President Barack Obama announced that he is directing the Department of Labor to draft new rules to rein in potential conflicts of interest among Wall Street brokers who provide financial advice.
The change does not sound very big, but it is. It would require brokers to follow a "fiduciary" standard when brokers giving investment advice to clients.
What's that mean? It means brokers have to place their clients' interest over their own interests.
Don't they have to do that now? Well, no, not exactly.
Right now the requirement is that advisors place their clients in investments that are "suitable." That's all well and good, but that's a very wide term that allows investors to potentially overcharge for services.
For example, suppose a broker wants to put a client into, say, midcap stocks. Suppose he has three potential midcap funds he could use...two are actively managed midcap funds with substantially the same performance, and the third is an ETF that is indexed to a midcap index. In the former case, the broker collects a commission from the mutual fund (paid by the client); in the latter, he also collects a commission which is half of the first fund, and in the case of an ETF would not get paid at all.
Which fund does he choose? Under the "suitability" requirement that currently prevails, he can put them in any of the three, because they are all "suitable" even though one is clearly less expensive and will save the investor money over time.
However, under a "fiduciary" standard, the broker would have some obligation to consider the cost of the fund and to advise the client it may be better to use the cheaper fund.
Mind you, it does not require that the cheapest fund is the one that should always prevail, only that a fiduciary would naturally have to consider that.
This sounds perfectly reasonable: do what a prudent investor would do.
So why does the industry oppose this? There are two reasons:
1) They can be sued more easily. They don't want clients coming to them and saying, "Tell me why you have me in a 2 percent fund when I could be in a 1 percent fund with the same performance?"
2) They don't want to see their profits (and margins) compressed. They phrase this differently: they don't want to see advice get more watered down. In a sense, there is something to this. You do get what you pay for. The less worthwhile it is for firms to pay attention to you, the less they will pay attention. It will force the business to move more toward the kind of "robo-advisors" that have been springing up.
But that's no reason to oppose a fiduciary standard. There will be more robo-advice, and you will pay more for hand-holding, as well you should. But you should have a fiduciary standard attached to any advice that is given.
In its heart, the industry knows this. That's why many brokers have now moved away from commissions and toward flat fees, usually called "wrap" fees, of, say, 1 percent, where there are no conflicts.
These are brokers, by the way. Registered investment advisors (RIAs) already have a fiduciary obligation. They get paid a flat fee by the client.
The Labor Department tried to pass a similar rule several years ago, but opposition from the financial industry and some lawmakers effectively killed it. They're trying again.
The proposal will be published some time in the next several months, during which there will be a comment period.
Bottom line: commission based, non-fiduciary standards are a dying breed. The sooner it goes away, the better.