investment advisers as fiduciaries: a new Labor Department proposal

The Labor Department proposed new rules today that would require that brokers or financial planners or other professionals giving advice to individuals on their retirement savings act as fiduciaries.

what a fiduciary is

Being a fiduciary means being legally bound to give advice that’s best for the client, without regard for any benefits the adviser might get for recommending one investment over another.

Strangely, in my view, the fiduciary standard is not the rule advisers work under now.  Rather, advisers are only required to recommend products that are “suitable” for customers, meaning they fit the client’s goals, financial circumstances and risk tolerances.

The difference?

Another way of saying the same thing, the fiduciary is required to do what’s best for the client; under the old standard the adviser has simply got to avoid products that damage the customer.

For example:

A broker/planner has two general equity fund offerings:

–Fund A has a long history of strong investment management, consistently beating the S&P 500, and charges low fees

–Fund B has weak managers and an equally long record of sub-par investment performance, consistently losing to the S&P.  It also charges fees that are double the size of Fund A’s.  However, Fund B offers higher commissions to brokers who sell its product, plus trips to weekend informational seminars at resort locations to those who sell the most of it.

Under current rules, a broker/planner is permitted to recommend B over A, even though B is only better for the broker, and will presumably be considerably worse for the client.

costs are the smoking gun

Other than in hindsight, it may be hard to say whether manager X is better than manager Y.  And managers who consistently underperform are eventually culled, even in retail brokerage houses, where the emphasis is typically on strengthening the sales force, not the portfolio management team.

But I think it would be hard for a fiduciary to defend recommending one so-so product over another that costs half as much, and for selling which the fiduciary gets gifts, trips or a corner office and a secretary.

traditional brokers will be hurt the worst by these rules

That’s because they charge the most–partly to compensate highly-paid salesmen, partly to fund an expensive network of retail sales offices.

The traditional retail brokerage business has been dying a slow death since the advent of discount brokerage services in the 1970s.  Imposing a requirement that brokers do the best for their clients is another nail in the coffin.

for now, the rules only affect retirement savings accounts,

…not general savings/investments.  I presume this limitation is the result of fierce lobbying by financial advice providers opposed to the fiduciary standard.  But we may just be seeing the thin edge of the wedge.

should brokers be fiduciaries?

…my answer is Yes.

In his recent spate of initiatives, President Obama is proposing that retail brokers be legally declared to be fiduciaries, the way investment advisers already are.   I’ve written about this before, when the SEC carried out a study of the topic, ordered in the Dodd Frank Act, which it published in early 2011.  Nothing happened back then.  Probably the same result this time.

The issue?

As I see it the change would mean that, for example:

–unlike today, your broker would have to point out, when he gives you a computer-generated analysis of your financial needs and a resulting asset allocation, that the names suggested consist solely of funds that pay fees to be on the list–and that potentially better-performing, lower cost funds that don’t pay have been excluded.

–that his (about 90% of traditional brokers are men) favorite fund families, whose offerings he always touts to you, also treat big producers like him (and a companion, usually) to periodic educational seminars at a sunny resorts in return.

More than that, depending on how any new regulations are written, he might also have to tell you that the trade his firm is charging $300 for could be executed just as well at a discount broker for less than $10.

brokers say No!

Brokerage houses are strongly opposed to Mr. Obama.  They’ve apparently already raised enough of a lobbying fuss in a very short time to cause the President to weaken his proposal.

How so?  From a business perspective, wouldn’t it make sense for traditional brokers to hold themselves to a higher standard of conduct?   They might thereby improve their very low standing  in the public mind and possibly stem the continual loss of market share they’re suffered over the past decades.

Two practical problems:

loss of skills

–over the past twenty years, brokers have homogenized their sales forces, moving them away from having their own thoughts and opinions about stock and bond markets to being marketers of pre-packaged products and ideas developed at central headquarters.

The ascendancy of pure marketing over investment savvy may have had sound reasoning behind it (although I regard it as one more triumph for the former in the battle of jocks (traders) vs. nerds (researchers) that I’ve witnessed through my Wall Street career).  However, most of the experienced researchers who had the skills to shape an investment policy and retrain the sales force have been fired either before or during the recent recession.

It’s easier in the short run to lobby against change than to revamp operations–or rehire the newly laid-off nerds needed to accomplish the task.

red ink = loss of bonuses

–in almost any phase of economic (or any other kind of) life, the status quo is extremely powerful.

Traditional retail brokerage is extremely high cost.  Remember, the retail broker himself nets only about half the fees he generates.  The rest goes to support very elaborate–and now seriously outmoded–bricks-and-mortar infrastructure and central overhead.  Lowering fees to get closer to discount broker levels, spending to raise the quality of proprietary products sold or consolidating real estate would all diminish–or even temporarily erase–operating income.  In a culture that values short-term trading profits over all else, it’s hard to develop support for a move like this.