New Fiduciary Rule for Investment Advisors: Questionable Benefits and Substantial Costs

 

Economists Ink: A Brief Analysis of Policy and Litigation

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HAL J. SINGER
View Hal J. Singer’s Profile
EI Special Consultant Robert Litan served as Associate Director of the Office of Management and Budget and Deputy Assistant Attorney General in the Antitrust Division. EI Principal Hal J. Singer is a Senior Fellow at the Progressive Policy Institute, and an Adjunct Professor at Georgetown University’s McDonough School of Business. This article is based on their study, “Good Intentions Gone Wrong: The Yet To Be Recognized Costs of the Department Of Labor’s Proposed Fiduciary Rule,” which was funded  by the Capital Group.

The Department of Labor (DOL) recently adopted new fiduciary rules for securities brokers and others providing financial advice to savers managing their individual retirement accounts (IRAs). Previously, the only requirement the government imposed on those advisors was that their advice be “suitable” for investors, given the investors’ income, assets, and willingness to assume risk. Under the new rule, advisors will have fiduciary obligations to the extent they receive transaction-specific direct commissions from the sponsors of investments they recommend. These rules likely will have costs that far exceed their benefits.

Payments from investment companies have been a major form of compensation for financial advisors. DOL believes that this system results in extra costs to investors because it causes advisors to give “conflicted advice” that favors investments with the highest commissions rather than those that are best for the investor. DOL estimates that by eliminating these extra costs, the rule will have annual benefits relative to the value of IRAs of 25 basis points (i.e., 25 one hundredths of a percent) or about $3.8 billion net of compliance costs.

Yet DOL has overestimated the costs of conflicted advice and thus the potential benefits of the new rule. DOL argues that funds sold by brokers receiving commissions had higher fees and thus inferior performance to other investments. Once brokers no longer have an incentive to steer customers to poorly performing funds, consumers will realize higher returns on their IRAs. The supposed finding that broker-sold funds perform poorly, however, disappears if the analysis considers foreign rather than domestic equities or is done for a different time period. Thus, there is no sufficient evidence that broker-sold funds consistently underperform other investments.

Moreover, the fiduciary rule may result in serious harms to small investors. Without commissions, financial advisors will have no incentive to service such investors. Advisors may either withdraw from this segment of the market or begin to charge those investors a fee based on a percentage of their assets, a “wrap fee.”
Thus, the rule may cause many small investors to lose the services of financial advisors, services that have significant benefits. Two such benefits are coaching to stay invested during market downturns and assistance in rebalancing portfolios. The annual value of just those two benefits has been estimated to be 44.5 basis points, almost twice the DOL’s estimate of the benefits of the fiduciary rules. This estimate ignores the value of other benefits that would also be lost, such as encouragement to increase savings and take greater advantage of employer matching plans.

Advocates of the proposed rule assume naively that “robo advisors” will eventually fill the gap, so small savers will continue to be advised. But emails and tweets from a robot will not prevent an investor from selling in a panic. The value of human interaction during periods of market stress will swamp anything else a small saver does with respect to outcomes and retirement security.

Alternatively, small investors may be able to continue to use a broker but have to pay a wrap fee. Fee-based advisory relationships, however, generally cost much more than commission-based relationships. Paying brokers a wrap fee is likely to result in added annual costs to small investors of 31 basis points. These costs are much greater than the supposed benefits of the fiduciary rule. For example, an investor with a portfolio of $100,000 would pay $310 in annual fees, whereas DOL estimates that investor’s benefits from the rule would be only $250.

A simple calculation indicates how much the rule is likely to cost investors. Assume conservatively that the only assets that are affected by the rule are the $1.487 trillion of IRA investments in mutual funds with a front‐end load—that is with commissions and expenses deducted at the time of purchase. That figure is the estimated average annual value of those investments between 2017 and 2026. (In reality, the costs of the rule would also be felt by investors who rely on broker assistance without the use of a front end load.) Assume further that half of investors (on a dollar weighted basis) lose their brokers as a result of the rule, while the remaining half maintain their brokers but are forced to convert to a wrap fee compensation model. The rule’s costs to investors, which as noted are a fraction of their affected assets, would be over $5.6 billion a year. Even assuming that DOL’s estimate of the rule’s benefits is correct, the costs net of benefit would be just under $1.9 billion a year.

DOL argues that its rule will not cause financial advisors to either abandon small savers or switch them to a wrap fee arrangement because it includes Best Interest Contract Exemptions (“BICE”). The BICE allow brokers and advisors who meet certain conditions to receive commissions and marketing and distribution fees from mutual funds. The requirements to qualify for BICE, however, are so onerous that advisors are more likely to forgo commissions than to use the exceptions. Moreover, DOL’s whole argument for the benefits of the fiduciary rule is based on the contention that the rule would stop advisors from receiving commissions from investment companies. It cannot then turn around and say that because of BICE, the rule would not have that effect.

DOL has an alternative to the fiduciary rule that would reduce the costs of conflicted advice without imposing large costs on small investors. DOL could require brokers to make additional disclosures of the cost of broker compensation. DOL rejected enhanced disclosure rules with only the unsupported assertion that investors could not understand the additional information. Certainly DOL should have at least tried these rules before adopting the fiduciary rules with their questionable benefits and significant costs.