I was concerned that the U.S. Labor Department's new fiduciary rule wouldn't go far enough. Yet the rule unveiled on April 6 to address conflicts of interest inherent in the advisory business is the first one with teeth.
What's the root of the problem the DOL is addressing? Consider the first point in the DOL's "Summary of Action" fact sheet: Backdoor Payments & Hidden Fees Often Buried in Fine Print Are Hurting the Middle Class.
Many advisers advertise themselves as fee-only advisers, collecting fees as a percentage of assets and operating with a fiduciary obligation to put their clients' best interests first.
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Yet they can also dually operate as brokers and collect commissions without disclosing to the client. Double or even triple the compensation they collect from clients may be from commissions on the products they use, including mutual funds, private real estate investment trusts (REITs), structured notes and more.
The most common source of commissions for brokers is run-of-the-mill mutual funds. While you may be familiar with the fees embedded in mutual funds, you might not realize that your adviser could be getting 80% of those fees.
For example, the A share class of a mutual fund can have a front-end load as high as 5.75%, and your adviser may pocket up to 4.25%. Given that the fund may have a C share class offering with lower costs, how could any adviser choosing A shares claim to act as a fiduciary?
So while your adviser may claim he is only charging you 1% to 2% of assets under management, he can legally be charging you commission on investments without your knowledge that lead to actual fees of 3% to 5% of your money.
That's almost twice the return on the longest dated U.S. Treasury bond yielding 2.65%. That's equal or greater to the entire yield available to investors in the iShares iBoxx $ Investment Grade Corporate Bond ETF (symbol LQD), which is currently 3.65%. Your fees could be eating up your returns, subjecting you to the wrong type of portfolio and devastating your nest egg.
Furthermore, these "backdoor payments" the DOL is referring to are hurting more than the middle class. High-net-worth individuals experience some of the most egregious fee abuses, getting pushed into private illiquid investments such as private REITs and business development companies (BDCs), for which advisers were taking fees as high as 10%.
Here's the teeth to the DOL's fiduciary rule: Sales of commission-based products will still be allowed if the adviser and investor enter into a best interest contract, known as a BIC or BICE (for best interest contract exemption). Among other things, the BICE would commit a firm and adviser to providing advice in the client's best interest, note that a firm has adopted policies and procedures designed to mitigate conflicts of interest and clearly disclose hidden fees or backdoor payments.
Firms technically have until January 1, 2018, to fully comply with the DOL rule, but the time to implement its principles is now. You can't afford to wait.
In this current low interest rate environment, where the returns on conservative investments are so low, the fees on such investments are low as well. This creates an incentive for hybrid advisers to put clients in higher-fee, higher-risk equity products. And never before has there been such a disparity in fees on riskier equity investments compared with conservative fixed-income investments.
Is your portfolio too risky? Are you overinvested in stocks at a time when Standard & Poor's 500-stock index is overvalued compared with historical norms simply because that's the best way for the adviser to enrich himself?
Demand your adviser disclose any conflicts now!
If your adviser cites the timing of the rule and refuses to abide by the rule now, then move on. You can't afford two more years with that person. The easiest and most important investment decision you can make is to use a fee-only adviser who has no broker-dealer affiliation and can thereby not legally accept commissions at all.
See Also: One Simple Step to Get Sound Investment Advice
James M. Sanford, CFA, the Founder and Portfolio Manager of Sag Harbor Advisors, has worked on Wall Street since 1991 and was the top U.S. salesperson in U.S. Credit Product by revenue in 2007 and 2008.
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