The Department of Labor’s proposed fiduciary rule has led to a furious debate over whether low- and middle-income Americans will be deprived of financial advice. Three years ago the U.K. made similar changes affecting the delivery of financial advice, and those changes were studied in detail. I’ll assess what we can learn from the British studies and give my views on additional steps the U.S. should take to improve financial outcomes.
The DOL proposal
The fiduciary rule requires that investment recommendations be in the client’s best interest rather than meeting a weaker standard, such as being “suitable” for a particular client. The DOL proposes expanding ERISA’s fiduciary rules to cover a broader range of retirement advice. Rollovers from 401(k)s and IRAs are a particular area of its focus because today such transactions are rarely covered under fiduciary rules. Advisor compensation is a specific target of the proposed rules, which would prohibit advisors from receiving sales commissions unless the advisor and client both sign a “best interest contract exemption” (BICE). This exemption allows commissions, but requires that advisors’ product recommendation be made “without regard” to compensation.
Many in the financial services industry have argued that the BICE rules are too cumbersome and the effect will be to eliminate commissions and create a shift to fee compensation. They further argue that the demise of commission-based sales will result in the advice business shifting exclusively to upscale clients, and low- and middle-income segments will lose out.
The U.K. approach
In 2006 the United Kingdom’s Financial Services Authority (FSA) established a Retail Distribution Review (RDR) to evaluate how advice was being provided, and at the beginning of 2013 the recommendations of the review were implemented. The biggest change was a banning of advisors receiving commissions, requiring that clients be charged fees. Advisors were also required to make it clear whether they were offering independent advice or restricted advice, i.e., advising on products from a single provider. Finally, the qualifications for practicing as a financial advisor were made more stringent.
Similar to the U.S., concerns were raised that the RDR changes would have an adverse impact on low- and middle-income individuals. The U.K. has now had a few years to assess the effects. It’s still too early to gauge full impacts in the U.K., but the research so far can still provide useful insights. Professor Andrew Clare of London’s Cass Business School has been the principal author of two studies: “The Guidance Gap” and “The Impact of the RDR on UK’s Market for Financial Advice.” Both studies involved interviews with financial industry executives and surveys of financial advisors and individuals.
Findings
The first study found clear evidence that the RDR would increase the “guidance gap,” or the numbers of individuals operating without financial advice but lacking confidence to be do-it-yourself investors. They estimated that 43 million of the 50 million U.K. adults would fall in this guidance gap because of insufficient assets, an unwillingness to pay the level of fees advisors charge and advisors being driven out of the business (higher qualifications, loss of commission charging).
Separate surveys of advisors and individuals showed stark disconnections. Pre-RDR, only 50% of individuals realized that the cost of commissions was passed onto them. There were 29% who thought the advice was free even though they realized advisors received commissions, while 9% thought the advisors were salaried. Only 19% of those individuals currently saving and investing said they would be likely to seek financial advice in the future if charged explicit fees for the advice. The average hourly fee advisors planned to charge in the post-RDR world was £165 ($265), whereas the vast majority of individuals surveyed felt that an appropriate fee would be less than £50 ($80).
Advisors were asked what minimum level of investible assets clients would need to continue to be serviced under RDR, and the median answer was £50,000 to £75,000 ($80,000 to $120,000). The study’s authors estimated that 69% of the U.K.’s adult population have less than £25,000 ($40,000) in investible assets. These U.K. figures are roughly comparable to the U.S. – the 2103 Survey of Consumer Finances (SCF) showed a median value of $50,000 for households in the 50th to 75th net worth percentile.
The second study focused more on advisors in the U.K. There were 40,000 investment advisors registered with the FSA in 2011, and the number has fallen to about 31,000 currently. The study’s authors expect more downsizing based on a supply/demand analysis. Survey results indicated that the average advisor will need to earn £1,500 ($2,400) annually from 150 clients to generate target revenue of £220,000 ($352,000). With an average 1% in fees, the average client will need £150,000 ($240,000), but there aren’t nearly enough clients with this level of wealth to support the advisory business. The authors estimate there are roughly 30 potential clients per advisor rather than the needed 150.
Overall the authors forecast a bifurcation of financial advice in the U.K. Upscale clients will receive improved service from a smaller force of better-qualified and less-conflicted advisors. But an unintended consequence of RDR will be that the guidance gap will expand to 85% of the adult population.
Implications for the U.S.
There has been much debate in the U.S. about the potential impact of the DOL’s fiduciary proposal. The evidence from the U.K. indicates that rules changes that ban commissions (or, in the case of the U.S., discourage their use) will have the unintended consequence of increasing the guidance gap. In both the U.K. and the U.S. we are talking about widening the guidance gap that already exists, not the creation of such a gap.
Those who argue that low- and middle-income clients will be well-served by less-conflicted advisors and willing to pay fees instead of commissions have a weak case. Certainly there is anecdotal evidence of success in providing fee-only planning for the middle market, e.g. The Garrett Planning Network cited by President Obama, but it is highly unlikely that such successes will spread naturally to provide broad-based coverage.
This leaves us a question: What can be done?
Solutions
One way to keep the guidance gap from expanding would be to abandon the DOL fiduciary proposal and keep the advice business operating under today’s standards, or adopt less drastic modifications than DOL proposes. The problem with a “do-nothing” approach is that conflicted advice (where the advisor has incentives that are not aligned with the client’s best interest) costs the public a lot of money. The figure of $17 billion, mostly from high fees and sub-par returns, estimated by Council of Economic Advisors (CEA) was highlighted by President Obama when he spoke earlier this year in favor of the DOL’s fiduciary proposal. It’s worth reading the actual CEA report, where they cite the $17 billion figure, but actually estimate a range of $8.5 billion to $33 billion based on a careful analysis, including a detailed review of 10 different independent research reports. So there is a need to look for ways to do better.
Here are four ways the guidance gap can be reduced, even with adoption of the DOL’s proposal:
Robo-advice – Some have suggested that robo advisors will be able to fill the guidance gap left in the wake of more stringent fiduciary rules. These could either be robo companies operating autonomously or in combination with advisors. Industry thought leader Bob Veres has proposed a model where advisors offer services to the full wealth spectrum of clients but with robo-services for lower wealth clients to keep fees down. People are becoming more and more comfortable dealing with computers (and less trusting when dealing with people) so the robo initiative certainly has potential.
The robo approach may be able to help during a client’s working years while assets are accumulating and the focus will be on the encouraging savings, asset allocation and periodic rebalancing. But de-accumulating after retirement poses a bigger challenge. Besides asset allocation and rebalancing, planning needs to deal with Social Security-claiming strategy, withdrawal plans, the possible use of annuities, how to utilize home equity and planning for potential long-term care. These issues are more important for clients of lesser means than for the upscale clients where the retirement phase is still heavily focused on investment management.
Guidance – The U.K. studies explored the role that “financial guidance” could play – providing people with the information they would need to make decisions on their own. Such guidance could be provided by employers, the finance industry, academic institutions, independent web-based companies or by financial advisors. Development efforts might include government support. Close to 60% of those surveyed in the U.K. said that they would be likely to use such a service.
Although responses were positive in the U.K. survey, there’s always the question of whether guidance will be enough when it comes to important financial decisions. Many people want to be told what to do rather than being given a range of options. There have been fledgling efforts at providing guidance in the U.S. Examples include the Society of Actuaries Retirement Decision Briefs and the Financial Security Project developed by the Center for Retirement Research at Boston College. The federal government has also stepped in with a recently launched HHS website. For guidance to be useful, it needs to be free of sales bias.
A public option – Employees of the federal government have a straightforward way to save for retirement, utilizing the Thrift Savings Plan (TSP), which offers five low-cost index funds, target-date funds and a single-premium immediate annuity (SPIA) option for turning savings into lifetime income. Last year Senator Marco Rubio (R-FL) proposed that the TSP be opened up as an alternative for non-government workers. (This would offer a much more robust approach than the Administration’s myRA rolled out earlier this year.) Making such a low-cost, easy-to-understand retirement program widely available and actively promoted would generate a lot of media attention and social networking discussion, so the public would become much more educated about planning for retirement. Also, having such a program as a benchmark would create healthy competition in the retirement savings business. A big part of the problem with financial literacy is that people are offered such a dizzying array of alternatives. It’s much easier to educate people when they can focus on a small number of alternatives from a trusted source.
States are also beginning to offer “public option” plans for private workers as described in this Wall Street Journal article. However, a strong national program would have a better chance of gaining momentum than an assortment of state initiatives.
Subsidized financial advice – In January 2009, economist Robert Shiller wrote an opinion piece in the New York Times recommending a program to provide government subsidized financial advice. Shiller’s underlying idea was that there are positive externalities (benefits) associated with people making good financial decisions, so it makes sense to “subsidize advice enough so that lower-income people will really buy it.” He proposed that subsidized financial advisors should be regulated to verify qualifications, act in the clients’ best interest (the fiduciary standard), accept only the subsidized hourly fee and never any commissions or kickbacks.
Given all that was happening in the economy in early 2009, Shiller’s proposal didn’t get much attention, but it merits careful consideration and fleshing out of details.
Putting it all together
Picking the best solution from those listed above won’t close the guidance gap--all four proposals are mutually supportive. If we set up a public option that gains widespread acceptance, it would help the robo-approach and advisor-based guidance to be much more focused. Shiller’s subsidy proposal would also fit best with a simplified retirement-savings plan structure so that planning services could be delivered efficiently.
Putting together such a combined structure will not happen automatically. It will require government support to implement the fiduciary standard (and expand beyond retirement accounts), open up the TSP to non-government employees, provide a subsidy for advice and support guidance programs. Such an effort would be big, but not colossal, and will make a huge difference.
Joe Tomlinson, an actuary and financial planner, is managing director of Tomlinson Financial Planning, LLC in Greenville, Maine. His practice focuses on retirement planning. He also does research and writing on financial planning and investment topics.
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