Conflict of interest in financial advice has got President Obama's attention!
The President of the United States of America - the most powerful man on the planet - devoted a full speech to one topic: conflict of interest in retirement advice provided on commission oriented models and the need to put clients' interests first when offering retirement advice.
He made these comments last year, he said he will keep pushing for new rules, and those comments have now taken the shape of a new rule proposed last month - in April 2016 - by the US Department of Labour (DoL), which can significantly impact financial distribution business models in the US.
All intermediaries will now have to abide by common fiduciary standards
The entire text of the new rules proposed by DoL are available here. The sum and substance of the new rules is that from when the rules gets implemented (Jan 2018), all intermediaries who offer retirement advice (whether they are broker-dealers, MF distributors, insurance agents, financial planners, RIAs or any other form of intermediaries) will have to abide by a common standard of fiduciary obligations that require the intermediary to act in the best interests of the investor.
Role of a distributor
As things stand today in the US, distributors are required to establish product suitability whereas RIAs are required to act in the best interests of the investor. What this means is that when preparing a retirement plan, a distributor (they call them broker-dealers there) is supposed to do risk profiling to establish suitability of asset classes. If equity is suitable as per the risk profile and needed as per the financial plan, the distributor can then recommend any equity fund - even the ones he gets the highest commissions on. There is no separate disclosure requirement on the commissions he earns.
Role of an RIA
An RIA is supposed to go a step beyond. After establishing that equity is both suitable and necessary, he then has to recommend equity products that are in the best interests of the investor. This could mean opting for lower cost funds. It could mean opting for index funds if the RIA is not convinced that actively managed funds will outperform the benchmark (which most don't in the US). It means in short, acting in the best interests of the investor. Since the RIA is paid by the investor and does not earn any commissions, it works well for everybody.
Now, everybody has to act like an RIA
Now, what the new DoL rules say is that all intermediaries - when offering retirement advice - must abide by a common fiduciary standard that entails putting the investor's interests first. A distributor who offers retirement advice will now be required to justify why a particular fund that he is recommending is in the best interests of the investor. He will not only have to disclose all his commissions clearly, but is also liable to be pulled up if he recommended products (with commission disclosure) which he knew at the time of recommending, were perhaps not in the client's best interests. For example, if he is recommending an actively managed large cap equity fund which has consistently underperformed the benchmark, and most peers have done likewise, even if he discloses his commission as required, there is a question on whether he should have, in these circumstances, advised a lower cost index fund.
Essentially what the DoL rule does is to make every intermediary who offers retirement advice act like an RIA, whether they are registered as investment advisors or not. The distinction between distributor and advisor is set to rapidly blur in the world's biggest financial market.
Hectic lobbying
The rule is being hotly contested by the industry. Fears are being expressed that this will push distributors towards an RIA model, which will then deprive retail investors of advice, just like what is happening in the UK and Australia. The research and analysis on the basis of which DoL concluded that bad retirement advice was being offered, is being hotly contested as well.
This rule has been in the making for a few years now, and a lot of lobbying has taken place to prevent it from seeing light of day. Its when President Obama decided to lean towards the DoL rule, that the die started getting cast, which has now come about as a new set of rules for the industry to abide by. Lobbying will continue as the rule is enforceable only from Jan 2018. And in 2017, the US will have a new President. What's important to note for all of us is the fact that conflict of interest in commission based models is a topic that has got even the most powerful man on the planet to think about and take a position on. What's important also to note is that its not SEC that has proposed these rules, it is the DoL that is driving this agenda, which most would argue rest in the domain of SEC.
The final word
Acting in the best interests of investors is an article of faith for any responsible advisor - whether he/she be a distributor or an RIA. But until regulators around the world are convinced that not all intermediaries are acting in the best interests of their investors, you will see more regulatory activism to enforce this. India is no exception to this trend.
As President Obama so eloquently put it, "Financial advisors absolutely deserve fair compensation for helping people save for retirement and helping people figure out how to manage their investments. But they shouldn't be able to take advantage of their clients. The system makes it harder, in fact, for those financial advisors like Sheryl who are trying to do the right thing, because if she's making really good advice but somebody who is competing with her is selling snake oil, she's losing business. And ultimately, those clients are going to lose money. So, today, I'm calling on the Department of Labor to update the rules and requirements that retirement advisors put the best interests of their clients above their own financial interests. It's a very simple principle: You want to give financial advice, you've got to put your client's interests first. You can't have a conflict of interest. And this is especially important for middle-class families, who can't afford to lose even a penny of the hard-earned savings that they've put away. These folks aren't asking for any special help or special consideration. They just want to be treated with fairness and respect. And that's what this new rule would do. And for outstanding advisors out there, it levels the playing field so that they can do what they know is the right thing to do -- putting their clients first."
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