Politicians. Used car salesman. Mechanics. There are but a few professions less trusted than financial advisors. The lack of consumer trust is arguably well-deserved as there is nothing trustworthy about opaque conflicts of interest, hidden fees, or bad advice that lines the advice giver’s pockets. There is nothing trustworthy about consumers being sold expensive annuities that they do not need. For an industry that advertises trustworthiness, financial advisors do so much to destroy it.
Most consumers think that financial advisors are financial advisors just like doctors are doctors. Yet the reality is that financial advisors operate under two very different sets of legal guidelines – a fiduciary standard and a suitability standard. Politicians and lobbyists are debating right now over the issue of these differing standards, with everyone from the SEC chairwoman to the President speaking out on the matter. Unfortunately, most consumers do not understand that two distinct guidelines exist for financial advisors. This lack of consumer understanding – not the two distinct guidelines – is actually the problem.
What are the Two Standards?
Some financial advisors operate under the “fiduciary standard” which mandates that they work in the best interest of their investors. Alternatively, other financial advisors, insurance agents, and stock brokers are bound by the weaker suitability standard which merely requires that they recommend suitable products. The Director of Investor Protection for the Consumer Federation of America, Barbara Roper, describes well the suitability standard:
“Brokers just have to recommend products that are suitable. But they can recommend the worst of the suitable products, the one with the highest costs or the poorest performance if it happens to be the one that offers them the highest financial compensation.”
There is a Grand Canyon-sized gap between suitable advice and best interest advice. An insurance broker can sell the most expensive insurance product with the fattest commissions, provided it is suitable. A financial advisor can promote high priced mutual funds that are not in his client’s best interest from a fund family that sends his family on vacation to Hawaii every year. A stock broker can steer clients into the mutual fund share class with the biggest load, even if cheaper share classes of the same fund exist. A fiduciary can receive commissions and promote high priced funds but the difference is that he is bound to disclose the commissions he earns and explain why he chose a particular investment over another.
Why Does this Matter?
A February 2015 Council of Economic Advisors (CEA)[i] study estimates that the annual cost to IRA accountholders of conflicted investment advice is $17 billion dollars. Add brokerage, 401(k), and other account types and the aggregate cost of conflicted advice is tens of billions of dollars each year. The same study suggests that if two retirees take withdrawals over retirement – one with conflicted advice and the other without – that the retiree with conflicted advice would run out of money five years earlier.
Abundant academic literature illustrates the extreme costs of individuals receiving conflicted advice. A recent study finds that funds sold by conflicted intermediaries may cost consumers between 1.12% – 1.32% per year in lower returns[ii]. Another 2012 study[iii] explains:
Portfolios of broker clients are significantly riskier, and underperform by as much as 2 percent per year on a risk-adjusted basis…Although we cannot conclude that those investing through a broker would have been better off investing on their own, our findings suggest that brokers are a costly and imperfect substitute for financial literacy.
What is the Proposed Solution?
Securities and Exchange Commission Chairwoman, Mary Jo White, supports a uniform standard of fiduciary responsibility for all financial advisors. Such a “uniform standard” would require stockbrokers, insurance agents, and financial advisors to put their clients’ interests ahead of their own. Under such a uniform standard, consumers would not be confused by multiple standards or have to understand if their advisor was guided by one or the other.
The Dodd-Frank Act gives the SEC authority to create a uniform standard Wall Street and insurance industry lobbyists have for years opposed any efforts to adopt a fiduciary rule. They argue that imposing a fiduciary standard on all financial advisors would raise costs and ultimately deprive middle-class consumers from needed financial advice.
What Can You Do to Protect Yourself?
The deep pockets of insurance industry and Wall Street lobbyist groups make it easy to envision a continuation of consumer confusion and the two standard status quo. It pays not to wait for regulation and instead be your own regulator. You should know the answer to all of the following questions when it comes to the person or firm in charge of your financial well-being. If you are uncertain of all the answers, then ask the questions of your financial advisor.
- How are you paid?
- Am I the only one who pays you?
- Do you receive any non-financial compensation from other parties such as free vacations?
- Is your bonus or salary tied to the products you sell or investments you recommend?
- Does your business have ownership in other businesses (insurance companies, mortgage providers) that might conflict your advice?
- Do you disclose conflicts of interest?
- Do you adhere to the fiduciary standard? If not, why?
- Will you sign the Fiduciary Oath? If not, why?
It is also valuable to ask the advisor to give some examples of conflicts that he or she regularly faces and how they are handled. If the advisor explains that their fee structure eliminates conflicts of interest, then it may be time to walk away. Every fee structure creates conflicts. An advisor who doesn’t admit those conflicts is either not forthright or simply failing to question their own motives.
Finally, don’t rely on the advisor’s “fee-only” label for comfort. In CNBC’s recent 2015 list of the Top Fee-Only Wealth Management Firms, 9 of the top 10 advisors were not truly fee-only advisors. The fee-only label often ignores the fact that advisors may receive indirect commissions or compensation from affiliate businesses. Ask the questions.
The point to all of this is not necessarily to say that a fiduciary standard is the perfect model for everyone. The important concept is that consumers need to simply understand the conflicts of interest that can cloud the advice received. If your advisor is receiving compensation from recommended investments, insurance, or annuities, you need to determine if that might lead to misleading advice. If your advisor is not disclosing conflicts of interest, you should be concerned with what else he or she is not disclosing. If your advisor refuses to sign the Fiduciary Oath to put your interests ahead of his or her own, you should understand why.
Evidence overwhelmingly indicates that conflicted advice has a huge cost to consumers. You should not sacrifice a successful retirement merely because your advisor was not loyal to your best interests and you did not ask the hard questions to recognize the problem.