As long as American consumers cannot discern between ethical actors (who adhere to a bona fide fiduciary standard at all times, without disclaimers of core fiduciary duties, and keeping the clients' best interests first even when unavoided conflicts of interest are present and disclosed) and actors bound only by the weak suitability standard, the demand for financial planning and investment advice will stagnate. Consumers will often choose to "go it alone" - as many have.
We have a problem in America.
The world is far more complex for individual investors today than it was just a generation ago. There exist a broader variety of investment products, including many types of pooled and/or hybrid products, employing a broad range of strategies.
This explosion of financial products has hampered the ability of plan sponsors and individual investors to sort through the many thousands of investment products to find those very few which best fit within the retirement plan or individual investor’s portfolios. Furthermore, as such investment vehicles have proliferated, plan sponsors and individual investors are challenged to discern an investment product’s true “total fees and costs,” investment characteristics, tax consequences, and risks. Simply put, retirement plan sponsors and their participants are at a vast disadvantage.
Information Asymmetry is Vast and will Never Disappear.
Disparities in the availability of information, or its quality, or its understanding, lead to advantages by those endowed with the ability to decipher, discern and apply the information correctly. It must be recognized that efforts to enhance financial literacy, while always worthwhile and important, will never transform the ordinary American into a wholly knowledgeable consumer of financial products and services, just as we cannot expect the average American to perform brain surgery.
Given the sophisticated nature of modern financial markets and complex array of investment products, it is not just the uneducated that are placed at a substantial disadvantage – it is nearly all Americans. Hence, other means are necessary to negate advantages brought on by information asymmetry.
If Disclosures Alone were Sufficient, There Would be no Need for the Fiduciary Standard of Conduct.
Substantial academic research has revealed that disclosure is not effective as a means of dealing with the vast information asymmetry present in the world of financial services. Indeed, as the sophistication of our capital markets had increased, so has the knowledge gap between individual consumers and financial advisors.
Additionally, academic research now reveals that disclosures, while important, can lead to perverse results – i.e., worse advice is provided if the advisor, following disclosure, feels unconstrained by the application of the fiduciary standard of conduct.
The Need to Embrace Fiduciary Principles for Certain Actors.
Because of the vast information asymmetry, and due to the many behavioral biases consumers possess which deter them from effectively spending the time and effort to read and understand mandated disclosures, there exists a great need for financial and investment advice. In such situations, our fellow citizens place trust and confidence in their personal financial advisor. It is right and just in such circumstances that broad fiduciary duties be applied to these financial intermediaries.
The absence of appropriate high ethical standards for all providers of personal financial advice, whether to plan sponsors, plan participants, IRA account owners, or others, is a glaring current gap in the financial services regulatory structure.
The Need to Ensure Distinctions between the Types of Financial Intermediaries.
Individual consumers should be empowered to more easily identify the difference between the financial advice role (to which fiduciary status should attach) and the product marketing role (an arms-length relationship, to which only far lesser obligations, such as ensuring suitability, apply). Currently these roles are closely intertwined, and it is exceedingly difficult for consumers to distinguish between them (in part because the product marketer type of intermediary possesses no incentive to make that distinction clear).
Our regulators possess the authority and the ability to ensure that consumers are not misled by the use of titles and designations, and they should ensure that all those who hold themselves out as trusted advisors – or who actually provide advisory services – are bound to act in the interests of their clients under the fiduciary standard of conduct. But, our regulators do not appear to have the backbone to prevent ongoing fraud from occurring. As a result, most consumers who possess "financial consultants" (or advisors with similar titles) believe that their advisor is bound to act in their best interests; sadly, in most instances the advisor is not bound by a fiduciary standard, but is only governed by the suitability standard (designed to protect the advisor, not the consumer).
Investor Distrust = Less Capital Formation & Less U.S. Economic Growth.
The siphoning of profits by Wall Street, away from the hands of individual investors, has led to a high level of individual investor distrust in our system of financial services and in our capital markets. In fact, many individual investors, upset after finally discovering the high intermediation costs present, flee the capital markets altogether. (Many more would flee if they discovered all of the fees and costs they were paying, and realized the substantial effect such had on the growth or preservations of their nest eggs.) The effects of greed in the financial services industry can be profound and extremely harmful to America and its citizens. Participation in the capital markets fails when consumers deal with financial intermediaries who cannot be trusted.
As a result of the growth of investor distrust in financial intermediaries, the capital markets are further deprived of the capital that fuels American business and economic expansion, and the cost of capital rises yet again. Indeed, as high levels of distrust of financial services continue, the long-term viability of adequate capital formation within the United States is threatened, leading to greater reliance on infusions of capital from abroad. In essence, by not investing ourselves in our own economy, we are selling our bonds, corporate and other assets to investors abroad.
It is well documented that public trust is positively correlated with economic growth. Moreover, public trust is also correlated with participation by individual investors in the stock market. This is especially true for individual investors with low financial capabilities – those who in our society are in most need of financial advice; policies that affect trust in financial advice seem to be particularly effective for these investors.
The lack of trust in our financial system has potential long-range and severe adverse consequences for our capital markets and our economy. As stated by Prof. Ronald J. Columbo in a recent law review article: “Trust is a critical, if not the critical, ingredient to the success of the capital markets (and of the free market economy in general). As Alan Greenspan once remarked: ‘[O]ur market system depends critically on trust - trust in the word of our colleagues and trust in the word of those with whom we do business.’ From the inception of federal securities legislation in the 1930s, to the Sarbanes-Oxley Act of 2002, to the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, it has long been understood that in the face of economic calamity, the restoration and/or preservation of trust – especially investor trust – is paramount in our financial institutions and markets.”
There is no doubt that “[t]rust is a critically important ingredient in the recipes for a successful economy and a well-functioning financial services industry. Due to scandals ranging in nature from massive incompetence to massive irresponsibility to massive fraud; investor trust is in shorter supply today than just a couple of years ago. This is troubling, and commentators, policymakers, and industry leaders have all recognized the need for trust's restoration …."
Less Trust = Less Use of Financial Advisors
The issue of investor trust in financial intermediaries does not just concern asset managers and Wall Street’s broker-dealer firms; it affects all investment advisers and financial advisors to individual clients. As Tamar Frankel, a leading scholar on U.S. fiduciary law, once observed: “I doubt whether investors will commit their valuable attention and time to judge the difference between honest and dishonest … financial intermediaries. I doubt whether investors will rely on advisors to make the distinction, once investors lose their trust in the market intermediaries. From the investor’s point of view, it is more efficient to withdraw their savings from the market.”
In an Oct. 30, 2014 article by Donald Liebenson, "Why Don't Self-Directed Investors Use a Financial Advisor?" - appearing in Spectrum's Millionaire's Corner online publication, "[t]he primary reason for 36 percent of non-Millionaires who elect to go solo regarding their wealth management and financial planning is that they do not believe that a financial advisor would be looking out for their best interests."
Personally, I have seen this time and again. Once burned (or, in some instances, burned several times) by non-fiduciary "financial consultants" and "wealth managers," the consumer turns to self-directed advice. And, too often, consumers who are burned by their "financial advisors" often turn instead to bank depository accounts, thereby avoiding investments in the capital markets (which, by limiting supply of capital, increases the cost of capital to companies).
What Now? Regulatory Solutions?
We can hope that the White House will permit the U.S. Department of Labor (specifically, the Assistant Secretary of EBSA, Phyllis Borzi, and her team) proceed to re-issue the "definition of fiduciary" rule, which would logically apply fiduciary rules to advisors to plan sponsors (who are themselves fiduciaries, and hence should rarely if ever rely upon non-fiduciaries for advice). Given the importance of retirement security for our fellow Americans, the extension of ERISA's sole interests standard to IRA accounts is part of the proposal. Yet, tens of millions of dollars (if not more) are being spent each and every year and hundreds of lobbyists (working on behalf of large Wall Street firms and insurance companies) seek to prevent this rule from seeing the light of day, or alternatively to delay the issuance of the proposed rule. I've been waiting since early 2013 for the DOL's proposal to be released; let's hope an early 2015 release will occur.
We can also hope that the SEC will act, using its authority, to extend the Investment Adviser Act's fiduciary standard (as modified to a degree by Dodd-Frank) to all providers of personalized investment advice, however registered. Yet, the SEC has delayed the process of engaging in rule-making by ordering up another economic analysis. And, given the intense pressure exerted by Congress on the SEC, Chair Mary Jo White may desire to focus on other issues the SEC is required to act upon, pursuant to Dodd Frank. Additionally, as a result of actions taken over the past three decades, the SEC has already gutted the fiduciary standard - by permitting waivers of core fiduciary obligations (and hence permitting double-dipping and similar abuses), and by permitting an easy removal of the fiduciary hat (and, in essence, hat-switching back and forth). Even if the SEC acts, it is unlikely that the SEC's fiduciary standard will be a strong one; the SEC's fiduciary standard will likely continue to be weakened by "particular exceptions" (as the late Justice Benjamin Cardoza warned against).
We can hope that the various state securities administrators step up to the table and adopt new model statutues and/or rules setting forth a bona fide fiduciary standard. But, given the continued preemption of state authority by Congress, they may be fearful of the backlast which would likely ensue from Congress (which is substantially influenced by Wall Street's lobbyists).
The Private Marketplace Solution ... Who Has It?
While continuing to advocate before federal and state policymakers on the fiduciary standard remains important, I believe it is time to also search out and embrace a marketplace solution.
It is important, however, for this marketplace solution to embrace a bona fide fiduciary standard - with principles that are broad and all-encompassing, yet with subsidiary principles (or rules) which illuminate upon the broad principles and leave little or no avenues for those who seek to circumvent the rules by creative "interpretations" of the broad principles.
What is a bona fide fiduciary standard? As stated above - it is not just disclosure of a conflict of interest, when a conflict of interest exists. Rather, it proper management of that conflict of interest. Of course, fiduciary duties also involve a strong professional duty of care.
Where can we find a bona fide fiduciary standard? We can start with The Committee for the Fiduciary Standard (or "CFS," of which this author serves as Chair of its Steering Committee), a group of volunteers. The CFS posits that the fiduciary standard as currently applied under the Advisers Act can be summarily articulated as a set of five core principles:
- Put the client’s best interests first;
- Act with prudence, that is, with the skill, care, diligence and good judgment of a professional;
- Do not mislead clients--provide conspicuous, full and fair disclosure of all important facts;
- Avoid conflicts of interest;
- Fully disclose and fairly manage, in the client’s favor, unavoidable conflicts.
These five core principles form the basis of The Committee for the Fiduciary Standard's "Fiduciary Oath," which all consumers should insist on be signed by their financial advisor or investment adviser:
PUTTING YOUR INTERESTS FIRST
I believe in placing your best interests first. Therefore, I am proud to commit to the following five fiduciary principles:
- I will always put your best interests first.
- I will act with prudence; that is, with the skill, care, diligence, and good judgment of a professional.
- I will not mislead you, and I will provide conspicuous, full and fair disclosure of all important facts.
- I will avoid conflicts of interest.
- I will fully disclose and fairly manage, in your favor, any unavoidable conflicts.
Firm Affiliation ____________________________
Yet, today we see terms such as "best interests" are being co-opted by non-fiduciary. (Witness, for example, FINRA's embrace of the term in recent communications.) Hence, further definition of the principles appears to be required.
While the world "fiduciary" is not utilized in the CFS' Fidicuary Oath, the five principles flow from the broad fiduciary standard of conduct applied to investment advisers, which is commonly set forth in the United States as a triad of broad fiduciary duties – due care, loyalty, and utmost good faith. As a result, from the CFS' five core principles we can discern additional specific principles in applying the fiduciary standard which can serve to guide both fiduciaries and their clients.
To this end, I propose "Professional Standards of Conduct" which, together with the Five Core Principles and the "Fiduciary Oath," all bona fide fiduciaries can voluntarily subscribe to. Set forth below, these Financial Advisor and Investment Adviser Professional Standards of Conduct are patterned, in part, after the Model Rules of Professional Conduct of the American Bar Association (as attorneys also possess fairly strict fiduciary obligations toward their client). The included footnotes, below, further explore each specific standard.
Which Organization(s) Will Step Forward?
There are many organizations which possess some form of voluntary adherence to a "Code of Ethics" or "Fiduciary Oath" or "Standards of Conduct." At times interpretations of these standards permit actors to not be required to be a fiduciary at all times, when providing financial advice. At other times these voluntary codes are ill-prescribed and/or possess giant loopholes.
Which organization(s) will step forward to adopt clear and unequivocal fiduciary standards for its members, at all times when fiduciary standards are applied?
Which organization(s) exist now, if any, around which we - as an emerging profession - can voluntarily embrace as our professional standard of conduct?
- CFP Board?
- Alliance of Comprehensive Planners?
- Garrett Planning Network?
- CFA Institute?
- AICPA/PFP Section?
- fi360 (AIF)?
- Institute for the Fiduciary Standard?
In each instance, exploration is needed as to whether the organization embraces bona fide fiduciary standards of conduct (as set forth in detail, below) to the delivery of all personalized financial and investment advice.
Moreover, even with the adoption of the proper oath and standards, the organization must be committed to providing media exposure to its "Fiduciary Oath" and "Standards of Professional Conduct," through concerted promotion, in order to ensure an increased awareness by consumers of where consumers can go for trusted advice. Only in that manner will consumers avail themselves of the trusted financial advice which they need in order to better secure the attainment of their financial goals. Only in that manner will the vast majority of Americans eventually secure trusted advice, leading to increased capital formation and U.S. economic growth. As well as more secure personal financial futures.
Of course, if none of the above organizations is willing to embrace professional standards of conduct, of the form set forth below, should a new organization be formed? If so, should it be private and for-profit, or private and not-for-profit?
These are difficult questions. Let us hope we can explore these questions, and find potential solutions, in the months and years ahead. For the sake of a true profession. For the sake of all Americans.
Ron A. Rhoades, JD, CFP(r)
Asst. Professor, Business Department
Program Director, Financial Planning Program
Alfred State College
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The foregoing article represents the individual views of Ron Rhoades, and should not be attributed to any organization with which Ron is affliated in any manner. To contact Ron Rhoades, please e-mail: RhoadeRA@AlfredState.edu. Thank you.
(NOTE: THESE PROPOSED STANDARDS CAN BE MODIFIED TO ALSO APPLY TO THE DELIVERY OF OTHER ASPECTS OF FINANCIAL ADVICE.)
INVESTMENT ADVISER PROFESSIONAL STANDARDS OF CONDUCT