Most investors would probably agree that getting conflict-free advice from their advisor is not asking too much. The idea that investment or financial advice should put the investor’s interests first seems reasonable enough. In practice, it’s not so simple.
No doubt, many advisors sincerely try to provide objective and conflict-free advice. Wall Street Journal columnist Jason Zweig reported finding hundreds of websites by financial advisers, all aligned with a well-known broker-dealer, claiming to do so. They all touted their “conflict-free” advice or made some similar claim to be free of ethical dilemmas. The idea has powerful appeal, but investors should not rely on the sales pitch. Conflicts of interest are pervasive throughout the financial services industry and they are not always easy to identify.
The most obvious conflicts arise in the sale of commission-based products such as mutual funds with a sales load, annuities, and certain insurance products. A financial professional who is paid by selling commission-based products has a conflict of interest that is typically obvious to the investor. The professional’s interest in selling receiving transaction-based compensation is regulated only by his or her personal integrity and, if subject to regulation by FINRA, by what is currently known as the “suitability rule.”
The suitability rule requires a determination that a particular product is suitable for the investor’s financial situation and objectives. Under current regulations, the recommendation to purchase a particular product needn’t be in the investor’s “best interests,” merely suitable for the investor’s circumstances.
Take the following example. A variable annuity from which an advisor earns a commission might be perfectly “suitable” for an investor looking for tax-deferred growth. However, that product may not be in the investor’s “best interests.” There may comparable products that pay a lower commission or no commission at all and therefore charge lower annual expenses. The advisor is not necessarily obliged to disclose the conflict and inform the investor of the other options.
And even if it’s obvious that the advisor is being paid a commission, the investor may not know the amount of the commission, how it is paid and for how long, and how the commission impacts the ongoing costs to the investor of owning the product. The conflict may be obvious, but the details are not readily apparent.
Another common example involves the use of 529 plans, a very popular tax-preferred education savings account. Many states, such as New York, offer two versions of the plan: one that is only available through financial advisors and for which a commission or load is charged, and another that allows the investors to go direct to the fund company and invest in low cost, no-load funds. If an advisor directs the investor to the commission-based plan without disclosing the lower cost option, have the advisor’s interests taken precedence over the investor’s?
The selection of a mutual fund share class is another common scenario where conflicts arise. Many mutual funds feature a multiple share class structure. The different share classes all own the same underlying investments, but each share class charges the investor different fees and expenses. Some share classes result in the payment of compensation to the advisor, while others don’t. The share class preferred for the advisor’s business model may not be the optimal choice for the investor.
Lest anyone conclude that commission-based accounts are categorically bad and fee-based accounts are categorically good, consider a recent lawsuit involving “wrap accounts.” Wrap accounts are investment accounts in which the portfolio is managed for a fee as a percentage of assets that covers all management fees, commissions and any brokerage fees. They are often promoted as an entrée to superior investment managers. Because there are no separate charges for transaction costs, these accounts may also offer investors the assurance that their account won’t be churned.
A prominent national firm was sued recently in a class-action for moving clients from commission-based accounts with low activity to fee-based managed accounts resulting in higher fees. Regulators refer to this as “reverse churning.” The suit alleges that these investors would have been charged substantially less had they remained in the commission-based accounts. The suit further alleges that shifting these investors into fee-based accounts served the interests of the investment firm at the expense of the investors. The fee-based accounts charged annual fees ranging from 1.35 percent to 1.5 percent of assets under management.
And then we have proprietary products. These are investment products, such as mutual funds and annuities, which are sold by someone affiliated with an investment company or financial firm which issues or sponsors the products. The use of proprietary funds remains common. Banks, credit unions, insurance companies, broker-dealers, and even some advisory firms may offer their own funds because it diversifies their business model and adds an additional revenue stream.
Proprietary products raise a number of issues for investors to consider. For example, proprietary mutual funds may be more expensive than and underperform comparable non-proprietary funds. The offered menu of proprietary funds may be limited from the perspective of desired asset class coverage and diversification. Proprietary products may have restrictions on their transferability, making it difficult for investors to move their accounts in the future. Lastly, advisors who sell proprietary products may receive higher compensation than they would from the sale of comparable non-proprietary products. In the class action mentioned above, the suit also alleges that the firm pushed the use of proprietary funds managed by a subsidiary without disclosing the conflict of interest.
Even fee-only advisors who wish to portray themselves as above the fray cannot escape all conflicts of interest with their clients. Fee-only advisors generally represent themselves as fiduciaries, meaning that they under a legal duty to put the client’s interests ahead of their own. But fee arrangements create at least potential conflicts even for fiduciary advisors.
Consider the very common scenario of an investor retiring with a 401(k) and needing to decide whether to keep the funds in the 401(k) or roll them over to an IRA. Any recommendation by a financial advisor needs to acknowledge the potential conflict of interest. There may be good reasons to leave the plan – lower fees, better investment options – but the advisor stands to lose fees if the client keeps the funds with the retirement plan. The same dilemma is present when an investor solicits advice regarding taking a pension annuity or a lump sum distribution. This is not to say that good advisors won’t give balanced, objective advice, only that the conflict needs to be acknowledged and weighed.
One national firm recently announced, after being prompted by federal regulators, an investigation into “potentially inappropriate recommendations on rollovers for 401(k) plan participants.” Federal regulators have been pushing for a fiduciary rule that would require advisors and brokers to put the investor’s interests first when advising on retirement accounts. Those rules were vacated by a federal appeals court, but the SEC continues to push for more transparency and for the application of an industry wide fiduciary standard.
In the meantime, conflicts of interest permeate the investment business. In the future we will explore the kinds of questions investors should be asking.
This article originally appeared in the May 25th 2018 edition of Rochester Business Journal. Download a PDF copy.