The Golden Rule is having an impact on the financial services industry.
This biblical phrase, “Do to others as you would have them do to you.” (Luke 6:31) has driven discussions about the ethics of reciprocity for over a thousand years, but at many of the nation’s largest financial services firms, this lesson is unknown in everyday business practices.
But this may be changing thanks to a new government regulation that will call for more complete disclosure by financial product salespeople about how they are being compensated from their firms for selling a specific investment product to less sophisticated clients.
The new Department of Labor (DOL) rule, known in the industry as the fiduciary standard, is in the final stages and was sent to the White House for review, according to the Office of Budget and Management. The rule was shepherded through an arduous, years-long approval process by Phyllis C. Borzi of the DOL.
After a decade of contentious debate, intentional stalling by the financial industry, attempts to get the SEC to issue less stringent rules, and heavy anti-regulation lobbying, the DOL and the White House are moving to get the proposal enacted, so it can be signed by President Obama before he leaves office. Even then, Republicans, who generally oppose regulations, will seek to overturn the rule if they get the chance, along with Obama’s other key program, the Affordable Care Act and the new Consumer Protection Financial Bureau.
Yet despite this contentious opposition from some investment companies, the average investor has probably never heard of this issue. That is because the mainstream financial media–Bloomberg, CNBC, Fox–don’t discuss an issue which is essentially giving average investors more control over what they buy. In essence, the DOL’s fiduciary rule proposal presents a fundamental change in the power structure in favor of average investors who now have monetary recourse to recoup losses resulting from advice tainted by conflicts-of-interest.
Decades ago, the financial industry fought to make arbitration, rather than the courts, as the venue where losses from bad advice were adjudicated. Arbitration was chosen since it would grossly favor the financial industry in these disputes. The fiduciary standard essentially reverses some of the industry’s power by making it more accountable based on the new higher, pro-investor fiduciary standards. While it looks like a simple change to the average investor, it is one that will fundamentally change the brokerage selling business model. And if there is anything the financial services industry hates, it is change, especially when it gives investors more power.
Not the Best Time for Honesty
The proposed fiduciary standard is coming at a bad time for the financial services industry. Recent market volatility accompanied by falling indexes, has cut profits at wealth management firms. The fiduciary standard will force salespeople to disclose their conflicts-of-interests and may also cut into commission profits at major firms where selling more expensive, less suitable products has contributed to profits for decades.
As a precursor to how honestly dealing with the public will changes some aspects of the financial services industry, Ameriprise CEO Jim Cracchiolo said in a Financial Planning magazine interview, “We expect to have to make some adjustments in the commission-based business.” Ameriprise will be able to work with either a fee- or commission-based business, Cracchiolo said. In a separate story, Financial Planning quoted Paul Reilly, the CEO of Raymond James, which has 2,600 office nationwide, that while the DOL rule is “well intended, it is not good for clients.”
The prevailing industry complaint is that giving investors honest advice will cost investors more never gets seriously challenged by the financial press. A closer look shows that it will cost brokers more in lost sales than it has in the past, when they sold more expensive products. How this translates into higher costs for customers (as the industry continues to repeat) could only happen if the brokerage firm sought to replace that lost revenue by charging clients more in fees and by raising other expenses.
Now, why this would happen is confusing to unsuspecting investors, but the industry has phrased their opposition to the fiduciary rule this way since it would impact their corporate profits, not the portfolio profits of naïve investors.
That’s because 401(l) investors alone pay $164 million in fees daily to the financial services industry, plus the new rule will change revenue sharing and 12b-1 fees that cost investors another $9.5 billion annually, as shown in the book, How 401(k) Fees Destroy Wealth. Plus, many brokers will have to explain their rationale when suggesting new investment options to clients, which could force them to sell better-suited, less expensive products to clients.
In short, what the financial services and wealth management industries will be forced to do is increase the bottom-line net returns to their clients because client fees can be reduced as a result of lower fees and expenses. Lower fees directly translate into higher net returns for clients. These potential higher returns come at a time of exceptional market volatility and unpredictable market returns. Yet, as many academics have proven including John Bogle of Vanguard, fees and expenses are the two variables investors can directly control that increase their returns without additional risk.
But some firms that want to avoid increased customer transparency are exiting the business. AIG, one of Wall Street’s shadiest operations, said it would sell its broker-dealer operation. AIG CEO Peter Hancock said the new fiduciary rules would increase the firm’s compliance costs (a standard industry excuse). But AIG would certainly want to avoid disclosure based on its history.
In March 2009, Think Progress reported that the government was going to intervene for a fourth time to help A.I.G. avoid bankruptcy. “The government already owns nearly 80 percent of the insurer’s holding company as a result of the earlier interventions, which included a $60 billion loan, a $40 billion purchase of preferred shares and $50 billion to soak up the company’s toxic assets,” the report said. These federal rescue operations were certainly not the result of the company’s transparent operations.
So how much will honesty hurt the financial services and wealth management businesses? A Bloomberg news report quoted an analyst at FBR Capital Markets, who said the new rule would have a “chilling effect on sales and commissions.” “Chilling” is analyst-speak for fewer commissions because more expensive, and often less appropriate investment products, won’t be able to be sold unless the broker makes the case why they are better than a less expensive alternative.
This could also mean lower broker incomes. One Merrill Lynch district manager said he was moving to a higher-level supervisory role as a result of the new rule since his commissions would be cut. Certainly, more high-commission firms are thinking of exiting the business rather than giving their customers an even break.
This could also mean that mutual fund wholesalers, and their internal support staffs, could be reduced, especially if revenue sharing and 12b-1 fees are scrutinized.
This army of expensive fund wholesalers brings in new fund sales, but do not add one penny in net returns to investors.
Of course, there are thousands of financial professionals who already have adopted the fiduciary standard in their daily practices. These Registered Investment Advisors (RIAs) are fee-based and have advocated for the rule. They should now use it as a major marketing edge to show how they are more transparent and conflict-free than the competition.
All of these changes that are just beginning to occur as a result of the fiduciary rule may usher in a new period of what the economist Joseph Schumpeter called “creative destruction” This process happens when outmoded jobs are eliminated. Schumpeter also said this process is an essential part of capitalism, so it should be no surprise that the financial services industry is now facing one of its own creations. Ironically, all of this is happening simply as a result of implementing the Golden Rule.
Congratulations, Chuck, on a terrific article.
May I encourage you and your fellow journalists to not only call for honesty but to highlight the pervasive dishonesty and outright frauds in the financial services industry.
My website contains many documented examples of the pervasive frauds committed by life insurers and their agents in their sales efforts.
It could also be useful for you to report about the inadequate disclosure of the life insurance industry’s products because inadequate disclosure is a prerequisite to misleading and deceptive sales.
Remember the lawyer’s adage: Where there is no truth, there are no lies.
Without consumers being told the necessary information to make a good decision, or being told where to go to get the good, necessary information – because unfortunately the web and even mainstream journalism has so much misinformation – consumers are basically sitting ducks ripe for plucking.
Finally, while the fiduciary standard has much support – and has laudable objectives – can anyone tell me how sales people who don’t even have good information or product knowledge can be fiduciaries? No one can be a fiduciary without good information, so given the life insurance industry’s documented inadequate product disclosures no one but a real expert (of which there are very, very few) even knows what they need to know to actually properly do a fiduciary-like job.
Again, congratulations on a solid and important article.
Thanks for your note. Disclosure is also tied to the distrust of Wall Street (including the insurance industry) and this has now become a major campaign issue. As a matter of fact, I suggest that the conflict-of-interest relationships that taints most advisor-client and insurance agent-clients relationships are at the heart of the distrust of Wall Street, along with the obvious examples of people and banks that perpetuated a huge fraud that destroyed the U.S. economy and got away with murder. Interesting to note that it was the insurance industry after the Civil War that started revenue sharing. They did this because they knew they were largely selling commodity-type, complicated products, so paying someone an under-the-table commission was the best way to push your product into buyers’ hands. This was so successful that it was picked up by the mutual fund industry many years later.