The Department of Labor has been in the process of instituting a new rule on retirement accounts. This rule concerns how financial advisors, commonly known as stockbrokers, make recommendations to their clients.
Currently financial advisors operate under a rule that recommendations they make must be “suitable.” The new regulation states that the financial advisors will need to operate in a “fiduciary” capacity, or in the best interest of the client.
This rule only concerns retirement accounts. For someone who has a personal account, this new rule does not apply.
At first glance someone might think that there is little difference between someone recommending a suitable investment versus acting as a fiduciary, or in the best interest of a client. Oftentimes there is little difference between the two, but operating as a fiduciary is a higher standard.
The difference between the two standards oftentimes amounts to the commissions a financial advisor might earn on a particular investment. The higher commission product might be suitable, but it might not be in the best interest of the client under the fiduciary standard.
When paying for financial advice investment advisors are typically paid by trades generated, or by fees from asset under management. Years ago most financial advisors were compensated through the buying and selling of securities, though the industry has been moving increasingly towards a fee based arrangement.
Fiduciaries are normally paid on a fee basis, generally determined by the amount of assets under management. This would be a typical arrangement for someone who manages a trust account.
The concern of regulators is that under the current standards of suitability many investors may be getting biased recommendations from their advisors. The controversy becomes in whether the rule change will cause many smaller investors not to receive any financial advice at all. This is because many financial firms might institute higher minimum fees to account for the cost of the new regulation.
For some investors paying an “inflated” commission on a few trades per year might be preferable to having a fee based arrangement. For example, purchasing a stock with a discount broker online typically costs about $5 to $10. That same trade with a full service broker could easily cost $100. If there is a purchase and a sale the cost is essentially doubled.
The reason for the higher cost of the trade is that an individual is paying for advice. If that person has an account of $100,000 and makes six trades during the year, at a $100 per trade that is an annual expenditure of $600. Under a fee arrangement of 1% of assets the annual cost would be $1,000.
Clearly the system of paying a broker high commissions for each trade can easily cause the broker to recommend more trades than would be optimal to generate more commissions. A fee-based method of compensation will have less bias, but for some investors the fee based arrangement could be more costly.
One approach that is becoming more popular is the use of automated, or “robo” advisors. This is a way for an investor to get financial advice, though certainly not on a personal basis. This approach will typically recommend index products, and the investor might pay an annual fee of around .3% versus the normal 1%, or more for a managed account.
This new regulation will start to take effect in April of next year, and will be phased in over time. This regulation will accelerate the move towards fee based products and away from the commission based model. Some brokers may still offer the commission based structure, but clients will need to sign a “best interest contract.”
Investors should be as informed as possible about their financial picture. If someone has the need for financial advice, they should know how their advisor or planner is being compensated, and how much in fees or commissions are being paid yearly. The new rule may certainly cause some higher account minimum fees that might not be practical for smaller investors, but the use of a “robo” advisor could be a viable alternative.
