A breath of fresh air has wafted over the financial services community as the Department of Labor’s new fiduciary rule has clicked into place, in spite of all the kicking and screaming by the industry. Empty claims of “extra expense of compliance” and “loss of cost-effective advice” have mercifully fallen on deaf ears.
Bear in mind, the term “fiduciary” defines someone who makes financial decisions and recommendations “in the sole interest of the beneficiary of the trust.” Any advisers receiving income as they offer advice or recommend investment products to a retirement account (which is money in a trust) are now deemed to be fiduciaries and must recommend what is in the best interest of their clients — or be subject to lawsuits. Until now, their advice only needed to be “suitable” — a directive that meant different things to different advisers. The telephone boiler room depicted in the movie “Wolf of Wall Street” painted a picture of the limitations of the word “suitable,” and only the most egregious were ever shut down by regulators.
The new regulation is a game changer. It means that an adviser or broker cannot recommend an investment product that pays a higher fee (to the adviser) than a comparable product that is cheaper. Simple enough. The industry is adjusting and moving toward flat advisory fees typically in the range of 1 percent per year based on assets under management. So, this is an improvement because no single investment offers the incentive of paying more income to the broker or adviser. The mutual fund industry is moving toward funds that pay no commissions whatsoever, so the adviser or broker will be sending a bill for advisory services independent of the investments themselves.
Until now, mutual funds typically charged an annual expense ratio, which was automatically deducted from assets, and from this money the broker (or retirement plan adviser) received some percentage of what the fund collected. It amounted to something between 0.25 and 1.00 percent of account assets. But some funds charged upfront sales commissions plus an ongoing annual fee. And then there were “contingent deferred sales charges,” which were back-end charges if the money wasn’t left in the fund long enough (typically five years) for the fund company to recover the sales commission they had paid up front. And so on.
The question for investors will be, “Do I want to pay anything?” It’s a brave new world that offers a range of cost-effective investment products. The proliferation of index funds which buy passively managed cross sections of different subsets of the stock and bond markets have gained an upper hand. Exchange-traded funds offer simply a variation on the index fund concept — some tax benefit and pricing throughout the day from second to second — but they are still basically index investment products offering different cross sections of the markets.
The idea that it is difficult for actively managed money to outperform a comparable index of the same fund type continues to be the subject of debate. Enough actively managed funds have effectively outperformed their benchmark index to sow seeds of doubt on the widely publicized battle, but the fact that in 2016 alone a combined $500 billion poured into index funds and ETFs at just Vanguard and Blackrock says that investors are voting with their feet.
So where does that leave those of us with retirement assets in 401(k) plans, 403(b) plans and IRAs? Fee transparency is the starting point that is the most important product of the regulation, but advisers will be under pressure to make a case for their added value as they send a bill each month to clients who will be writing a check. Going forward, advisers will largely assist clients by managing the right combination of index products from year to year. In any case, there promises to be a seismic shift in an industry whose client-adviser relationship may adopt the long-standing practice in Hollywood — namely, “First we sign the contract; then the negotiation begins.”