Reuters Money
Financial disclosures can make advice worse: Yale study
Washington watchers are sure to see a lot of one particular word in the months to come: disclosure.
The Securities and Exchange Commission is preparing a fiduciary standard for brokers that is expected to require them to disclose their financial conflicts. The Consumer Financial Protection Bureau plans to launch next week with a plan for new mortgage term disclosure forms. And Elizabeth Warren, the president’s adviser who set up that agency, has given speech after speech in which she discusses the virtues of requiring clear disclosures as a mode of financial regulation.
“Regulations should be about making sure that customers have the information they need to make the decisions that are right for them,” she has said, in some form, over and over.
There’s just one thing wrong with all of those disclosures: They don’t always work. Sometimes, they actually encourage consumers to make bad decisions, according to a new survey of academic research.
“We aren’t saying that disclosure or transparency is a bad thing,” Daylian Cain, an assistant professor of organizational behavior at the Yale School of Management, and one of the study’s authors, says. “But our research has found some instances where it has a perverse effect and can make consumers worse off. It just doesn’t work as well as we think it does.”
In addition to the obvious problems with disclosures done poorly — those overly long, incomprehensible, 60-page boilerplates that come attached to every new account and that Warren wants to simplify — there are disclosures done well enough that still have the wrong effect, says Cain. He is skeptical that commissioned investment salespeople will be able to act in the best interests of their clients if they simply are required to disclose that they are paid to sell certain products. (The leading securities industry trade group asked the SEC for just such a rule in a letter released today.)
“We found that conflicted advisers who disclose their conflict gave worse, more selfishly biased advice than those who didn’t disclose. They felt more comfortable giving misleading advice,” he says.
Four rules of picking a financial adviser
It’s a question financial experts get all the time: how should I chose an investment adviser?
The number of people offering some form of financial advice is growing fast. According to Smart Money, “the ranks of financial planners, college aid advisers, mortgage brokers and more are expected to increase by 30 percent by 2018, to 271,200″ per the Bureau of Labor Statistics.
Obviously some of those 271,000 people will be better than others. So how do you find the right adviser?
That seems like a simple question, but it turns out that checking off the boxes on a list of questions doesn’t really cover it. Whether you like it or not, choosing an investment adviser requires a certain amount of faith. “A good relationship in terms of financial advice has a lot to do with trust,” says Carl Richards, founder of investment advisor Prasada Capital, and a prolific writer about personal finance. “That’s a tough reality in the post-Madoff world. If you’re going to get good advice you’re really [going to be] talking about some things that are really, really important to you.”
How do you chose a doctor, a lawyer or an accountant? That’s a good gauge of how you’ll find someone to help you plan your financial health, too.
Legally, an investment adviser is meant to be someone you can trust. Like your lawyer, they have a fiduciary responsibility to put your interests first. This is not the case with brokers (a/k/a stockbrokers) who make money selling stuff and actually legally have an obligation to their employer. (This distinction may change. A recent study by the Securities and Exchange Commission says brokers who provide advice should also be fiduciaries, but for the moment, they are not.)
But there’s a big difference between legally trustworthy and someone you actually trust. Author Mike Piper‘s rule of thumb: “Ask yourself this question: “If my portfolio had just gone down 40 percent in the last three months, and this person was telling me that I need to just stick with our investment plan rather than take my money out of the market, would I be able to believe him? Would I have sufficient trust in the plan we designed together to be able to stick with it?” If you can’t answer “Yes” to that question, you should probably keep looking.”
I want to stress the value of working with an advisor who is NOT fee based. When you buy groceries at the grocery store, the grocer makes a “commission.” The same holds true for most consumer products. Receiving a commission does NOT automatically mean that the advisor is unscrupulous. Nor does that mean that the recommended investment is unsuitable.
Historically, most advisors have received commission based income. Ask yourself this: Why would so many advisors want to make the complex, costly, and time consuming transition to fee-based advising? In and of itself, it’s not a bad system. But, advisors make this transition to reach the “next level” in their business operations. Neither system is always bad or always good. Your comfort level with the advisor and his investment recommendations, recommendations from his clients regarding the advisors expertise and integrity, etc. are much more important.
Fire your financial adviser, unless they are a fiduciary
If you have a conventional stock broker or agent acting as a financial adviser working on commission, fire them.
Now that the SEC has endorsed a “uniform fiduciary standard of conduct” for brokers and investment advisers, there’s no reason to settle for anything less. This is a financial professional who, by law, must put your interests first.
In the past, the SEC did little to protect you from the ravages of a commission-driven world. Few knew the difference between a “financial consultant” (a broker) or a “certified financial planner” or “registered investment adviser.” The latter two are fiduciaries.
Having a fiduciary is one of the best investor protections around. If they wrong you, you can sue them. As a requirement of the Dodd-Frank financial reform law, the SEC needs to write the rules codifying this key investor protection and Congress needs to rubber stamp it.
It’s also time to move on to fix the broken system that deals with investor disputes. With brokers and agents, you typically sign away your right to sue. You are then subject to inadequate “suitability” standards that don’t offer much protection at all. Not only is it extremely difficult to sue, you are forced to settle most disputes in an industry-run arbitration system.
Countless investors are cowed by the process of proving that they were sold inappropriate investments by brokers. Although the industry doesn’t release the numbers — they should — most investor arbitration lawyers say that about 80 percent of wronged investors settle with brokerage firms for a fraction of what they are owed rather than go through arbitration.
Not surprisingly, investors don’t like the fact that even if they choose the arbitration process — which is billed as a cheaper alternative to litigation — it will cost them thousands in an attempt to get their money back and will face at least one industry member on a three-person arbitration panel. It’s like having a lawyer being the foreman of a jury in a legal malpractice trial.
First, let’s talk about equity-indexed annuities. I say they’ve been troubled because of marketing abuses. Don’t take my word for it. NASAA, the group that represents state securities regulators, found that these kinds of annuities have been cited in one-third of investment abuses involving seniors. See http://www.nasaa.org/NASAA_Newsroom/Curr ent_NASAA_Headlines/9280.cfm. Marketing of these vehicles are poorly policed and commissions are high — 6% is hardly a bargain in a world in which ETFs can be sold at NO commission and provide much better coverage of most asset classes. And to set the record straight, the fiduciary or fee-only model is not without its flaws. Bernie Madoff was supposed to be a fiduciary. But right now, it’s a better model that places legal responsibility squarely with the advisor, who must do right by the client instead of being hostage to a quota/commission schedule. The SEC made a huge leap forward, but it’s up to individual investors to police their advisors. No agency will ever have enough cops on the beat.
Cheaper financial advice: Will you get what you pay for?
If brokers had to put their clients’ interest ahead of their own, those clients would pay more for financial advice and their investments, an industry group reported recently. A couple with $200,000 in retirement assets would pay roughly $460 more a year in additional fees.
The study was commissioned by the Securities Industry and Financial Markets Association (SIFMA), the group representing megabrokers and banks, as part of its effort to influence a forthcoming rulemaking from the Securities and Exchange Commission. The SEC is supposed to report to Congress before the end of January 2011 about whether it should require brokers to be fiduciaries – professionals who are legally required to put their clients interests ahead of their own. Currently, fee-only financial advisors are typically fiduciaries, but brokers are required to meet lesser standards: They simply have to recommend suitable investments, and can put their own interests above their clients, say by recommending more expensive investment choices that pay commissions, as long as they are suitable.
Investor advocates criticized the study. ”It’s so incoherent as to defy objective evaluation,” Barbara Roper of the Consumer Federation of America wrote to the SEC. Knut Rostad, chairman of a financial advisors advocacy group, the Committee for the Fiduciary Standard, called the report “a fantastic mythology.” But IRA Hammerman, SIFMA’s general counsel, defended the study, which was performed by Oliver Wyman, a consulting company. “Retail investors deserve strong protections from a new uniform fiduciary standard without sacrificing choice of products and services or facing higher costs,” he said.
The premise of SIFMA’s study and position is that middle-income investors can get more affordable advice if they pay for it indirectly, through mutual fund sales fees and other commissions, for example. SIFMA also said that some investments, such as corporate and municipal bonds, are primarily traded through commission-charging brokers. It would be hard for savers and investors to buy those products if the SEC came down hard on commissions.
But most observers aren’t expecting that. They believe the SECwill walk a fine line that doesn’t eliminate commissions. The Labor Department recently moved to apply the fiduciary standard to more pension plan advisors, including brokers. Commissions wouldn’t be prohibited, but would have to be collected only if they fit a client-first perspective and were fully disclosed. The SEC is likely to follow the Labor Department’s lead, suggests issue-watcher Ed Lynch, a fee-only retirement plan advisor with Dietz and Lynch Capital.
But a fiduciary standard that leaned on disclosures of potential conflicts isn’t really a fiduciary standard at all, says Rostad. “If disclosures become the answer to addressing conflicts of interest, the fiduciary standard hasn’t been weakened, it’s been removed,” he said. Roper believes a disclosure-driven rule would offer existing brokerage clients greater protections, but “even if you improve the standard, you’re better off going to someone who is paid exclusively by you to be an advisor.”
No fiduciary for all
The following is a guest post by Tim Kochis, the chairman and former CEO of Aspiriant. Barron’s ranked him fifth in its inaugural listing of the “Top 100 Independent Advisors” in the U.S. in 2007.
As the SEC prepares to begin its six month evaluation of the current rules governing registered investment advisors and brokerage firms, I hope that it takes a nuanced view of reality. Given the array of services, business models and client relationships that need to exist, I strongly believe that imposing a strict fiduciary standard on every firm and individual, in all circumstances, would be a big mistake.
It is important to distinguish sales efforts, the execution of transactions and the brokering of trades from the giving of advice. Imposing a fiduciary duty (putting the client’s interest first) is unrealistic in the sales environment or when brokering an investment between two customers, one a buyer and one a seller. Where both parties are clients, which client’s interest must the financial institution put first?
A non-fiduciary sales environment exists in all economic realms. We rely on consumers’ natural skepticism, access to alternatives, broadly available factual information, and a increasing flood of internet-based opinion to discipline price and quality in virtually everything else we might buy. Why can’t we simply apply caveat emptor to all financial services?
What makes many financial services unique is the industry’s rapid pace of innovation and the unavoidable uncertainty about the future outcomes its services are designed to address, combined with the low level of financial sophistication that afflicts many consumers.
A variable rate, interest-only mortgage, for example, can be a wonderful device for a client with a long horizon on ownership of the property, the discipline to invest (not spend) the cash flow savings, and the financial depth to withstand occasional interest rate spikes. That same device can spell disaster for a client with thin resources, no investment plan, and who must or chooses to sell the property early in the term. The solution, in this example, is certainly not to ban this form of mortgage, or to make any discussion of it be fiduciary in nature, but to make sure that advice about a specific client actually using it be rendered in a fiduciary context.
Disclosure of potential conflicts and “suitability” requirements already exist. Criminal laws and civil remedies for fraud or deceit are already in place. Having to tell the truth is already the law. But, legislating a new regime where all financial services are fiduciary would be impossible to put into practice.
Great ideas. Many Private Banks attempted this approach when they started buying brokerage firms. It works.
How the fiduciary standard should apply to brokers
The debate over what constitutes financial advice is heading into overdrive.
As part of the pending financial reform legislation, the job of establishing a higher “fiduciary standard” for brokers will rest in the hands of the Securities and Exchange Commission. On June 25, I sent out an email blast to more than 200 financial advisers (and their press people) to get their opinions about the pending legislation. Overwhelmingly, I heard from independent advisers because the big brokerage firms rarely authorize their advisers to talk to the press directly.
Now the Reuters wealth management team got a chance to sit down with John Taft, head of the Royal Bank of Canada’s U.S. Wealth Management and CEO of RBC Capital Markets Corporation. RBC has more than 800 financial advisers in its stable.
The biggest challenge for the SEC, Taft says, is figuring out how the fiduciary standard will apply to advisers affiliated with brokerage firms, whose breadth of services tends to be much larger than independent financial advisers. “Wealth management firms do much more than just advise clients,” he says. For example, advisers who are attached to a brokerage firm also sell life insurance, offer lines of credit to investors, and trade securities like stocks “on a one-off basis.”
Taft expects the SEC to take a tiered approach when applying the fiduciary standard. “We are not afraid of the fiduciary standard. We act as fiduciaries all of the time,” Taft says. But the fiduciary standard cannot be a “one-size-fits-all solution,” he adds.
Once the legislation is signed into law, the SEC plans to study the issue for six months.
For more of our interview with Taft, check out this Reuters story.
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