If you doubt the public need to be protected from their local mob bosses banks, their latest hissy fit is an admission that they can’t make what they deem to be enough profits unless they take advantage of their customers.
This object lesson is IRAs. Bloomberg reports that if brokerage firms who manage IRAs were required to act as a fiduciary, as in put their customers’ interests first, many would exit the business.
The dirty secret of the retail asset management business at brokerage firms is that their profits depend on treating you badly. Unless you are a big enough customer that they would not like to lose you, you are going to be abused (well, take it back, even being a billionaire is not rich enough to be safe from bank predation). The one check on this, ironically, is that salesmen are de facto small businessmen in a bigger corporate umbrella, and their clients are their book of business. They thus have incentives to make sure the customer thinks he is being treated well (whether he is actually treated well is another matter).
The big firms have generally if not completely inferior in-house fund management products they push (inferior by virtue of higher fees and/or not so hot performance). Your “investment advisor” also has an incentive to encourage you to trade if you are in a commission-paying account. The alternative, a wrap fee account, has annual charges that make a serious dent in your principal over time.
Now there may indeed be some imprecision in where the Labor Department draws the line between a fiduciary and someone who is merely peddling products. But the examples the industry defenders cite as practices they want to continue are troubling:
If firms are considered fiduciaries by the Labor Department, selling investors bonds from a brokerage’s inventory or recommending a trade that would generate a commission may be considered a conflict of interest and a “prohibited transaction,” said [Jim] McCarthy [of Morgan Stanley].
The bond example I find particularly troubling. Yes, bonds are over the counter products, so they are always going to come from some firm’s inventory, either the firm that the client is already doing business with or a third party. But unless the account in question is pretty large, it has no business buying bonds The transaction sizes for most individuals are the equivalent of odd lots, and the buyer is almost assured to get a worse price than an institutional investor. The overwhelming majority of individuals are better off putting their money in bond funds.
The article made it clear the industry was trying to say that small fry (those with under $25,000 in an account) would be hurt, when those are the least economical for high cost players like full service brokerage firms, also raising doubts about the banks’ argument. Someone with a small balance needs to keep transaction costs down even more than investors with bigger balances. And while they’d presumably want to preserve their profits with the small fry, I’d bet their real aim is to preserve their freedom of action with larger accounts, which is where the real juice is.
Similarly (and maybe I am hopelessly old fashioned) I have never liked the retail brokerage model (it probably has a lot to do with having worked on Wall Street). If you need advice, pay for advice and get low cost execution. Or if you are too small to afford advice, do some homework on asset allocation and buy index funds (one big caveat: read Benoit Mandelbrot’s The Misbehavior of Markets. Everyone needs to recognize that the tenets of financial economics underestimate the risk of markets and as a result, encourage too much risk-taking. Any standard advice on what level of stock holdings are desirable needs to be dialed down. Rule number one of investing is preservation of capital, and that too often is ignored).
It was depressing but predictable that this Bloomberg story was one sided; this article replayed the arguments of SIFMA, the industry lobbying group. But it’s probably an accurate reflection of how the consumer has no advocate when financial rules are being nailed down.
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As noted a simple way to fix the issue, go with an execution only brokerage house that deals online only. Then if you want advice pay for it. This sort of behavior has always been the way wall street works in the old days the swaqk box before the market opened told the broker what to push that day. In general assume brokers are used car salespersons in disguise, and that they have ethics no better than the stereotypical used car salesperson. Actually this is one message that should go out of the CFPB that you must not assume anyone really cares about what happens to you.
I have a number of friends with money that insist on throwing it at these sot of used car salesmen.
Conservation of capital is not advice they get…at least that I hear about. It seems to be concept that has gone the way of the Dodo bird.
They refuse to listen to my advice because I am not rich and therefore must not know anything.
In my defense I do want to say that I have taken $70K out of my IRA in the past two years (I have a disability) and still have more money in it than before I started taking money out…..what could my IRA be in?
Dear Psychohistorian;
Possibly “Langley Econometrics,” a wholly owned subsidary of “Conservative Investment Associates. They specialize in ‘exotics,’ like Afghan Poppy, West African Diamond, and the ever profitable Latin American Cocao Futures.
“They refuse to listen to my advice because I am not rich and therefore must not know anything.”
LOL!
This very American bias of “if you’re so smart, how come you ain’t rich” bullshit.
I remember being thrown this line at me 2 weeks before the 2008 market debacle. A very wealthy friend of my brother was talking about loading the truck on financial stocks since they were getting dirt cheap. I’ve just read a report from the Journal Les Affaires (in French) from Montréal talking about how scared the best managers of La Caisse de Dépot et de Placement (biggest public Pension Fund in Canada) were of the derivative mess. It was the final straw that convinced me something had to give badly, and very soon.
So, stupid me had to blurt: “For God’s sake, at least hedge with puts. This stuff is cheap because we’re heading for an epic blow up!”
Needless to say that I wasn’t taken seriously. WTF did I know?
The rest is history as they say.
Yves,
Another fine piece, thank you for highlighting the Bloomberg article. One small quibble though: I am not sure it makes sense even for small investors to buy bond funds, where the fees are merely hidden, and where trading fees can be generated at will over time. I would rather pay an odd lot price for a bond I like.
I believe unless you trade in fairly liquid bonds with transparent prices (like on-the-run Treasuries), the brokers are going to hose you with spread coming and going.
Few years ago (about the time UK RPI was negative), I was looking into buying short-end UK index gilts. The one I liked I could see on Bloomberg quoted as around 94 IIRC, and quick check with a friend at a bond desk said that that was indeed where they were (for even 1m lot). I tried to buy sub 1m (but still large six digit figure) from my broker and was quoted 97 – so I told them to stick it.
The fees (management fees, etc) are explicit, the SEC requires the same disclosure of bond funds as they do of equity funds.
Dealers can’t rape Fidelity and Vanguard the way they can rape you. Those firms trade in big sizes, Fidelity even provides trading services to small hedgies.
It’s certainly possible to get ripped off buying odd lot bonds. It’s also possible to invest in actively managed bond funds that charge ridiculous annual fees. But TRACE data is now publicly available, so there’s no more excuse for getting ripped off on a bond than there is for paying anything over 50 bp / year for a fund.
A few years ago I worked on a study of small investor costs using TRACE data. By comparing small lot and institutional lot prices (and adjusting for intraday Treasury movements), we found typical small lot costs of 15 – 30 bp of yield, with the higher end being for low grade bonds. This is comparable to or less than the cost of most passively managed funds. Indexing is cheaper, but you can’t customize it to your future liabilities.
Back in the day, Lebenthal offered direct purchase of pretty much any new-issue municipal bonds at reasonable commission rates. I can’t seem to find a similar service today.
I get regular calls from my retirement fund broker lamenting low rates, and offering some “step-up” product that will pay 5% in 8 years. Of course, for the first 5 years it pays about 2%, and is callable at any time. When I mention that my credit union is paying over 3% for government backed CD’s he changes the subject quickly. The brokered products are high priced, high risk, low return junk. The fact we are tethered to these products as part of our retirement accounts is thievery.
Thanks for your sharing!
I didn’t think I was crazy constantly reading the SIFMA fighting this rule tooth and nail.
Whatta ya think about the Kraft lawsuit and what appears to be an awesome Judge.
It seems the little guy is fighting back, and might have their day in court. Or I am reading that wrong?
Link:
http://www.huffingtonpost.com/dan-solin/court-rules-krafts-401k-p_b_906937.html
It is fine to say that investors who can’t afford advice should educate themselves and invest directly without the services of a broker. That’s what I said for the first 20 years I worked on this issue. “If you can’t afford advice from a fiduciary adviser, develop an asset allocation plan and dollar cost average in a few index funds until you have enough money to make advice affordable.” And, during that time, the percentage of investors who invested directly dropped. So much for my skills as an investor educator.
The reality is that investors want someone to turn to for recommendations. And, since brokers have been allowed to call themselves financial advisers and market their services as primarily advisory in nature, investors do not make a distinction between these salespeople and fiduciary advisers. That is why investor advocates have made a priority of pushing for a fiduciary duty for brokers when they provide investment advice.
The SEC appears to be on the cusp of proposing such a rule. Under the SEC approach, brokers would be free to charge commissions and sell from inventory, but they’d have to put the interests of the client first and disclose all conflicts of interest. Who knows whether or how this will work in practice, but it is a significant improvement over the status quo, where brokers are free to act as advisers without the best interest obligation or any duty to disclose conflicts.
Despite the concessions it has made to the broker-dealer business model, the SEC continues to get pushback from the Republican Commissioners and some members of Congress, who are clearly laying the groundwork for a legal challenge based on the adequacy of the SEC’s cost-benefit analysis. The major broker-dealer trade associations have raised concerns about certain details of the proposal but have not launched the kind of attack on the SEC proposal that they have unloaded on the DOL.
One reason is that the DOL rule presents a different set of challenges, because ERISA imposes very strict limitations on third-party compensation and having an adverse interest to the client. As a result, it does not lend itself to the approach the SEC proposes to take, which imposes the best interest standard without fundamentally altering the commission-based business model. Will brokers continue to serve IRA accounts if they can’t charge commissions? Probably not, at least not for the small investor who is socking away $2,000 a year.
The way DOL has proposed to deal with this is by providing a sellers exemption you could drive a truck through. It completely over-estimates the ability of average investors to know when a seller is acting only as a seller and not offering advice. We know that investors don’t understand the difference between brokers and advisers, can’t tell whether their service provider is a broker or adviser even after the differences have been explained to them, and expect recommendations to be offered in their best interest. The DOL seller’s exemption ignores all that. It is, of course, the only part of the revised definition the industry likes.
With its broad seller’s exemption, the DOL proposal threatens to introduce into the retirement plan arena precisely the problem the SEC is seeking to solve in its jurisdiction. If it is applied in the IRA context, for example, the seller’s exemption would leave these IRA investors without fiduciary protections precisely when they need it most.
That said, I do not disagree with the industry complaint DOL has rolled this definition out without providing any explanation of how it would apply existing or new prohibited transaction exemptions. PTEs, for better or worse, are the life blood of ERISA. Without that clarification, we don’t know for sure how the new definition will interact with new business conduct rules for swaps dealers, where there appears to be a conflict. And we don’t know for sure how it will be applied in the IRA context.
Under the circumstances, there does seem to be a genuine need to take this proposal back, make some revisions, and provide an opportunity to comment on it in combination with the guidance on PTEs.
Barbara,
Investors need to educate themselves, there is no way around that. If they want help, they have been some very successful investment clubs, and there are also organizations with modest annual fees that provide independent information, as well as fee based investment advisers.
I don’t disagree. I’ve said for years that, if you don’t have a big portfolio or a complicated financial situation, investing can be easier than it looks. And there are tons of really very good educational materials available. But, after working in this area for 25 years, I’ve also faced the reality that many (most?) investors will not educate themselves. They will place their trust in their “financial adviser” and assume he or she is acting in their best interest. In advocating policy positions, I try to base them on the world as it is rather than on the world as it ought to be, and for me that means not relying too heavily on investors’ willingness or ability to educate themselves.
” The SEC continues to get pushback from the Republican Commissioners and some members of Congress, who are clearly laying the groundwork for a legal challenge based on the adequacy of the SEC’s cost-benefit analysis.”
This “cost-benefit analysis” nonsense is the cross of gold on which justice is being executed at the SEC. Proxy access for investors in director elections was thrown out by the courts last week on this basis. Since when is fairness subject to “cost-benefit analysis”? If all of our laws were weighed this way, we would live in a state of lawlessness.
Sadly, I do understand the reality that our current regulatory regime requires this bogus “cost-benefit” weighing.
I took a look at the individuals who testified to the congressional subcommittee on this issue. Only one made an argument that demonstrated the cost to the small investor of the products that are typically sold to retail investors. I am a fee only advisor who charges for advice on an hourly basis. I am a member of a couple of networks who are attempting to advocate on behalf of consumers when it comes to these issues. None of them participated in this testimony – so maybe they’re not that well known after all. The likely explanation is that they do not have the financial resources to buy a seat at the table.
On research – I can’t tell you how many women tell me “Suze Orman says to buy individual bonds”. I’m the one who has to break the news that, as Yves describes, it isn’t that easy or smart. Their eyes glaze over and I guess they are thinking “why is this woman making this sound so hard”.
Finally – Yves – thank you for reinforcing my view that the risks of investing are often understated. It helps me to know that someone with your smarts believes as I do.
I’ve lost a couple of clients because I was unwilling to invest as aggressively as they would have preferred. These were clients who had not saved enough for retirement (believe me, there was room in their budgets for additional savings). They were looking for the stock market to redeem them and wouldn’t accept my preservation of capital arguments.
Even investment clubs are not to be relied upon. While serving on a grand jury last year, one of the cases brought before the jury involved the scamming of investors through a connection promoted by their investment club.
The bank cases we heard were even more hair raising. Apparently, for some criminals it is quite easy to steal funds electronically from TBTF banking accounts with just the tiniest bit of personal info. Criminals can do this successfully for years/decades without banks catching them (because TBTF banks feel this is too expensive to investigate considering the other money they can make). How one of these cases came to the attorney general’s office was IT staff at the bank had their personal accounts robbed, had occasion to compare notes, figured out that as a group they appeared to be concurrent victims and made the report.
If we don’t guard the castle gates ourselves, there is no politician, no bureacrat, no economic planner, no president, no party, no investment adviser, nobody going to gift us what we seek. Haven’t we learned by now that people with the very loveliest credentials and marketing support can say anything, but that doesn’t make it true? Verify, verify everything. Where money accumulates, there are criminals, looking to place a tap. If we’re lucky, it is only a tap.
There is LITERALLY no way around investors educating themselves.
The principle is the following. If you are not well-educated enough to manage your own money, you are not well-educated enough to be able to select an advisor either.
IPOs are my favorite example of Wall Street products that are not what they appear to be for retail investors. Your broker will brag all day long about “getting you in” to an IPO. What he won’t tell you is that, by long-standing tradition, he gets 4% of the value of what he places with his clients as his own “underwriting fee” (paid for by the main underwriters). This legal kick-back ensures that he is indifferent as to whether the IPO falls in price when it starts trading.
I would love it if others would post examples of similarly egregious practices. Someone should be compiling a list!
Surely the biggest scam of the lot is the whole 401(k) business. A walled garden of garbage barge fifth rate choices stuffed down employees throats by firms that put way more effort into winning the mandate to than into anything related to retiree returns. Turn all those worthless savings into valuable fees. It’s disgusting, and should be converted into an open investment vehicle (I make a point of converting all of mine to self-directed IRAs whenever I move).
I am shocked to hear that brokers are not already covered by fiduciary duty laws. When I rolled my 401(k) into an IRA, I trusted my credit union’s advisor completely, and went with his recommendation about which fund to invest in. Am I naive to think that even in the absence of a duty to put my interests first, the fact that the account is through a credit union means I’m getting advice that is not self-serving?
A quick google search of “investing through credit union” shows that many offer products as broker/dealer representatives. A broker is held to a “suitability” standard, which is quite different than a fiduciary duty.
Do you know how your adviser got paid for working with you? Ask him/her to disclose the commissions he earned on the recommendations he/she made to you. Find out the amount of any trailing commissions. If you can’t get a straight answer, that is probably not a good sign.
Check out this article on paying for investment advice. http://www.investopedia.com/articles/basics/04/022704.asp
(This article may under estimate the cost of hourly advice. If you live in a major metropolitan area, the going rate is probably $225 per hour, or higher.)
Google “fee ONLY adviser” and see if you can find someone locally that will work with you. Many will want to manage your investments for a fee of 1% of your assets. You might find an hourly adviser that can help you figure out if you are paying the credit union guy/gal too much.
Good luck
Thanks for the advice.
One of the biggest crimes in financial markets is the inability of small investors to simply buy corporate bonds, the actual paper bonds, from companies and hold them to maturity. Bond fund churn and fees are part of why retail investing is going down the tubes.
Just get a 5 year bond and stick it in the safe.
I’ve noticed this problem too. The financial companies have made it even harder to buy individual bonds than it used to be, and that’s saying something.
I think a large corporation (Google? ExxonMobil?) could probably issue bonds under a direct sale, no commission program quite successfully.