Are unscrupulous brokers and financial advisers scamming Grandma and Grandpa out of $17 billion each year through investment advice that is not objective? That’s what the Council of Economic Advisers (CEA) implies in a February report titled The Effects of Conflicted Investment Advice on Retirement Savings.
What does conflicted advice mean? It refers to the standards that brokers and financial advisers are held to when giving investment advice. Advisers are held to a lofty “fiduciary” standard, which is an obligation to hold your interests above their own in all their investment advice and recommendations. While brokers are held to the lower “suitability” standard — meaning that their advice must be suitable for your situation but not necessarily the best possible.
Fiduciaries must disclose conflicts of interest and methods of compensation, among other aspects of their position. Brokers do not have to disclose conflicts of interest and are free to steer you toward financial products that provide them higher compensation if they choose to do so — as long as the products are suitable for your needs. This issue is the central point of the CEA claims.
CEA reviewed academic studies in the field, focusing on the $7 trillion in individual retirement accounts (IRAs) that Americans hold, as well as the rollovers into those plans from 401(k)s and other defined contribution retirement plans. CEA came to the following conclusions:
- Conflicted Advice Lowers Returns – CEA estimates that conflicts of interest result in returns that are 1% lower annually than non-conflicted advice from a fiduciary.
- $1.7 Trillion in Affected Assets – Products that generally produce conflicts of interest because of their payment structure have accumulated $1.7 trillion in investment assets, according to CEA’s analysis. Applying the 1% assumption, this means that $17 billion in potential returns to retirees is being diverted — presumably into commissions and fees to brokers that only meet the suitability standard.
- Retirement Funds Run Out Sooner – CEA claims that conflicted advice drops the estimated value of a rolled-over IRA by 12% over a thirty-year drawdown, thus causing a retiree to run out of money five years earlier than with fiduciary advice. In essence, it has the same effect as losing $12,000 off the top for every $100,000 in rollover funds.
Based on the CEA study, the President is proposing regulations through the Department of Labor (DOL) that, among other potential changes, would require the fiduciary standard be applied to brokers and financial advisers engaged in anything other than general education programs about retirement plans and IRAs — in other words, those providing individual retirement investment advice.
The arguments for updating the fiduciary rule seem obvious in improved transparency and higher returns to clients. Who could argue with applying the fiduciary standard across the board? Understandably, brokers are not thrilled with the idea, and much of Wall Street agrees — but what are their arguments against the proposal?
- Questionable Assumptions – The Securities Industry and Financial Markets Association (SIMFA) issued their own report questioning the “simplistic” methodology of CEA, citing one example of including the entire market for annuities ($600 billion) in IRAs without giving their reasoning.
We also question the inherent assumption of equivalent returns. Non-conflicted advice does not always equal the advice that provides the best returns. Still, nobody doubts that at least some Americans are paying higher fees to brokers because of these conflicts.
- Coordination with the SEC – Rep. Ann Warren (R-Mo) calls the proposed action “a solution in search of a problem,” and is introducing House legislation to force DOL to wait until the Securities and Exchange Commission (SEC) acts on a similar rule that covers retail investment advice. SEC and DOL do have some degree of overlap, and failure to coordinate could lead to conflicting regulations.
- Restricting Access – Because of the added efforts fiduciaries must take, their services tend to cost more and also require minimum account balances ($100,000 is not uncommon). Below a certain account balance threshold, it is not economical for a fiduciary to handle a client’s business. SIFMA cites data from the UK showing that after similar legislation was enacted, brokers dropped 310,000 investors due to the unprofitability of their smaller accounts.
We think it is reasonable to update the fiduciary rules, but this needs to be done in a way that achieves the objective of addressing truly unscrupulous brokers without imposing rules so tight that access is restricted or cost-prohibitve. It is also worth considering whether consumers accept the risks and are being burned by them, or do not understand that the risks exist at all.
Meanwhile, you can protect yourself regardless of what the government does. Nobody is forcing you to use an adviser that follows the suitability standard. If you cannot assess risk yourself, seek an adviser who is verifiably held to a fiduciary standard.
Finally, remember that adviser competence is equally important. Fiduciaries can be wrong in their advice just as those meeting the suitability standard can, and a bad fiduciary can cost you just as much money or more than a good broker meeting the suitability standard.
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