Broker dealers, which make up much of the US investment industry, are held to a far lower standard, and that loophole costs American investors billions of dollars every year, according to a government analysis. Now the US Department of Labor proposing to raise standards for broker dealers.
For over 40 years, broker dealers and other purveyors of financial advice have not been held accountable for what they recommend. They can sell products loosely defined as “suitable,” but which may also be expensive and opposed to their clients’ best interests.
Given the complexity of finance, many customers are simply unaware of hidden fees that may eating into their savings. They don’t know what fees they are paying and how much those fees erode their retirement savings over time.
Consider the following example: If you’re buying a car in a Ford dealership, you can be pretty confident that the salesperson is going to try and sell you a Ford no matter what’s best for your lifestyle. Nonetheless, that Ford salesperson wouldn’t also take a 1% hidden commission on your gas purchases for the life of the vehicle. But something similar happens in investing when the fiduciary standard isn’t applied to brokers selling funds.
Another big challenge with investment products and a motive for these new standards is that relative to many other goods and services in investing, unfortunately, you simply don’t get what you pay for.
To return to the car example, buying a more expensive car generally results in getting more: a larger vehicle, better performance, premium finishes and styling or the latest technological gadgets.
In investments, study after study has demonstrated that paying more just erodes your savings and actually gets you a lot less when retirement comes. Again, the problem is that advisors not held to the fiduciary standard have an interest in selling expensive funds.
It hurts the investor, but results in greater commissions for the seller.
My favorite study in this area comes from Morningstar. What I like about the study is that Morningstar has their own famous star ratings, which have some value in predicting investment performance, but in this study they show fees are a better predictor of performance than their own star ratings.
Now, it can be hard to accept this conclusion that high fees are counterproductive. People can point to a chart of a supposed great fund with stellar returns and high fees. That’s true on the surface.
More Is Less
However, the investment industry kills many funds every year. If a fund is a dud, it tends to die pretty quickly. Only the better performers stick around. This means that for every great performing fund with a long track record, you’re not seeing all the skeletons in the closet. These are the also rans that died along the way and no longer appear on any sales website or prospectus.
If you by a high cost fund today, you’re more likely to be buying into one that will fall by the wayside than one which will deliver good performance. Investing past performance is no real guide to future performance. There’s no reason to expect a fund with great stock picking will continue to deliver that. Some high-fee funds get lucky for a while.
Another absurd trend is that a lot of “active” funds actually track the index to a much greater extent than you might expect (as I wrote about here). So a high-fee fund may not even be really trying to outperform the benchmark, and a passive fund would get you the same result for lower fees.
America’s Retirement Problem
The problem of high fees and potential conflicts is made worse because the number of individuals bearing the risk of their retirement planning has grown sharply in past decades.
The US has shifted from over 60% of retirement assets being managed directly by employers in defined-benefit plans 40 years ago to under 40% today. Defined-benefit means that you are guaranteed a certain payout, often linked to salary from your employer in retirement. Those plans are on the decline.
This gives Americans’ more direct management of their retirement plans, along with bearing the risk of a bad outcome. More and more individuals make their own investment decisions and bear the risk through 401(k)s and IRAs. Employers once had to bear the risk of retirement saving, relying on professionals to handle important investing decisions such as selection decisions and negotiations with providers. Now the risk falls on individuals who often don’t understand the fees they pay or the quality of advice they are given.
The Council of Economic Advisors estimates that conflicts of interest and high fees cost American working and middle class families $17 billion a year. That’s comes to approximately $140 in extra costs for every American household per year. Those costs come from paying an average of 1% more per year in fees than they should. Over time, that 1% adds up. The Council calculates that those fees can erode 17% of your savings leading up to retirement and then a further 12% in retirement.
Most Americans don’t know that they can do better.
Of course, the Department of Labor rules are just a draft proposal at this stage. They have a long way to go before they’re implemented, and powerful forces in finance will likely resist the changes.
The new proposal to impose fiduciary standard on broker-dealers would improve investment prospects for all Americans, making lower-fee products more mainstream. However, even if the rules fail to pass, you as an investor, can take the following steps to protect yourself.
If you do seek professional investment advice, be sure to work with a Registered Investment Advisor, who are held to a fiduciary standard. This is not a silver bullet. It doesn’t guarantee low fees or first quartile investment performance, but it does largely eliminate the risk of conflicts of interest.
If you invest yourself, consider low-fee products. Exchange Traded Funds (ETFs) can be a good choice. Vanguard and iShares ETFs have some attractively priced funds that accommodate a broader set of investment approaches. It’s clear that lower fee funds offer the prospect of improved performance based on history and Vanguard and iShares ETFs are a good place to start for investment that are diversified, low cost and trade on major exchanges just like stocks do.
For example, in your brokerage account, rather than entering AAPL as the ticker to buy Apple stock, you can enter VTI and purchase a diversified Vanguard Exchange Traded Fund (ETF) containing over 3,000 stocks for a cost of 0.05% a year. Similar mutual funds can cost over 1% on average. To achieve diversification at low cost, ETFs can be extremely useful.
With luck, the Department of Labor rules will lead to improvements in how retirement investments are marketed and sold. In the interim, work with a RIA and consider low-cost ETFs as a way to ensure that you’re not exposed to excessive fees and conflicts.
$17 billion is a lot of money to be wasting on bad retirement outcomes.