Fifty years ago, when factory/union workers comprised the American middle class, the majority of Americans’ retirement savings were company pension plans (defined benefit plans) created by an employer. As America evolved into a service economy, middle class workers experienced a drastic shift how they received their retirement benefits as defined benefit plans (DBPs) were largely replaced by defined contribution plans, such as 401Ks and IRAs.
The shift represents more than just a change of how retirement assets are managed; it also shifts the onerous of responsibility onto the individual (and their financial advisor). Instead of leaving retirement savings in the hands of the employer, workers now are in charge of their own destiny. They must decide how much they want to set aside, how it should be invested, and by whom. As baby boomers start to retire in record numbers, this new retirement regime is being put to the test and the results don’t look great so far.
Source: Employee Benefit Research Institute. EBRI’s estimates for 1998-2008 were done using Department of Labor and Current Population Survey data.
The increase in personal financial responsibility encourages individuals to search for professional advice for their retirement plans which can end up being a large portion of their overall net worth. While most financial advisors adhere by the “client comes first” model, others end up viewing a client as a potential opportunity to sell lucrative, high-commission products. According to the White House Council of Economic Advisers, retirement savers lose approximately $17 billion a year- approximately 1 percentage point of returns not including the normal fees and expenses associated with a typical retirement account – due to advisors recommending higher fee investments that may result in lower returns for the investor. One percent over several decades can easily mean the difference between retirement and bankruptcy.
Department of Labor Fiduciary Rule
As a result of the study mentioned above, the Department of Labor announced a new fiduciary rule for retirement advice, requiring that an investment must be in the client’s best interests. While somewhat vague, the new fiduciary standard means that if an advisor is deciding between two investments that are expected to yield a similar return, but one has a higher-fee, the advisor is legally obligated to recommend the lower-fee investment unless the advisor can specifically explain why the higher-fee choice is better for the investor.
As of now, a commission-based income model for financial advisors is fairly common- roughly 25% of all advisors utilize it. For the advisors working on commission, the new standard will require them to recommend lower-fee investments, hence, these advisors may see less revenue. Many advisors truly do advise in their client’s best interest; however, there are only so many low-fee recommendations that a commission based advisor can make before it drastically affects their income.
This change will likely create a shift from firms using a commission model to a flat rate fee model. While on the onset this may seem like a win for investors, there is a negative side effect of this new system.
What Does This Means for Investors?
Imagine a client that has a retirement account value of $30,000 and an advisor that has previously made profits off higher fee investments, now has to start charging a percentage of clients’ assets. For example, let’s say an advisor charged 1% – his firm would now receive $300 in total annual fees. After overhead, expenses, and a small payout to the advisor, firms could have a hard time making any money on this account. They would be forced to either set higher minimums ($500,000 or above) or create a completely automated solution that might not be suitable for many investors who have special circumstances or require a more customized approach. To take it a step further, now these accounts could be left to fend for themselves with even worse outcomes.
Yes, the rule will allow investors to listen to their advisors more confidently, but how effective will this rule be if the investor doesn’t have access to an advisor in the first place? Although the rule intends to eliminate investment advice that is not in the client’s best interest, it may be subsequently eliminating the access to an advisor of middle-income clients, forcing them to invest individually as some firms will not be able to afford advising smaller accounts.
Loosened Restrictions… Helpful?
Before releasing the final rule in early April, the Labor Department spent six “laborious” years editing the rule while listening to opponents. As a result, some restrictions were loosened, such as the fact that advisors are still allowed to recommend higher fee investments; but they are now legally required to disclose all conflicts of interests including hidden fees. Although this may seem like potential protection for advisors, it will still be significantly harder to advise revenue-optimizing investments without fear of negative consequences- the rule allows clients to file class-action lawsuits if they feel their advisor has not followed the fiduciary standard. Here come the contingency attorneys!
There is still a heavy debate as to whether this new fiduciary standard will end up helping middle class Americans- by disallowing expensive investment vehicles – or hurting middle class Americans – by limiting the investment advice they will be able to seek.
While the end result is yet to be seen, some regulation in the way of investment advisors poaching on the uninformed public is probably a net benefit. However, none of this solves the larger looming disaster: the vast majority of Americans simply don’t have enough in their retirement savings to live comfortably for their ever-lengthening lives.
This article was written by Duncan Rolph from Forbes and was legally licensed through the NewsCred publisher network.
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