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Commentary By Emily Top

Roll Back the Fiduciary Rule

Economics Regulatory Policy

Next week the White House will hold a series of events on regulatory reform. It is time to roll back the Conflict of Interest Rule, i.e. the “Fiduciary Rule,” put in place by President Obama’s Labor Department.  The Department required financial salespeople to reveal any potential conflicts of interest they may have when providing retirement investment advice.

Since the start of 2017, President Trump and Labor Secretary Alex Acosta have delayed the rule’s initiation and compliance date, and they need to get rid of it once and for all.

Everyone agrees that advisors should put the best interests of their clients foremost, and, in fact, the overwhelming majority of advisors always have exercised proper fiduciary prudence in their recommendations, regardless of whether compensated on a commission or flat fee basis.  Both commission paid brokers and flat fee advisors depend on having satisfied customers who will come back for future services. 

Markets are efficient when it comes to communicating people’s disappointing experiences in any line of service, whether plumbers, auto mechanics or financial advisors, and a financial advisor who gives bad advice, whether from self-interest or ignorance, will soon find no clients at the door. 

The government’s rulemaking falsely characterizes commission paid brokers as self-interested.  Instead of crafting a strategy to identify and stop the very few bad actors in the financial advisory industry, the government has put forth a heavy-handed regulation that will be costly and impractical to implement.  The Fiduciary Rule will do more harm than good. 

The original Fiduciary Rule was created in 1974 under the Employee Retirement Income Security Act. Under the act, the definition of a fiduciary was a person that engaged in specified plan activities, including giving investment advice for a fee or compensation, monetary or otherwise. Since then, the Department of Labor has used a five-part test to determine whether a financial salesperson should be considered a fiduciary.

According to the Department, the rule is outdated and does not cover participant-direct 401(k), IRAs, and rollover plans. The Department is concerned that financial salespeople who receive commission for directing and advising clients on these plans may have a conflict of interest – some financial products receive higher commissions than others-- and provide imprudent advice.

Originally, the rule only applied to advisors who gave clients ongoing advice and charged a fee for their service. However, the new rule expands its coverage to include anyone who gives recommendations or solicitations on retirement plans.

In the past, broker-dealers, insurance agents, and planners were only required to meet the “suitability” standard, meaning their investment recommendations for retirement plans must meet the client’s needs and objectives. The goal of the Fiduciary Rule is ensure that people offering retirement planning advice to investors are legally obligated to put the client’s best interest first.

With the rule in place, stock brokers and all other financial salespeople, including insurance brokers, are required to sign a disclosure agreement with clients, called a Best Interest Contract Exemption. The contract delineates when advisors may have a conflict of interest, for example, when they would receive higher commissions for selling a certain financial product.

The new rule could push financial advice out of the range of middle-class Americans. A recent study conducted by Deloitte revealed that the start-up costs for financial institutions to implement the rule will exceed $4.7 billion. Another estimate suggests that the rule will cost the industry $2.4 billion a year. These costs will arise from an increase in paperwork and other compliance costs.

Similar rules have been put into place in other countries with negative results. In 2006, the United Kingdom’s Financial Service Authority (FSA) created a Retail Distribution Review. Beginning in 2013, the FSA banned commissions and required advisors to charge fees on clients instead.

Initial studies suggest that the new review process has negatively affected the financial services industry in the U.K. Advisors indicated that they had to raise the minimum level of investible assets necessary to receive advice from an advisor. The median amount advisors required was $80,000-$120,000, too high for most of the U.K. adult population. The U.K. also saw a 22 percent decrease in the number of available financial advisors between 2011 and 2015. The authors of the study hypothesized that the number of clients with the level of wealth necessary to support the industry was too low to generate enough revenue to keep advisors in business.

Although the Department of Labor’s Fiduciary Rule does not completely ban commissions, experts fear the entire commission structure may be completely eliminated. If this were to occur, we could anticipate similar consequences to those in the U.K.

Proponents of the rule argue that investors lose from a lack of transparency and commission structures. The Fiduciary Rule, they contend, would allow for clearer interactions between client and advisor. In addition, proponents cite a report released by the White House Council of Economic Advisers (CEA) that estimated that $17 billion is lost from retirement funds each year from biased advice.

The $17 billion estimate has many flaws.  The CEA used a few academic studies to estimate that approximately one percent of assets subject to commissions are outperformed by similar financial products that are sold without a broker or without commissions. Given $1.7 trillions of assets are found in IRAs, CEA estimated that $17 billion (one percent of $1.7 trillion) must be underperforming. This is hardly a reliable estimate, especially because none of the cited studies account for the asset-weighted performance of broker-sold funds.

Dr. Reuter, cited in the CEA study, recently updated his analysis. His new examination led to quite different results. Instead of commission products being outperformed by 1 percent, he found they were only outperformed by 0.18 percent. This new estimate lowers the $17 billion estimate substantially.

What supporters of the rule do not recognize is that the Fiduciary Rule does not necessarily fix the loss in retirement funds from commissions. The rule merely shifts how clients pay for financial advice. Instead of paying from their funds, the higher costs faced by the financial services industry likely would be passed along to clients in the form of an upfront fee.

If the Fiduciary Rule is not repealed, investors, especially with lower to middle incomes, may lose access to some, if not all, retirement fund products. A recent survey of U.S. financial professionals found that 75 percent of respondents would take on a fewer number of clients with assets starting under $25,000 if the Fiduciary Rule remains in place.

The Fiduciary Rule may be well-intentioned, but the overlooked consequences of the rule may result in reduced accessibility to advisors and funds within the industry. To avoid these costs, the Fiduciary Rule should be rolled back.   

 

Emily Top is a research associate at Economics21. Follow her on Twitter @EmilyKTop.

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