I Fear the New Financial Adviser Rule Won't Protect You Enough

But you can protect yourself by working with a fee-only adviser with no broker-dealer affiliation.

Any day now, the Department of Labor is expected to issue a proposed regulation that would require all financial advisers to act in the best interest of their clients. The need for this "fiduciary rule" seems frighteningly obvious, and why the government has to force advisers to put clients' interests first is troubling.

Even more troubling is the army of opposition the finance industry is assembling via its lobbying groups to kill or dilute the measure on Capitol Hill. Witness crony capitalism at its worst. Currently, the Financial Services Institute, the Securities Industry and Financial Markets Association, the Financial Industry Regulatory Authority and most major financial advisory firms are all opposing this DOL rule.

Prior to the Dodd-Frank financial reform act, signed into law in 2010, a number of studies suggested that the majority of customers of firms registered as both broker-dealers and investment advisers had little to no understanding of how such hybrid professionals operate. Customers were largely unaware when their financial adviser was acting as a broker (subject to a suitability standard) versus as an adviser (subject to a fiduciary standard). Most clients didn't understand the differences between the two standards, either.

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Here's the difference: A registered investment adviser (RIA), who operates on a fee-only basis, charges clients a fixed rate based on assets under management. This type of professional is bound by a fiduciary obligation, requiring him or her to put a client's interest first. Brokers make money by collecting commissions on the products they sell to a client and have no obligation to put that client's interest first.

Many advisers advertise themselves as fee-only advisers. Yet they double or even triple their compensation by earning commissions on investments such as mutual funds, private real estate investment trusts (REITs), structured notes and other products. Furthermore, in this current low interest rate environment, where the returns and fees on conservative investments are low, broker-advisers have even more incentive to sell clients higher-fee, higher-risk equity products.

The most common source of commissions for brokers is your run-of-the-mill mutual fund. You may be familiar with the fees embedded in mutual funds. What you might not know is that your adviser could be getting 80% of those fees. For example, with high-fee A shares of a fund, the fee, or front-end load, can be as high as 5.75%—and your adviser may pocket up to 4.25%. That's in addition to the 1% to 2% he is claiming to only charge you for managing your money. Given the C share option of the same mutual fund comes with lower costs, how could any adviser choosing A shares claim to be acting as a fiduciary?

Yet there is nothing illegal about any of this. FINRA doesn't view an RIA who also operates as a commission-broker to be violating his fiduciary obligation. And that is an absolute flagrant omission in laws protecting investors.

In addition, recent abuses have come to light (opens in new tab) involving less-common investment offerings for high net worth individuals. These are private, non-listed and non-traded business development companies (BDCs) and REITs for which advisers were charging clients fees as high as 10%.

Instead of recommending these high-cost investments, advisers can suggest a plethora of low-cost, highly liquid, publicly traded entities that offer perfectly viable, if not superior, risk alternatives. The proposed DOL rule specifically mentions private non-traded REITs as a caution flag and limits their use in retirement funds.

The ability of these hybrid broker-adviser businesses to operate without disclosure to the client has to end. But industry lobbyists are fighting required disclosure of hidden fees and backdoor payments inherent in the hybrid model.

Under the 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.

Notice how the BICE rule doesn't cap fees or the levels of commissions adviser-brokers earn. It simply requires disclosure. This rule takes aim at the main profit engine of the banking system today—the asset management side of the business. Yet, an aggressive counterattack of industry lobbyists is protecting tens if not hundreds of billions of dollars in fees.

The finance industry's lobbyists claim that a requirement to disclose compensation adds an undue regulatory burden. This comment is disingenuous at best because the banks absolutely already have this crucial data. Commissions are the key aspect of an adviser-broker's compensation, and the only piece of data used to calculate the compensation for the broker. It is also used to determine profitability of clients, regions, entire business and product lines.

Congressional opponents of the Obama administration and recipients of industry lobbyists' money will attempt to oppose this rule under the guise that it's an unconstitutional invasion of the legislative body's exclusive right to rulemaking. But if we let the debate be shrouded in this constitutional controversy, we miss the true need and impact of the rule.

If FINRA and the SEC don't take the opportunity to expand this current proposal to all client investment accounts rather than just retirement accounts, investors will have to take steps to protect themselves. What's the easiest and most important defense of all? Use a fee-only adviser who has no broker-dealer affiliation and thereby cannot legally accept commissions at all.

James M. Sanford, CFA, the Founder and Portfolio Manager of Sag Harbor Advisors (opens in new tab), 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.

This article was written by and presents the views of our contributing adviser, not the Kiplinger editorial staff. You can check adviser records with the SEC or with FINRA.

James M. Sanford
Founder & Portfolio Manager, Sag Harbor Advisors

James M. Sanford, CFA, the Founder and Portfolio Manager of Sag Harbor Advisors, has worked on Wall Street since 1991. Mr. Sanford spent 11 years as a Managing Director at Credit Suisse, marketing credit derivatives and convertible bonds. From 2005 to 2007, Mr. Sanford managed the Hedge Fund Credit Sales team at Credit Suisse within the overall Credit Sales group and was the top U.S. salesperson by revenue in 2007 and 2008. Mr Sanford has a wide-ranging product background, a rarity for RIAs and even most Equities Portfolio Managers.

Phone: 631-740-4498
E-mail: jim@sagharboradvisors.com