There’s a blood in the water right now for the financial industry, and it’s because investors often don’t understand how they’re paying for investment advice.
The United States Department of Labor is proposing a new guideline for retirement investments referred to as the Fiduciary Rule. The rule would require financial industry professionals working with clients investing in retirement accounts, including 401ks and IRAs, to act strictly in the best interest of the client and disclose any conflicts of interest.
Time for a head scratch and the question, “Wait… they’re not already doing that?”
The answer to that question isn’t necessarily as black and white as you might assume. There are two main camps for investors to turn to when looking for advice, Registered Investment Advisors (RIAs) and broker-dealers. RIAs are fiduciaries, meaning they are obligated to serve the best interests of their clients. Broker-dealers up to this point have only been held to the standard of “suitability obligation” roughly translating to mean that they must be sure their investment advice is suitable for their clients.
Isn’t this a little confusing? Suitable vs. best interest, what’s the difference? Think of it this way – you’re thinking about buying a car, so you call Don Ready at the GMC dealership. Don is going to sell you a GMC which will serve its purpose and get you from point A to point B. Or you could instead consult Jorge, an independent car broker, who can shop any dealership or any brand to fit all of your needs (price, gas mileage, color, etc). Both Don and Jorge want to find a car for you, but their end goals are slightly different. Think of Don as a suitability “broker dealer” while Jorge acts as a fiduciary advisor.
Broker-Dealer or Broker = Suitability
Investment Advisor = Fiduciary
Now keep in mind that this has worked because these are two different business. While most investment advisors simply charge a flat percentage fee or hourly rate, a broker-dealer typically earns commissions and fees from a variety of different products and services they sell to clients.
While I believe the vast majority of the financial industry’s professionals do work with the best interests of their clients at heart, the current broker-dealer business model that is in place incentivizes brokers to sell financial products that provide them with commissions.
Up to this point, this practice has been loosely regulated. Under the new rule, brokers will still be allowed to set their own compensation models and charge for their services by way of commissions, revenue sharing, 12b-1 fees, and asset management fees. However, the rule will legally require brokers to act in their clients’ best interest (not just suitable) and disclose any conflicts. This new rule would essentially move all brokers to instead act like investment advisors because they would now all be held to a “fiduciary standard.”
From an investor’s stand-point this sounds like a great plan. However, there is some worry with how this will impact the business model for the financial industry as a whole.
Broker-dealers actually serve an important function in the financial industry. They’re firms that invest for both clients (broker) and the firm itself (dealer). These firms include traditional Wall Street organizations like J.P. Morgan and UBS, as well as other large commercial banks, investment banks and even small independent boutique firms, many of which would likely sound familiar to you.
These firms provide the infrastructure that facilitates stock trading. They help companies launch IPOs, and they work with the U.S. government by bidding on Treasury bonds and other securities. They also facilitate stock splits and dividends among many other important tasks that helps keep the markets moving day-to-day.
All that said, there is no ignoring that these groups have gotten a bad reputation. From the movies to the real court cases and crime, Wall Street doesn’t have a squeaky clean reputation. When you think about it, though, neither do all doctors, lawyers, politicians or even the teachers in Atlanta’s public school system. But just because there are bad actors in every industry, it doesn’t mean the industries as a whole are evil, and Wall Street is no exception.
When it comes back to the new Fiduciary Rule that the Department of Labor is pushing towards, I'm torn. I do believe that investors are best suited to work with fiduciaries which is what the government is pushing towards for retirement accounts specifically. However, there's already a multi-trillion dollar industry that does just that. So to force the mammoths of Wall Street to all reevaluate and change their business models completely could interrupt the very functionality of our entire financial system.
I'm of the belief that broker-dealers serve an important role in this industry, as do investment advisors. We need the operational function of both parties. Instead of new government regulation, I believe that education as to what roles these parties serve is ultimately the key that will lead to success for more retirees.
Certified financial planner Wes Moss offers financial and accessible investment advice to Atlanta Bargain Hunter readers.
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