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Americans saving for retirement will continue to face the risk of being vulnerable to financial advisors who charge hidden commissions. That appears to be the implication of an executive order President Trump signed last week, where he called for a review of the Department of Labor’s “fiduciary rule,” which sought to protect mainstream investors and was to take effect on April 10, 2017. Currently, two federal courts have upheld this Obama-era rule and another rejected a request to delay its implementation.
The fiduciary rule would require financial advisors to have their clients’ best interest at heart when recommending investments that apply to the rollovers of 401(k) or 403(b) accounts into IRAs. Currently, the practice is simply to meet the suitability standard — whether an investment is suitable to a client based on their age, risk tolerance and other factors — but does not consider hidden commissions, said Wharton professor of business economics and public policy Kent Smetters. At present, it is legal for advisors to recommend an investment that pays them a higher commission over a similar option that would save their clients money.
That doesn’t mean Obama’s fiduciary rule doesn’t have its flaws. Smetters noted that it started out as a “very clean, simple rule” that required the IRA rollover process to have a person’s best interest at heart. Commissions are fine if they are disclosed properly and clients understand them. The problem is hidden commissions; clients don’t know they could have cheaper options. However, Smetters said that industry lobbying led to changes in the fiduciary rule that “basically snuck [hidden] commissions back in.”
Another shortcoming is that the fiduciary rule does not apply to financial advice for taxable brokerage accounts that are “commission-driven and involve conflicts of interest issues,” Smetters added. Meanwhile, he pointed out that a fiduciary standard already exists as part of the Employee Retirement Income Security Act [ERISA]. “When you roll over a 401(k) or 403(b) into an IRA, the ERISA protections including fiduciary protections still apply to that rollover.”
Smetters spoke about the Trump administration’s move to review the fiduciary rule during an interview with the Knowledge@Wharton show on Wharton Business Radio on SiriusXM channel 111. (Listen to the podcast at the top of this page.)
Impact on ‘Ordinary Investors’
Generally, Smetters said that he has not been a fan of certain financial regulations, such as the post-financial crisis Dodd-Frank Act, Sarbanes-Oxley and the Volcker Rule. The financial services industry’s opposition to these regulations is “legitimate” because the regulations serve to “kill capital formation, and a lot of it is really vague like the Volcker rule.” But the fiduciary rule currently under scrutiny is a different case. “A lot of the Dodd-Frank [regulations applied to] sophisticated counterparties.”
However, the fiduciary rule affects ordinary investors. “We’re talking about your mom, your father saving for retirement who potentially could be taken advantage of.… I would be happy to change the suitability requirement and make it a fiduciary requirement that includes that cost difference,” said Smetters.
These commissions could be hefty. For example, on a $100,000 account, the “front-end load” or upfront fee, could reach $5,700 and then the fund could collect another $1,000 a year in 12b-1 fees for marketing and distribution. Small investors would be better off choosing low-cost index funds from Vanguard and other mutual fund companies, Smetters noted.
Smetters, a former Bush administration official, hoped that President Trump will side with small investors in this instance. “This is one area where the Trump administration could show they are in favor of Main Street and not Wall Street.… But my guess is … this is on the path of repeal.” However, investors could protect themselves by choosing “fee-only” advisors, who only charge upfront hourly fees or a project fee. They are different from “fee-based” advisors, he added, who “charge you a fee and a lot of these hidden commissions.”
“This is one area where the Trump administration could show they are in favor of Main Street and not Wall Street.”
The bottom line is that what the advisors against the fiduciary rule were “arguing for is that you have to kind of trick people out of their money,” Smetters said. “You have to make it less transparent so they are buying your services as though their services must somehow be a good thing.”
‘If I Had a Magic Wand’
According to Smetters, the fiduciary rule protects unsophisticated investors planning their retirement savings. “I have no problem if a person understands how much they are paying and they want to pay a large fee,” he noted. “What I get upset about is that, by definition, we are talking about a population where [individuals] are asking for advice because they are unsophisticated, and the only way they would understand how they are being tricked on the commissions is if they were in fact very sophisticated.”
Although the fiduciary rule is a much-needed protection for investors, the way the proposal has taken shape did warrant a second look, according to Smetters. “It is a big mess.” When the Obama administration first introduced the rule in April 2016, it took a “non-commission approach” to financial advisory services for retirement accounts, he said. But the financial services industry lobbied to get the so-called “Best Interest Contract Exemption” worked into the fiduciary rule.
Smetters pointed out that this exemption and other language basically allowed hidden commissions back in. “My excitement about the rules substantially diminished, partially because it redefined ‘fiduciary’ to mean someone who could collect a [hidden] commission.” Despite the revisions, “the [fiduciary] rule probably did more good than bad,” he added. “I would have repealed it and replaced [it with a new standard], and not just do a repeal. Nonetheless, the Trump administration is right — the rule got really messy.”
Smetters laid out the ideal scenario for investor protection. “If I had a magic wand, I would have the rule be a true fiduciary requirement that is not compatible with commissions,” he said. “All IRA rollovers are only handled by a fee-only advisor where the charge is on an hourly basis or is a project fee with no hidden commissions. I would [also] go beyond that and include that rule for all financial advice to households, including your private brokerage account.” He added that the U.K. and Australia have switched over to the fee-only model and Germany is in the process of doing so.
“We are talking about a population where [individuals] are asking for advice because they are unsophisticated, and the only way they would understand how they are being tricked … is if they were in fact very sophisticated.”
Digital platforms that offer investment advice could “in theory” be an alternative for investors, but he also called for caution. “My big concern about the [digital] platforms [is that they make] a lot of promises, especially regarding tax-loss harvesting and massively inflating the gains from that,” he said. (Tax-loss harvesting is the practice of offsetting losses incurred on the sale of securities against taxable income to reduce tax owed or boost a refund.) “Secondly, they are all set up just for younger accumulators, but they are tax-inefficient if you try to take your money out.”
Meanwhile, Wall Street has been preparing to comply with the fiduciary rule’s deadline of April 10. Merrill Lynch, for example, has said it will stop charging commissions on retirement accounts but instead assess fees based on a percentage of assets. However, Smetters thinks the rule’s implementation will be delayed. “Ultimately, that decision could be made by the career staff there, but the head of the Department of Labor, who is a political appointee, could decide not to move forward with this rule,” he said. As a result, “we are going to be back to where most financial advisors operate on a commission basis and are enriching themselves at the expense of a lot of people.”
Smetters also doesn’t see the U.S. following the footsteps of the U.K., Australia and Germany anytime soon. Phasing out commissions is one move that would appeal to Democrats, but many financial services firms are located in Democrat-heavy “blue” states like New York, Massachusetts, California.
“The Democrats who should be concerned about this from those states are in favor of the financial services industry because they are representing their constituents,” Smetters said. Republican-leaning red states, meanwhile, tend to dislike increased regulations so the issue is a non-starter there, too. “So you have this weird coalition of red and blue states that will keep this non-fiduciary practice alive for a long time.”