I originally titled this post, "Our Industry needs a Gut Check." But Nerdwallet thought this one tested better. I'll let you decide.
The Department of Labor recently issued a new rule regarding financial professionals who advise clients on retirement accounts such as 401(k)s and IRAs. Although the rule is complex and comes with some caveats, it can be boiled down to this: Effective April 2017, retirement advisors must put their clients’ best interests first. This is called the fiduciary standard.
The new rule won’t necessarily eradicate bad investment advice, but it’s a step in the right direction, and it’s a good thing for investors.
The ‘suitability’ standard
The fiduciary rule may seem simple and logical, but it’s causing a major upheaval in the financial industry. Currently, the vast majority of brokers are held to the “suitability” standard, meaning they can recommend any product to a client that is reasonable. In other words, it doesn’t have to be the best product for the client, it just has to be suitable.
The new rule is long overdue. The fact that the standard for a broker giving advice is essentially, “You are not allowed to rip off your clients — too much,” is an embarrassment to the industry. This allows for all kinds of questionable practices such as selling clients high-fee or potentially inappropriate products like variable annuities, unit investment trusts and expensive mutual funds. These products often do more to benefit the issuing company and the advisor than the client. It’s like if your doctor prescribed you the most expensive drug available when aspirin would be appropriate, just because he or she would receive a commission for prescribing it.
Here’s an example among mutual funds: the Fidelity Contrafund (FCNTX), from one of the largest mutual fund companies, is a popular growth fund found in many retirement accounts. More than $109 billion is invested in the fund, and it’s rated as a four-star fund (out of five) by research and ranking firm Morningstar. The total expense ratio of the fund is 0.7%, meaning that you pay $7 in administrative fees for every $1,000 invested in the fund. Consider that at $109 billion in assets, this generates $763 million in fees for Fidelity - enough to pay 100 analysts almost $8 million per year!
Of course, this may well be reasonable if the performance of the fund were good compared with other large-capitalization growth funds. However, a similar four-star-rated fund called the Vanguard Growth Index ETF (VUG) outperformed the Contrafund over the last one-, three-, five- and 10-year periods:
The main reason for this outperformance is lower fees. The Vanguard ETF is a passive product, meaning it merely tries to track a predetermined stock index and is less expensive. It has a 0.08% expense ratio, or about one-ninth of what Fidelity charges on the Contrafund.
In my opinion, it would be hard for advisors to come up with well-reasoned, data-supported arguments as to why such higher-fee products are in their clients’ best interest.
Client interests first
Though all retirement advisors will soon have to adhere to the fiduciary standard, I still recommend that investors choose independent registered investment advisor (RIA) firms, which have always been held to the fiduciary standard. To me, the fiduciary model — putting the investor first — is the only long-term advice model that makes sense for both the advisor and the client. It reduces potential conflicts of interest by mandating that clients’ interests are put first, making the relationship simpler and more straightforward.
Of course, there are good and bad actors in every industry and every type of business model. Many brokers and advisors put their clients’ interests first and always have, while a few try to profit primarily for themselves. This regulation won’t change the fundamental behavior of advisors who are looking to profit at the expense of their clients. But at least it makes it easier to understand and identify what these bad actors might be doing, and I can’t help but think that is a good thing.
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