Monday, May 8, 2017

The DOL Fiduciary Rule: Simply Great for the U.S. Economy, American Corporations

Dear U.S. Dept. of Labor Secretary Acosta:

Two very important considerations relating to U.S. Business and the U.S. Economy are often overlooked in discussions about the DOL’s Conflict of Interest Rule:

FIRST - The Rule Benefits American Business, via Minimization of the Risks of Plan Sponsors.

Currently firms that sponsor ERISA-covered qualified retirement plans are at substantial litigation risk, due to lack of expertise in choosing the right lineup of investment options.

Interestingly, in most cases, the “retirement plan consultant” to the plan sponsor, who provided recommendations as to which funds to include in the plan, is “off the hook” (as they hide behind the suitability shield). Hence, broker-dealer firms are often dismissed (or granted summary judgment) in the initial phases of class action lawsuits brought by plan beneficiaries against the plan sponsors.

In essence, a delay and/or repeal of the DOL fiduciary rule will hurt American business owners (plan sponsors), large and small, by shifting risk from broker-dealer firms to most other American businesses.

With the DOL fiduciary rule in place, business owners will then be entitled to rely upon the advice they were provided. Since business owners large and small are not typically highly trained in the worlds of portfolio design and investment product selection, this only seems fair. Business owners concentrate on growing their business. And business owners higher trusted experts to assist them with navigating the complex world of investments.

SECOND - The Rule Benefits the U.S. Economy, as it Fosters Greater Accumulation of Capital. This in Turn Lowers the Cost of Capital for U.S. Firms and Spurs U.S. Economic Development.

The prospect of the DOL Rule has already resulted in substantial reductions in asset management fees at a number of mutual fund companies and other product providers.

The academic research is clear – lower fees and costs result in higher returns for individual investors, and greater accumulations in their retirement nest eggs. Currently the excessive extraction of rents by Wall Street firms and the insurance companies substantially impairs the growth of retirement nest eggs. This means that senior citizens will need greater services - from all levels of government - during their retirement years. This is a burden governments can ill-afford in the future, and will likely mean greater levels of taxation upon our citizens.

Just as importantly, lower investment product fees result in greater accumulation of capital in our economy. Over time, the impact is huge. Just as a rough estimate, we are talking about a likely 10% to 20% greater accumulation of capital over the next 20 years (and possibly much more). Even greater benefits result later, as the effect is cumulative.

The accumulation of capital, in turn, provides the fuel to turn the innovations from our researchers in American business and higher education into new products, bringing new benefits to Americans and to the world.

Such greater accumulations of capital can also lower the costs of capital to American business. This spurs on the undertaking of additional projects, which in turn results in both greater profits to American business and greater economic growth.

IN SUMMARY, when you expand the army of trusted, expert advisers to aid American business owners, qualified retirement plan participants, and IRA owners, GREAT THINGS HAPPEN.

Please consider the interests of all businesses, large and small. (Not just the handful of Wall Street firms and insurance companies that oppose the fiduciary rule.) And please consider how the DOL Fiduciary Rule will promote new business formation, job creation, and the expansion of the U.S. economy.

Thank you.

Saturday, May 6, 2017

Dear Thrift Savings Plan: Are You Shortchanging U.S. Government Workers?

An Open Message to the U.S. Government's Thrift Savings Plan:

There is a great deal to be admired about the U.S. Government's Thrift Savings Plan (TSP). Its low fees and costs (including low turnover, and hence low transaction costs, within the funds). It's L funds (Lifecycle Funds), that make investing easier for government employees. The stable value feature of the G fund and (in a fairly low interest rate environment) its attractive yield, given the lack of interest rate risk.

Yet, upon closer scrutiny, the TSP only has 5 investment options (plus the Lifestyle Funds):

  • G Fund: Government securities (specially issued to the TSP)
  • F Fund: Government, corporate, and mortgage-backed bonds
  • C Fund: Stocks of large and medium-sized U.S. companies
  • S Fund: Stocks of small to medium-sized U.S. companies (not included in the C Fund)
  • I Fund: International stocks of more than 20 developed countries
And, here's the rub. Over the past 25 years academic research has revealed "factors" that can be utilized to gain additional risk exposures, while also leading to high probabilities (over 10-20 year periods) of additional returns. While literally hundreds of factors have been discovered, only a handful have both withstood academic scrutiny and are "investable" at a fairly low cost. Examples of these factors include the value risk premium, the small cap risk premium (with newer research indicating its concentration among either micro cap stocks or small cap value stocks), and the profitability factor. (Others exist, as well.)

Yet, the Thrift Savings Plan has no funds that take advantage of these factors and this academic research. The result? Underperformance of a portfolio that uses only the TSP funds, relative to what could be achieved, is likely to occur by 1% to 2% a year (or greater) over most 10-20 year periods of time. Given the effects of compounding, this is likely to translate to 25% to 50% (or greater) lesser accumulations in their retirement accounts, at least for those government employees who invest fairly aggressive in equities (as they should) starting at age 25 and continuing to age 45. (Note that saving and investing wisely, early on in one's career, is key to building the foundations for a successful retirement and "financial freedom.")

Nor do the Lifestyle Funds stack factor exposures with the equity premium, while lowering allocations to fixed income - which portfolio construction has a high likelihood of achieving the desired levels of returns but with much less overall risk exposure.

So, I appeal to you, on behalf of my friends who work for the U.S. government and who participate in the TSP. Please add:

  • A multifactor total U.S. stock market fund with tilts toward value, small cap, and profitability.
  • A multifactor total foreign markets fund with the same tilt, and providing exposure to both foreign developed markets and foreign emerging markets.
  • The use of such multifactor funds within your LifeStyle Funds (or some new Lifestyle Funds).
  • For employees who desire to best integrate their TSP funds with their outside investments, additional individual funds should be offered in these research-favored asset classes:
    • U.S. large/mid cap value stocks;
    • U.S. small cap value stocks;
    • International developed markets large/mid cap value stocks;
    • International developed markets small cap value stocks; and
    • Emerging markets value stocks.
Our government workers endure many sacrifices to serve the public. Please, TSP, take your stewardship of these workers' hard-earned savings to the next level, to better serve them.

Friday, May 5, 2017

A Message to Morgan Stanley About Its (Lack of a Fiduciary) Culture

I'd like to step out of character and briefly comment on a story that's been circulating recently - Morgan Stanley's decisions to drop sales of Vanguard funds (as new holdings). The reason suggested by commentators? Because Vanguard does not make payments for shelf space (i.e., revenue sharing). In other words, Morgan Stanley will make more money selling funds that do make payments for shelf space. (Of course, Morgan Stanley is not alone - many broker-dealer firms engage in the same practices.)

In a related story, it was reported that Morgan Stanley would pay their financial advisors less if they recommend Vanguard funds.

Assuming such reporting is true, then I would just like to opine ....
  • Payment for shelf space is an insidious practice. It creates a huge conflict of interest for the firm, and its advisors. Such arrangements should not be permitted to exist under a fiduciary standard, for no benefit accrues to the client. Payments for shelf space have to come from somewhere; they often result from management fees in the mutual funds (which management fees are kept higher than they need to be, by the presence of revenue sharing arrangements). And, the academic research is compelling ... higher-cost funds result in less returns to investors, all other things being equal.
    • (Other insidious practices that will become extinct someday: 12b-1 fees; soft dollar compensation.)
  • The conflicts of interest resulting from pursuit of higher fees to the firm from proprietary products or from products which pay revenue sharing cannot (the vast, vast majority of the time) be defended under the DOL's Impartial Conduct Standards. The 237 words of the Impartial Conduct Standards, elegantly written, should serve as a guide for true fiduciary conduct.
  • Under the DOL's Impartial Conduct Standards, the firm and its advisors must adhere to the prudent investor rule. One of the major aspects of that rule is to not waste client assets. This drives fiduciary advisers to seek out the lowest-cost fund or ETF in each asset class (all other things being equal). If a higher-cost fund is recommended, justification for the expenditure of the client's hard-earned wealth must exist. Not just mere justification - but justification that will stand up in court or in arbitration (with the burden of proof rightfully falling on the adviser and firm, when a conflict of interest exists).
  • Is dropping low-cost funds from a platform, in order to favor funds that pay a firm revenue sharing, a breach of the firm's fiduciary obligation under the Impartial Conduct Standards (and ERISA, generally)? That remains to be seen.
    • Probably not, at least under BICE. (And perhaps Morgan Stanley's actions are indicative of how BICE can be manipulated, through structuring what is available to clients. I have always expressed the view that BICE should be viewed as a transitional measure. If BICE indeeds becomes operational, it should be sunset after a few years, lest tomfoolery take place to use BICE to escape the application of the fiduciary principle.)
    • Suffice it to say, however, that it is clear that the spirit of the fiduciary principle is violated, in my view, at the minimum.
To operate as a fiduciary, your compensation arrangement with the client should be level, and agreed to in advance.

Then, as a fiduciary adviser, with your compensation set, you should search out the marketplace for the very best products available to the client. If those happen to be Vanguard funds, you should seek to have them available to your clients - if not directly on your firm's platform, then perhaps directly via Vanguard.

For a fiduciary is required to be an expert, and to exercise due diligence. And to use this high level of professional due care for the benefit of the client. And neither the firm nor the adviser should, under any circumstances, seek to take advantage of the client.

To Morgan Stanley, I convey these messages:
  • If these news reports are true, and if dropping Vanguard funds was the result of the motivations commentators have suggested - I suggest this. Reverse your decision.
  • Stop ... stop ... stop ... creating perverse incentives for your financial advisers to sell proprietary or other funds that pay the firm more, over lower-cost funds.
  • Otherwise, many of your good advisers, who want to do the best for their clients, and who want to be expert, diligent stewards of their client's hard-earned wealth, will eventually depart your firm.
  • Sure, many other advisers, who don't desire to work in a fiduciary culture, and who are willing to take on the added liability (and severe reputational risk) that results from working in a conflict-ridden environment, will likely stay with your firm.
  • Under a conflict-ridden culture, the legal claims will continue. And the litigation costs will continue. And ... oh yes, good new advisers won't be attracted to your firm. It's a dismal path your firm is on, over the long term. Short-term profits may abound, but long-term the firm has a poor future ahead of it.
  • If your advisers act as fiduciaries, don't compel them to also act as product-sellers. The two roles are simply incompatible. To paraphrase many a jurist, "a man cannot wear two hats at the same time."
To Morgan Stanley, I also state:
  • Change your decision-making. Or change your leadership.
  • For the instillation of a true fiduciary culture is driven from the top, always. And strong leadership embracing a bona fide fiduciary standard will be required to move your firm forward, not backwards.
  • If Morgan Stanley's current leadership can't embrace the changes in the industry, and if they fail to understand that the firm's market share will only shrink if its conflict-ridden business model continues to exist, then perhaps its Board of Directors should think about a change ... before Morgan Stanley's ship cannot be turned, and it either capsizes or diminishes in size to become a toy boat in a broad fiduciary sea.
To all dual registrant firms ... don't try to circumvent the fiduciary principle. In an era where greater transparency is required, and fiduciary practice models continue to win in the marketplace (either with or without the aid of regulatory initiatives), it is incumbent upon your firm to go "all in." Learn what is required under a bona fide fiduciary standard of conduct. Then structure your firm, and your services to clients, and the products offered on your platform, accordingly.