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.