April Newsletter: New Rules for Financial Advisors in your Favor (with a slight Catch)

Posted by Alex Frey (@alexhfrey )

Imagine you have a choice of two S&P 500 Index Funds. Both funds entirely mimick the S&P 500 Index by holding a capitalization-weighted aggregate of all stocks in the benchmark. Before fees, their performance will be exactly the same. The only difference: one fund charges a management fee of .5% of assets under management, while the other charges a performance fee of .04% of assets under management.
Given such a choice, all rational individual investors would choose the lower-cost fund. 

But what you may not realize is that if you take your money to a trained financial advisor, you might be surprised which one you end up in.
That's because although many think they are paying financial advisors in order to pick the funds that will result in the best performance for them, that is really only true of a specific kind of financial advisor. Other “financial advisors” actually have no legal or ethical responsibility to pick the best fund for you, and can instead choose a worse-performing fund based on the commission (“kickback”) it pays them.
This issue is at the heart of a major story in the finance news this month.

This month, the U.S. Department of Labor (DOL) announced some new rules that will apply to anyone selling investments for Individual Retirement Accounts (IRAs), 401(k) accounts, and 403(b) accounts. The new rules require that anyone selling investments for these accounts must act as a fiduciary. A fiduciary is required to put the interests of the client ahead of his or her own interests. The new rules will go into effect next year. 

We’ll come back to the fiduciary concept shortly, but first let’s review the status of the various people who may act as investment advisors. The Investment Advisors Act of 1940 requires that investment advisors, who are in the business of recommending specific investments, register with the Securities and Exchange Commission (SEC). As Registered Investment Advisors (RIAs) they have always (since 1940) been required to act as fiduciaries. However, the 1940 act created exceptions for brokers and dealers. So, stock brokers and insurance agents were not required to register. In the past, they have been covered by the weaker suitability standard. This standard requires that brokers and agents show that an investment is suitable for the client (taking into account their risk tolerance and stated preferences), but it allows them to sell products which may provide higher revenues to the seller (i.e., higher commissions). 

The confusion is that it can be very difficult for an average person not steeped in industry jargon to tell who is an RIA operating under a fiduciary duty, and who is a broker who is essentially a salesmen, when both can operate under the same generic “financial advisor” label. The terms financial advisor or financial planner are generic terms which can mean several different things. 

Some financial advisors or planners are in the business of providing general advice about life situations (how much insurance does the client need, how much money should they be saving for retirement, should they have a special estate plan, etc.). Those advisors do not need to register with the SEC. 

Others are in the business of selling mutual funds either sponsored by their own company, or by a third-party. These “brokers” earn money on a commission-basis, but they still may refer to themselves as advisors or financial consultants. They often operate on a commission basis. Obviously, this creates the potential for conflicts of interest. The broker may be tempted to sell a high commission product when a lower commission product (or a no commission product) would be better for the client. Some insurance products, such as annuities, have been often sold under this weaker suitability standard. Under the suitability standard, brokers may also be tempted to do a lot of unnecessary buying and selling to generate more commissions.

Finally, RIAs provide advice on specific investments, and they are required to register and function as fiduciaries. To avoid conflicts of interest that would conflict with their fiduciary status, they usually operate by taking a fee that is based on the amount of funds under management or by charging a fixed fee. Thus, the advisor’s interests are aligned with the clients in that it is in the interest of both parties to pick investments that have the best growth prospects taking into account the client’s risk tolerance. 

The new DOL rules apply only to retirement accounts (the DOL has no authority to regulate other types of investments). When the new rules are in effect, brokers and insurance agents will have to follow a fiduciary standard when dealing with retirement accounts. This should force them to provide better and lower cost investments to their clients. It may also eliminate the commission as a way of paying brokers and dealers.

So has the DOL solved the problem? Not entirely. The new rules do not apply to other investments outside of a retirement account. Holding all “financial advisors” to a universal fiduciary standard has long been discussed, but heavy industry lobbying has so far been successful at tabling any prospective legislation. So you should be aware of possible abuses in other types of accounts and remember that the new rules won’t take effect for another year. 

If you ever enter the market for financial advice, we recommend looking for an advisor with the right certification and fee structure.

Registering with the SEC and following a fiduciary standard does not guarantee that an advisor has good qualifications. In fact, almost anyone can claim to be a financial advisor or financial planner. However, there is an organization called the Certified Financial Planners Board that has established criteria for a person to become a Certified Financial Planner . These criteria involve specific courses that must be taken and tests that must be passed. The CFP Board also requires that all Certified Financial Planners act as fiduciaries. If you choose to have a financial advisor (or planner), the CFP designation provides some assurance that you are dealing with a competent and ethical person. The new DOL rules really shouldn’t change anything if you are dealing with a CFP. 

We might note that the insurance industry also has designations that are somewhat similar to the CFP. Insurance agents can earn the Chartered Life Underwriter (CLU) designation or the Chartered Financial Consultant (ChFC) designation. Each designation requires certain course work and requires the recipients to work to high ethical standards, but it isn’t clear that these ethical standards are the equivalent of a fiduciary standard. At the end of the day, money speaks volumes, and insurance agents typically are paid on a commission basis. 

Fiduciaries are not required to impoverish themselves in order to follow a fiduciary standard. The SEC and the DOL are aware that advisors need to make a living and need to be paid. In fact, it is possible for an advisor to work on a commission basis and still claim to be operating as a fiduciary. To do so, he or she must make the claim that the product with a commission is really the best product for the client. However, most registered advisors work by charging a fee based on the assets under management, and a few work by charging a fixed fee (perhaps based on hours spent preparing a plan). In principle, this avoids conflicts of interest. If you are choosing an advisor, you need to understand exactly how much they are charging you directly and what other remuneration they may be getting (such as 12b -1 fees from mutual funds). We prefer fixed fee advisors, but not many work in this way. Fees that are charged as a percentage of assets under management many look small on an annual basis, but they can become significant over a period of years. A 1% annual fee can reduce the end value of a 30 year investment by well more than 30%, because it takes away money that otherwise would have compounded. You should also be aware that some advisors may be “dual hatted”. They may function as fiduciaries when preparing a financial plan, but may act as brokers or insurance agents when helping the client carry out the plan. Thus, they may not always be wearing their fiduciary hat. The new DOL rules should eliminate this possibility, at least for retirement accounts. 

We think that the new DOL rules are a good thing that will give people more confidence in their financial advisors. We also think that there are many good reasons why someone might want to have a financial advisor to deal with life issues. However, as an IvyVest subscriber, you know that we don’t think advisors can earn their keep just by picking investments. By choosing a diversified portfolio of low cost ETFs, you avoid commissions and keep management fees very low. We think this gives you the best chance of good returns with the least possible risk.

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By Alex Frey