Wall Street’s lobbyists are now in full press mode as they attempt to stop the Department of Labor from issuing a proposed rule on conflicts of interest. While the text of the proposed rule is not even yet known, Wall Street knows that their best shot at stopping the DOL's proposed rule on conflicts of interest is that the rule never even sees the light of day.
Of course, these same lobbyists have previously stated that they embrace a “new federal fiduciary standard.” Hence, why are they objecting?
Let’s examine the three major arguments of these dozens of paid lobbyists and ascertain if they have any validity.
1. "Commissions Will Be Banned under the DOL’s Proposed Rule."
What’s interesting about this assertion is the fact that Asst. Sec. Phyllis Borzi has repeatedly (many, many times) addressed the issue, and has stated over and over again that commissions will not be banned.
Many fiduciary advocates believe commissions cannot be paid under ERISA’s fiduciary dictates and the prohibited transaction rules, nor under a fiduciary standard, generally. Yet, nothing in the common law of fiduciary standards (that I have been able to find) prohibits commission-based compensation. What is required is that any fees and costs paid by the client be reasonable for the services provided.
The DOL is likely to provide blanket exemptive relief to brokers who would become fiduciaries to defined contribution plans and IRA accounts under the new rules. The nature of that exemptive relief is unknown. There is likely to be a “seller’s exemption” – in which fiduciary obligations don’t apply to those who remain at arms-length with the plan sponsor / IRA account holder. For those to whom fiduciary standards do apply, there is likely to be an exemption from ERISA’s strict fiduciary standards for those who charge commissions for the provision of advice, rather than ongoing advisory fees or flat fees or hourly fees.
I would note that the DOL has not gone so far as Australia, New Zealand, England and some other regulators, who have largely negated the practice of charging commissions on any investment products (including many insurance products with investment components).
Might other problems exist for brokers acting as fiduciary advisors, other than mere payment of a commission? Perhaps, depending upon the text of the rule and the exemptive relief granted, or not granted. These potential problems include:
A) A problem exists whenever variable commissions exist, under a fiduciary standard. In other words, if one product can be provided for a commission of 3%, and other provided for a commission of 5%, the fiduciary must be prepared to justify (as the fiduciary will bear the burden or persuasion, if challenged) that the higher-commission product was better for the client. Often, this will be a tough burden of proof to meet. I believe it likely that product providers will offer retirement classes of shares with a fixed commission structure, and no breakpoints.
B) Another problem exists, however, if the same mutual fund offers share classes with lower fees. We have seen this over and over again in the courts, as plan sponsors (who are fiduciaries) are held to account. Often the plan sponsors state that they relied upon their non-fiduciary “retirement consultants” (as is the case in Tibble v. Edison, currently before the U.S. Supreme Court). The result is often that the plan sponsor is “on the hook” while the “retirement consultant” (a brokerage firm) is “off the hook” by hiding behind the very low and ineffective suitability standard. And therein lies the rub – large and small business owners are often left by non-fiduciary retirement consultants to fend for themselves in class action litigation, with no recourse against the brokerage firm.
A similar problem might exist if breakpoints are available, as is common for Class A mutual fund shares. Would breakpoints be provided based upon each individual participant’s plan contributions (or IRA rollover or contributions)? Or would breakpoints be provided based on the contributions of all participants to the plan? Why not the latter, at least for defined contribution plans, given that one of the advantages of such plans is the ability to exercise certain economies of scale.
C) Variable revenue-sharing payments, which provide additional compensation to brokerage firms who give a fund priority on their platform (called “payment for shelf space”) and/or were higher amounts are paid should certain levels of sales of a fund (or fund family) be attained, represent a dark corner for any fiduciary. This type of practice must likely be stopped – period.
D) Another problem exists with soft dollar compensation. Though permitted by statute, the SEC has largely been ineffective in insuring that soft dollars (higher commissions paid by mutual fund companies, out of the fund, in return for research) are reasonable in amount for the research actually provided, and that the research is actually utilized by the fund’s investment adviser(s) in making decisions. I suspect that the DOL will provide exemptions for soft dollar compensation, although I hope that they assert standards as to same. Given that bid-ask spreads and commissions have declined over the last several years, particularly as funds use electronic trading platforms (NYSE Arca and many others, including dark pools), one must question the continued justification for paying high commissions for securities trading undertaken by funds. I hope that DOL’s standards for exemptive relief reflect this present-day reality.
How can the brokers avoid these issues? Simple. If you desire to sell on a commission basis, sell funds specifically designed for the retirement market – no separate classes of shares, no breakpoints, fixed commission rates, no revenue-sharing, and no soft dollar compensation. In other words, avoid variable compensation.
Another solution is for brokers to just utilize no-load, no 12b-1 fee mutual funds and exchange-traded funds. Brokers might then negotiate a commission with the plan sponsor, each year. If small amounts are contributed to the plan, then larger commissions may be justified. If larger amounts are contributed, then smaller commissions might be justified. Commissions could be deducted directly from the contributions, not paid by the product providers. In my mind this is a far better solution than the “fixed commission” strategy previously mentioned, as it permits plan sponsors to negotiate compensation each year (thereby avoiding restraint of trade issues that might arise from fixed commission schedules).
While the brokerage and asset management industries may shout at the rooftops that such a solution is “too disruptive,” the industry has adopted before (e.g., largely getting rid of Class B shares). It can adapt again. Just get rid of variable compensation arrangements, and go to a negotiated commission arrangement, with fees deducted by the plan administrator/recordkeeper/custodian based upon contributions made to the plan. It’s a simple solution to the problem of commissions, which could be easily implemented.
2. "(Small) Consumers Will Not Be Able to Access Advice Under a Fiduciary Standard."
On Feb. 23, 2015, the National Association of Plan Advisors (NAPA) set forth their argument against the DOL’s conflict of interest rule, echoing what we have long heard from lobbyists from Wall Street (via SIFMA, FSI) and the insurance industry (NAIFA). NAPA stated:
“The best way to address concerns about ‘hidden’ fees is through better transparency, not by blocking 401(k) participants from working with the advisor of their choice,” [Brian Graff, Executive Director of the National Association of Plan Advisors (NAPA] explained. “If the administration moves forward with this proposed rule, American savers will be forced to pay out-of-pocket for their financial advice, or be limited to financial products with identical fees. Tens of millions of American savers who cannot afford to pay out-of-pocket will lose access to their financial advisor or be severely restricted in their choice of financial products. This is a wolf in sheep’s clothing. This so-called ‘conflict-of-interest’ rule is really the ‘No Advice’ rule.
“No advice means less retirement security. People who have had a financial advisor for 4-6 years have 58% more assets than those who have not, so it is not surprising that 80% of people feel more secure about retirement because they have worked with an advisor of their choice. The ‘No Advice’ rule can be dressed up to look like a consumer-friendly proposal, but when you look beneath the feel-good rhetoric, what you find is a dangerous regulatory overreach that should be stopped before it does serious harm to the retirement security of millions of working — and retired — Americans.“
This is perhaps Wall Street’s main argument in opposing the fiduciary standard. However, the evolution of financial advice over the past decade, and especially over the past few years as online investment advisors have blossomed, demonstrate that this is argument is the insurance company / broker-dealer acting as a “sheep in wolf’s clothing.” Let’s examine just a few of the developments.
First off, many fee-only financial advisors exist. Many of these (including those in the Garrett Planning Network, over 300 strong) charge hourly fees for advice. Others charge a flat fee for a financial plan, which might vary from a few hundred dollars to several thousand dollars (or more, depending upon the scope of issues addressed). Financial planning should be undertaken in a fiduciary capacity – even the SEC agrees with this. And often financial planning is an essential prerequisite prior to the delivery of investment recommendations.
Let me provide an example. Suppose a client comes into an “investments” firm with $20,000 to invest. A broker might sell the customer a Class A mutual fund, with a 5.75% sales load, resulting in compensation to the brokerage firm of $1,150 (plus, in all likelihood, 12b-1 fees of 0.25% annually, plus possible payments for shelf space, plus payments of marketing expenses for client educational seminars or brokers’ educational activities). Yet, if the client went to a fee-only advisor, that client would likely receive a comprehensive financial plan. This plan might advise that the client needs to first maximize contributions to her or his defined contribution plan, to get the employer match. Or the client may need to establish as cash reserve with all or some of the money, or pay off debts which possess high interest rates. And, even if the client is provided advice to invest in mutual funds, the recommendations are likely to be funds which are low-cost, no-load, no 12b-1 fees.
In essence, for the same fee, the client has received far more, and far better, advice, from a fee-only advisor than from a broker.
Brokers will yell that investment advisers, particularly of the fee-only variety, don’t work with small clients. Yet, there are two major fallacies to this argument.
First, most brokers don’t work with small clients. Instead, smaller clients are referred to “call centers” and investment products sold to them, typically on a commission basis. Many of the larger brokerage firms possess minimums of $100,000 to $250,000 to work with a broker, face-to-face. Of course, some investment advisory firms also possess minimums. And in both business models – brokers and investment advisers – there are those “financial advisors” (however licensed), including teams of advisors, who will establish their minimums much higher (often at levels of $1M, $5M, $10M, $20M, and even higher).
Second, and most importantly, there are many, many investment advisory firms that work with small clients, and have very low or no minimums. Betterment, LLC, charges an annual fee of only 0.35% on the first $10,000 invested, with a ten dollar minimum initial deposit. $10! – That’s it! Fees go down to 0.15%, depending on the total amount managed. While fund fees are in addition, the firm generally selects very low-fee broad market index exchange-traded funds. And – here’s the key – ongoing investment advice is provided, not just a one-shot “invest in this” arrangement (such as typically comes with commission-based compensation). The firm has tens of thousands of clients (as of a year ago, and they have more than doubled in size since then).
Look also at the XY Planning Network. Clients can get fee-only advice on an ongoing basis for a low, fixed monthly retainer. None of the advisors require a minimum amount to invest. While all advisors on the platform offer monthly retainer fees, many of the advisors also offer investment advice for a flat fee, hourly fees, or a percentage of assets under management.
There are many, many other examples of firms that serve both plan participants, as well as IRA account owners, while being subject to a fiduciary standard of conduct at all times.
The fact of the matter is that advisory fees have been under tremendous pressure. Technology has enabled efficiencies of scale to develop for the delivery of both financial and investment advice.
So why is the anti-fiduciary crowd yelling so much, that small investors cannot be served? Perhaps it is this – Wall Street’s brokerage firms and the insurance companies cannot extract (through commissions, 12b-1 fees, and/or other forms revenue-sharing payments) the excessive rents which their business model appears to require. Perhaps they are unwilling to compete on price.
Yet, the sad fact, as many, many an academic researcher has noted, is that the greater the fees and costs extracted by the financial intermediaries, the lower the returns the investor – plan participants and IRA account owners in this instance, will achieve.
But wait, they say. All that is needed is “disclosure” of fees, costs, and conflicts of interest. Yet, study after study has found that individual investors, even when provided with financial literacy education, seldom read disclosures and – even if read – seldom understand them. There are many, many behavioral biases which individual investors possess which negate the effectiveness of disclosures.
By way of further explanation, academic researchers have long known that emotional biases limit consumers’ ability to close the knowledge gap. Recent insights from behavioral science call into substantial doubt some cherished pro-regulatory strategies, including the view that if regulators force delivery of better disclosures and transparency to investors that this information can be used effectively.
Note as well that, as observed by Professors Stephen J. Choi and A.C. Pritchard, “instead of leading investors away from their behavioral biases, financial professionals may prey upon investors’ behavioral quirks … Having placed their trust in their brokers, investors may give them substantial leeway, opening the door to opportunistic behavior by brokers, who may steer investors toward poor or inappropriate investments.” Stephen J. Choi and A.C. Pritchard, “Behavioral Economics and the SEC” (2003), at p.18.
Moreover, Robert Prentice, who researches ethical decision making, writes, “not only can marketers who are familiar with behavioral research manipulate consumers by taking advantage of weaknesses in human cognition, but … competitive pressures almost guarantee that they will do so.” Robert Prentice, “Contract-Based Defenses In Securities Fraud Litigation: A Behavioral Analysis,” 2003 U.Ill.L.Rev. 337, 343-4 (2003), citing Jon D. Hanson & Douglas A. Kysar, “Taking Behavioralism Seriously: The Problem of Market Manipulation,” 74 N.Y.U.L.REV. 630 (1999) and citing Jon D. Hanson & Douglas A. Kysar, “Taking Behavioralism Seriously: Some Evidence of Market Manipulation,” 112 Harv.L.Rev. 1420 (1999).
As a result, much of the training of registered representatives of broker-dealer firms and of insurance agents involves how to establish a relationship of trust and confidence with the client. Once a relationship of trust is formed, customers will generally accede to the recommendations made by the registered representative, even if a bevy of disclosures is presented to them.
As Yale University Professor Daylian Cain, Carnegie Mellon Professor George Loewenstein, and Univ. Cal. Berkeley Prof. Don Moore have observed, “sunlight fails to disinfect.” Cain, Daylian M. and Loewenstein, George and Moore, Don A., When Sunlight Fails to Disinfect: Understanding the Perverse Effects of Disclosing Conflicts of Interest (July 7, 2010). Journal of Consumer Research, Forthcoming. Available at SSRN: http://ssrn.com/abstract=1635819.
Perhaps that’s why Wall Street embraces this new “federal fiduciary standard” – which is really just “suitability” plus “casual disclosure” of fees, costs and conflicts of interest via web sites that must be first be accessed by investors (rather than disclosures provided to them). Because Wall Street knows that disclosures don’t work.
Let’s put the arguments of SIFMA, FSI, NAIFA, NAPA and some many other paid lobbyists to rest. Simply put, small investors ARE BEING SERVED now under a fiduciary standard. Don’t state otherwise – it just makes you look foolish and deceitful.
And another thing – to those members of SIFMA, etc., who continue to oppose fiduciary duties. Just because your business model doesn’t permit you to extract excessive rents from Americans should a fiduciary standard be imposed, and just because you can’t compete in a fiduciary landscape using your current business model, does NOT mean that your business model needs to be preserved. Get with the times. Your very expensive “cheese” is being moved. It’s time for you to adapt, or perish. (Of course, perish seems more likely. For even as Wall Street with its expensive marketing channels has tried to delay and stymie regulatory reforms, which seek to foster competition in the best interests of customers, the Wall Street broker-dealer firms and the insurance companies continue to lose market share to fiduciary advice providers – a little bit each year.)
3. "The SEC and DOL Should Coordinate, and the SEC Should Go First."
ERISA’s “sole interests” fiduciary standard augmented by prohibited transaction rules (under which exemptive relief can be granted provided the exemption is in the “best interests” of the plan participant) is different from the Advisers’ Act “best interests” fiduciary standard.
The fact exists, that in the current Administration, Wall Street and the insurance companies don’t appear to possess a great deal of influence with the tough and determined Phyllis Borzi and her team of capable staffers in the Employee Benefits Security Administration (EBSA, which is part of the DOL). However, due to the “revolving door” for staffers at the SEC, and several other other reasons, Wall Street has a much better chance of “regulatory capture” of the SEC’s rule-making process. Much depends upon SEC Chair’s Mary Jo White ability to resist Wall Street’s influence at the SEC; this is difficult for her considering that many of her key staff worked on Wall Street, or for law firms that represented Wall Street’s interests. Staff tend to heavily influence rule-making processes at the SEC, unless the Chair and at least two commissioners are exceptional at resisting the subtle, and not-so-subtle, influences at work.
Wall Street’s and the insurance industry’s lobbyists are suggesting that the SEC should “go first,” or that the DOL and SEC proceed only at the same time. Why? What rationale exists, for one to go before the other, or for both to go at the same time, when the very laws that govern their standards are different, and the standards themselves are different?
This is a stall tactic, plain and simple. And, in Congress, it’s not just a tactic designed to stall. The bill previously introduced to let the SEC proceed first, under this stall tactic, included such onerous requirements and restrictions as the bill's sponsors would have effectively halted, in place, any rule-making, not just at the DOL but also at the SEC, on the fiduciary standard. This is what Wall Street's lobbyists really want, even more than delay through obfuscation.
Wall Street and the insurance lobbies are spending tens of millions of dollars (if not hundreds of millions of dollars) to stop the DOL’s fiduciary rulemaking, and to influence the potential application of fiduciary standards by the SEC upon brokers who have chosen to provide “personalized investment advice.” Much of these funds are being spent promoting untruths and falsities.
Under close examination the major arguments Wall Street and the insurance lobbies make don’t withstand scrutiny. They don’t reflect reality.
The reality is, they are up in arms because their business model cannot compete. Wall Street and the insurance companies do not want rulemaking to occur which will foster competition on an even playing field.
Wall Street screams that any proposal must be “business model neutral.” Yet this in itself is a fallacy. For the fiduciary standard, at its core, is a restraint on greed. If the business model contains so many economic levers which encourage greed, via multiple conflicts of interest, it will not survive in a fiduciary environment. Wall Street must change its ways. In so doing, Wall Street must accept the fact that our fellow Americans care far more about their own financial security than Wall Street’s huge diversion of the returns of the capital markets into its coffers.
The battlegrounds in these fiduciary wars are many. Given the extremely heavily monied and very influential lobbyists from Wall Street and the insurance companies, and their sheer number, the relatively few fiduciary advocates have an uphill battle ahead of them – even with support from the White House.
Can you assist in these battles? Send a fax or letter to your U.S. Senators and U.S. Representatives today. Ask them to deny these attempt, through positions proven wrong, to stifle the fiduciary standard and the fair competition which results thereunder. Ask them to protect individual Americans, rather than through legislation preserve a business model in which the American consumer is fleeced via multiple conflicts of interest and often-hidden compensation. Ask your Senators and Representative to better secure the financial future of our fellow citizens, rather than preserve, at Wall Street’s urging, a business model which an informed modern consumer neither needs nor desires.
Ron A. Rhoades, JD, CFP(r) is a Professor of Business at Alfred State College, Alfred, NY. In July 2015 he will be joining the faculty of the Finance Department at Western Kentucky University, where he will chair its vibrant Financial Planning Program. This article represents the author's own views, and not any organization, firm, or institution with whom he is associated. Ron may be reached via e-mail at: RhoadeRA@AlfredState.edu.