Benjamin P. Edwards is a professor at Barry University School of Law.
Financial advisers no longer use telegrams and pneumatic tubes to execute customer orders, but they charge their customers based on an equally outdated and inefficient model: compensation is based on commissions for individual orders. With changes to the market, the law governing financial advisers should also evolve because their roles have changed.
The need for reform has long been clear. Twenty years ago, a Securities and Exchange Commission task force on compensation recognized that the stockbroker commission structure creates far too many conflicts of interest. Instead of fixing the problem, Congress and financial self-regulators have simply slapped patch after patch on our increasingly outdated Depression-era regulatory infrastructure.
In the current conflict-rich environment, Wall Street gorges itself on the public’s retirement assets. While transaction fees are costs to the public, they’re often juicy paydays for financial advisers. A study by the White House Council of Economic Advisers found that Americans pay approximately $17 billion annually in excess fees because of such conflicts of interest. The high fees mean that the typical saver will run out of retirement money five years earlier than he or she would have with better, more disinterested advice.
Destitute retirees impose costs on everyone, adding pressure on taxpayer-funded public support systems and younger generations. Faced with a do-nothing Congress, the Obama administration turned to the only lever available to protect the public: rulemaking through the administrative process. The Labor Department created a 1,000-plus-page rule that extended fiduciary protections to any advice involving money in retirement accounts.
Anthony Scaramucci, a member of President-elect Donald Trump’s transition team, recently derided the fiduciary rule as a “Federal Babysitter” for your 401(k). He called for the regulation to be scrapped and argued that the free market should decide where to place assets, claiming that “firms putting client interests first thrive organically in a capitalist system.”
This is simply not true. If it were, Wall Street would have an unimpeachable reputation for honesty and integrity because all the liars and cheats would already have been driven out of business. To the contrary, free markets frequently teem with manipulation, exploitation and deception. A market unfettered from regulation leaves market participants able to manipulate ill-informed and excitable humans into making unwise decisions. Specifically, financial advisers regularly receive fat kickbacks for steering trusting clients into expensive, actively managed mutual funds. This practice hurts ordinary investors and contributes to needless complexity and volatility.
If Scaramucci and the Trump team intend to junk the Obama administration’s fiduciary rule, they should consider market-focused solutions. In an article forthcoming in the Ohio State Law Journal, I argue that simply banning commission compensation in connection with personalized investment advice would put market forces to work for consumers. This structure would kill the incentive for financial advisers to pitch lousy products with embedded fees to their clients. While the proposal might sound radical, Australia and Britain have already banned commission compensation linked to investment advice without any significant ill effect. While some might pay a small amount more under such a system, the amount of bias in advice would go down, likely more than offsetting the additional cost with investment gains.
To be sure, Scaramucci and others may worry that banning commission-based compensation might dissuade financial advisers from servicing smaller accounts. This fear is unwarranted. Evidence indicates that assistance from a commission-compensated financial adviser leads to lower-quality asset allocations than simply leaving people to invest on their own. Moreover, a free market with transparent costs for savers from upfront or hourly fees seems likely to function more effectively. Consumers will be more likely to demand quality for their dollars rather than unknowingly parting with them through embedded commissions and fees.
A more honest free market — without a strong incentive for advisers to betray clients — would also create new winners and losers. Asset managers offering active services would likely struggle. Scaramucci’s firm, SkyBridge Capital, markets mutual fund shares to ordinary investors with ongoing 2 percent annual fees. One percent of that high fee (the maximum amount permitted by law) comes from a distribution and service fee, most of which gets returned to the financial advisers and brokerage firms that steered their clients into Scaramucci’s high-fee fund. Under a different system, Scaramucci could keep charging a pricy 2 percent — but he would have to sell his products without paying financial advisers to pitch his funds.
Republicans concerned about excessive regulation and red tape should embrace a clean ban on commission compensation. It might not make investing great again, but it would at least make it fairer for the little guy.