Soapbox: How to Restore Trust

It’s no secret that most individuals are unhappy with the investment advice they’ve received recently. Unless advisors received a source message from the spirit world that told them to advise their clients to move to cash (the non-Reserve Funds kind) 12 months ago and stay there, investment results have been disappointing.

I’m not laying blame on advisors. Indeed, most have followed the teachings of Modern Portfolio Theory that a portfolio of investments representing prudent asset class diversification will carry the day. But despite that logic, it appears the theory was flawed. It didn’t work in 2008 and the result is a general loss of trust among clients toward the investment advisory process.

At the core of this loss of trust is a potentially greater fundamental issue. It is the simple fact that most advisors are compensated on a variable basis depending on the type of products they offer. This seems to fly in the face of what clients need and ultimately what advisors must have to win trust back. In the current compensation hierarchy, equity portfolios garner the highest fees while conservative fixed income garners the least. If you apply this variable compensation system to the current environment you see this fundamental flaw clearly. An advisor who moved all his clients to short-term Treasuries a year ago might well have the endearing love of all his or her clients. But they would also have done so knowing that they wouldn’t be getting paid as much.

If we want advisors to act in the best interest of clients, there should be a compensation system that incents them to do so regardless of what type of product makes the most sense for the client at the time.

So how do we go forward? Advisors need to be able to provide prudent investment advice that wins back the trust of clients, particularly at a time when people need financial guidance more than ever. Advisors also need a systemic platform in order to do so. The Department of Labor has offered an idea and, in fact, a new set of regulations that hit the Federal Register on January 21, 2009 (View the document here.).

In short, the regulations, which were initially set to go into effect on March 23, 2009, but now are up for comment–and potential delay and alteration under the new Administration–would create sweeping changes for how investment advice is delivered to any IRA owner in America that receives “investment advice.” They also lay a clear path for how plan sponsors can implement investment advice for plan participants.

The new regulations, if adopted, would create a fiduciary standard requirement for all IRA investment advice, and make it optional for defined contribution plans. This means advisors who deliver the advice would be required to be in a “level fee” environment, or work from an audited “computer model” if they chose to remain in a variable compensation model. These “Fiduciary Advisors” would also be subjected to annual audit and monitoring mandates.