Longtime readers of my columns know that I am not a fan of government regulation. Nevertheless, there are times it is needed to protect consumers. This column is about new regulations that have the potential to save investors billions of dollars in costs.
Internal fees in mutual funds
Some months ago, I wrote a column about the hidden fees in mutual funds. Many investors don’t know that the same mutual fund may have different classes, with some classes having much higher costs than others. Most investors don’t know that a significant portion of such added costs are rebated back to the adviser’s company in the form of 12-b-1 fees (technically, a “marketing payment”).
Just as Disneyland is the “happiest place on earth,” Wall Street is the “greediest place on earth.” We have seen with our own eyes, in previous employment, advisers high-fiving when they have extracted excessive fees from an unbeknownst client. And many portfolios we see in our business coming from other advisers are rife with such fees.
Potential clients, of course, often ask what their fee costs will be. While our fees are among the lowest in the industry, some potential clients have told us that one of the big brokerages is quoting lower. While we can’t say we are always the lowest, most of the time it appears that our fees are higher because none of those back-door fees have been disclosed (‘til now, that is!)
New fee disclosure rules
On Wednesday, April 7, the Department of Labor came out with new disclosure requirements on the pricing or cost of retirement accounts, including individual retirement accounts. These rules were originally proposed in 2010, but the securities industry fought hard to prevent them or significantly water them down. The delaying action bought them seven years, as the new rules don’t begin to take effect until April 2017, and are phased in. For purposes here, it will be January 2018 before they have any real impact.
One of the arguments used by the securities industry was that the new rules would be so burdensome and expensive that clients with small account balances would have to be dropped. This is a specious argument. There are ways to take small accounts and put them into low-cost programs that are likely to produce market type returns for the risk level the client chooses.
All of the following quotations are from the DOL website:
“Many investment professionals, consultants, brokers, insurance agents and other advisers operate within compensation structures that are misaligned with their customers’ interests and often create strong incentives to steer customers into particular investment products. These conflicts of interest do not always have to be disclosed and advisers have limited liability under federal pension law for any harms resulting from the advice they provide to plan sponsors and retirement investors.
“The Department’s conflict of interest final rule and related exemptions will protect investors by requiring all who provide retirement investment advice to plans and IRAs to abide by a ‘fiduciary’ standard — putting their clients’ best interest before their own profits.”
The “fiduciary” vs. the “suitability” standard
For many years, those working in the investment industry have been under the “suitability” standard, which means that the recommended investments must be suitable for a client’s situation. For example, it isn’t suitable to purchase illiquid assets for a client that needs his/her funds within a short period of time. But that doesn’t preclude the adviser from choosing investments that pay himself or herself the hidden fees (12-b-1), even if there is a class of the same investment that doesn’t have such a charge and is lower in cost to the investor.
Under the “fiduciary” standard, the adviser must put the client’s interest before their own, so it would be a violation of the standard for the adviser to put the client into the higher cost investment if there is a similar, lower-cost one, or the same fund has a lower-cost class.
Registered investment advisers have always been subject to the “fiduciary” standard. And now, at least, in theory, so will the rest of the industry. But, don’t count Wall Street out yet. In the long six-year battle, Wall Street secured something called a “best interest contract exemption,” which “permits firms to continue to rely on many current compensation and fee practices,” language which appears to let Wall Street weasel out of real disclosure. But the saving grace is that the new regulations do provide the investor the “right to obtain specific disclosure of costs, fees, and other compensation upon request.”
These regulations have been a long time coming. It is estimated that the cost of conflicted investment advice is $17 billion annually. I suspect that Wall Street will figure out ways to meet the requirements of the “fiduciary” standard and still not comply with the spirit of the law. But the real clout of these regs is the investors’ right to know the real cost, if they are smart enough to ask (which Wall Street hopes they won’t be). In fact, now that the new regs have been promulgated, an investor should make it a habit to ask their adviser for the “all in” cost, including, “fees or charges paid … and a statement of the types of compensation the firm expects to receive from third parties in connection with recommended investments.”