There are some changes coming for financial advisors
because the Department of Labor has just issued new rules which govern
financial advice regarding retirement plans. There has been a little
coverage in the mass media, but like many new rules from Washington, the
final rule is complex. The rule, its exemptions and amendments are
hundreds of pages long. The financial and consumer press is saying
things like “The ‘fiduciary rule’ is a great victory for retirement savers – MarketWatch“, and “New Rule Says Financial Advisers Must Act In Your Best Interest – Consumer Reports“.
It’s true the new rules might improve the landscape for consumers and
retirement accounts, but how will the rules really affect consumers? How
will it affect the process of choosing a financial advisor? In this
blog posting I want to discuss some of these issues. Sorry about the
length, but the subject is complicated.
What is a Financial Advisor anyway?
The sad truth is that anyone can call themselves a financial advisor. Someone could be selling vinyl siding one day and work for an insurance company as a “Financial Advisor” the next day and there are no laws or rules they would be breaking. A friend of mine in the insurance industry, once told me that its really easy to be hired in his industry. The criteria is: Can you fog a mirror? The situation is slowly getting better. To understand who are the people who call themselves financial advisors, you need to understand who they work for and how they get compensated for their work.But the most common Financial Advisors work in the following functions:
- Insurance Agent – This is someone who works for an insurance company or agency and typically sells commissioned insurance products. Some insurance companies do more than insurance and do some financial planning. Metlife, MassMutual, AXA, Prudential, and NY Life are all insurance companies with employees who call themselves financial advisors.
- Stockbroker – This is someone who works for what in the industry is called a “wire house”. It is also known as a Broker/Dealer. A Stockbroker is interested in investing your money for you. There are large Broker/Dealers who employ their stockbrokers directly, like Merrill Lynch, Morgan Stanley, UBS, and Wells Fargo. There are also smaller Broker/Dealers who allow RIA Investment Representatives to work with them (see RIA description below). While Stockbrokers primarily are interested in investing your money, some do financial planning and nowadays almost all of them call themselves financial advisors.
- Registered Investment Advisor (RIA) – A Registered Investment Advisor is a company which is either registered with the state (under $100 million in assets under management) or with the Securities and Exchange Commission (SEC). An RIA is often a smaller firm and primarily works with clients for investment management, but often does financial planning and sometimes sells insurance as an insurance broker (meaning they can sell insurance from multiple companies).
- Bank – Remember banks? They were feeling left out of the investment management game and over the past few years have merged with broker/dealers or have created their own. This is really a hybrid of a bank and a stockbroker with brokers working in the bank branches trying to sign up people for investment management. PNC and Wells Fargo do this, being both a commercial bank and a Broker/Dealer. Merrill Lynch is part of Bank of America, and TD Ameritrade is owned, at least partially by TD Bank (itself part of Toronto Dominion Bank). Banks make much more money selling you investment products than CD and savings accounts, so they would much rather have you invest with them in the side of the business without FDIC insurance. While I am sure there are exceptions, banks are very concerned with their own liability and most of them will not offer financial planning. But yes, they also will call their individual brokers “Financial Advisors”.
How do Financial Advisors Get Paid?
This is an important part of the equation. Everyone wants to get paid for their work and financial advisors are no exceptions. The problem is that the way financial advisors might get paid can set up a conflict of interest with their clients. This conflict of interest is often not disclosed because many advisors don’t need to disclose it. The law allows them not to.Paid by Commission
Many financial advisors are still paid by commission. A commission is a payment that an insurance company or a Broker/Dealer makes directly to their agent or broker as compensation for selling a product. What is the product? It’s a life insurance policy or an annuity in the case of an insurance agent or insurance broker. It may be an annuity or a mutual fund in the case of a stock broker. Yes, many brokers also sell annuities. Wonder why annuities are so popular today? Its because brokers make a lot of money selling them. Annuities can be good fits for clients, so just because brokers make money selling them doesn’t mean they are not good solutions. The problem is the undisclosed conflict of interest.One way of selling mutual funds is by commission. A mutual fund commission is also called a “load”. It is an extra fee that is built into the mutual fund price that you pay when you buy (and sometimes when you sell) a fund. And then there is the old-fashioned way that brokers might make money from commissions and that is a commission on every trade. This also creates a conflict because in this model, more trades means a higher income for the broker.
Conflicts and Commissions
So what’s wrong with commissions? There is nothing wrong with commissions themselves except the conflict of interest they create between you (the client) and your advisor. How does the advisor make more money? By selling you products that are best for you (low cost, high performing) or by selling you products that make the advisor the most money (highest commissions)? How do you know? You don’t actually know and that’s the problem. Everyone needs life insurance at some point in their lives and life insurance is almost always sold on commission. You will need to buy life, auto, home, and sometimes disability and long term care insurance on commission. There are really good, low-cost products out there, but you need to understand the conflict of interest of the person selling you the product. Same thing with annuities. An annuity can be of great benefit to the client, but it can also be of great benefit to the advisor who sells it!Paid by Salary
There are financial advisors who are paid by salary. These are advisors who work for discount brokers like Fidelity or mutual fund companies like Vanguard. You will definitely get low priced investments at these companies, but there are issues with this form of compensation as well. There can be hidden conflicts of interest.Conflicts and Salary
Salaried financial advisors typically work for large companies. While the advisor gets a salary whether or not they have you as a client, they certainly benefit from having you as a client. These companies are run on metrics, just like most large companies. But the metrics might include number of new clients the advisor signs up or the total size of accounts signed up. Do well on the metrics and the advisor might get a bonus or a trip to the company’s annual sales conference in Aruba. And when these companies sell insurance products (and some of them do sell them), its the company itself which might get the commission. So while the advisor doesn’t get anything directly for selling you an annuity, the company makes money and so the advisor’s boss might ask the advisor why he didn’t sell 10 annuities this week. Clearly selling you an annuity is in the advisor’s best interest even if they don’t get a commission directly.Paid by Fee
The financial advisor world is moving towards paying advisor by fee. There are two types of fees: a direct fee for services or a fee paid as a percentage of assets under management. Fees paid for services are great because it means the client pays the advisor directly for their services. In this case there is actually no conflict of interest at all. The advice is not tainted by how the advisor is paid because the advisor gets the same fee no matter what he/she advises the client to do. These advisors typically charge an assets under management (or AUM) fee for investment management. The AUM fee is a percentage of the value of the client’s account, typically paid to the advisor quarterly. This is fairly transparent because the client sees what they are paying, but there are still actually some conflicts of interest with this remuneration model.Conflicts and AUM fees
The conflict with AUM fees has to do with the size of the account. Remember that there are two ways for accounts to grow, one is that the investments do well. If the investments do well, both the advisor and the client benefit. So there is no conflict there. But the other way for the value of the accounts to grow is for the client to put more money into the accounts. While this is often good for the client, sometimes its not. An example is a client who needs money to live on or has some extra expenses. In this case, the advisor’s advice may not be unbiased because the advisor does not want the client’s account size to shrink. There is also a conflict of interest regarding 401k accounts rolling over to IRAs. The 401k may not be under the advisor’s management, but if the client does a rollover into an IRA under the advisor’s management, the advisor makes more money. Conflict! The new DOL rules address the rollover conflict.What is a Fiduciary?
A Fiduciary is someone who acts in your best interests and holds your best interests above his or her own. Are financial advisors fiduciaries? They should be, right? Well, before the DOL rules (see below) go into effect, the answer is: often not.Who is a Fiduciary?
First of all CFP® advisors have agreed to be Fiduciaries. This means a CFP® advisor always works in the client’s best interests while doing comprehensive financial planning, whether the advisor works for an insurance agency, wire house, RIA, bank, or any other institution. Advisors who work for RIA firms are also fiduciaries, but often only regarding financial advice, not necessarily when selling products such as annuities if they are also working for broker/dealers. Even CFP® advisors have actually only agreed to be fiduciaries while performing comprehensive financial planning services, not necessarily while selling products. It’s often very confusing to understand when the CFP® advisor is actually acting in a fiduciary capacity.Who is NOT a Fiduciary?
Insurance agents, stockbrokers, and broker/dealer representatives are mostly not fiduciaries. Instead they work under a “suitability” guideline. So an investment or product does not need to be in the client’s BEST interests, only suitable for the client. It is true that there have been arbitration cases which investors have won based on the advisor selling unsuitable products to clients, but it is a much weaker standard than the suitability standard. CFP® advisors only agree to be fiduciaries while in a financial planning role. There is a grey area about whether they are “planning” when the make a product recommendation. At any rate, a CFP® advisor who is not working for an RIA is only regulated as a CFP® by the CFP® board. So they can be stripped of their CFP® certification, but that is really the maximum sanction if the CFP® does not act as a fiduciary when they are supposed to.Arbitration
Remember that every time you sign an agreement to open a brokerage account you have to sign a pre-dispute arbitration agreement? It turns out that the SEC and many state securities regulators have stated that they will not accept pre-dispute arbitration agreements for RIAs. This means that you can actually sue an RIA in court for misconduct or not being a fiduciary. The same is not true for brokers and it is also not true for custodians that RIAs use to hold client accounts. But it gives consumers greater protection when dealing with RIAs that they don’t get with many other financial firms.The new DOL rules
The Department of Labor has just issued new rules and now you have some of the knowledge to understand what they do and don’t do to help consumers when dealing with financial advisors.Retirement Accounts Only
The first thing to understand is that the DOL rules apply to retirement accounts only. The rules do not apply to taxable brokerage accounts or life insurance or non-qualified annuities. The rules DO apply to any kind of IRA account, 401(k), 403(b), or 457 account. So if you just inherited $100,000 from Aunt Bessie and go to a financial advisor for advice, nothing has changed regarding that advice. The DOL rules do nothing to help you. On the other hand if you are retiring from 40 years of working as a teacher and need help with your pension and 403(b) account, the DOL rules will hopefully help you get better advice no matter who you go to.Fiduciary Standard for Advice
The DOL rules basically say that anyone advising clients on retirement plans is subject to the more-stringent Fiduciary standard and not the suitability standard. It doesn’t matter who the advisor works for or how the advisor gets paid. It is important to understand that not all education is subject to the rule. So an educational seminar may not be subject to the fiduciary standard, but specific advice about your money or account will be.Reasonable Compensation
The DOL rules allow advisors to be compensated reasonably by flat fee. Presumably this will cover both direct fees (for financial planning) and Assets Under Management fees (for investment management). There is still a question about what reasonable compensation means. Reasonable does not mean low and it does not mean average. But it is possible that it will mean overall lower costs for consumers.Best Interest Contract Exemption
The new DOL rules still allow financial advisors to sell commissioned products to clients in retirement accounts. There are cases where this might be appropriate and the DOL did not want to outlaw the practice completely. However, financial advisors now have to prepare a “Best Interest Contract Exemption” document which the client must sign. This document must explain exactly why the commissioned product is in the client’s best interests and explain the conflicts of interest which might lead the advisor to recommend the investment or product. In other words, the client needs to acknowledge that the advisor explained how he/she gets paid and how that affects their advice.The BICE document will also be used for IRA rollovers. It may or may not be in the client’s best interests to roll money from a 401(k) or similar workplace savings account to an IRA. But as I explained earlier, it is often beneficial for the advisor for the client to roll the money over to an IRA. The BICE document will ensure that clients understand the inherent conflict of interest for this advice and understand the true pros and cons.
Class Action Lawsuits
An interesting part of the DOL rules is allowing class-action lawsuits. Currently, when you open an account at a broker or custodian, you always sign away your rights to any kind of lawsuit. The DOL rules basically say that not only can you sue a broker or custodian, you can bring a class-action lawsuit if the broker’s wrongdoing affected many of their clients. This could be of benefit in cases where the loss to each client is very small, but the overall impact for all the broker’s clients is large.Implementation Timeline
The DOL rules become law June 7, 2016, but because the rules are complex and might change practices in the financial services industry quite a bit, implementation has been delayed until April, 2017. There is also a transition period until January, 2018 for the BICE exemptions to fully take effect.Unintended Consequences
Mostly the DOL rules are good for consumers. It should definitely improve practices around retirement accounts and reduce bad practices in the industry. But the DOL rules are complex and it will raise costs in the industry. These costs are likely to be passed on to customers. It is possible that firms will stop working with clients who have smaller amounts of money or move them to an automated system without direct advice. It is also possible that some firms will stop working with client’s retirement accounts. Already some firms have sold their broker/dealers because they have decided they don’t want to deal with the DOL rules.How are clients of Cereus Financial Advisors affected?
Cereus Financial Advisors is an RIA, so already Cereus is already a fiduciary to its clients for all investment accounts. Additionally, yours truly (David J. Haas) is a CFP® advisor and therefore a fiduciary. At Cereus Financial Advisors, we generally don’t sell commissioned investment products anyway. We also don’t sell private REITs or other non-traded investments (which was part of the DOL crackdown). We do sell insurance, but not in retirement accounts (other than fixed annuities). In fact the only practice that it will affect is IRA rollovers. There are times where we might recommend an IRA rollover and when we do a rollover for clients, we will need to execute a BICE exemption. So the DOL rules should not affect Cereus clients much at all.More Information
Here are some useful links to get more information:- https://www.dol.gov/ebsa/newsroom/fs-conflict-of-interest.html
- http://www.consumerreports.org/personal-investing/new-rule-financial-advisers-act-in-best-interest/
- http://www.letsmakeaplan.org/cfp-pros-their-expertise/selecting-an-advisor
