Enlightenment regarding financial products that benefit investors is often ignored for years until the new concept gains enough traction to create a life of its own. Then everyone piles on while wondering, “Why didn’t we think of this earlier?”
The invention of money market funds back in the early 1980s is one of my favorite examples. Investors left their money in savings accounts making 4 percent until they finally wised up many years later, recognizing that they could make 18 percent in a money market fund that was just as secure. The slow creation of trust ignited the mutual fund industry, which had been in the backwaters of financial services since the ’30s.
Today, the latest sea change in the industry centers around arcane Labor Department rules requiring fiduciaries of retirement plans (including individual retirement accounts) to be independent of any income streams derived from investment products that pay commissions or from products created by their own organizations. Come April, anyone who purports to be an adviser to one of these plans will be considered a fiduciary and will be barred from collecting income in any way from the financial products on which they offer advice.
To explain this hall of mirrors impacting financial services, a “fiduciary” is legally obligated to make all decisions in the sole interest of the beneficiaries of the retirement plan. This means company owners and managers choosing investments for their company’s plan. Up to now, anyone selling investment products has represented themselves as an “adviser” as they sell retirement plans or as they handle IRAs in the “wealth management” departments of major financial institutions. Nevertheless, their service contracts have specifically stated that they were not to be deemed fiduciaries, because their employers wanted to be insulated from lawsuits.
The Labor Department says “advisers” are fiduciaries if they offer advice regarding investments. This sets up a conflict of interest if those advisers sell investment products, because they can’t possibly be “making all decisions in the sole interest of participants.”
They therefore have a choice: Either they can offer advice but must charge a flat or percent-of-assets fee based on total assets to avoid any incentive to recommend one investment over another, or they must stop offering investment advice and just let retirement plan participants make the most of automated advisory services or a do-it-yourself educational process. This option begs the question of why advisers should be involved at all, so it will not be a popular alternative.
A second part of the new law calls for the fee to be reasonable based on the level of services provided. Until about five years ago, fees charged to participants were never disclosed. Nobody ever received a bill or wrote a check. The money just trickled out to advisers and vendors on a daily basis and often equaled as much as 2 percent per year -- or more. Who knew?
To illustrate the slow trajectory by which good ideas get adopted, I wrote an editorial for the Wall Street Journal back in 1995, whereby I explained the hidden cost of typical fees and commissions and how they reduced final account balances by as much as 35 percent. Play around with the “what if” tools at Thecalculatorsite.com and you can see where I got my numbers. The magic of compound interest works against us in pernicious and destructive ways when we pay a bill with money that could otherwise have been compounding tax free.
My subsequent articles in The New York Times and Money magazine drove home the point -- and then nothing happened. More than 10 years later, Rep. George Miller, D-Martinez, while chairman of the House Committee on Education and the Workforce, held hearings on the subject. Those hearings, at which I testified, resulted in a quarterly disclosure of fees to all participants -- a first step to casting daylight on the subject.
Thanks to that daylight, we are finally seeing the results -- dramatically reduced costs in retirement plans and a major shift in the financial services industry. In a recent Wall Street Journal article titled “Game Over for Broker Commissions,” Merrill Lynch announced that it will no longer allow brokers or advisers to sell commissioned products in any retirement plans, including IRAs. It’s all negotiated flat and/or percentage-based fees from here on out.
New products and concepts in the financial services industry have a long gestation period before they become a reality for most people. The “status quo bias” clearly rules this giant industry. If something innovative makes sense today, investors shouldn’t hesitate to take advantage of it now rather than waiting for it to become the norm some ten years into the future.