Trader Talk

Why new rules for financial advisors may save you money

After long delays, the Department of Labor is poised to release new rules Wednesday on the legal obligations of financial advisors. The new rules will likely require brokers to abide by a "fiduciary" standard putting their clients' best interest before their own.

This is a battle about getting your financial advisor to act in your best interest. It's also a battle to lower the cost of investing, which, depending on your advisor, can be anywhere from cheap to very high.

In one sense, it's simple. There are essentially two different types of financial advisors: brokers and investment advisors. Both can sell you stocks and bonds and ETFs and mutual funds, but the standards are different.

Sam Edwards | Getty Images

Brokers are licensed to sell investment products on commission, as well as for a fee. These brokers must adhere to a "suitability" standard when selling stocks and bonds, which simply requires that the investment be appropriate for the investor.

Investment advisors only charge fees. They have a higher "fiduciary" standard that requires them to consider not only what is suitable but also to act in the best interest of the client.

The White House is alleging that brokers often overcharge investors by placing them in investments where they can collect hefty commissions. A White House Council of Economic Advisers analysis found that these conflicts of interest result in annual losses of about 1 percentage point for affected investors.

The rules being released by the Department of Labor are clearly trying to nudge brokers toward a fee-based business. They will likely allow them to continue to charge commissions, but there will have to be more disclosure on exactly how much is being charged.

All this is good. There's no reason investment advisors shouldn't act in the best interest of their clients at all times, which includes saving them money on commissions and fees where possible.

Fortunately, the industry has been moving in the direction of charging a flat fee instead of commissions for several years. A whole class of advisors — Registered Investment Advisors (RIAs) — has grown up to provide independent financial advice for a fee, no commission.

That RIA space is growing fast: there's already roughly $4 trillion under management. JMP Securities estimates that the ranks of RIAs have grown 9 percent between 2010 and 2015, whereas the ranks of commission-based regional broker dealers has declined 4 percent.

Here's the problem: commissions generate big money for old-school firms like Merrill Lynch, Morgan Stanley, and Goldman Sachs.

Suppose you want to invest $100,000, and your broker wants to put you in a mid-cap fund. One fund might be a mutual fund and your broker will charge you a commission of, say, 2 percent, or $2,000. He may also have the option to put you in a different fund — say, a low-cost ETF — and charge you only a 1 percent yearly fee, so he collects $1,000.

Both are "suitable," but the costs to you — and the profit for the broker — are different. There's $2,000 for one versus $1,000 for the other. Big difference, even if over several years he might make more with just charging a yearly fee.

There's another problem. Your broker might put you in a mutual fund that charges ancillary fees like 12b-1 fees, some of which they share with your broker. But cheaper investments like ETFs don't charge these kind of fees.

It all adds up to less money for brokers and their companies.

What does this mean for you?

1) Expect more brokerage firms to convert commission-based accounts to fee-based accounts. That's good news.

2) Expect more growth in the RIA business and the companies that cater to them. For example, firms like TD Ameritrade and Schwab and Fidelity already have substantial relationships with RIAs. They charge little or nothing to use their platforms. Instead, the game is to sell the client more services and products.

3) The big will be getting bigger. It's great news that investors will be able to save money. But the upshot is that the brokerage business is becoming a very low-margin business that is almost entirely dependent on massive scale to make money. You may find that your friendly regional brokerage firm you have used for years has suddenly merged.

4) Those with small amounts in their mutual funds and retirement accounts may get less services. The industry has warned that squeezing their profit margins may force them to drop clients with low assets. It simply won't be profitable to keep someone who has, say, only $25,000 in an account without charging higher fees or commissions. Depending on how the rules are written, this may be an issue. Those with small sums in their accounts may be dropped or forced to stay in accounts that continue to charge higher commissions. An alternative is for them to move to RIAs who charge low fees and put them in low-cost ETFs.