Monday, June 5, 2017

How the Department of Labor's Fiduciary Rule Will Impact Retirees and Financial Institutions

Saving for retirement can be a challenge. Depending on what you invest in, it can yield a high or low rate of return. It also doesn't help if the financial advisor helping you manage your retirement account is not acting in your best interest. As John Oliver illustrates in his episode on retirement saving last year, you could get screwed over in paying hidden and not-so-hidden fees while financial advisors could be profiting off of it. In 2015, the Council of Economic Advisors attempted to put a price tag on the bad advice from financial advisory $17 billion a year. Granted, this CEA figure has been criticized (see here and here), but it does provide a form of problem-framing. In attempts to help those saving for retirement, the Department of Labor (DOL) passed the "fiduciary rule" (see full text here). The fiduciary rule was supposed to take into effect back in April. However, Trump ordered a delay for 180 days in February, which means that the fiduciary rule is to come into effect this week.

Some of you might be asking yourself what a fiduciary even is. A fiduciary is someone who holds a legal or ethical relationship of trust, which in this context is someone entrusted to take care of money or assets for another individual. What the DOL's new fiduciary rule does is that it elevates certain financial professional working with retirement plans or providing retirement advice (e.g., investment advisory, insurance brokers) to the level of a fiduciary. What this means is that any of these financial professionals would be held up to the legal and ethical standards of a fiduciary. Financial professionals covered under this law would have to reveal potential conflicts of interest, and that all fees charged need to be clearly stated. We already have fiduciary standards under the Employment Retirement Income Security Act of 1974 (ERISA).

However, the standards are now higher with the new fiduciary rule because it means that the advice meets the client's needs and objectives. The fiduciary law has not made some financial services providers happy, which is why BlackRock and Vanguard were pushing Trump for an even longer delay. What I have to wonder is whether the DOL's fiduciary rule is more of a case of stopping financial advisors from screwing over their clients, a case of excessive regulation that will do nothing to help clients of financial services, or something in between.

At first glance, the law seems very intuitive and common-sense. The fiduciary rule was created with the intent of ensuring that investors receive quality financial advice so they can have enough to save for retirement. Why would anyone be against advisors acting in their investors' best interest? Shouldn't they be acting in a professional and ethical manner? Isn't that just good business practice? There is a difference between expecting that financial professional act professionally and adding on a litany of regulations for them to follow, and as we know, regulations come with costs.

The Right-leaning American Action Forum (AAF) released its April 2017 study on the fiduciary rule. As the graphic below shows, it is not flattering. The AAF estimates that it will cost those with an IRA an extra $813 per account per year, as well as paying $1,500 in duplicative fees. Consulting firm A.T. Kearney found in its detailed findings that through 2020, the financial services industry is expected to lose $20 billion as a result of the fiduciary rule.

The DOL puts the costs at a lower rate than the AAF does, and the Left-leaning Economic Policy Institute concurs in detail with the DOL's analysis. In its regulatory analysis of the fiduciary rule, the DOL estimates that the fiduciary rule could cost anywhere between $10 billion and $31.5 billion over the next decade (DOL, p. 10). The DOL also estimates that investors would stand to make $33 billion to $36 billion in gains over the next decade (ibid.), although interestingly enough, the centrist Brookings Institution puts it at $108 billion.

The fiduciary rule has the potential to limit investment advice for those with lower retirement accounts. The Cass Business School found that when the British government passed a comparable version of the DOL's fiduciary rule, it resulted in advisors largely abandoning those with savings below $220,000. As a result of Britain's equivalent of the fiduciary rule, the U.K. Financial Conduct Authority found that the number of firms asking for a £100,000 minimum more than doubled [from 13 percent to 32 percent] (FCA, p. 19). To bring the accessibility issue back to the United States, consulting firm Oliver Wyman estimates that 7 million IRA accounts would fail to qualify for an advisory account under the new fiduciary rule because the balance will be too low.

Even for those who view the DOL fiduciary rule as a positive step, such as those over at the Brookings Institution (Bailey and Holmes, 2015), there is still concern that the rise in compliance costs could mean abandoning clients with small-scale savings. There are technically alternative ways of paying for financial advice that do not create obvious conflict of interest. However, brokers will not be able to find a way to provide cost-effective advice to less wealthy investors. How so? Brokers who use the commission structure will find it too expensive under the new DOL rule (not to mention that a commission structure would be rendered inherently conflicted under the new law), and a flat fee is inefficient for smaller investors, which account for up to 76 percent of IRA investors. A study from McKinsey shows that advisors earn 0.54 percent on commission-based accounts while earning 1.18 percent on fee-based accounts. What the McKinsey finding means is that the average account would be hit with an extra $800 cost year, which would be unaffordable for many.

Another cost that is up for debate is that of litigation costs. If the fiduciary inadvertently provides bad advice or the client selects safer portfolio options (thereby yielding a smaller rate of return), it could open up lawsuits. The DOL estimates that it would increase premiums by 10 percent, or $300 a year. However, an independent analysis from Oxford Economics begs to differ. The issue with putting a number on the litigation costs is that the unknown nature of the effects the fiduciary status will have. Oxford Economics not only believes that the DOL is wildly underestimating, but that the fiduciary rule would complicate compliance and litigation risks (Oxford, p. 11, 19-20). In 2016, there were 4,000 arbitration cases alleging wrongdoing by a broker. With elevating brokers to the legal status of fiduciary, it is not unfeasible to think that litigation costs would skyrocket.

Even in spite of the fees, I think another important question we should ask ourselves is whether enough Americans are able to save for retirement with the status quo. This is not to justify the morality of the financial professionals that do take advantage of others, but to ask whether the American people are left with nothing to save as a result of swindlers. I took a look at 401(k) retirement accounts earlier this year, which can provide some insight. To summarize, we're not in a retirement crisis. We've had more people save for retirement as a result of the 401(k). 75 to 85 percent of those who save with a 401(k) have enough for retirement. What is more is that since 1989, retirement savings have been exceeding inflation. The 401(k) is not perfect, and financial professionals could perhaps give better advice to help their clients. However, the situation is not so dire where financial advisors are robbing their clients blind while leaving them with nothing to live off: far from it.

Financial services companies have already reacted to the fiduciary rule. MetLife and AIG have already left the brokerage market all together. Merrill Lynch replaced its commission-based retirement accounts with a fee-based model, which could end up costing more. State Farm and Morgan Stanley have already drawn back on its brokerage business in anticipation of the fiduciary rule. And to think that these are the big firms. Much like Dodd-Frank disproportionately affects smaller banks because it was more difficult to gather the resources to fully comply with all the regulations (see GAO report), I would expect smaller financial advisors to have a similar issues, especially a similar trend in smaller firms leaving and the subsequent market consolidation that we observed in the banking sector with the enactment of Dodd-Frank (see Fed data here).

In many ways, the fiduciary rule is "Obamacare for your IRA," especially that bit of "if you like your plan, you can keep it." If the 401(k) provides for more-than-adequate retirement savings, then a fiduciary rule that forces many advisors towards fee-based could make it more difficult to invest in retirement, thereby exacerbating income inequality. Costing both the financial advisors and investors is not protecting people, but pricing many out of saving for retirement. If more tax-advantaged vehicles are abandoned, especially those for lower-income individuals, it would probably mean greater reliance on Social Security, which would be deleterious given how strained Social Security already is. A simple disclosure rule explaining the compensation structure to their advisees could very well do the trick. What will not do the trick is the fiduciary rule. Once it goes into effect, it will not be at all surprising if or when we see saving for retirement become all the more elusive and unreachable for the average American because some bureaucratic entity that doesn't have much experience in financial regulation unleashed feel-good policy with bad results.

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