “Please Stop Paying Commissions for Loaded Funds”
- Sales targets and payouts. This is when an advisor gets a bonus for putting clients into certain investments, most likely proprietary products (think hedge funds, closed ended REITs, etc).
- Variable commissions. The commission may be higher based on different products. Think indexed universal life insurance policies.
According to the Investment Advisers Act of 1940, Section 211(g)(1),
…The Commission may promulgate rules to provide that the standard of conduct for all brokers, dealers, and investment advisers, when providing personalized investment advice about securities to retail customers (and such other customers as the Commission may by rule provide), shall be to act in the best interest of the customer without regard to the financial or other interest of the broker, dealer, or investment adviser providing the advice. In accordance with such rules, any material conflicts of interest shall be disclosed and may be consented to by the customer…
Pretty simple. Receive personalized investment advice, and you should be getting it from someone who lives by a fiduciary standard – meaning that they put your best interests ahead of their own.
However, for years, a lot of salespeople traipsing around calling themselves advisors in all but act have been pushing loaded, high commission products (think of the retail strip mall “investment advisor” and you know who I’m talking about…a client of mine has a friend who is a sales rep for one of these companies, a man whom my client has nicknamed “Churn”) using the word “incidental” to cover their tracks. Why? Because the investment advice they gave was incidental to the sales process, giving them an exemption from having to abide by a fiduciary duty.
So, let’s step back for a second and define fiduciary duty.
Simply put, fiduciary duty means that the person who is giving you advice and telling you what to do with your money has to put your best interests ahead of his own – he can’t line his pockets unnecessarily at your expense.
OK, you say. So what?
In all honesty, if you’re reading this website, you’re probably savvy enough not to fall for the most egregious of the offenses – the high commission products and the high sales load products. Therefore, whatever comes out of the Department of Labor probably won’t affect you one way or the other.
However, if you believe the White House’s numbers (which I have no reason not to believe), conflicted advice costs the average investor $17 billion per year. That’s effectively a $17 billion wealth transfer from investors to conflicted advisors.
If you’re a libertarian or don’t like government intervention, you’d probably say that the market should sort this out.
But, the problem is that it hasn’t.
There are a couple of reasons why.
First, most of these advisors probably do think that they’re doing the right thing by their clients. They get a couple of weeks of sales training, get lots of rah-rah speeches about how they’re helping Americans who need them most, and they’re sent out into the streets to knock on doors. They find people who were doing nothing about their finances, put them into some products which were marginally better than doing nothing (yes, investing in a front-loaded actively managed mutual fund is, over time, better than doing nothing, but only just), and then get paid handsomely for their efforts.
At this point, selection bias takes over. They don’t conduct exit interviews with the people who see the light and realize that there are a nearly infinite universe of better investment choices out there, but, rather, listen to the few customers who say how much the advisor has helped them. Therefore, they hear the good things, and keep on plowing away selling the same old products thinking that they’re helping the widows and orphans of the world to have more financial security.
In a very narrow interpretation, they are right. However, if they’d take off the blinders and consider the rest of the options out there, they’d have trouble justifying their position. Thank goodness for willful blindness! I imagine if you asked most of these advisors to sign a fiduciary oath, they’d gladly do it because they really think, in their heart of hearts, that they are doing the right thing by their clients.
However, the perverse psychology of what they are doing is the second reason why the market forces have not reduced conflicts of interest.
As we saw in “Why a Conflicted Adviser Doesn’t Help You by Disclosing His Conflicts of Interest” and “The Psychology of Fiduciary Duty”, advisers who have and disclose those conflicts actually build a closer psychological bond with prospective (and existing) clients than those advisers who don’t have the conflicts in the first place.
Yes, simply put, by saying I have no conflicts, I am less likely to garner your trust than the strip mall “investment advisor” who lays out the laundry list of conflicts like a sinner sitting in the confessional. Furthermore, once the conflicted advisor has disclosed those conflicts, he feels more moral latitude to line his own pockets in a psychological moral actions balancing act. According to his limbic system, he’s already done good by disclosing the conflicts, so now he can be a little naughty and act in a way that might not be in your best interest because, hey, you’re going in with eyes wide open. From the investor’s point of view, the trust is built because the advisor disclosed the conflicts, so, according to the investor’s limbic system, the advisor who has conflicts would never think to line his own pockets because he’s already disclosed the conflicts.
So, we have the psychology of the conflicted advisor and the psychology of the investor working against making sure that we do the right thing.
That’s why public policy matters in this case. Even when we know that we’re getting a raw deal, we can’t help but fall prey to our own limbic systems and take the raw deal anyway.
We take the raw deal to the tune of $17 billion a year.
Therefore, the only way to avoid this situation is to ensure that no conflicts exist in the first place.
I’m usually a fan of market-based solutions. This time, I’m not.
Does that mean that brokerages can’t charge commissions? Not at all. If you choose to buy a stock or a mutual fund, there are costs associated, and the people executing on your wishes should make a reasonable profit on that action.
Does that mean that planners and advisors can’t charge for their services? Not at all. They are providing a valuable service and should get compensated for that value.
However, when you’re putting your trust (psychologically gained in your limbic system, remember?) in someone’s hands regarding your financial well-being and your future, then that person should have your interests first and be legally obligated to do so. There’s a difference between getting compensated for your work and convincing someone to buy a financial product because it’s going to pay you better than anything else will.
I personally hope this effort puts a lot of strip mall “investment advisors” in a real pickle, because there’s not much argument that high load funds are better than no load funds. That’ll be an interesting one to see argued in court.
In the interim, until this law gets passed…which may not happen, mind you, as we haven’t even seen the proposal…make sure that whomever you take investment and financial advice from is legally obligated to put your best interests first.
Want to read more? Check out the Department of Labor’s page about fiduciary advice.
What do you think? Needed? Meh? Or government intervention where it’s not necessary? Let’s talk about it in the comments below!