Would the Labor department ban commission sales for advisors?
During the third day of the DoL's ongoing hearings into a proposed fiduciary rule for all planners who advise on retirement assets, a top department official indicated he has started to worry that commission sales of investment products may be inherently "conflicted" and unavoidably harmful to investors.
Timothy Hauser, a DoL deputy assistant director, ended a midday panel Wednesday expressing his concern and putting listeners on alert.
"Just a cautionary word," he began.
After mulling all the industry input since hearings began Monday, Hauser confessed that he had asked himself, "Is lurking in [firm's] policies and procedures … a sense in which the firm's conflict of interest is just being directly transmitted to the advisor?
"If the policy and procedure essentially says, 'The more money this recommendation will make for the firm, the more money I am going to pay you,' that's aligned, alright – but it doesn't necessarily seem like it's aligning the advisor's interest with the customers.
However, the very intent of the fiduciary rule – which would compel advisors to put their clients' financial interests before their own – is to align advisors' interests with their clients, Hauser said.
The hearings conclude today. The department will take further online comment for at least two weeks before closing the comment period.
Hauser did not immediately respond to emails and phone calls asking him if the department might decide to ban all commission sales.
The current draft of the rule, released in April, preserves the commission sales business model, as long as retirement savings brokers sign legally binding contracts saying they will serve their client's best interests.
However, it's not possible to serve a client's best interest while also trying to sell them products for commissions, one expert on the panel says.
For this reason, the United Kingdom recently outlawed the sale of commission-based financial products, Marcus Stanley, an investor advocate with the nonprofit Americans for Financial Reform, reminded the Labor officials.
He urged the department not to be swayed by strenuous industry opposition to the rule, but to pass it as written, in order to save retirees billions of dollars American retirees are estimated to lose annually to bad advice on their retirement savings.
"An effective rule will face strong opposition from those in the financial sector who benefit from the current system," Stanley warned Labor officials. "Gains to investors who are no longer steered into high cost products generally represent losses to the seller of the investment product. So the billions of dollars that investors stand to gain from an effective rule are also billions of dollars in reduced profits for Wall Street professionals.
"The DoL must not weaken or reverse this rule in the face of criticism from those who profit through conflicted financial advice. If this rule did not impact the profits and business models of some in the financial industry, it could not achieve its goal of benefitting investors."
To learn, in detail, how conflicts of interest affect mutual fund sales, Labor officials asked for specific details about the fees and commissions advisors receive for selling them. They learned relatively little in response; the following exchange illustrates how difficult it is for any investor, not to mention government officials running a national inquiry, to truly understand how commissions and fees impact their actual savings and investment choices.
Labor official Joseph Piacentini began by sketching a scenario in which he was trying to choose between two mutual funds.
"I can see what the load is that I would pay for each fund and I can see, if I look, what the expense ratio might be for each fund. So, in that sense, I know what I am paying, but how do I know – Do I know? – What my advisor is being paid in connection with the recommendation of one fund or another?"
W. Mark Smith, a lawyer who has represented banks, broker-dealers and insurers, stepped in to answer.
"Joe, there is no mandated disclosed, individualized account-level disclosure of commissions, as the regulatory regime stands right now," Smith told him.
"OK," Piacentini continued. "So, let's say just hypothetically that these two funds have the same amount of front-end load. Am I correct, though, that the advisor might be paid a different share of that load, depending on which of the two funds that they recommend?"
"Possible," Smith said, hesitating slightly, "not terribly likely. Given the compensation practices in the industry, it's very likely that the same level of compensation would flow through to the advisor."
"But," Piacentini said, "depending on … I understand there are these things called 'payout grids', right? that determine the share that's paid out ... "
"Right," Smith said.
"Sometimes the amount that's paid out," Piacentini continued, "can depend on not only which fund is recommended, but on how much volume of that fund a particular advisor has sold and how much revenue that's generated for the fund family. Is that correct?"
"I don't know that I can confidently answer that for you off the top of my head," Smith said.
"OK," Piacentini said, dropping that inquiry and moving to another one. "So I can see from the fund's prospectus whether there's a 12b-1 fee and how much it is?"
"Exactly," Smith confirms.
"But I wouldn't know how much of that is or is not paid to my advisor?"
"It," Smith began, "The same sort of structure as applies …"
"And, so," Piacentini interrupted, "if the 12b-1 fees between the two were the same, the amount paid to my advisor, though, might be different between the two funds?"
"Yeah," Smith said, "Nah, I don't think that, yeah, again – possible – not common, but possible."
"And I also can observe what the asset manager of the fund is paid, right? What the management fee is for that fund, right?"
"Absolutely," Smith said.
"But," Piacentini continued, "I don't necessarily know whether that asset manager is paying some revenue back to the distributor, back to the advisor."
"I think that is commonly disclosed these days in the product-level prospectus," Smith responded.
"Would I know the amount that was paid back to the advisor, if that was the same or different for the different funds?" Piacentini asked.
"Not necessarily," Smith said.
Abandoning further efforts to obtain this elusive information, Piacentini took another tack by asking Smith to simply presume that he had found it somehow or another.
"So I knew in detail all this information for the different funds that were offered me," Piacentini proposed. "As a consumer, then, how would that influence my decision?"
A few seconds pass before Smith said, "… Try that one again?"
"So, let's say that, as the prospective investor," Piacentini responds, "now I know what the load share is for each of the funds that would be paid by each to my advisor. I know whether or what share of the 12b-1 fee they would be paid, whether they are receiving revenue-sharing from the asset management, how much that would be for each of the funds. So now I have this information and I also, perhaps, have a recommendation now from the advisors telling me that, of these two similar funds, they think this is the better one to choose.
"Maybe I can see that the better one, the one recommended, has a larger load share paid to my advisors, but a smaller 12b-1 fee. I mean, would that – should that – information have any bearing on how I interpret the recommendation? And if so, what kind of bearing?"
"Well," Smith began, "the investor of course has definitive information on what they are paying for the investment, right? But, what the friction on the return from the investment is going [to be], they have definitive information about that."
"Yes," Piacentini says.
"To the extent that," Smith says, "this particular investor finds it instructive to understand what the compensation is coming to the advisor – and not all investors think about that in exactly the same way, right? To the extent that they find it instructive, there certainly is information available in the system today to at least give them some kind of order of magnitude and notion of what kind of compensation is flowing into the distribution channel and ultimately to the advisor."
"OK," Piacentini says, sounding unconvinced.
Before he can ask an entirely different question, Hauser steps in.
"If I can ask one follow-up question from Joe's question, Mark," Hauser begins, "So, assume we somehow manage to effectively convey the scope of the particular advisor's conflicts of interest. I'm an investor looking to you for expert assistance in making an investment decision that I'm not really competent to make without your assistance. What good does that disclosure do for me? How do I translate the fact that you've told you have a conflict of interest into better investment decision-making?"
A pause ensues.
"Can you think of any way to do that?" Hauser prompts Smith again.
"That the possession of that kind of information by the investor translates into better investment decision-making?" Smith repeats.
"Right," Hauser says. "I mean, It seems to me that that would be the point of disclosure, but one of the things that's always puzzled me about it [is] what good does that do for me in making a better decision? And I haven't been able to think of a way it does. Can you?"
"Sure," Smith says brightly. "I mean, isn't the point is that you've provided more information to the investor that lets them understand the filter through which the recommendation is coming and make a judgment about whether that's a recommendation that they want to take into account or not?"
Smith turns the question back to Hauser, "Isn't that the point of the disclosure?"
"So this whole thing," Hauser continues, "maybe tells the investor they should be on guard on whether to trust you at all, but assuming – and maybe they should go to somebody that doesn’t have a conflict – but how does the disclosure itself help if they stick with you in making a better investment decision? Or does it? Is its only function to kind of disclose a conflict so they can decide to go elsewhere or … How is it going to contribute to better investment results?"
"You know, I, well," Smith responded after a short pause, "I'd be glad to think about that a little more, Tim, and get back and we'll get back to you if we have anything more to say about that."
'IS THAT NAÏVE?'
A moment later, Stanley, the investor advocate, jumped in to tell the DoL officials: "You really put your finger on why a lot of us don't believe that a disclosure-only approach to this is going to effective because it puts people in a difficult situation where they either insult person across the table and essentially leave or, or set aside the information that they've received, to some degree. And that's just, that's just not something that is going to fix the problems that we see out there."
Later, Hauser suggested that, by deciding to allow commission sales, the department and investors are undertaking a risk.
Leaving the fiduciary rule as currently written, he said, "We're going to tolerate a fair number of compensation streams that would normally just be flatly prohibited because of the potential incentives they create for the people recommending the products."
He then said he'd been wondering, "Is that naïve?"