San Juan Mountains

San Juan Mountains
San Juan Mountains: Grenadier Range

Tuesday, February 7, 2017

Fiduciary Rule Hypocrisy

Former King Obama made up a new financial rule that brokers were expected to follow starting April 10th of this year.  It was called the Fiduciary rule and despite much confusion about what it is about, the bottom line about this rule is that it makes brokers operating on commission illegal operatives.  Proponents of the rule, namely those who operate on a fee only basis, allege that the new rule will force all investment advisors to give the best advice to their clients, as if commission based brokers have been giving inferior advice all these many decades and only fee only advisors have been giving good advice to their clients.  This is a long-standing war between the two camps and until recently the free market was allowed to determine who was winning.  Customers in this free market were free to chose the type of investment advisor they wanted to utilize.  Then King Obama decided to mix things up with his declaration that commission based advice would become illegal this year.
In direct response to our former King, King Donnie has recently signed an Executive Order that delays the implementation of the Fiduciary rule.  He has commissioned a 120 day study into the debate between the commission only and fee only investment advisors and it is expected that he will overule Obama's directive and allow both types of advisors to go forward.  Let's hope so.  Does anyone out there believe in their inalienable right to choose?  I sure do.  I would expect many liberal women would support my position as well.  They are always shrilly declaring that they have a right to choose. 
The fact that investment advisors have been very quick to embrace the new rule should give investors pause.  Why would investment advisors be so quick to adopt a new rule that will ostensibly reduce their compensation because they will no longer be able to gouge their customers with high commissions?  Answer:  because the Fiduciary rule will not reduce their compensation.  Fee only advisors have long held the moral high ground in the debate with commission based brokers because they allege they make recommendations that are in the clients best interest alone.  They claim that if an advisor earns a commission on a product it is impossible for that product to be in the client's best interest.  They also claim that they make less money than commission based brokers because commission rates are higher on inferior investments, thus enriching unscrupulous brokers and harming Mom and Pop investors. Let's consider this alleged fact for a while today.
I just finished a long conversation with my broker.  I asked him to give me some hypothetical situations that would illustrate his brokerage business so I could run some comparisons of what it would cost me to follow his advice.  Here are the parameters he gave me for an average broker who has been in business for a while and has built up a nice clientele.  In this case, like my broker, he has not been following the Fiduciary rule and has derived all of his compensation from the commissions he charges customers like me.  His average rate of commission for all sales in 2016 was 2.5%.  In addition, he received an annual trail commission, paid quarterly, of 0.25% of all assets invested with his firm that had been there for at least a year.  Those two commissions were the sole source of his income and they were paid directly by his clients.  I have never objected to paying those commissions and am quite satisfied with the qualify of the advice I have received from him over the years.  I would be most upset if he is forced out of business by the application of King Obama's Fiduciary rule.
In contrast to the allegedly immoral commission based brokers, the fee only advisors earn no commissions.  They are compensated by fees charged against the value of their client's accounts, on a percentage basis.  According to my broker, the overwhelming majority of fee based investment advisors charge an annual fee of 1% of the value of the client's account for their "objective" investment advice.  Let me construct a six year model of the total fees I will pay to my two different brokers, one fee based and one commission based, on a $250,000 IRA rollover I would like to make tomorrow.  Let's see who is giving me the best deal.  In the first scenario I will assume that my investment realizes zero return over the next six year period.  In the second scenario I will assume that my investment realizes 12%/year in total return over the next six years.

Commission Based Broker:  Zero Return
  • 2.5% commission on the $250,000 initial investment is $6,250
  • 12b-1 trail commissions on a static $250,000 investment account would be $625/year or $3,750 for the six year period.
  • After six years I have paid $10,000 in commissions to my broker and my account is worth $240,000.
Fee Based Broker:  Zero Return
  • 0.0% commission on the $250,000 investment is $0.
  • Annual 1% fee on the $250,000 investment is $2,500 or $15,000 for the six year period.
  • After six years I have paid $15,000 in fees to my broker and my account is worth $235,000.
In the above illustration the break-even point between the two types of brokers took place between the third and fourth years.   Up until the third year I paid less money to the fee based broker.  After the third year I paid more money to the fee based broker for his services.  At the end of six years I had paid 50% more to the fee based broker for the exact same level of service as the commission based broker.  Moreover, the longer I would stay with the fee based broker the greater the disparity in my total costs would become.  That 1% annual fee is a very steep price to pay for "objective" investment advice.

Commission Based Broker:  12%/year Return
  • 2.5% commission on the $250,000 initial investment is $6,250.
  • 12b-1 trail commissions on an investment that grows at 12%/year for six years total $6,447.
  • After six years I have paid $13,322 in commissions to my broker and my account is worth $427,263.
Fee Based Broker:  12%/year Return
  • 0.0% commission on the $250,000 investment is $0.
  • Annual fee of 1% on an investment that grows at 12%/year for six years total $20,291. 
  • After six years I have paid $20,291 in fees to my advisor and my account is worth $420,294. 
In the above illustration the break-even point between the two types of brokers took place between the second and third years.  Up until the second year I paid less money to the fee based broker.  After the second year I paid more money to the fee based broker for his services.  At the end of six years I had paid 52% more to the fee based broker for the exact same level of service as the commission based broker. In addition, the disparity in my total costs paid between the fee based and commission based broker would continue to widen as the impact of the 1% annual fee charged by the fee based broker did its magic.  It is not hard to see why investment advisors are flocking to the fee based system.  They make considerably more money than commission based brokers and they do so while telling their clients that they are on their side.  What a scam it all is. 

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