Many ordinary investors have a negative impression of financial professionals, pointing to episodes like the financial crisis and market meltdown of 2008 as evidence that those who provide investment advice are in it for their own gain rather than to help people. Obviously, that's not true of every investment advisor.
However, a new report from the President's Council of Economic Advisers looked at the impact that conflicts of interest among investment advisors have on retirement savers, and identified several problem areas in the industry. As a result, the Labor Department is expected to propose new rules to impose tougher standards on the professionals who provide retirement financial advice, and that prospect has drawn plenty of debate from consumer groups and the financial industry.
How do conflicts of interest affect you?
As more Americans have had to take responsibility for managing their retirement savings in IRAs, 401(k) plan accounts, and other retirement investments, the amount of assets potentially subject to conflicts of interest has soared. According to the CEA report, more than 40 million families have a total of $7 trillion in IRAs alone, and 75 million families have either an IRA or an employer-based retirement plan available to them.
The CEA makes a relatively simple case. In reviewing extensive academic literature on the subject, they determined that investors lose about 1 percentage point of returns annually due to conflicts of interest. The report estimates that about $1.7 trillion of total IRA assets go into investments that generally create conflicts of interest between advisors and their clients, concluding that the impact of that 1 percentage point hit is $17 billion per year.
In particular, the report singles out retirees who are told to roll over a 401(k) balance to an IRA as a source of lost wealth, asserting that those who get advice from someone with a conflict of interest will lose about 12% of their nest eggs during the course of a 30-year drawdown. With the average IRA rollover for those ages 55 to 64 exceeding $100,000, the report concludes that retirees lose more than $12,000 as a result of conflicted advice from financial advisors.
Among the types of investments that create conflicts of interest are those that involve revenue-sharing arrangements between advisors and the companies that manage the investments they recommend, as well as sales loads from mutual funds, variable commissions from security sales and insurance products, and targeted sales incentives for specific investments. The added pressure that financial professionals get from these arrangements can tip the scale toward recommending products even when an alternative might create a better result for the client.
Two solutions for retirement savers
In response, the Obama administration directed the Labor Department to establish rules that would impose what's known as the fiduciary standard on those offering retirement savings advice to clients. The fiduciary standard requires that advisors act in clients' best interests over their own.
Proponents of the measure argue that the new rules will prevent unscrupulous tactics like account churning, unnecessary transfers of assets from account to account, and sales of risky and costly products that often have lower returns than cheaper alternatives. Exemptions to the rules would allow those professionals who work to educate workers in employer-sponsored retirement plans and similar initiatives to keep doing their much-needed work, while hopefully ending disreputable behavior among others.
Opponents responded that imposing a fiduciary standard would impose new costs on investment advisors, stopping some from providing any advice at all for retirement savers. Moreover, some are concerned about how imprecise phrasing of rules could lead to unintended consequences for those who are satisfied with their current arrangements.
Whatever you think about the new rules, there are steps you can take right now that will have the same positive effect. In essence, all you have to know is this:
- All investment professionals charge you for the services they provide. People who say their advice is free only mean that you don't have to write a check for their services -- but you can count on some of your investment dollars getting moved into your advisor's pocket somehow.
- Therefore, the best advisors are those who are upfront about how they get paid.
- Many reputable financial professionals have started to charge their clients on an hourly basis. That way, you only pay for the services you need, and your advisor can choose whatever investments are in your best interest. Moreover, by avoiding the traditional fees based on a percentage of assets under management, you won't see your fees automatically increase as your savings go up.
Conflicts of interest aren't going to go away overnight, and even new regulations won't make the problem that retirement savers face disappear entirely. Your best defense against conflicts of interest is to know that they're present throughout the financial industry; so you need to take every piece of advice you get with a grain of salt, and consider whether your advisor might get something out of it on his or her end.
Dan Caplinger has charged for financial advice on an hourly rate in the past and encourages more financial planners to follow his lead. He has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.