From the January 2017 issue of Investment Advisor • Subscribe!

A Conversation on Conflicts of Interest

An advisor challenges me on the need for a fiduciary standard in the real world

What's an extra $10,000 if the product you're paying for is the same? What's an extra $10,000 if the product you're paying for is the same?

I recently had the following email exchange with a veteran financial advisor about my Nov. 10 blog on ThinkAdvisor.com regarding profit motive in the advisory business and crossing the line between sales and advice.

Reader: “I enjoyed your recent article. The trend I observe for definition of ‘best interest’ is to mean lowest possible fees. This seems to be a public perception that is being fueled by the DOL fiduciary rule. In many other industries, if one has a high profit margin, they are hailed as an astute business person. In the same scenario, an investment professional is more likely to be called a less favorable term. As a 20-year veteran of this industry and an honest person, this is extremely frustrating to me.

“I prefer this viewpoint: Conflicts of interest are not going away; rather, they must be managed. I submit that life itself is fraught with conflicts of interest we all face every day. Legally requiring someone to act in the best interest [of clients] does not remove conflicts of interest faced by a business person. It does not solve the problem. It does not give a remedy. I rarely see this side of the story told.”

Clark: “Thanks for the email and your thoughts. You have focused on the key issue in the fiduciary debate: the conflicts of interest themselves. It seems to me that all conflicts of interest should not be lumped together. For instance, retail salespeople have a large conflict as they legally and practically work for their employing firms, not for their ‘clients.’ If the U.S. was to follow Great Britain’s lead and require all retail financial advisors to act in the best interest of their clients at all times (as we currently require of trust officers and pension advisors), the sales conflict would be eliminated.

“On the other hand, the amount of the fees that fiduciary advisors charge their clients is a clear conflict that’s hard to see being eliminated. The good news is that it’s an obvious conflict that’s easy for clients to understand. But even with that said, in the pension industry the potential for abuse is eliminated by setting a standard fee for all pension advisors: 1% of assets, I believe.

“In the retail financial industry, the Investment Advisers Act of 1940 requires fiduciary advisors to avoid or eliminate conflicts when possible, and to mitigate them when they are unavoidable. This mitigation can come in many forms, including disclosure (provided the disclosure is made so that the client can truly understand the full nature of the conflict), especially of all the costs to the client of the conflicted advice versus the alternatives. For example, some advisors have used a ‘fee-offset’ to eliminate the conflict of commissions by reducing their AUM fees for that period by an equal amount.”

Best Interest = Lowest Cost?

“Which brings us to your second point about best interests equating to low costs. I think it’s important to note that unlike most other industries, costs are the central issue in financial services. Whether I pay $30,000 or $40,000 for my Chevy truck, I will still get the same benefit from it: It will still drive the same, cost the same to maintain and last for the same amount of time.

“But in financial services, the costs investors pay, year after year, on the products they buy will directly affect their benefit: growth of their portfolios. So focusing on all the loads and fees and other costs involved in investments is clearly appropriate. (I would go so far as to say the suitability standard, which doesn’t require brokers to consider investors’ costs in their advice, is a travesty and the main reason folks are advocating for a universal fiduciary standard for brokers as well as for RIAs.)

“With that said, I completely agree that the ‘lowest cost investment’ is not necessarily in a client’s best interest (which I’ve written about a number of times this year). As the folks at Active Share can show, some active managers do add value substantially greater than their costs. The question that’s been raised by the fiduciary debate and the DOL’s new rule is: How can advisors demonstrate that their higher-priced investment recommendations are truly in their client’s best interest?"

“Currently, plaintiff attorneys are jumping on this issue, and the courts are sorting out the answer, in their slow, deliberate way. I do believe that platforms like Active Share and others will eventually be acknowledged to provide proof of value. But we’re not there yet, and in the legal void, many industry lawyers are rightly advising their advisory and broker-dealer clients that the safe play at present is to use low-cost ETFs. It’s an unfortunate situation, but I have to say, it’s one that, in my view, the financial services industry brought upon itself by failing to be cost-conscious on behalf of its clients.

“Ultimately, I suspect that the best defense for advisors recommending higher-cost investments will be that they work at independent, stand-alone advisory firms, which are paid solely by their clients’ AUM fees (or flat fees), and therefore have nothing to gain from one investment recommendation rather than another, other than when their clients’ portfolios grow larger.

“In contrast, brokerage firms that sell proprietary products, underwrite securities that they then sell, or take marketing fees from specific product manufacturers will have a much harder time demonstrating the appropriateness of these higher-cost products.

“As for your point that ‘in other industries, people who have higher profit margins are considered astute business people,’ it’s important to make a distinction between ‘business people’ and ‘professionals.’ For hundreds of years, Anglo-American society and law has recognized the difference between business transactions (such as buying a truck) in which both sides understand that one side wants to make a sale for as much as possible while the other side wants to pay as little as possible, and professional relationships (such as doctors, lawyers, clergy, accountants) in which one party depends on getting sound advice that is in their best interest. In getting said advice, the professional, with far superior knowledge and experience, is in a dominant position, and therefore is held to a high standard of client or patient care.

“In financial services, the line between salespeople and professional advisors is often blurred, with clients believing they are getting advice in their best interest, when in fact they are being sold a product. There’s nothing wrong with sales, as long as the investor isn’t led to believe they are getting advice. Unfortunately, in the financial services industry today, that line is often blurred.”

Reader: “First, I am all for acting in the best interest of clients. [But] I am also a small government person: To have a truly free world each individual must take on a certain amount of responsibility themselves, separate and apart from the government. I like your example of the Chevy truck. But unlike the investment world, a person is free to pay $10,000 more for the truck if they so choose as long as they can get approved for the loan or they have the cash. Sure, it will perform the same as the person who got a better deal.

"But what about that extra $10,000? What’s the opportunity cost? Could that person have used it to pay for a year’s room and board for their college student? What kind of quality of life are they missing due to ‘overpaying’ for this truck? Could that $10,000 have been better deployed elsewhere? […] Furthermore, why do trucks like the Cadillac Escalade even exist for $90,000? What possible justification could there be for such egregious overpricing? This line of questioning on the car purchase may seem ridiculous, but that is exactly what we in the investment world are faced with when we are questioned about decisions our clients made.

“And therein lies the rub. In a free world, people must have the opportunity to make a wrong decision — whether they buy a $90,000 Escalade or a variable annuity. In both instances, the client may be satisfied with the decision and feel it was worth it. Why should someone else question it? Yet car dealers and salespeople are not at risk of getting sued because the person used his child’s college fund to buy a truck. Yes, we should do what’s in the best interest of the client, [but] the burden should not fall solely on the advisor.”

Clark: “I agree: People do need to take responsibility for their own decisions. Yet I doubt that many people would think that an investor who was seeking fiduciary financial advice and went to a broker who was holding him- or herself out as a ‘trusted financial advisor,’ and whose firm spends millions of dollars to advertise the quality of the ‘advice’ provided by its ‘financial advisors,’ somehow ‘made a bad decision.’ People also have to take responsibility for their actions."

 

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