If you’ve been paying attention to financial news, you’ve probably heard mention of the fiduciary rule. This rule was approved last year under the Obama administration, with the goal of increasing transparency within the investment realm. It was designed to force advisors to suggest investment products to their clients that were more affordable, rather than being able to suggest ones that instead provided these advisors with higher commissions.
While the rule has not yet been implemented (it was slated to go into play this April), it looks like its run may be short-lived. Today, President Trump signed an executive order that is likely to halt the implementation of the rule, along with ordering a widespread review of the Dodd-Frank Act.
This has many up in arms, as the fiduciary rule seems to be a matter of common sense and integrity. Forcing ALL advisors to offer their clients less expensive investment products, rather than higher priced ones that may result in bigger commissions, seems like a great idea. Transparency throughout any industry should be mandatory… so why nix the rule?
Yes, There Is Already a Fiduciary Obligation…
For almost 80 years, a fiduciary obligation — called the fiduciary standard — has been in place. This was implemented with the Investment Advisors Act of 1940, intended to affect most types of investment accounts. This standard implements an expectation that advisors need to place their client’s interests ahead of their own. The advisor is always supposed to act in the best interests of their clients, in every situation, whether the client is aware of it or not.
The reach of this standard is far and wide. An advisor cannot, for example, make trades on a client’s behalf that would result in higher commissions or fees for himself or his firm. An advisor is supposed to make all efforts to ensure that the investment advice given is not only accurate, but complete. They are bound to a “best execution” standard, while dictates that the purchase and sale of securities should be completed with the best possible combination of low cost and efficiency. Advisors are also prohibited from buying securities for themselves before they buy them (or advise their purchase) for their client.
Lastly, and perhaps most importantly, the existing fiduciary standard already prohibits the potential of conflicts of interest. In fact, if a potential conflict of interest is present, the advisor must disclose this to the client before any trades take place. Which begs the question…
Then, What Would the Fiduciary Rule Even Change?
As mentioned, the fiduciary standard already has provisions to avoid and prohibit conflicts of interest between advisors and their clients. This is, of course, the heart of the fiduciary rule… so why the new implementation?
Well, the difference primarily lies in the types of retirement account providers to which the existing rule applied.
As it stands today, the fiduciary standard does not technically apply to insurance reps, broker-dealers, and financial company reps (other than investment advisors). These individuals, instead, are bound by the suitability standard.
The suitability standard is much simpler and much less comprehensive. In a nutshell, it says that an advisor only needs to assess a client’s risk and tolerance before offering investment products and advice. Essentially, gathering a client’s preferences is enough, as long as the products the advisor subsequently recommends match those preferences. This opens up the possibility of a very large grey area… if an advisor simply believes that a product suits a client’s risk tolerance, it’s fair game.
The new rule, though, would make sure that everyone was bound to the fiduciary guidelines. Rather than having the freedom to pick financial products that simple lie below a client’s threshold, all advisors would need to first disclose the fees, limitations, conflicts of interest, etc. of the product. As of now, just the designated investment advisors are bound to such. The fiduciary rule simply hoped to expand this rule to anyone and everyone offering any sort of investment-related advice.
Why It’s Happening
Well, the argument seems to be that the fiduciary rule could actually harm many of the lower-income investors out there, in a number of ways. First, it would prevent advisors from recommending more expensive investment products to their clients when lower priced alternatives exist — even if the higher priced ones were a better match in the end.
Forcing advisors to be transparent about fees and compensation sounds like a great idea, unless the client then chooses their investment product based on this information alone. If an advisor puts three different funds in front of a client, with one having a noticeably higher rate of commission, the client is less likely to lean toward that fund. But what if it had a good chance of outperforming the others? To combat this, potential investors would need to take into account all components of a financial product, not just seek to avoid fees where they could.
Does limiting suggestions to lower cost financial products actually harm the client? Could narrowing their options actually be taking away their investment freedom, causing harm in the long run? Some fiduciary rule-protesters think so.
Another way that this rule could harm lower-income investors is through financial advisor services. Today, some companies are able to offer free or low-cost investment advice to their customers. The new regulations threaten to increase their fees for providing such, resulting in some of the smaller savers being denied advice or simply being unable to afford it.
The Impacts Overall
The fiduciary rule has also been challenged as detrimental to the smaller firms and dealer-brokers in the industry. The cost of compliance with the rule is expected to be high, with additional technology and compliance experts being an added, necessary investment.
As a result, we could expect to see many of these companies disband or be acquired. It’s actually already being seen, in the case of American International Group and MetLife Inc. brokerage operations. Both of these have already been sold off in anticipation of the fiduciary rule’s April 10 implementation date.
What does this really mean, though? Less diversity in the industry, for starters, as the independent companies disappear. Also, as the consolidation continues, it threatens to eliminate (or make difficult to find) advisors who will be able to offer smaller plans. Once again, this has the potential to greatly impact the lower-income investors.
It’s interesting to note that when the United Kingdom implemented a similar rule in 2011, their investment industry had exactly this response. Independent companies could not keep up or could not afford to comply with the technology and changes required. So, they forged paths with larger corporations. As a result, the number of financial advisors in the U.K. has dropped by a whopping 22.5% ever since, creating an even bigger guidance gap than had previously existed.
This effect makes it easy to see why the fiduciary rule has been referred to as “Obamacare for your IRA.” While the rule is necessary and important in many ways, its impact of narrowing the advisor industry down to fewer and fewer options is certainly a check mark in the negative column. Having options and healthy competition between companies is generally a big benefit for consumers.
All Hope Is Not Lost
For proponents of the fiduciary rule who are appalled to see its (likely) overturn today, I have some good news. Many of the financial services companies that were slated to be impacted by its April roll out are going to move forward with their new standards. They had already put new changes in place and believe that transparency is an important part of the advisor-investor relationship.
Companies like Morgan Stanley and LPL Financial Holdings, Inc. have both said that they still plan to move forward with the new standards that they have already worked to create. Hopefully, this idea of working in the best interest of the customer catches on and spreads, on its own, throughout the industry.
Until then, we wait and see.
Updated February 4, 2017 and originally published February 3, 2017.