By: Joe Zender
On April 6, the Department of Labor released a new regulation pertaining to the duties owed by financial advisors to their clients.[1] The new regulation, which is scheduled to go into effect on January 1, 2018, transforms fundamental aspects of the financial services industry.[2] The new rule, called a fiduciary duty rule, requires financial professionals to act in the best interest of their clients.[3] While a savvy investor or an ethical advisor may have already required this as part of their relationships, many retail investors do not know the ramifications of such a duty. The new rule forces this type of duty. Opponents of the rule argue that the new regulation will increase costs across the financial services industry, which could force small budget investors out of the advising market, during a time when they could use it. At the same time, those who can still afford the advice should receive better tailored and more transparent advice from their financial professionals. On the other hand, the new regulation adds one more hurdle for an industry that can ill afford one at this time, when robo-advising is becoming more prevelant.
Financial advisors meet with their clients to discuss the clients’ goals, objectives, and long term plans.[4] They explain the types of financial services available to the client and offer advice on the course the client should take.[5] Registered investment advisors have already been held to the fiduciary standard.[6] However, the new Department of Labor regulation would clarify who the duty would cover, because financial advisors use a wide array of titles, from wealth managers to financial planners.[7]
Prior to the Department of Labor’s new regulatory changes, financial professionals, other than registered investment advisors, were only required to use a “suitability standard”, which required them to sell suitable products for the needs of their clients.[8] Often times an advisor suggests investment options like stocks or mutual funds, and places trades for the client in conjunction with advice and guidance.[9] Financial brokers on the other hand can only sell stocks and financial instruments.[10] These two financial professionals also differ on how they charge for their services. Brokers make their money on commissions per trade, while financial advisors typically charge a percentage of total assets on an annual basis, typically ranging from 1% to 2%.[11]
While a savvy investor would make sure that their financial professional held a fiduciary duty towards them, many investors do not. Under the suitability rule, a broker could legally steer clients towards investments that paid out larger commissions or were even products managed by their own company.[12] The new rule allows those that can afford a financial professional to receive more transparency, particularly, that their broker is not selling them products which enrich the broker at their expense.[13] Not all finance companies are opposed to the new regulation. Merrill Lynch said that they, “support a consistent, higher standard for all professionals who advise the American people on their investments.”[14] The higher standard appears to be a good change for retail investors, however, as with all governmental regulations, there will be unintended consequences. In addition, if investors were more intelligent on who they selected to be their financial advisor, this regulation would be entirely unnecessary.
Opponents of the higher duty rule argue that their new duties will prevent them from helping more people with their retirement planning.[15] The Securities Industry and Financial Markets Association, an industry trade group, one of the largest opponents of the new higher standard, said it remains “concerned that the DOL’s rule could force significant changes to current relationships, which may leave clients without the help they need to prepare for retirement, at a time when we all agree that more can and should be done.”[16] The new rule could be costly to firms, adjusting the entire way they do business, which could force budget investors out of the advising marketplace because it just is not profitable for advisers to take them as clients.[17] The people that most need help with retirement advice, the poor and downtrodden, could have less access to that advice because of the new regulation. Just because financial professionals will be required to act in the best interest of their clients, does not mean they need to take on clients if they do not want to.
In addition, as the new rule burdens financial companies more, they may have to increase their fees in order to cover the additional costs.[18] In 2012, federal regulation compliance encompassed $2 trillion in costs in the United States.[19] To argue that more regulations and costs are needed, is counter to economic thought, which would say increased costs lead to more market concentration as companies attempt to spread out the fixed costs of complying with the regulations.[20] Furthermore, economics would say that more market concentration can lead to even higher prices.[21] While the intentions of the regulation might be pure, the consequences of it could be to prevent the poorer segments of the population from getting important financial advice and could also raise the costs to other clients of advising services.
The opponents of the new fiduciary rule are also poised to challenge the regulation in court under the Administrative Procedure Act.[22] The opponents would likely argue that the new regulation is arbitrary and capricious, and the courts need not defer to it.[23] They are unlikely to succeed however, because of the difficulty proving the arbitrary and capricious nature of the regulation.[24] Additionally the opponents cannot rely on Congress overturning the regulation because too many Democrats would not want to counter a regulation promulgated and supported by President Obama.[25] While legally, it appears the regulation will survive, it does not mean the costs associated with it should be allowed to enter the market.
The financial advising industry is bombarded on a number of fronts. While some projections say that the industry may add as many as 74,000 jobs over the next ten years, the future looks bleak.[26] The advent of the so called robo-advisor has caused significant strain in the financial services industry. A robo-advisor is a wealth management service that provides automated, algorithm-based portfolio advice without the use of a financial advisor.[27] While there are countless services, robo-advisors are becoming increasingly sophisticated.[28] Like other industries that have been replaced by automation, financial advisors are progressively needing to provide value to their clients that computer cannot.[29] New regulations like those posed by the Department of Labor, only make it more difficult for human advisors to compete with robo-advisors. While many advisors charge 1 to 2% in annual fees, robo-advisor firms can afford to charge a lot less for the same service, sometimes as low as .25%.[30] The costs associated with possessing a fiduciary duty will only make normal advising less viable.
Robo-advising might seem like a great idea, as it could offer those pushed out of traditional advising because of the costs, an avenue to receive advice about their investments. However, some of the robo-advising firms do not offer well-tailored enough advice to help plan for retirement and some investors like the ‘human touch’.[31] Whereas robo-advisors are great at directing investments, analyzing betas, or finding values in the stock market, they are ill-equipped in understanding the goals and objectives of an individual person.[32] Planning an estate, for the purchase of a house, or in analyzing the risk tolerance of an investor is something an experienced advisor can do much better than a computer. Only one third of the American population would be comfortable using a totally automatized advising service.[33] While robo-advisors still are not fully capable of displacing traditional advisors, they are eating into a market segment that may not be able to withstand more compliance and regulatory costs.
The Department of Labor’s new regulation, requiring a fiduciary relationship between financial professionals and their clients is a great idea in theory. It allows those who can afford it a guarantee that their financial professional is doing what is in their best interest. However, a savvy investor would have already been in a fiduciary relationship with their advisor, and that savvy investor is now going to be punished for others’ ignorance with higher costs. Additionally, the added cost of compliance may force those who most need the investment and financial advice out of the market. Lastly, the added costs to the financial advising industry, is not what it needs during the ascension of robo-advisors, who are a cheaper alternative, even though less people feel comfortable with them at this time. While the new Department of Labor’s regulation will be heralded as a success for the common man, as a destruction of ‘greed’, it may end up having the exact opposite effect as it was intended to have, less access and worse financial advising available for everyone.
[1] Fiduciary (Retirement Accounts), National Association of Insurance and Financial Advisors (2016), http://www.naifa.org/advocacy/federal-issues-positions/fiduciary-(retirement-accounts).
[2] Elizabeth O’Brien, Obama administration targets financial advisers better at enriching themselves than clients, Market Watch (April 6, 2016), http://www.marketwatch.com/story/new-fiduciary-rules-set-to-protect-retirement-savers-2016-04-06.
[3] Id.
[4] What Personal Financial Advisors Do, Bureau of Labor Statistics (Dec. 17, 2015), http://www.bls.gov/ooh/business-and-financial/personal-financial-advisors.htm#tab-2.
[5] Id.
[6] Elizabeth O’Brien, Obama administration targets financial advisers better at enriching themselves than clients, Market Watch (April 6, 2016), http://www.marketwatch.com/story/new-fiduciary-rules-set-to-protect-retirement-savers-2016-04-06.
[7] Id.
[8] Id.
[9] What Personal Financial Advisors Do, Bureau of Labor Statistics (Dec. 17, 2015), http://www.bls.gov/ooh/business-and-financial/personal-financial-advisors.htm#tab-2.
[10] Eve Kaplan, The Difference Between A Stockbroker, Financial Advisor And Planner Explained, Forbes (Mar. 15, 2012), http://www.forbes.com/sites/feeonlyplanner/2012/03/15/the-difference-between-a-stockbroker-financial-advisor-and-planner-explained/#7b93c32a9fc7.
[11] Id.
[12] Elizabeth O’Brien, Obama administration targets financial advisers better at enriching themselves than clients, Market Watch (April 6, 2016), http://www.marketwatch.com/story/new-fiduciary-rules-set-to-protect-retirement-savers-2016-04-06.
[13] Id.
[14] Reactions to the Labor Department’s Fiduciary Rule, Wall Street Journal (April 6, 2016), http://www.wsj.com/articles/reactions-to-the-labor-departments-fiduciary-rule-1459954904.
[15] Id.
[16] Id.
[17] Id.
[18] Id.
[19] The Cost of Federal Regulation to the U.S. Economy, Manufacturing and Small Business, National Association of Manufacturers (2014), http://www.nam.org/Data-and-Reports/Cost-of-Federal-Regulations/Federal-Regulation-Executive-Summary.pdf.
[20] William F. Shughart II, Industrial Concentration, The Concise Encyclopedia of Economics, http://www.econlib.org/library/Enc/IndustrialConcentration.html.
[21] Id.
[22] Reactions to the Labor Department’s Fiduciary Rule, Wall Street Journal (April 6, 2016), http://www.wsj.com/articles/reactions-to-the-labor-departments-fiduciary-rule-1459954904.
[23] Id.
[24] Id.
[25] Id.
[26] What Personal Financial Advisors Do, Bureau of Labor Statistics (Dec. 17, 2015), http://www.bls.gov/ooh/business-and-financial/personal-financial-advisors.htm#tab-2.
[27] Robo-Advisor, Investopedia (2016), http://www.investopedia.com/terms/r/roboadvisor-roboadviser.asp.
[28] Can Robo Advisers Replace Human Financial Advisers?, Wall Street Journal (Feb. 28, 2016), http://www.wsj.com/articles/can-robo-advisers-replace-human-financial-advisers-1456715553.
[29] Id.
[30] Id.
[31] Id.
[32] Id.
[33] Id.