As the second installment in my series of posts on understanding the industry, launched with my October 19 blog, Financial Services Explained, Pt. 1: The Cost of Everything, here’s an email I recently received from a financial planner about conflicts of interest in the financial advisory industry.
In it, he expresses a very widely held view within the brokerage community that “life is full of conflicts,” with the implied conclusion that we all should just get over it and drop the issue. What follows is his email, and my response.
CFP: “The trend I observe for [a] definition [of] ‘best interest’ is to mean lowest possible fees. This seems to be a public perception that is being fueled by to 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 does not remove conflicts of interest faced by a business person. It does not solve the problem. It does not give a remedy.”
Me: You have focused on a key issue: the conflicts 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 in practice work for their employing firms, not for their “clients.” If the U.S. was follow Great Britan’s lead and require all retail financial advisors to act in the best interest of their clients at all times (as we currently do with 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.)
That’s why 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), and transparency, especially of all the costs to the client of the conflicted advice versus the alternatives. 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.
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, it will still drive the same; but the costs that investors pay, year after year, will directly affect the 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 so say that the suitability standard, which does not require brokers to consider investors’ costs in their advice, is a travesty, and the main reason folks are advocating a universal fiduciary standard.)
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 rules is this: how can advisors demonstrate that his/her 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, industry lawyers are rightly advising their 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, standalone advisory firms which are paid solely by their clients’ AUM fees (or flat fees), and therefore have nothing to gain from their recommendations 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.
The bottom line on conflicts of interest, as recognized by law and common sense, is that when financial advisors have a financial incentive to act in other than the best interests of their clients, it poses a serious financial threat to those clients’ financial well-being.
In my view—and that of many others—simple disclosure is rarely an effective remedy. That’s due to the lack of understanding among most retail investors of how the financial services industry works—that virtually all the money it makes comes out of their pockets, one way or another—of basic financial principles, such as the time value of money and the power of compounding interest, or expenses; and the lack of transparency of investment fees, loads, expenses and other costs.
Consequently, usually the safest alternative for investors is to work with an advisor who is required by law to eliminate conflicts when possible, to mitigate them when it isn’t and whose only conflicts are readily obvious to their clients—such as the size of their AUM fees.
See all the blog posts on our Clark Explains the Industry landing page.