As we prepare for the new advisory regulations set to be implemented this coming June, requiring advisors to pursue the best interests of clients, we’re still far away from this ideal.
In an effort to reduce conflict of interest when obtaining investment advice, the Securities and Exchange Commission is finally ready to enact what they believe will be a substantial change in the relationship between retail clients and investment advisors by requiring that advice not only be suitable but also be in the best interests of their clients.
This sure sounds laudable, but the “best interests” addition only addresses the potential for advisors to put their own interests ahead of their clients, even though this is a big enough open sore in the process to merit signaling out. How well we can achieve this goal of the pursuit of their actual best interests is a whole different story though.
To actually take this to the level of best interest would involve not only acting impartially in a setting where the advisor’s own well-being is at stake, it would also require them to choose well for their clients in a manner that can be measured against a standard of care. We have this in other professions like law, where the quality of the advice that your lawyer provides you can be measured against standards of good practice which is required to even know whether malpractice has occurred or not.
The fact that we do not have anything remotely resembling this in the investment advisory profession is the biggest hole that we have to address, even though coming up with such a thing would be a formidable challenge. It’s not that there aren’t standards out there now, but they are very rough. For instance, it is clear that someone looking for income stability over a long period of time wouldn’t want to put everything on the line in a risky trade the way that some investment bankers have been caught doing, where for instance if oil rises we strike oil or go bust if it doesn’t. Our approach with retail clients is almost entirely defensive though and only addresses the most heinous of acts.
It is natural for regulators to be concerned with protecting clients against excessive risk first and foremost, but there is another side to this, which also involves risk, and this is promoting strategies that are inferior and especially ones that are less likely to achieve the objectives and needs of clients.
A good example of this failure would be selling an annuity to someone who is 55 years old and has a million dollars saved up and wants to retire. The client is told that they can use this to receive $40,000 after taxes every year for life, and since they could get by nicely on that amount right now, this may sound like a sweet deal that will take them into their golden years in comfort without having to sweat out investment risk.
If they were told that this amount in their later years would decline below the poverty line and they would be left in squalor by this plan in the end, they may think twice about this, but these things aren’t discussed. It’s actually likely that neither the advisor nor the client has accounted for inflation very much here, and we’re not even talking inflation risk here, as even the very low amount we have these days will do this plan in.
We’d actually need a lot more than just a million dollars to make this work. There need not be any conflict of interest to end up in this place, as a conflict of understanding will do just fine.
Each year you will have to get by on less and less as inflation eats at your fixed income until you get to the point where cutting back becomes genuinely painful, and it should be obvious from the outset that this plan not only will not provide the level of comfort desired, $40,000 per year in present value, it is guaranteed to fail miserably.
This is not to say that annuities do not have their place, but not at the margin like this, and at a minimum the distributions need to actually succeed in doing what they are supposed to do, allowing for not only the possibility but the probability of success, or as close to it as we can reasonably obtain. We have enough to afford the luxury of trading returns for comfort, but if we cannot afford this, it becomes a big mistake.
When we deconstruct the crime, we see that not only has the advisor not provided good advice here, they often have chosen this plan based upon it padding their own pockets more. If you earn your living from selling investments, it is all too easy to have your own interests substantially influence your recommendations, with such a strong incentive in place.
We Need to Do More Than Just Dissuade Conflict of Interest a Little
It is not even the potential conflict of interest that is the central problem here, it is the fact that investments are recommended that do not serve the best interests of clients that is the real issue, whether or not a conflict of interest influenced these inferior recommendations or not. If the advice is bad, it doesn’t matter why.
The squeakiest wheel here is the conflict of interest part though, to the SEC’s ears anyway, which they seek to address with these new regulations, but even this is murky and all the regulations involve is making a few additional disclosures which may have little effect on the decision-making process. They are told certain investments are in their best interests, and yes, the advisor is being compensated for it, but they will likely see this not as a conflict but as a win-win situation, even though only one party may win in this deal and it may not be them.
Unless the decision is particularly bad though, we’re basically left to take the word of the advisor as far as what drove their choosing the particular investments that were recommended. You can’t just go by higher fees if the investments are substantially different. In some cases, if an identical investment was able to be offered with significantly lower management fees, we might be able to argue that the interests of the client were subordinated, but we’re mostly left to rely on the honor system.
We’re really left to substantially rely on the advisor’s moral sense of duty here, which is not what regulation is supposed to rely on since it is the task of this to actually keep people in line and not just rely on hope to achieve this. This new requirement of putting clients’ interest first may indeed point things in the right direction somewhat, but whether or not we tell advisors to ignore competing interests, this monster remains and we’re left to hope they will just say no to it and instead choose a straighter path.
If we are to allow people to act both as an advisor and a broker, we really need a much better standard of care than this, where compliance can be extended to require some basic principles that promote the interest of clients to be followed. What happens now is that clients are subject to an interview and their answers are used substantially to guide the recommendations, which is a lot like relying on patients to provide significant input on medical matters, where the doctor would ask some questions and then base their medical advice upon that.
If neither the doctor or the patient knows very much about the right way to practice medicine, then we’re in real trouble.
There are two main elements that become under examination when interviewing a client, which are risk tolerance and investment objectives. There are other considerations like liquidity, and although this doesn’t come up that often, if we’re promoting illiquid investments, we need to make clients aware of this sort of risk as well. If we set someone up with an inadequate amount of income and also include illiquid assets, and they have to liquidate them, this can see them needing to dump them and get considerably less, if they can sell them at all.
We cannot just ask someone how much risk that they can take on and rely on their uninformed answer. Often times, neither the advisor nor the client has much of a sense of what the risks are, especially the risk is not achieving your objectives, and whether this results from investment losses or just running out of money doesn’t matter when we end up in the same regrettable place.
When we put clients into excessively conservative positions, they may have a subjective risk aversion to investment risk, but also need to become aware enough of what we could call systemic risk, the risk of our portfolio failing to provide what we need. We therefore need to start in the future and work back, rather than just saying things like we don’t like stock market risk but not investing in them actually provides a higher overall risk of failure.
If someone with a modest portfolio gets stuck with too conservative investments, this in itself can doom them, and very often does. Any sensible standard of care needs to include our actually looking to help them achieve their goals, and not just pander to the client’s lack of understanding by handing them the shovel and having them dig their own hole, or worse, our grabbing one as well to help.
While personal incentives can have advisors more eager to shove poorer choices at their clients, if we are sincere about wanting to promote their best interests, we need to realize that such a duty extends well beyond conflicts of interest and actually involves proactively pursuing this task. It’s not that all advisors fail at this, but the industry as a whole does an absolutely terrible job at this, and even segregating advisors and brokers won’t do much to help this.
The Next Step is to Wonder Whether Being Both an Advisor and a Sales Person is Wise
We may wonder though if it is a good idea at all to allow brokers to wear the advisor hat as well, because this always is going to present a challenge. We wouldn’t want to hire a lawyer in a divorce proceeding that also represents the other litigant and gets paid more if we lose the case, and instructing this lawyer to be impartial in the face of this won’t be near enough to provide us a reasonable level of the assurance of impartiality.
This goes beyond the advisor/broker though, as the firm itself is going to be leaning on profits that benefit their bottom line. If the correct strategy involves investing in something not in their inventory, only the truly naïve would think that a broker would step aside and send them elsewhere to make their purchase and keep their jobs for very long.
When we look at the assortment of things that are promoted by registered investment advisors who are also dealers, we see all sorts of exotic things being put on the table, things that cost investors more and may not be appropriate for them at all. Clients are paying more for this service rather than just venturing off with something like an index fund, and end up paying both higher fees and not getting adequate results to justify them, and they often will have to endure both higher costs and inferior risk to reward ratios.
If the SEC was actually serious about fixing the conflict of interest problem, the first step needs to be to put an end to this problem that this duality involves, especially since there is no good way to police this to promote compliance with a best interest standard or do anything but beat back the worst of the grafters a little.
Some people make the mistake of thinking that advisors from independent advisor/broker firms actually provide advice that is more independent, but the opposite is true in practice. The firm might be independent, in other words not one of the big firms in the industry, but this comes with less resources for compliance and enforcement which makes it even more difficult to keep them in line.
Separating these roles in the way that retail and investment banking used to be separated, where a firm cannot ever offer both services, is just a start though, as it won’t help much if you actually see an independent advisor, who may be unbiased but often will not be anywhere near competent enough.
This part is a monumental task though and requires that the industry itself rethink their approach to advising considerably. It not only is much more risk-averse than even common sense would dictate, they only look at one side of the picture, drawdown risk, without placing this risk in the greater context of the investment objectives themselves.
People who have an inadequate portfolio are in dire straits already, where the risk of going broke is so high that nothing should be automatically excluded. If we instead choose to set our clients up for failure by leaning on simple-minded strategies such as an equal distribution of stocks in bonds in all weather, which may be not be suitable for everyone but especially for clients whose needs are greater, that’s not taking us toward what we really need.
By pandering too much to their and our risk aversion, we’ll both be happy enough seeing returns that are merely a pittance and just lead us by the hand out into the cold, where we could have instead thrown a few logs on the fire that may have provided a few sparks but see this get well covered by the extra amount of heat that is generated.
If you are sitting in retirement and only have a few years of principal left to live on, this is not the time to just lock the door and sit tight and just wait for it to be broken down by reality.
Someone needs to sit down with these clients and have both the client and the advisors leave their biases at the door and examine the various approaches that we can take in detail, where we actually faithfully seek to measure both the risk and returns of each. Otherwise, we’ll never know which path is in their best interests and just end up wandering into the woods like Little Red Riding Hood and into the waiting arms of the Big Bad Wolf.
Formulating our plan in accordance with the true needs of clients remains a pretty foreign concept overall though, and we will require a new breed of advisor to best guide them toward success, one that actually has a good grasp of risk/reward. At present, this sort of revolution is not even thinkable on any real scale, given how much power and control the status quo gang has.
There is much to do as far as having the investment industry as a whole genuinely seeking the best interests of their clients, and these new rules do help a little, but there is so much left to do here. If we don’t realize this though, it will never happen.