If you are an investor, as I am, you will be impacted by the new law. The new law declares that broker/dealers are now subject to the "fiduciary standard," a standard that registered investment advisors have been subject to but that brokers were exempt from. Brokers had previously been subject to a "suitability standard" as they considered which investments to recommend to their clients. Briefly, the distinction between the two standards is this:
- Fiduciary Standard: Applies to all registered investment advisors (RIAs). RIAs are under the federal supervision of the Securities and Exchange Commission (SEC). RIAs derive their income by charging fees for rendering investment advice to the general public. According to SEC regulations, the fiduciary standard requires them to only recommend the "best" investment vehicle for each specific client. The "best" investment vehicle is defined as one that does not pay a commission to the RIA when he sells it. If a RIA sells an investment and earns a commission it is automatically deemed to be a "conflict of interest" and he is in violation of the fiduciary standard. Whether a particular investment is actually a good idea is not really the point of the fiduciary standard. The primary reason the fiduciary standard exists is to create the fiction that the advice given by RIAs is objective because they do not earn commissions on the investments they recommend.
- Suitability Standard: Applies to all registered broker/dealers (BDs) of investment securities. BDs are under the federal supervision of the Financial Industry Regulatory Authority (FINRA) which is a quasi-governmental organization with over ten thousand rules and regulations that apply to every BD doing business in this grossly over regulated country. Under the terms of the suitability standard a broker does not have to recommend the "best" investment to his client but he is free to recommend any investment that is deemed suitable for him instead. Thus, if a BD is faced with the option of recommending an investment that pays him a 4% commission versus another investment that would pay him a 3% commission he would satisfy the suitability standard by selling the higher paying investment, provided both are "suitable." According to King Obama this looser standard for investment advice costs "working families," whatever they are, billions of dollars as the years go by.
I have been an investor since I graduated from college. I use a BD for my investments and do so because I have carefully considered what is in my best financial interest over the long term. I am happy to pay my broker a commission in exchange for a quality investment. I do not see his recommendation as a conflict of interest simply because he earns a commission when I make a purchase. The claims being made by King Obama are patently false and give neophyte investors bad information when it comes to selecting whether to go with an RIA or a BD. In fact, Obama has things exactly backwards in my view. People who go with RIAs spend much more money on fees and expenses than those who go with a BD. Allow me to explain why.
When I buy a mutual fund from my broker I pay an upfront commission somewhere between the maximum of 5.75% and the minimum of 1%. Because I have been investing for many decades my commission is towards the lower end of the spectrum. The broker makes a maximum of 5% and a minimum of 1% on all trades that I send his way. If I were to buy the exact same mutual fund from a RIA I would end up purchasing “R” class shares and pay no commission to the RIA whatsoever. So far it looks like the RIA is the way to go, right? Let’s continue.
All mutual funds have operating expenses. Class A shares, which are all I have ever owned or ever will own, have operating expenses that include a trail commission, paid to my broker, known as the 12b-1 fee. The 12b-1 fee on all my shares is .25%/year. If a fund has operating expenses of 1.25%/year my overall total return will be reduced by that amount each year. .25% of those expenses are the fee I pay to my broker for the privilege of his services on my accounts. If I buy R class shares in the exact same fund I will pay annual expenses of 1.00%/year. Once again it looks like the RIA route is the way to go, doesn’t it? Not quite. There is one more thing you need to know.Let me let you in on a shocking revelation.....RIAs do not work for free. From what you have seen so far you there is no way for them to derive income for their services, either from upfront commissions or 12b-1 trail commissions. Where, exactly, does their income come from? All RIAs derive their income in the exact same way. They place your portfolio into an in-house account that they then enter into a contract with you to “manage” for the tidy little sum of 1%/year. The net impact is that once you add in the fee for service charged by the RIA (some charge even more than 1%/year and a very small handful charge less than that amount) you will be paying 2%/year for the advice on how to manage your account compared to the 1.25% I pay to my broker. That extra .75% comes right off the top of your total returns, thus giving you significantly lower total returns over the lifetime of your portfolio when you use the RIA model. You can tell yourself you are saving all sorts of money in commissions and that the advice you are receiving is objective but that will be cold comfort when you realize, years later, that your portfolio value is much lower than it could have been if you had not paid the 1%/year fee to your RIA.
My broker has told me that he could convert his firm to an RIA shop, thus escaping the burdens of the regulatory scrutiny of FINRA, and sell me commission free shares only. He would also charge me 1%/year on the value of my accounts in order to earn his living. The net impact of changing his business model would be an immediate 4X increase in his annual income. Now as much as I like my broker and appreciate his advice over the years, I would really not like to see his income quadruple, knowing that his extra income is coming out of my portfolio value. It galls me to no end that RIAs claim to have the best interests of their clients at heart when they make 4X what my broker makes to recommend the same funds. It galls me even more that Obama has sided with the RIAs and accused honest brokers of dealing with their clients in an underhanded fashion simply because they earn commissions.
There is one further downside associated with RIA accounts in which you pay the advisor 1%/year of the value of your account for the privilege of following his market timing and investment selection advice. Being paid 1%/year gives RIAs a strong incentive to do something with your funds. All RIA accounts that I have seen over the years are guilty of attempting to time the market, switching to and fro between various funds and sectors and inevitably deriving a lower rate of total return for the client than a simple buy and hold approach would have derived. So not only are you paying 1% for the market timing advice of your RIA, you are paying for it again as he executes his recommendations and harms your overall total returns.
The federal government needs to get out of the regulatory business. The federal government needs to stop regulating investment advisors, whether they be RIAs or BDs. Let the free market determine which advisors are good and which are bad. Let the free market determine how much they should be paid for their advice. Freedom is always good for the consumer, even consumers of investment products. Sadly, like every other part of life in the Socialist Democracy of Amerika today, there is no freedom to be found in the realm of investment advice.