A perfect illustration of this phenomenon occurred just before the financial collapse of 2008. Researchers conducting a study sent “mystery shoppers” into 284 Boston-area financial advisors. When clients walked in with the kind of low-cost, diversified portfolio independent experts recommend, only 2.4 percent of advisors approved of it and some 85 percent recommended making a change. Financial advisors were eight times more supportive if clients had a less-than-ideal strategy of chasing returns—one that was more likely to generate commissions.
Despite all this, the pretend clients didn’t smell a rat. In fact, they were smitten: Some 70 percent of them said they’d use the advisor to invest their own money.
There’s little reason to think things have changed. Finra, the private watchdog that oversees non-fiduciary advisors, barred or suspended 1,244 individual brokers last year, up from 843 in 2012. Clients still rarely know what’s going on, or what it’s costing them, industry experts said. Christine Lazaro, director of the free Securities Arbitration Clinic at St. John’s University in New York, said people who came to her just assume “the broker was doing what was appropriate.”
“They are always very surprised,” she said, especially by what advice was costing them. “The broker leads them to believe they’re not paying any fees at all.” According to a Cerulli Associates survey last year, a majority of investors in their 60s and 70s either aren’t sure what their fees are or believe incorrectly that they pay nothing for advice.
But paying they are. Offering financial advice is enormously profitable, with U.S. investment firms achieving operating profit margins as high as 39 percent, according to the CFA Institute. And once advisors collect enough client assets, they can get huge bonuses for switching firms (and bringing their customers with them). Until recently, the going rate was a bonus of more than three times the annual fees and commissions the advisor brings in the door; an advisor with $200 million under management could expect a bonus of $6.6 million. (The threat of the Fiduciary Rule, however, caused bonus offers to plunge.)
Meanwhile, the total cost of bad advice to consumers—in higher fees and lower performance—is probably much higher than the $17 billion estimated by Obama’s Council of Economic Advisors. The CEA figured investors are losing an extra 1 percent annually on $1.7 trillion in individual retirement accounts controlled by conflicted advisors. But IRAs represent just an eighth of the $56 trillion in financial wealth Americans control, according to Boston Consulting Group.
Various academic studies show conflicts of interest costing investors dearly. One found that funds sold by brokers did 0.77 percentage points per year worse than funds bought directly by investors—even if you ignore some big broker fees. Another study compared investors advised by brokers with investors put in a target-date mutual fund. Those who got advice underperformed by 3 percentage points per year.
It’s hard to blame consumers for falling into these traps. The rules governing financial advisors could hardly be more confusing. While some are already fiduciaries, required to put their clients’ interests first, most advisors must merely recommend products that are “suitable” to client needs, a term open to wide and profitable interpretation. Making the whole thing more baffling, another group of advisors are “dually registered,” meaning they can act as a fiduciary or a non-fiduciary, depending on the situation.
Wealthy people, often pushed to buy faddish products with high fees and mediocre returns, aren’t immune either. Hedge funds perform poorly on average, while charging typical fees of 2 percent per year plus 20 percent of any gains. Then there are those structured products, such as the aforementioned reverse-convertibles. If advisors were required to put clients in the best reverse-convertibles—as a Fiduciary Rule could eventually demand—Egan calculates that investors’ risk-adjusted returns would rise by over 2 percentage points per year.
Wall Street argues that strict regulations on financial advice will make it less affordable for middle-class investors. The Fiduciary Rule “will adversely affect the ability of millions of Americans to save for retirement, increase the costs of retirement accounts while limiting access to advice and products,” the Securities Industry and Financial Markets Association wrote in a letter to the Labor Department. But if advice as it currently exists is riddled with conflicts and hidden costs, supporters of the rule ask, does it even deserve to be called advice?