Important, New Protections for Investors

This week the U.S. Labor Department issued new regulations that mandate your financial advisor to conform to a “fiduciary standard” when recommending investment products for retirement plans.

Unlike the previous standard of “suitability”, which only required that a recommended product not be inappropriate for a client, a fiduciary level of responsibility requires that only the single best investment product or strategy be recommended, as viewed from the client’s perspective.

Of course, defining what the “best” product is for a client is to some extent subjective, but there are certain situations where one product would clearly be preferable to another. For example, a passively managed exchange traded index fund with very low fees would generally be regarded as preferable to an actively managed fund with higher fees whose overall performance was no better, or worse, than the ETF.

The intent of the rule is to eliminate abusive practices that have existed for decades involving investment products with absurdly high sales charges and annual fees that are far above reasonable payment for services rendered. You can quibble over whether saving 15 basis points (0.15) on one mutual fund versus another is worth fighting over, but it’s hard to argue that paying an up-front sales charge of 8% is better than paying a much lower one, or none at all.

Annuity Fees

Not that long ago the retirement market was mainly the province of the insurance industry, which underwrote the annuity contracts that funded most company pension plans. Since the employer paid the premiums for those contracts out of corporate funds, its employees didn’t much care how efficiently that money was being invested so long as their pension checks showed up on time in retirement.

In truth, many of those old annuity contracts were hugely profitable to the insurance companies, which could hide large fees inside a byzantine maze of product features designed to obfuscate the true cost of the plan. And so long as the insurance company had enough money in reserves to pay the pension obligations under the contract, it was free to invest the rest of the premiums however it liked.

That worked okay until the junk bond market expanded rapidly in the 1980’s, providing what appeared to be the perfect arbitrage opportunity for the insurance companies issuing the contracts. Just as banks earn a profit by paying its depositors a lower interest rate on savings while charging a higher rate to its borrowers, the insurance company could guarantee a relatively modest interest rate in its annuity contracts while investing the money in much higher paying junk bonds.

Unfortunately, the junk bond market imploded under its own weight, bringing down many corporate pension plans with it. That forced the first major round of revisions to retirement plan law, including much more stringent requirements on exactly how much money must be held in reserve, and how that money could be invested making those contracts considerably less profitable to the folks selling them.

Of course, the retirement plan “consultants” who made a fortune off of recommending those investments didn’t take that action lying down. They simply moved on to a new set of products that fell outside the scope of the regulatory requirements, including mutual funds, managed accounts, and alternative investments that could also be structured to generate fat sales commissions for the investment representatives selling them.

At the same time, globalization began squeezing profit margin of U.S. companies to the point that many of them abandoned defined-benefit pension plans altogether, replacing them with employee-funded defined contribution plans such as 401(k) accounts. That meant it was now the employee’s money that was paying those fees, and not the employer’s funds.

And that’s essentially how we got to the point that the Labor Department felt compelled to mandate that investment advisors act in your best interest, and not their own. The unfortunate fact of the matter is that if left to their own devices (or sense of ethics), some advisors would continue to find ways to sneak overpriced products into your portfolio.

To be clear, most advisors are decent people who make a genuine effort to do what is best for their clients. But some bad actors ruin the retirement plans of many unwary consumers. Under the old law they could get away with it if in some way they could argue their actions were suitable, but now they will have a much tougher time claiming they are acting in a fiduciary manner.