The Obama Administration proposed this summer to impose a fiduciary duty on financial advisors that provide retirement advice. This duty includes the duties of due care, loyalty, and utmost good faith when advising a client. This proposal puts investors’ retirement interests first rather than the profit interest of the advisor selling a financial product that may not be the best for the investor.
This proposal is crucial because consumers are on their own to make their money last during retirement. Many don’t have a good grasp on how to do so successfully. Advisors with a fiduciary duty, such as Certified Financial Planner™ professionals and Registered Investment Advisors, can better help these consumers meet their retirement goals.
The proposal, however, is not an absolute prohibition on the use of sales-based compensation for retirement investment advice. The proposal provides an exemption for sales-based compensation. Thus the proposal won’t align all retirement investors’ interests and those of their advisors one hundred percent. The regulatory requirements for the exemption will only inundate consumers with additional disclosures that are likely cause greater confusion.
My hope is that the rule, if adopted, will move more advisors to charge fees rather than receive sales-based compensation for their advice. By doing so, we can get to a point in the future where sales-based compensation for retirement advice will be outlawed. But in the meantime, I encourage you to ask whether your financial advisor has this duty to you now.
A Fiduciary Duty is Currently Not Owed to Retirement Investors (or Any Investor)
Under existing law and regulation, loopholes exist that allow financial advisors to provide advice about and sell financial products that may only be “suitable” for consumers. Compensation practices, which are completely legal, also provide incentives to advisors to place their own interests (and those of their financial institution employer) ahead of the investor’s interests. Currently advisors are permitted to recommend products that are more expensive to consumers, pay more to the advisors, and provide lower returns to the investor.
The proposed rule changes this regulatory scheme for retirement investors.
A fiduciary duty requires that the advisor put the client’s interest before their own interest (usually meant to be profits). In legal terms this means – the duty of due care, the duty of loyalty, and the duty of utmost good faith.
A fiduciary is not in a typical seller-buyer “arms-length” relationships. The seller represents himself or herself or a product manufacturer or distributor in arms-length transactions. The customer is bound to protect himself or herself by shopping and finding the best deal. This doctrine is called caveat emptor (“let the buyer beware”). Each party is free to be self-serving. I recall an episode of the 1970s Brady Bunch illustrating how Peter learned this lesson the hard way.
By contrast, an advisor with a fiduciary duty acts as the “purchaser’s representative” on behalf of the client. The duty requires the person to possess loyalty to the client because of the potential for abuse. The advisor does not represent the product manufacturer or distributor.
A common example of how this proposed rule could work is when a consumer considers rolling over their 401(k) plan assets into an Individual Retirement Account. Whether to roll over and how to invest their retirement nest egg is one of the most important financial decisions for retirees. Unfortunately not all advisors are required to make rollover or IRA recommendations in their clients’ best interest under the current regulatory framework.
Advisors that are Certified Financial Planner™ professionals have a fiduciary duty. This proposal is not a change for them. You can verify a CFP®’s their credentials here. Registered investment advisers (“RIAs”) also have a fiduciary duty. You can check their credentials here.
Securities brokers, sellers of annuity products, insurance agents currently do not have this duty if they aren’t CFP®s or RIAs. The proposal will affect them the most. Not surprisingly, they are the ones who have filed the most comments opposing the rule. These advisors have a duty to provide suitable products, but not ones in the client’s best interest.
The financial industry has lobbied hard to weaken the proposal. The proposal contains an exemption that allows the continued use of sales-based compensation for retirement investment advice. The exemption involves substantial regulatory compliance and consumer disclosures. After reading the proposed exemption, I thought an unscrupuous advisor could disclose away the newly imposed duty!
One of the likely effects of the exemption will be an increase in the disclosures that advisors provide to consumers if the advisor recommends products in which they receive a sales commission. Most consumers are unlikely to read or understand these disclosures. The disclosures likely will be explained as just “more government mandates.”
Financial products are arguably some of the most complicated products sold. The reason most folks hire an advisor is that they don’t want to be investment managers or don’t have the expertise to understand it. Clients of these advisors are unlikely to be better off – just more confused.
Consumers Are Better Off with a Fiduciary Standard
The argument about whether to adopt a fiduciary standard boils down to how the advisor is compensated for the advice. I believe a fee-based model aligns the advisor’s interest with consumers’ interests. It is transparent, it allows for easy comparison shopping, and it eliminate potential conflicts of interest.
It seems inconceivable to say with a straight face that if an advisor could make more money selling a product that was suitable, but not ideal, for the client that it wouldn’t affect the advice – consciously or unconsciously. I believe we are wired to preserve our self-interest. The proposed rule guards against this natural tendency.
Providers of financial products who have benefitted from selling products that aren’t in the consumer’s interest are opposed to the proposal. They claim that eliminating sales-based compensation will dry up retirement advice for the middle class.
Because of this argument and the strength of the financial lobby in shaping the exemption, my hope is that this proposal will be a transitory one. Once this duty is imposed, advisors are likely to move gradually to fee-based compensation for retirement advice. At some point in the future, a new rule could eliminate the exemption without fear that they will be drying up retirement advice for the middle class.
The Administration is likely to finalize its rule in the first half of 2016. We can then see the length of the transition period, how it changes practices among advisors, and whether consumers are better off. My guess is that more and more advisors will use a fee-based advice model and shun the additional regulatory disclosures that are used with the exemption. We can only hope so.