Wall Street is trying to kill a proposed White House-backed regulation that would require financial advisers to act in the best interest of their clients when giving advice on retirement accounts. Wait… you thought they already had to do that? Though such a rule may sound like common sense to most investors, Mark Whitehouse of BloombergView says it’s kicked off a spike in the financial industry’s lobbying spending to stop it.
Why? Because it would cost many big players, including full-service brokerages and life insurers, a ton of money. A recent report from a team of equity analysts at Morningstar has just laid out how much cash is on the line.
Morningstar argues that an important source of income for many brokers—sales commissions from the mutual funds they sell—could dry up. Large numbers of individual advisers would likely leave the business. At least $2.4 billion in annual revenue for financial services companies would be at risk, and their operating profits might take a 20% to 30% hit. And over $1 trillion of investor assets could shift into passively managed index funds, which are cheaper and and have a long record of performing better over time.
Here’s what the argument is all about. The stakes are high for the industry, but could also change how you invest and how you get financial advice.
Different advisers play by different rules
When you go to a financial adviser, you may assume that they’re supposed to give advice that’s in your best interest. But this is true only for a portion of advisers, who are known in the legal jargon as fiduciaries. Some other people giving advice, including many brokers and insurance agents, are held to a much less stringent standard known as suitability. This only requires the adviser to recommend a product that makes sense based on factors like a person’s risk tolerance and age.
In practice, that means the broker is less likely to get in trouble for recommending a fund that might not be the very best choice for you, but that just happens to pay him or her a high commission. If an adviser is held to the fiduciary standard, such payments would be harder to justify, or may even be prohibited. Using a fiduciary is no magic bullet for getting good advice: A broker can certainly put you into a portfolio of sensible funds, while a fiduciary might still have lousy investment ideas and high fees. But the idea of a fiduciary duty is that it at least reduces conflicts of interest.
The White House wants to hold brokers to higher standard
Last February, President Barack Obama called on the Department of Labor to extend the fiduciary standard for anyone giving advice about 401(k) money or Individual Retirement Accounts, or IRAs. That would include brokers recommending mutual funds or stocks, as well as insurance agents who sell annuities designed for retirement savings or income.
It may seem weird that the Department of Labor, of all branches of the government, is such a big player in regulating investment advice. But much of the investing that middle-class Americans do is via workplace retirement plans like 401(k)s as well as tax-advantaged accounts like IRAs. The Department of Labor’s role is to define who counts as fiduciary to such accounts. IRAs represent huge chunk of money—Morningstar puts it at $3 trillion of advised brokerage assets. So what happens to them affects how the whole money management industry does business.
How a fiduciary rule would hit advisers
The fiduciary rule doesn’t make it impossible to sell funds on commission. The argument by the Morningstar analysts is that it would often be difficult in practice, and in any case would change the kinds of investments that advisers recommend. One arresting statistic: The number of people working as financial advisers fell 29% after the United Kingdom implemented similar regulation.
In fact, a key industry argument against the new rules is that without the profits from sales commissions, many advisers won’t be willing to work with smaller, less profitable accounts. Morningstar agrees that some firms will likely drop their less affluent customers. So where will all the money go? It might not leave these smaller account holders as high and dry as Wall Street suggests.
How the rule would impact investors
Some investors will switch to accounts where advice is paid for annually as percent of asset management, no matter which funds the adviser recommends. Others will move on to discount brokers, like Charles Schwab, where investors pick stocks and funds on their own without advice. A new breed of low-cost online “robo-advisers” like Betterment and Wealthfront might also grab new clients, as Money has noted before. Those services put their clients’ money into exchange-traded index funds.
Indeed, index funds, like those managed by BlackRock and Vanguard, stand to see a rush of new cash, to the tune of $1 trillion, says Morningstar. The funds, which simply hold all the companies in an index like the S&P 500 tend, tend to be much cheaper than active funds whose managers pick specific stocks to hold. That’s an important advantage for customers paying explicit annual fees for advice. (And for advisers who want to show their clients that they are getting a good a deal.)
The do-it-yourself investors tend to like index funds, too. They are easy to understand and provide broad diversification, and thanks largely to their low costs, they tend to beat active managers over long periods. Last year index funds that track large U.S. companies beat 86% of their actively-managed competitors.
Congress is pushing the other way
In October, the Republican-controlled House passed a bill called the Retail Investor Protection Act that prevents the DOL from changing the standard. Although only three Democrats supported that bill, the rule change has critics among Dems, too, including Sen. Claire McCaskill.
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While the bill has yet to be taken up by the Senate—President Obama has vowed a veto if it passes both chambers—the House bill could put pressure on the Labor Department to amend or water-down its proposal.
If a strong version of the rule passes, and some advisers do stop working with smaller accounts, the interesting question is whether that’s really a bug in the regulation—or a beneficial feature. Consumer advocates and the Department of Labor argue that Americans lose roughly $17 billion annually to poor retirement investment advice, based on a report issued by the White House’s Council of Economic Advisers in February.
Even if you are skeptical of those numbers, investors were already moving fast to simpler, lower-cost investments. There is now $4 trillion in index mutual funds and ETFs, or roughly one out of every four dollars in funds. Many people don’t want advice on picking the most brilliant fund managers, because they’ve largely given up that hunt in favor of diversified passively-managed fund. If they need help, it’s in setting up an asset allocation plan—how much in stocks, how much in bonds—and an occasional check in to make sure they are on track toward their financial goals. Increasingly, a lot of that work can be done online or over the phone, or in a few sessions paid for by an upfront fee.
As Vanguard founder and index-fund pioneer Jack Bogle told Money in June, once you have a solid plan in place, the best reason to have an adviser is to prevent you from doing anything at all. You certainly don’t need one that makes you do the wrong things.