Wall Street vs Main Street: Who’s On Your Side?

As an investor, do you ever wonder who is looking out for your best interests?

If you have an investment advisor, presumably that person is your first line of defense against the known risks in the financial markets. If you are a self-directed investor, your brokerage firm should have safeguards in place to steer you away from those same hazards.

Unfortunately, that is not always the case. In my experience, the vast majority of brokers and financial advisors adhere to a high standard of business ethics. However, not all of them are as scrupulous as they could be.

To be clear, I am not referring to a Bernie Madoff level of fraud that defies all sense of morality. That type of predatory behavior falls into an entirely different category of abuse that goes far beyond any reasonable standard of ethics.

Instead, it is the more subtle forms of investor abuse that can be difficult to discern. Should an advisor recommend an actively managed mutual fund that has performed okay and pays a high commission, or a passively managed exchange-traded fund (ETF) that has performed just as well but pays no commission?

From the client’s perspective, that is an easy question to answer. However, from the advisor’s point of view, the financial ramifications of choosing one over the other can be problematic.

For that reason, pressure has been mounting within the industry over the past two decades to clarify exactly what the moral obligation is for an advisor or broker when doing business with a client.

Two weeks ago, that all came to a head with the passage of a new set of regulations governing financial advisory sales practices that will go into effect a year from now.

Regulation Best Interest

On June 5, the U.S. Securities and Exchange Commission (SEC) approved a new set of rules “designed to enhance the quality and transparency of retail investors’ relationships with investment advisers and broker-dealers.” That’s a polite way of saying that clients can’t be ripped off anymore.

The new law, dubbed Regulation Best Interest or “Reg BI” for short, stipulates that the best interests of clients must take priority over the financial interests of the firm or person making an investment recommendation. You may think that sounds so obvious that a rule requiring it shouldn’t be necessary.

Currently, advice of that sort need only pass a suitability requirement. Suitability means that an investment must be consistent with a person’s investment objectives and risk tolerance. However, it does not necessarily mean that the advice is in the best interest of the client.

Going forward, the onus will be on the advisors to determine that an investment is not only suitable but also in their client’s best interest. Under the old rule, it was up to the clients to figure that out for themselves.

Of course, most clients of financial advisors hire them for that very reason. Presumably, the advisor would only make recommendations believed to be in their client’s best interest. If not, how can a client know which advice to take and which to avoid?

Fees vs Commissions

Of particular concern to regulators are sales practices involving packaged products such as annuities and mutual funds. That’s because there is often a high sales commission paid to advisors on these products.

Those commissions are usually recouped via an annual service charge that reduces the net return to the investor. However, those charges are not always apparent to the investor since they are usually paid out of the assets under management and not as a separate payment made directly by the client to the advisor.

For that reason, the Financial Planning Association (FPA) has been lobbying strongly for a strict fiduciary standard of care. It believes that eliminating sales commissions altogether is the only way to avoid the potential for a conflict of interest.

The FPA favors a fee-only approach to providing advisory services, similar to how lawyers and accountants are compensated. Under that model, a client could pay an hourly rate or a set fee for services rendered regardless of the value of the assets being managed.

As a former financial advisor and a longtime Certified Financial Planner (CFP), I can see both sides of the argument. Although a fee-only model may seem less biased, it may also have the unintended consequence of pricing some clients out of the market who can’t afford to pay a fee.

The new rule may also dissuade advisors from recommending investment products that are ideally suited for a client’s needs but are more expensive than an alternative investment that may not perform as well. After all, investment performance is the single most influential variable in determining the extent to which a financial goal will be met.

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