One-Man Think Tank: With even governments abandoning pension plans, investors are being tossed to the fee-hungry wolves

Elizabeth’s note: Regulators sometimes miss the forest for the trees, and that seems to be the case with investor protection. Almost all of regulators’ moves assume a fairly interested, literate population. The truth is that even among the most highly educated people, nobody reads a prospectus. In this piece, Ron Rhoades steps back to look at the forest. Here’s his previous piece, in which he challenges Mary Schapiro to live up to Joe Kennedy’s conversion to decency. One-Man Think Tank: What would Adam Smith say about the fiduciary standard?”

The Ever-More Complex Financial World

We have a problem in America. The world is far more complex for individual investors today than it was just a generation ago. There exist a broader variety of investment products, including many types of pooled and/or hybrid products, employing a broad range of strategies. This explosion of products has hampered the ability of individual investors to sort through the many thousands of investment products to find those very few which best fit within the investor’s portfolios. Furthermore, as such investment vehicles have proliferated, individual investors are challenged to discern an investment product’s true “total fees and costs,” investment characteristics, tax consequences, and risks. Additionally, U.S. tax laws have increasingly become more complex, presenting both opportunities for the wise through proper planning, but also traps for the unwary.

As the sophistication of our capital markets had increased, so has the knowledge gap between individual consumers and financial advisors. Investment theory continues to evolve, with new insights gained from academic research each year. In constructing an investment portfolio today a financial advisor must take into account not only the individual investor’s risk tolerance and investment time horizon, but also the investor’s tax situation (present and future) and risks to which the investor is exposed in other aspects of his or her life.

The Days of Private Pensions … Gone.

As all investment advisers are aware, very few private employers today provide a monthly check in the mailbox of the retiree, with inflation adjustments, for life. Even some state governments, with budget challenges, desire to phase out pension-based systems in favor of defined contribution plans. The result is a tremendous shifting of the burden for providing for one’s financial future – from the trustees of pension systems and squarely upon the ill-prepared shoulders of the average American.

Proper financial planning and investment decision-making are essential to encourage both an increase in household savings and in order to invest those funds more effectively. If people do not make careful, rational decisions about how to provide for their financial security over the course of their lifetimes, then the government will have to step in to save people from the consequences of their poor planning. Not through pensions, but through other means of government support for the elderly in need.

Yet, the reality today is that individual Americans, on their own, can rarely navigate this complex financial world. Hence, it has become ever-more-essential that our fellow citizens turn to others for trusted financial and investment advice.

Protection for Consumers

In the vast majority of the well-regulated capital markets in the world, it is recognized that the imposition of high standards of conduct upon financial intermediaries is necessary to provide protection to consumers from unfair, improper, and fraudulent practices. Such protection fosters confidence in the capital markets by investors, which in turn promotes increased investor participation in efficient capital markets.

Federal securities laws and regulations protect investors largely through requiring the disclosure of information – whether it be of material facts regarding an issuer of a security, or of compensation paid to a financial services intermediaries, or of conflicts of interest which exist as to financial services intermediaries. However, disclosures do not address investors’ difficulties in dealing with the psychological issues of risk aversion, overconfidence, and cognitive dissonance. What we all feared: 'Better’ disclosure yields worse results, according to Yale professor’s study

Moreover, many investors do not enjoy the intended protections of securities laws because disclosures are either inadequate (as to the quality or quantity of information provided), incomprehensible to the individual consumer (in terms of the language or terminology utilized), or deficient in timing (i.e., coming only after the consumer makes a decision). While efforts have been made to formulate disclosures in “plain English,” this may have exacerbated a related problem – one in which individual investors receive a large volume of disclosure documents to the point of being overwhelmed.

The summary prospectus, Form ADV Part 2A and Part 2B, and other recent enhancements to disclosure documents are welcome developments. But reliance upon “better disclosure” is largely misplaced. A huge amount of academic research in recent years leads to the inescapable conclusion that, due to various behavioral biases consumers possess, disclosures are largely ineffective (and seldom will be read). Moreover, few consumers possess the resources to hire knowledgeable monitors in order to observe and report on the conduct of the financial advisor.

Fiduciary Duties Overcome the Inherent Ineffectiveness of Disclosures

Law has evolved to provide different layers of consumer protections. For “arms-length relationships” – law prohibits false representations (fraud). Other laws (such as the ’33 and ’34 Securities Acts) provide increased duties of disclosure upon those in superior positions of knowledge. Still other laws prohibit certain terms from finding their way into a contract. At times the law mandates certain contractual terms, forms for contracts, or even the form of a product.

Yet none of the foregoing protections can prevent one in a vastly superior position of knowledge from using that knowledge to reap often-hidden benefits to himself or herself, when that person is entrusted with other people’s money.

Given the inadequacy of other consumer protections, it is altogether necessary to impose the fiduciary standard of conduct upon those who provide investment advice. The attachment of fiduciary status provides consumers with the ability to trust their financial advisor to act in the consumer’s best interest, not the self-interest of the advisor, as to matters consumers do not fully understand (nor can be expected to understand).

But Should Not Consumers Be “Responsible”?

To accept the premise, advanced by many who oppose the fiduciary standard of conduct, that investors are responsible for understanding what they read and then will act prudently thereafter, it is necessary to conclude that investors are not only armed with timely and adequate disclosure, but also that they possess an ability to understand the disclosures which have been provided to them, both intellectually and unhampered by behavioral biases. However, consumer ability to understand is not only difficult due to the enormous knowledge base required to undertake decisions in dealing with a highly complex financial world, but also due to bounds upon human behavior that limit the extent to which people actually and effectively pursue utility maximization. Individuals possess substantial barriers, resulting from behavioral biases, to the provision of informed consent, even after full disclosure.(1)

Moreover, “not only can marketers who are familiar with behavioral research manipulate consumers by taking advantage of weaknesses in human cognition, but…. competitive pressures almost guarantee that they will do so.” (2) As evidence of the foregoing, many registered representatives, insurance agents, and investment advisers have been trained by consultants to first establish a relationship with a prospective client based upon trust and confidence, long before any discussion of fees or products; such training is commonplace in the securities industry. Indeed, I have received such training – from multiple different practice management and marketing consultants. These consultants are quick to point out the reality that – once a relationship of trust and confidence is accomplished – the “sale” of either the product or the service is then easily accomplished.

The fact is that we should no more expect the vast majority of individual consumers to be able to successfully navigate today’s complex financial world than we would expect them to act as their own attorney or physician.

Who Reaps the Benefits of a Consumer’s Savings?

Study after study has revealed that the average American individual investor today greatly underperforms the indices over the long term. Given the great disparity between the gross returns of the capital markets and the net returns individual investors receive, one must ask – where does the difference land?

Far too great of the returns of the capital markets flow to financial intermediaries, and fail to find their way to the individual investors. Much of this is due to “hidden” fees and costs which individual investors fail to understand – such as brokerage commissions (including soft dollar compensation) for trading of securities within pooled investment vehicles, principal mark-ups and mark-downs, bid-ask spreads, and market impact costs. Additionally, most individual investors are unaware of the substantial compensation broker-dealers receive by way of 12b-1 fees, payment for shelf space, and other forms of third-party compensation not reflected in up-front sales charges.

The way to properly assist investors in navigating today’s complex financial world is through an embrace of the notion of purchaser’s representatives (fiduciaries), who possess the fiduciary duty to keep total fees and costs reasonable for their clients. Financial advisors, armed with knowledge of the “hidden fees and costs” found in many investment products, and bound by a duty to act in the best interests of the client (and not as the representative of the product manufacturer), can and will apply economic pressure on product providers to lower fees and costs.

Ron A. Rhoades, JD, CFP® serves as Chief Compliance Officer and Director of Research for Joseph Capital Management, LLC, a registered investment adviser with offices in New York, North Carolina, Georgia and Florida. This article represents his views only, and not necessarily the views of any organization to which he may be affiliated.