In my November Investment Advisor column, “Why a Fiduciary Duty Matters,” I wrote about a recent study by the Institute for the Fiduciary Standard, which compared Form ADV disclosures of RIA firms ranging from small independents to large institutions.
The results were striking, particularly the comparison of disclosed securities infractions which showed that of the large firms: 56% have been convicted of or pled guilty to a felony (vs. 0% of RIAs), 89% ever had an SEC or CFTC violation (vs. 1% of RIAs), and 89% had been found to have made false statements, omissions, or been dishonest (vs. 1% of RIAs).
The IFFS study also found that the number and magnitude of the above infractions correlated to advisors’ conflicts with their clients’ interests: “Thirty-five percent of the RIAs and 100% of the large financial services firms reported employees who are registered representatives of a broker-dealer. Additionally, 39% of the RIAs and 100% of the large financial services firms reported employees who are licensed agents of an insurance company or agency. These numbers are significant as both brokers and agents owe a duty to their respective employers when they are ‘selling,’ rather than to their clients…. … In contrast, the authors found that the 25 RIA firms (18%) with ‘no material conflicts’ also had “no registered representatives and insurance agents and reported only receiving compensation from client fees.”
As a follow up to that story, I received an email and had a telephone conversation with a financial planner who felt that the above conclusions were unfair with respect to insurance agents. “Many agents, like my firm, are independent agencies. We work with a number of insurance companies, which enables us to find the most appropriate products for our clients. While it’s true that some companies may offer higher commissions or other financial incentives for recommending their products, because we are not their employees, we are under no obligation to choose products that are other than in our clients’ best interests.”
This is a good point, and an important statement. It’s one that I’ve heard quite often over the years, by both brokers and insurance agents.
Just because they have conflicts of interest doesn’t mean that they act on those conflicts, or deliver anything other than advice in the best interests of their clients. And, of course, they are right: it doesn’t mean that.
I’m sure there are many agents and brokers who do advise in the best interest of their clients, despite financial incentives (often quite large ones) to do otherwise. And I have no reason to think that this advisor isn’t one of them.
But that’s not really the end of the story, is it? The real question here is why conflicts of interest—particularly financial conflicts of interest—have been considered a problem over centuries of law and by people exercising plain common sense. The simple answer is that people tend to do what they are incentivized to do, and financial incentives are among the most powerful.
Over the years, I’ve seen many examples of this. I remember magazine ad salespeople, whose commissions were based on gross rather than net revenue, recommending deals with advertisers that would cost their magazine more than the revenue it would bring in. And in a more recent example, there’s the fiasco at Wells Fargo. Could it be that senior management, who are incentivized to increase profits, weren’t all too motivated to scrutinize the company’s “boom” in multiple client accounts?
As for financial advice, the point is that financial services companies—broker-dealers, insurance companies, product manufacturers—make more on some “products” or investments than others. Consequently, they are willing to pay more to sales firms and their agents or brokers to sell those products. And, of course, that “more money” is coming directly out of the clients’ pockets.
What does it really mean for a broker or an agent to ignore these incentives and act in the best interests of their clients? It could mean fewer promotions or advancements within their company, or fewer perks such as nicer offices or clerical help, or advisory teams, or T&E allowances. More importantly, it usually means less take-home pay: which affects everything from their children’s education, to lifestyle, to the house they live in and the cars they drive.
Which brings us to the big question: Can investors reasonably expect their advisor to ignore what are often substantial financial conflicts of interest in order to offer advice in their best interest? Even if an advisor does put their clients’ interest first, can they be expected to keep doing it when the markets go down, kids want to go to Harvard or Yale, parents get old and sick, etc. Life creates many reasons for all of us to need more money.
In answer to these questions, the IFFS study data is very clear: financial services firms with salespeople that do not have a legal duty to act in their clients’ best interests have a dramatically higher incidence of acting outside those interests. And despite what the securities industry and the SEC would have you believe, fiduciary RIAs almost always do right by their clients and, consequently, are a far better bet for retail investors.