Wednesday, March 30, 2016

The Case Against the Department of Labor (DOL) Fiduciary Rule



In my regular day job I work for a registered investment advisory firm (RIA) and provide comprehensive financial planning advice to clients. So most people don't know but the Department of Labor has proposed a new fiduciary rule that would put even more restrictions on an industry that is already highly regulated. Let me explain the current regulatory state of the financial industry before getting into the current proposed rule.

Currently, people in the financial industry are subject to various rules and regulators (depend on where they operate/size of the firm). An overview of the rules can be found here (60 pages worth-just a summary remember). The actual Securities Act of 1933 is 93 pages which can be found here. The Securities Act of 1934 can be found here which is only 371 pages. ERISA is another law that governs investment advice as well (especially for retirement plans). A summary of ERISA can be found here which is 76 pages (this is just the summary too). The actual ERISA law can be found here which is 460 pages! Clearly, people who claim the securities industry isn't regulated need to look at the data. Let's point out really what the rules are trying to protect against is fraud which can be dealt by contract law (breach of contract).

Right now there are two type of business models in the financial planning world. The first is the brokerage model which essentially is a company like Morgan Stanley/Goldman Sachs/UBS etc. These companies are under what is known as a suitability standard which just looks at a client's situation and looks at their unique characteristics and a product is recommended (i.e.-in practical terms this could be anything). The way people may money under this model is by selling a product with a commission. The commission can vary by the type of investment the broker recommends. Typically a brokerage firm will recommend Fund XYZ and then get a cut of the action from the fund company for marketing the fund (this is known as a 12b-1 fee). Let's not forget other professions like car sales people, real estate brokers, and insurance agents are compensated in similar ways. Also it is important to point out that the general public is aware this.

Brokers are required to take the Series 7 exam which is about 260 questions and a 6 hour exam. Also what is even more interesting is that let's say you are in college and want to get a head start on the Series 7 exam, you can't take it unless you have a brokerage company sponsor you (barriers to entry). If you want to provide any type of financial advice you have to take the Series 65 (I actually took this exam a few years ago) and the test is a 155 questions, takes 3 hours, and is $155 (again you can't take this exam unless a firm sponsors you-which makes very little sense).

The other type of model is the fiduciary model (I work in this realm). The fiduciary model is were the financial advisor places the interests of client ahead of their own.  Typically these firms seem to be more comprehensive and will look at the whole financial picture (investments, taxes, insurance, retirement planning) as opposed to just investing a brokerage firms do of just buying and selling securities for clients. On average RIA's charge a fee for the amount of assets they manage (which can range from about 2% to .4% depending on how much a client has under management). People are not paying for just investment advice but for comprehensive planning to try to integrate everything. Some firms charge hourly rates or project rates for certain things. In recent years there have been complaints that RIA firms only cater to high net worth clients (typically these firms have minimums they require to become a client). RIA firms still have compliance requirements such as filing an annual ADV form (from personal experience these are time consuming and provide little to no value as clients never look at them and if they have a question contact the advisor anyways). However, recently a network called XY Planning Network that targets younger people who may not have enough assets to work with other advisers and some in the network just charge a monthly fee/per hour fee for planning (market forces working).

The fiduciary rule (actual rule from the Department of Labor can be found here and the over 3,000 comments can be found here would ban investment advisors from charging commissions or charge a higher fee (percentage of assets under management) if a client rolled their 401k plan over to an IRA. Typically once clients retire they have assets in their company 401k. These assets are rolled over into a separate IRA (as this retains creditor protection). Advisors can charge a higher fee or commission if they get a client to sign a best interests (contract). If the contract is signed then the advisor can charge the higher fee. The idea is to get advisors from recommending products with high commissions (such as variable annuities/non-traded REITS) which can generate a good income for an advisor who recommends them but may not be best for the client. Of course, anyone with any common sense could ask the question of how the advisor is getting compensated. Clients always should ask questions about the products they are purchasing. As a result advisors will have to disclose how much they are making which of course will cause clients to leave and go elsewhere. Of course these clients won't have enough to join many RIA firms (most of these firms usually have minimums before they can take on clients). However, even I was surprised to learn that Edelman Financial services will work with clients who have as little as $5,000 (again market forces at work). Although, I would be curious to see if this amount increases if the fiduciary rule is passed.

RIA (registered investment advisors) firms have grown in the past number of years (again the free market at work). Between 2013 and 2014 over 2,000 RIA firms were started.  There are roughly 32,000 RIA firms in the United States. There is no surprise that RIA firms have been taking assets away from brokers (also known as wirehouses). RIA firms held about 23% of the assets under management which grew after the financial crisis. Median assets for RIA firms increased 67% from 2009-2013. Consumers are voting with their assets and have been migrating to RIA firms even before any type of legislation was passed (legislators are you listening?

Also with the use of technology many advisors can meet with clients virtually it doesn't always have to be in person. A technology known as robo-advisors have come online the past few years. Robo-advisors will rebalance investments to get clients to were they should be by automatically trade for the client (takes human emotion out of it). Also robo advisors typically invest in low cost index funds (which for young people who are trying to accumulate wealth are perfectly fine). As of December 2014 robo-advisors had about $19 billion in assets (this figure is continuing to grow). Companies such as Betterment and Wealthfront can manage your money for very small fee and does the trading for the client (taking the broker out of the picture). Although, robor-advisors haven't had type of serious market correction (like in 2008) to test themselves.

The problem with the fiduciary bill is it will add additional paperwork for clients (there is already of plenty of paperwork that clients have to sign/agree to on a regular basis). Brokers who usually get paid on commission will switch to a fee-based model which will end up costing even more than the commission based model on a percentage meaning consumers will pay more and try to seek out a registered investment advisor (many of whom probably won't take unless they have a minimum amount of money), or even worse consumers will try to invest money themselves which is probably the worst scenario. For example if someone has a $100,000 account and they purchase something that has a commission of $100 that represents only .1% cost. Now if the advisor after the fidicuary rule moves to a fee based model and charges 1% the client would have to pay $1,000 (10 times the amount of the product they purchased!). When Great Britain banned commissions smaller investors/general investing population were forced out. I would predict the same will occur after the passing of the fiduciary rule.

Regulation isn't needed for a fiduciary rule when consumers are already voluntarily moving money from broker dealers to registered investment advisors/robo-advisors without the force of government. If anything there should be a reduction in regulation in the financial sector. The Securities and Exchange Commission, FINRA, Securities Act of 1933 and 1934, ERISA, and state regulators all play a major role in the current regulatory state. People forget that stock brokers and financial advisors can't lie about the products they sell (this is known as fraud and we have laws against that). My prediction is the fiduciary rule will add substantial compliance costs, reduce people access to financial advice, and make the average person worse off. Economist Robert Litman did a study showing that the cost of the fiduciary rule would be $80 billion. These costs will be passed on customers. Add to this, Litman estimating that about 7 million will be shut out of advice with the fiduciary rule. I would ask the creators of this rule what are they trying to correct when many people and billions of people have gone from brokers to registered investment advisors (RIAs) and robo advisors?