A few weeks ago, amidst great fanfare, the US Department of Labor (DOL) finally gave birth to a rule requiring stockbrokers to act as fiduciaries with respect to their clients. (The rule had been in gestation for six years.) So celebratory was the news coverage that you could be forgiven for imagining that Warren Buffett had just offered to manage everybody’s money.
But before we go all gaga, let’s take a harder look at exactly what happened. First, though – in case any of my readers haven’t spent their lives riveted by the regulatory regime covering financial advisors – let’s look back at the regulatory landscape pre-DOL “fiduciary” rule.
For many decades there has been a sharp distinction between stockbrokers and registered investment advisors (RIAs). The latter are fiduciaries who must always put their clients interests ahead of their own; the former are not. Brokers are subject to the much-weaker “suitability” standard. Here’s an example.
An RIA and a broker are dealing with identical clients, both of whom need US large cap stocks in their portfolios. The alternatives are the Vanguard 500 Index Fund, an actively managed no-load fund from T. Rowe Price, and a very expensive, poorly performing, in-house proprietary fund that pays a big up-front sales load and a trailing commission.
The RIA could legitimately go with Vanguard or T. Rowe Price. Although the latter fund is more expensive, the RIA might firmly believe that it will outperform the index looking forward, net of its costs. The RIA could not select the proprietary product. That would be tantamount to putting his or her interests in a big payday ahead of the client’s interests.
But the broker – who could theoretically select any of these options – will always always always select the expensive, proprietary product. It gives him or her a big payday and it’s obviously a “suitable” investment for the client: the client needs large cap stocks and the fund is a large cap product. Never mind that it’s not the best product – or even the second best or the one thousandth best – it’s “suitable.”
This regime was great for making money for the likes of Merrill, Morgan Stanley, Goldman, etc., but it was lousy for getting new clients. RIAs naturally used their fiduciary status as a competitive weapon, and many newspaper and magazine writers told investors over and over again: “The first question to ask a prospective financial advisor is this one – ‘Are you a fiduciary?’”
Eventually, though, tired of losing business to the (mostly smaller) RIAs, brokers invented what we’ll call “dual registered monsters.” Our friendly brokerage firm, which is already registered as a broker/dealer, simply registers also as an RIA. Presto! Problem solved!
Our friendly broker now enters every meeting with prospective clients wearing her white “RIA” hat. “Am I a fiduciary?” she says. “You bet your britches I am!” “Great!” says the client. “Where do I sign up?” Once the client has been hogtied, our broker takes off her white “RIA” hat, puts on her black “broker” hat, and proceeds to stuff the poor client’s account with every over-priced, under-performing, proprietary product she can get her hands on. It’s the Mother of All Bait & Switch Tactics but, believe it or not, it’s perfectly legal.
One obvious way to combat this sort of nonsense is to make brokers fiduciaries, subject to the same standards as RIAs. Indeed, President Obama made this a priority for his administration, telling an AARP convention that:
“There are … financial advisors who receive backdoor payments or hidden fees for steering people into bad retirement investments that have high fees and low returns. So what happens is these payments, these inducements incentivize the broker to make recommendations that generate the best returns for them, but not necessarily the best returns for you. * * * And all told, bad advice that results from conflicts of interest costs middle-class and working families about $17 billion a year – $17 billion every year.”(1)
But whenever something sounds like a no-brainer, you can be sure that the brokerage industry will oppose it with tooth, hammer and claw. The DOL issued a proposed fiduciary rule in 2010, but had to withdraw it in the face of a huge industry tantrum. The DOL tried again in 2015 with the same result. Finally, a few weeks ago, the so-called “fiduciary rule” for brokers saw the light of day. Unfortunately, it was almost unrecognizable from the straightforward, sensible rule DOL had originally proposed, and it is light-years from the fiduciary rule that continues to apply to RIAs. We’ll take a look at that ugly saga next Friday.
(1) https://www.whitehouse.gov/the-press-office/2015/02/23/remarks-president-aarp.
Next up: Would You trust a Fiduciary Stockbroker? (Part 2)
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Please note that this post is intended to provide interested persons with an insight on the capital markets and is not intended to promote any manager or firm, nor does it intend to advertise their performance. All opinions expressed are those of Gregory Curtis and do not necessarily represent the views of Greycourt & Co., Inc., the wealth management firm with which he is associated. The information in this report is not intended to address the needs of any particular investor.
