Saturday, January 11, 2014

Aunt Bea Testifies: "I AM ANGRY. I FEEL BETRAYED" (A Tale of Fiduciary Woe)

Jan. 2014 update - I repost this, my most popular blog post of the last two years. True stories like this resonate with advisors and individual investors, and highlight the insidious nature of many conflicts of interest and the lax enforcement of a bona fide fiduciary standard by the SEC.

This is a sad tale, as so many tales of individual investors are today.

About Aunt Bea

Having retired about a decade ago from a Fortune 500 company, Aunt Bea (a real person, although for confidentiality reasons this is not her real name) was faced with taking a lump sum distribution from her defined benefit plan, to be rolled over into an IRA. In addition, Aunt Bea had other savings. Together with future receipt of social security benefits, this seemed more than enough to handle her financial needs in retirement – which could last 40 or 50 years, based on her good health and life expectancy upon her retirement.

Aunt Bea did all the right things. She asked around – family and friends – for financial advisors to interview. She interviewed several. In the end, she chose one of the largest “wealth management” firms and a team of “financial advisors” with fancy titles, such as “Senior VP – Wealth Management.” She received the firm’s Form ADV Part II (now known as Part 2A), and she was recommended a broad variety of investments.

“How much do I pay in fees?” – Aunt Bea inquired of her current financial advisors. “0.85% each year” was the answer, which according to Aunt Bea was the answer provided to her on several different occasions, with no elaboration and no caveats.

Aunt Bea was happy. She was, in fact, represented by “investment advisers” bound to act in her best interests, so she understood. Yet, it did not seem her portfolio was growing as fast as the overall market, especially in recent years.

That’s where I came in. Aunt Bea was about to provide testimony to Congressional staff on her experiences with her fiduciary advisors. The non-profit organization which had invited her to participate on the panel (which was advocating for the fiduciary standard), became a bit suspicious when Aunt Bea described her experiences. I was also scheduled to participate on the panel, and with Aunt Bea’s consent the non-profit organization asked me to review her monthly portfolio statement and report back to her the results of my analsysis.

Two Days of Reviewing Disclosure Documents.

Over the course of the two days available to me to undertake the analysis, I poured through the monthly statement, nearly 60 pages. As I undertook my analysis, I reviewed the large firm’s current Form ADV, Part 2A. I searched the web (including at times the SEC’s Edgar database) and reviewed an additional 40 other disclosure documents, including fund prospectuses, statements of additional information, a variable annuity prospectus, and occasional fund annual reports. I also obtained summary data from Morningstar.

Most of the documents I reviewed were between 30 and 150 pages in length. Fortunately, I knew where to look to access the data I needed. As a professor teaching advanced courses in investment planning, retirement planning, and insurance, I possess a very good understanding of all of these documents, and the terminology utilized. As a tax and securities law attorney, I understand the legal structure of the documents. I was hence able to obtain much of the data I needed, from these disclosure documents, in a very rapid manner – relative to most financial advisors (I suspect). And certainly a great deal faster than 99% of individual investors.

What was the result of my analysis? Here’s where the tale begins to turn ugly.

The Fees and Cost Analysis

First, understand that the vast portion of Aunt Bea’s portfolio (over 80%) were in two IRA accounts – both managed under investment advisory programs. (This is where the 0.85% annual investment advisory fee was assessed.) Aunt Bea had two other brokerage accounts with this dual registrant firm (i.e., both as a broker-dealer and as an investment adviser), which were also reflected in her consolidated monthly statement.

Second, I found that 24% of Aunt Bea’s account was invested in a variable annuity possessing total fees and costs of 3.75% annually. (The investment advisory fee was not applied against this investment.) While the variable annuity had a stepped-up death benefit guarantee, and a guaranteed minimum income benefit rider, I concluded that the high costs of the product and the limited nature of the benefits of these riders would yield benefits to Aunt Bea which, in my view, were largely illusory in nature.

Third, the broker-dealer, and its financial advisors, received way more compensation than the 0.85% annual amount they stated to Aunt Bea. They received “revenue-sharing payments” in the form of 12b-1 fees. Most of the mutual funds in the investment advisory accounts had 12b-1 fees in the range of 0.25% to 0.15% annually. One mutual fund in the brokerage account had a 12b-1 fee of 1% annually. While I cannot be certain that all of these 12b-1 fees were passed on by the funds to the broker-dealer firm, a frequently quoted statistic is that 80% of 12b-1 fees are, in fact, paid to broker-dealers.

Other revenue sharing payments noted in the funds’ prospectuses, including payments for shelf space. These are payments by fund complexes for “preferred marketing opportunities,” often paid by the fund’s manager from a portion of the management fees charged by the fund's investment advisor. The existence of such payments provides a disincentive to the fund’s manager to not lower management fees, even as economies of scale are achieved as the size of the fund increases. Again, it was not possible to discern if revenue-sharing payments were actually made, but Form ADV Part 2A of the dual registrant firm noted that the firm “receives other compensation from certain distributors or advisors of mutual funds” and that “revenue sharing compensation will not be rebated or credited” to its clients.

It was also noted that many of the mutual funds provided “additional compensation to registered representatives of dealers in the form of travel expenses, meals, and lodging associated with training and educational meetings sponsored.” Whether these particular benefits were actually received by these particular "financial advisors" is not known, although such practices remain fairly common in the broker-dealer industry.

Also, for trading of securities within the fund, many of the funds paid brokerage commissions back to the dual registrant firm at which Aunt Bea held her investment advisory accounts. The generally high portfolio turnover of these funds resulted in a relatively high amount of brokerage commissions (and other transaction costs within the funds, such as principal mark-ups and mark-downs, bid-asked spreads, market impact costs, and opportunity costs due to delayed or canceled trades). Additionally, the amount of brokerage commissions in many of the funds was higher than would be expected, due to the payment of higher brokerage commissions by the funds in return for research from the broker-dealer firm – a practice known as payment of “soft dollars.”

The dual registrant also had Aunt Bea invest in one of its proprietary funds. Of course, this fund had high fees and costs, as well. I could not discern if any of the management or other fees were rebated to the client.

In summary, I found that Aunt Bea was paying above 2% in “total fees and costs.” With another day or two of analysis, to better discern and analyze the data on transaction and opportunity costs (including those relating to cash holdings in the funds, which were above average in many cases), I would likely find that the total fees and costs ranged somewhere between 2.1% and 2.5%, and perhaps even higher.

To provide some context, let me only inform the reader that the average investment advisory fee paid for an overall investment portfolio of this size would be slightly below 1% a year. And, with the fiduciary advisor avoiding additional compensation and utilizing both low-cost and tax-efficient (where appropriate) investments, the additional fees and costs would be quite modest. In essence, Aunt Bea was paying about twice what she should have been paying, in total fees and costs. (And there are, as I pointed out to Aunt Bea, many financial / investment advisors who charge fees well below industry averages, and who also recommend very-low-cost mutual funds or ETFs to their clients.)

Contrary to the understanding of many individual investors that "expensive investment products must be good," the high total fees and costs incurred by Aunt Bea were certain to drag down the performance of her portfolio over time, and by a large amount (due to the effects of compounding of annual fee payments, and its affect on the resulting end values of a retiree's portfolio)..

Tax Efficiency: Not Present

Other aspects of Aunt Bea’s portfolio were troubling. The overall portfolio was not designed in a manner for long-term tax-efficiency. The location of assets, as between taxable and tax-deferred accounts, did not appear to reflect any long-term tax minimization strategy.

By way of explanation, as a general rule taxable accounts should hold assets which will secure long-term capital gain treatment upon their sale, such as tax-efficient, tax-aware or tax-managed stock mutual funds. Also, international stock fund allocations to taxable accounts can result in income tax credits; these tax credits are not available for international funds held in IRA accounts. In tax-deferred accounts fixed income investments should initially be allocated. In the Roth IRA account, which grows tax free, should be held the asset class with the greatest long-term expected returns, such as “U.S. small cap value stocks.” These are general rules, only, and there are some exceptions to these rules (none of which appeared applicable here).

However, since the bulk of Aunt Bea's overall investment portfolio was in IRA accounts, the effects of this inattentiveness to tax-efficient investing were somewhat ameliorated. If the investor had possessed a somewhat larger percentage of the portfolio in taxable accounts, the concerns expressed herein as to tax-efficiency would be much greater.

Investment Strategy: Was There One?

In the review of the investment portfolio I did not ascertain any overall strategy. Perhaps the overall investment strategy is contained in a separate document. Probably not, however, as Form ADV, Part 2A of the dual registrant firm expressly excluded from the investment advisory programs in which Aunt Bea was enrolled.

As to the equities (stocks, stock funds), there does not appear to be, overall, nor within the funds surveyed, a commitment to the utilization of investment strategies which have withstood academic scrutiny. These include utilization of the value and small cap effects (part of the Fama-French 3-factor model), momentum strategies, and the use of low-cost passive investment strategies.

Instead, within the portfolio was an emphasis on individual stock selection, or “active management.” As the academic research has shown, active investment strategies underperform, on average, passive investment strategies over long periods of time. (For a good explanation of this issue, without needing a heavy dose of statistics, see Rick Ferri’s recent article at

The portfolio had a great many different funds, but this did not mean that proper diversification was achieved. (It is possible to achieve a very high level of diversification from a handful of funds, if properly selected.)

I would note that two-thirds of Aunt Bea’s portfolio was invested in fixed income securities of some form. While this might sound conservative, the presence of number of high-yield bonds in the various funds, a floating note fund, and a structured fund investing in mortgage-backed securities of dubious quality (the fund was the subject of a class action settlement, in this regard, in 2009), presented obvious risks to Aunt Bea.

Aunt Bea was withdrawing 3.5% from her investment portfolio annually, and she expected this rate of withdrawal to continue. Yet, given the high fees and costs of the overall investment portfolio, and its present asset allocation, I projected that the portfolio would likely only sustain (with its current asset allocation) a rate of withdrawal of approximately half the current amount. In other words, Aunt Bea was likely to outlive this portfolio, the way it was currently structured, and given its high fees and costs.

I would note, however, that I did not know many facts which, if I were Aunt Bea’s advisor, I would like to know to complete my analysis and to provide recommendations to her. I did not sit with her for hours to explore her lifetime financial goals, values, history of reliance on professionals for advice, and many aspects of her financial situation. I did not review her personal expenditures budget, other assets and debt, and other risks to which she might be exposed in all aspects of her financial life. Hence, the focus of my analysis was limited (a fact noted in my report to Aunt Bea).

Additionally, since I was only provided a “snapshot” of Aunt Bea’s portfolio, I could not see the changes to the portfolio made over time. However, based on the purchase dates of many of the investments -  stretching back years – it did not appear that a great deal of changes had been made to the investment portfolio over time.

Yet, even with these limitations, I was able to discern that Aunt Bea was being harmed, by a high level of fees and costs, a questionable asset allocation, and a somewhat tax inefficient portfolio. And, while the precise amount of additional compensation paid to the dual registrant firm and its “wealth managers” will likely never be known, it is certain that insidious conflicts of interest were present – which no doubt affected the quality of the “advice” being provided.

Aunt Bea Goes to Congress

Shortly after I presented my 30-page analysis to Aunt Bea (not her real name, by the way), I found myself in a panel presentation in an overflowing committee room, providing information to Congressional staffers about the fiduciary standard of conduct and the importance of its potential application by the SEC and DOL.

Aunt Bea was the second-to-last panelist to speak that day. (I was the last.) Despite the fact that she is extremely self-confident and articulate, her voice was cracking as she related her experiences. “I feel … betrayed.” She related that she had often confirmed the fees which she was paying, by asking her “financial advisors,” and that she was repeatedly informed of a figure which was far less than what she was actually paying.

Aunt Bea continued, and with sad eyes, and anger apparent in her voice, she related to those present: “I trusted my financial advisors. I thought they were looking out after my best interests. I was wrong.”

When Aunt Bea finished her comments, it was my turn. Rather than exploring aspects of the fiduciary standard, as I had planned, I instead decided to ask Aunt Bea some impromptu questions. “Aunt Bea, if I may call you that … did you receive the Form ADV, Part 2 from the firm, and over the years did you receive the mutual fund prospectuses and annual reports? Did you read them and did you understand them?

Aunt Bea was a little taken aback by my question, at first. But, only a moment passed as she thought about it, and succinctly answered, “Yes, and no.” As we explored what she meant, it became obvious that she had received the documents. Despite her level of education (well above the average of most individual investors), she did not understand them.

Aunt Bea continued. “I trusted my financial advisors. They were supposed to be honest with me. I asked them direct questions. At no time did they explain to me that either they or their firm received additional fees.”

I then related, as a panelist, to those Congressional staff present, that Aunt Bea’s tale is by no means an isolated one. The financial services industry is full of "financial advisors" and "wealth managers" and "investment consultants" and "financial planners" who possess multiple layers of conflicts of interest. In fact, I estimate that 95% of “financial advisors” don’t avoid nearly all conflicts of interest, as they should. And the disclosures of conflicts of interest, when made by dual registrant firms and their employees, are often “casual” in nature, are not read by investors, and even if read are very seldom understood.

The panel discussion continued, and we answered a great many questions from the interested staffers there. We explored how plan sponsors (small and large business owners) are being increasingly sued for breach of their fiduciary duties (imposed by ERISA) after receiving conflicted advice from non-fiduciary “retirement plan consultants” and providing only high-cost funds in the qualified retirement plan sponsors. We further discussed the all-important decision of whether to roll out of a defined contribution plan upon retirement, and how much marketing by large financial services firms was directed at this life event.

The panel concluded, but Aunt Bea was not yet finished. She spoke up, stating, “Don’t let what happened to me keep happening to others. It’s up to all of you … make certain each and every financial advisor out there acts in the best interests of their clients.”

My Own Roller-Coaster of Emotions These Past Few Days

Over the past few days, as I worked through the analysis and uncovered conflict of interest upon conflict of interest, I myself became both angry – and sad.

We know that “dual registration” (i.e., registration as both a broker-dealer firm and as a registered investment adviser firm) has become increasingly common. We also know that about 88% of investment adviser representatives are also registered representatives of broker-dealer firms. (Of the remaining 12%, many of them also possess insurance licenses.)

I know that Aunt Bea’s “wealth management” firm possessed fiduciary obligations to her. As did the team of “financial advisors” working for that firm.

But … is this what the fiduciary standard has come to? Has it now become permissible to not candidly discuss with clients all of the compensation either the financial advisor or firm receives – especially when asked? Why do firms rely upon complex written disclosures (even then, “casual disclosures” which don’t quantify compensation amounts received) – when we have substantial academic evidence that investors don’t read the disclosures (due to many behavioral biases, which have long been studied and discerned by academia)? Even those that try to read disclosure statements, like Aunt Bea, rarely understand them?

I woke up this morning to find SIFMA (Wall Street’s lobbying arm) again touting a “new federal fiduciary standard.” Yet, as evidenced by SIFMA’s statements, this is nothing like the true fiduciary standard found under ERISA’s “sole interests” strict standard, or even the modestly less strict “best interests” fiduciary standard found in the jurisprudence of the Advisers Act. (As I recently explained, on behalf of The Committee for the Fiduciary Standard, in a July 5, 2013 comment letter submitted to the SEC. See

How do I feel today, after these past few days of experiences?

I am embarrassed – to call the “financial advisors” advised by Aunt Bea as my “colleagues.”

I am angry – that we permit such harm to come to hundreds of millions of our fellow Americans, by not applying the fiduciary standard properly.

I am distressed – that, in the face of huge amounts of cash flowing to Congress from Wall Street – and other sources of influence exerted upon both legislators and (some) agencies and their staffs – that the prospects for a bona fide fiduciary standard appear so dim.

I am saddened – that we are unlikely to see, in my lifetime, if the current course holds true, the application (and enforcement) of a bona fide fiduciary standard upon all providers of personalized investment advice and financial planning advice.

I am disappointed – that I will likely not be able to hold my head high someday and say, “I am a member of the honorable financial advisory profession. We provide expert personalized financial and investment advice which in our clients’ best interests at all times. We receive professional-level compensation, as should be afforded to our high level of expertise. We serve our clients with value-added services. More importantly, we promote, though the trust placed in our services by our clients, capital formation and the resulting U.S. economic growth which follows. As members of a true profession, we answer to a higher calling. We serve the public interest.”

I was asked today to speak to reporters, especially about what clients should do now – to ensure that they are being properly served. I’m just not in the mood to take these calls.

(I refer consumers, however, to my recent blog post on selecting financial advisors: “How to Choose a Financial Advisor: A Checklist for Consumers” – at

What Now?

I think about the profession, and where we might be headed, a great deal.

Is it worth the ongoing battle to try to counter the huge amount of lobbying Wall Street undertakes in the halls of Congress, and at the SEC? Is it worth trying to effect a fiduciary standard for all providers of personalized financial advice which is not “watered down” by Wall Street to some type of “casual disclosure only” standard (which is not - in any way, shape or form - a true fiduciary standard at all).

I wonder if we should instead, at some point, turn our efforts to develop our own professional standards of conduct? Why should we rely upon regulators – most of whom have never served individual investors under a true fiduciary standard – to define fiduciary standards for us? Should we, instead, formulate a voluntary set of true fiduciary standards, and see who is willing to adhere to same? (Bob Veres wrote about this recently … see a link to his article, found at

In Conclusion: My Recent Days of Frustration

In the end, I am frustrated, confused, and – to an extent – demoralized. What if, after all these efforts, over the past decade, by many well-meaning leaders of our emerging profession, we end up with a “new federal fiduciary standard” which is nothing more than the extraordinarily low suitability standard with some additional disclosures (casually made in a non-affirmative manner, designed to ensure that clients don’t understand the disclosures, and found hidden away within some long disclosure document or in a dark corner of some web site which consumers must search out, discover, read, and seek to comprehend)?

The late, great Justice Benjamin Cardoza – and many other jurists - will roll over in their graves if, as I suspect might occur, SIFMA’s “new federal fiduciary standard” is adopted by regulators. The “particular exceptions” of which Justice Cardoza so eloquently warned will swallow up the substance of the standard itself, leaving us with continued consumer confusion and disgust

What are the consequences if Wall Street "wins" and our fellow Americans - and our clients - lose these battles?

Won’t the financial and retirement security of my fellow Americans continue to be denied through Wall Street’s extraordinarily high extraction of rents? Won’t this continue to result in large burdens upon our governments, as they seek to provide essential services to our Americans who are so poorly prepared for retirement, precisely at the time when governments can ill-afford such burdens?

Will not the failure to limit Wall Street’s excessive diversion of the returns of the capital markets, away from the true intended beneficiaries of those returns – American investors – continue to constitute a huge drag upon much-needed capital formation, increasing the cost of capital to all U.S. business, and acting as the dragging anchor that slows the progress of the ship which is our nation’s economy?

What will happen to the Aunt Beas of the world?  Who will finish Aunt Bea's tale? Will this tale continue down the path of a Shakesperian tragedy?

What will happen to the “profession”? Will it become a true profession, or just an excuse to fleece consumers?

WHO WILL STAND UP - NOW - AT THIS CRITICAL TIME ... Who will join with many others, and say to Congress, the DOL, and the SEC – “We must have a true, bona fide fiduciary standard for all providers of personalized investment advice. We must restore trust in our financial system. We must achieve a true profession, founded upon and informed by the highest standard of conduct under the law, which serves not Wall Street but instead, properly, the public interest?” WILL THIS BE YOU

Ron A. Rhoades, JD, CFP® serves as Asst. Professor and Program Coordinator for the Financial Planning Program at Alfred State College, Alfred, New York. He currently serves as Chair of the Steering Committee for The Committee for the Fiduciary Standard, and he frequently speaks at conferences and in presentations to policy makers in Washington, DC on the fiduciary standard. In 2013, Ron was named one of NAPFA's "30 Most Influential" persons in NAPFA's 30-year history. He is an academic member of NAPFA and of the Financial Planning Association. Ron Rhoades is the author of several books and many articles on topics relating to investments and financial planning. He received the "Tamar Frankel Fiduciary of the Year" award in 2011, and also was named as one of the "Top 25 Most Influential" by Investment Advisor magazine in 2011.

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If you are a consumer interested in learning more about financial and investment advisory services from Prof. Rhoades and his fee-only investment advisory firm, ScholarFi, Inc. - please e-mail, or call Cathy Rhoades, Director of Client Services, at 607-247-5008.

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