The age of consumerism has passed over the financial services industry. This means average investors who buy mutual funds, insurance policies, annuities and other types of investments work under the assumption that their financial representative is working in their best interests.
This is a false assumption.
As numerous lawsuits and ongoing battles over the role of transparency and honesty in financial sales attest, financial reps serve two masters: their investment firm-employer and themselves. This means that many put their financial interests ahead of their customers. And it is this inherent conflict-of-interest that dominates most financial sales today that are made by large investment firms and insurance companies where the sales staff is compensated based on selling higher-priced investments over lower-cost ones, including investments that are ill-suited to their own clients.
The most recent example of how this conflict-of-interest has become the fabric in much of the financial services industry concerns the recent debate about the fiduciary standard and whether or not it should be adopted by the financial services industry.
Like most debates that concern reform in the financial services industry, this issue has been going on for close to a decade. At issue is whether financial sales people should put the interests of their clients before their own.
That sounds simple, but codifying the way financial reps recommend and sell products will fundamentally change the entire financial services industry. The industry has become so conflicted with this basic issue over which master to serve (the customer vs. the investment firm) that we now have salespeople known as brokers, registered investment advisors, wealth managers, financial representatives, financial consultants and wealth consultants.
While most people consider this a question of semantics, these names carry very different meanings and levels of disclosure. In practice, this raises the question of whether a financial salesperson should just sell the investment that gives them the best commission or whether they have to implement their due diligence and actually find the investment which most closely meets such key criteria as the client’s financial goal, risk tolerance, income, net worth, investment understanding and time horizon. These are not easy questions to answer.
The Concrete Impact of Fees on An Investor’s Bottom Line
Even worse, the dollar amounts in commissions, fees and other hidden compensation schemes are staggering.
Take the case of an investor with $100,000 in her 401(k) account. This investment can pay a 1.5% management fee to an adviser, plus a 1.4% annual fund expense charge, totaling almost 3% of a portfolio in total expenses annually.
Nobel Prize-winning finance professor Burton Malkiel estimated that, over time, fees of just 3% can devour up to 50% of an investor’s returns. The ill-effects of larger fees are even worse.
Even in plain vanilla mutual funds sales, the U.S Department of Labor (DOL) has identified 17 distinct fees that fund companies charge individual shareholders. And just to show that the average American is very uninformed about their own investments, a survey found that 71% of plan participants either don’t know what they pay in fees or think their 401(k) plan is free. It certainly is not free.
At the pension fund level, the damage of fees and commissions is even more devastating. In a May 2015 report in the New York Times, an audit of New York city pension accounts found that over the past 10 years, five pension funds paid out over $2 billion in fees to money managers and “have received virtually nothing in return,” according to New York City Comptroller Scott M. Stringer. The audit covered funds with assets of almost $160 billion. The funds involved cover 715,000 city employees, including teachers, police officers and firefighters.
Whose Money Is It Anyway?
While the scales of these two examples are obviously very different, what happened at the pension fund level is occurring at the individual investor level. The remedy from the individual investor’s perspective (after all, it is their money) is that they have to get accurate information so they can make the best decisions that will get them the best possible net return (net of all fees and expenses) over time.
This means they need objective advice from their financial salesperson. If that advice is tainted by undisclosed relationships, hidden fees and commissions, and other incentives that put their own client’s interest second, the individual investor loses.
That industry-wide conflicted situation exists today and it has to change. One main reason is that individual investors today assume all financial risk for their own retirement investments. This means every dollar they can retain can compound over their working lives to help them achieve a more financial secure retirement income. If $1 is lost to undisclosed commissions, it means less money for the owner of the retirement account. Yet it is this simple tug-of-war between providing plain old honest advice between individual investors and financial professionals that has emerged into a major industry battle. The stakes are huge.
And all this hinges on a simple question: Whose money is this anyway? The individual investor who earned it or the financial rep who wants to keep a lot of it without disclosing material information about how they are being compensated and why one investment is better than an alternative? The answer seems obvious to me, but the financial services industry refuses to come clean with its own customers. No wonder individual investors are skeptical of Wall Street.
Chuck Epstein is the editor-publisher of https://theprogressiveinvestor.org and the author of “How 401(k) Fees Destroy Wealth and What Investors Can Do To Protect Themselves.”