Whitehouse

A Memo that Should Give Brokers Pause

Whitehouse

Recently, a White House memo dated 1/13/2015 from the Chairman of the Council of Economic Advisers (Jason Furman) came to our attention. Co-authored with fellow Council member Betsey Stevenson, it calls out abusive trading practices that cost retirement savers billions of dollars, and it makes a powerful case for applying a fiduciary standard of care to brokers who service retirement plans or individual retirement accounts. The authors explained in a footnote that they used the term “financial advisor” to broadly include brokers, and they summarized the problem as follows:

“Moreover, the current regulatory environment allows fund sponsors and advisory service firms to create incentives for their advisors to recommend excessive churning (repeated buying and selling) of retirement assets and to steer savers into higher cost products with financial payoffs for the advisor.”

The “higher cost products” often have “conflicted payments” such as load-sharing or revenue-sharing arrangements. The authors assert there is a further harm “arising from a suboptimal market structure for the financial advice industry, whereby many firms have organized themselves on the basis of capturing conflicted payments rather than the delivery of high-quality financial advice.” Citing several studies, the authors “conservatively” estimate the cost to savers of conflicted advice to be 0.5 to 1.0% of underperformance per year which translates into dollar losses of $8 to $17 billion. They also estimate that a 30-year investor can expect to lose between 5 and 10% of his or her potential retirement savings or approximately 1 to 3 years’ worth of withdrawals during retirement. Here are the specific problematic behaviors identified:

  • Firms recommend inappropriate rollovers to 401(k) participants to collect fees for managing the assets.
  • Loads encourage brokers to excessively churn their clients’ investments.
  • Potentially because of the need to justify the high fees they collect, brokers tend to encourage their clients to invest in actively managed funds that underperform passively managed funds, funds with high recent past returns, and/or fund with higher-than-average exposure to several forms of market risk.
  • Advisors steer investors into variable annuities or other complex products with high fees.

As for the potential future direction of the American regulatory environment, the authors point to the U.K. where in January 2013, a new regulation was issued banning all commission payments from mutual fund providers to advisors and advisory firms, and from advisory firms to their advisors, in connection with retail investment advice. Under this regulation, advisors are only allowed to charge investors a fee, either as a percentage of the amount invested, a fixed fee, or an hourly rate, though their fees can vary based on the level of service  provided. Furthermore, advisors were required to meet a higher qualification level to demonstrate that they understood their fiduciary duties. Some opponents of this regulation argued that smaller clients would no longer receive advice because it would not be economical for advisers to provide it. However, this fear does not appear to have materialized, as the authors cite that within six months of the new regulation, 97% of advisors had attained the appropriate level of qualification, and the remaining 3% were on track to achieve it. Furthermore, many retail investment advisors continued to service clients with low account balances. As for the banks that exited the low balance market segment, they had already indicated their intention before the regulation passed. The authors cite similar bans on conflicted payments that have passed in Australia, Holland, Belgium, and Italy. France and Germany have opted for increased disclosure requirements in the hope that increased transparency will result in better behavior by financial advisors. Either way, we expect to see new regulations that brokers will not like.