Does Conflict-Free Advice Exist?
Conflicts of interest naturally occur in business. When any form of compensation is being exchanged for a product or service a conflict could exist.
In the financial services industry, conflicts of interest absolutely exist. When and how the conflict of interest manifests often depends on how the financial professional is compensated.
Most discussion and debate around conflict of interest in the financial services industry seems to surround commissionable product sales when a commission is earned at the time a product is sold. So, what does that look like?
Imagine two seemingly similar products that are designed to provide similar benefits to the intended target audience. From an industry outsider’s perspective, they look identical. However, from an industry insider’s point of view product A clearly has more value for the purchaser, but the compensation is lower than that of the inferior product B. What to do? How does the financial professional proceed?
Do you see the conflict? It exists because there is an incentive (financial in this case) to sell something that is inferior because it pays the seller more. It’s a classic example of a conflict of interest in our financial services industry, and it can manifest with the sale of any commissionable product like annuities, life insurance policies, mutual funds, real-estate investment trusts (REITs), and so on.
Is Anyone Doing Something About It?
Regulators, industry watchdogs, as well as financial services professionals have all made attempts to manage conflicts of interest. However, it’s nearly impossible to eliminate them.
One recent attempt to deal with conflicts of interest in the financial services industry was the Department of Labor’s (DOL) Fiduciary Rule proposed under the Obama administration. Although it was later vacated in the court system, it sparked nationwide awareness to the challenges within our current financial services industry.
Most recently the Securities and Exchange Commission (SEC) created their own rule for dealing with conflicts of interest in financial services. On June 5th 2019 the SEC adopted its new fiduciary standard of conduct affectionately known as Regulation Best Interest. However, many folks in the financial services industry and consumer advocacy groups don’t think it went far enough to protect consumers from unscrupulous sales people.
Many states are also adopting regulation at the state level to curb conflicted advice. They are individually taking it upon themselves to fill in the holes that are believed to have been created with Regulation Best Interest creating a patchwork of regulation across the country.
As you can see, there are attempts to protect consumers from conflicts of interest. Some are better engineered than others. Some are more effective than others. Nevertheless, for the foreseeable future conflicts of interest will continue to exist as long as compensation of any kind is exchanged for products or services.
There are several different camps that seem to have very passionate viewpoints on the subject matter. There are those who make a living selling financial products, and receiving a commission for the sale of those products. Frankly, there are good people in this camp committed to acting in their client’s best interest. They would argue that it is possible to act in your client’s best interest even when you are compensated through commission at the time a sale of product concludes.
Then there’s an opposing camp. The fee-only group who refuses to except compensation in the form of commission. Regardless of the circumstances, they won’t accept commissions on the sale of any product even if that is the only way for their client to access it. For many in this camp it is their belief that the only way to remove conflicts of interest is to except no commission under any circumstance, and be compensated strictly through charging a fee for advice and services rendered.
Is Fee-Only Advice Conflict Free?
It’s much easier to see the clear conflict of interest when talking about those who receive a commission on the sale of financial services products. We know that conflict of interest exists. It’s easy to spot. Whether a financial professional takes steps to manage the conflicts or not, it’s existence is an undeniable fact.
Fee-only advice on the other hand isn’t quite as clear. Many folks would argue that fee-only advice eliminates conflicts of interest, and I suppose it might eliminate conflicts of interest with regard to commissionable product sales. That would be clear.
However, there are conflicts of interest that exist for fee-only advisers. When a spotlight is shined on these conflicts of interest, I think it becomes clear that they exist and must be managed with as much passion and vigor as we would apply to the conflict of interest that arises when a commission is received for the sale of a product.
Fee-only advice tends to come in the form of one of three arrangements. A flat fee charged for advice or service. For example, an advisor might charge a flat fee to produce a comprehensive written retirement plan. Another common way that a fee-only advisor may be compensated would be through an hourly fee. Similar to the way that an attorney might be compensated, the hourly-fee advisor charges an hourly rate and is responsible for keeping track of the time spent on the advice or service rendered and then charging the appropriate hourly rate for the appropriate units of time. Most common however is the practice of billing based on assets under management (AUM), or assets under advisory AUA). Assets under management typically refers to investments that are managed inside of an investment account. Assets under advisory might include assets of the investment accounts, but in addition include real-estate, or other assets held outside of the investment accounts that are being managed. Under either arrangement, assets under management or assets under advisory, a percentage of the value of the assets is billed to the client on a reoccurring basis for advice and services rendered.
Each one of these arrangements has a potential conflict of interest associated with it.
A flat fee advisor who charges a flat fee for producing a comprehensive retirement plan may have little time involved in one plan that is less complicated, and much more time allocated to a plan that is much more complicated. Therefore, the client with the less complicated plan ends up paying the same as somebody that has a more complicated plan.
Advisors charging an hourly fee may have a conflict of interest with regard to the speed at which they finish their work. Perhaps they might be conflicted to spend more time to do a little more research whether necessary or not. Perhaps the advisor might take little bit more time on a project than they might otherwise if they weren’t being paid hourly.
Last but not least, there’s the fee-only advisor who charges a fee based off of assets under management or assets under advisory. This advisor may be disincentivized to make recommendations to clients that might shrink the pool of assets that are billable.
What’s really at stake for the fee-only advisor billing on assets?
Let’s look at an “assets under management” compensation model as an example. It is one of the most common ways that fee-only advisors are compensated in our industry. In order to explore the conflicts of interest that may arise we’ll have to develop a hypothetical story.
Let’s assume for a moment there’s a client with a $1 million portfolio of assets to be managed. It would not be uncommon for an advisor to charge a 1% management fee. Therefore, on a $1 million portfolio, the advisor is going to bill the client $10,000 per year for advice and services rendered.
In the unlikely event that the advisor does a terrible job growing the client’s billable assets beyond $1 million and the client for some reason decides to stay with the advisor for 10 years, the advisor would receive approximately $100,000 of billable services rendered throughout a decade. In reality, if the advisor grew the billable assets over time he would likely receive much more compensation.
Do You Have A Mortgage?
What if the client has a home currently worth $700,000. There’s an outstanding principal balance of $200,000, and the client makes monthly principle and interest payments to the lending institution. Their monthly mortgage payment is in the neighborhood of $2,000. The client asks the advisor, “should I pay off my mortgage?”
Where is the conflict of interest here? If the advisor tells the client to pay off the home it will result in a reduction of the billable assets under management by $200,000. One million of billable assets becomes $800,000 of billable assets. A $10,000 annual income for the advisor becomes an $8,000 annual income. It’s a 20% reduction in the adviser’s annual income on that client if he advises the client to pay off the mortgage. Can you spot the conflict of interest?
There are many pros and cons to either paying off your mortgage or caring a mortgage into retirement. There are many factors to consider and everybody’s circumstances are different. There’s no right or wrong answer that can be applied to everybody across the board. However, you can now see there’s a clear conflict of interest for a fee-only advisor who is being asked by a client as to whether or not they should pay off their mortgage.
Should I Purchasing Lifetime Income Stream to Compliment My Social Security and/or Pension?
Now let’s assume that the same client asks the fee-only advisor about using an annuity to produce an income stream for the rest of his life and that of his spouse. He’s heard that it’s a good way to eliminate the worry of running out of income in retirement. Their household needs $6,000 of monthly income to live off of adjusted for inflation. Their current combined Social Security checks equal $4,000 a month. They are both 66 years old and there’s a 50% chance that one of them will still be alive at age 90.
The market for contractual guaranteed lifetime income, which can only be purchased from an insurance company in the form of an annuity, varies by current interest rates, mortality rates experienced by the issuing insurance company, and product design. There are many different annuity products, and the contractual guarantees vary widely from one to another. They are not all created equally.
However, to keep things simple we’ll pretend that the client can purchase a lifetime income stream backed by the full faith and credit of an “A” rated insurance company for about $400,000. They receive a monthly check of $2,000 per month to complement Social Security benefits for the rest of their lives. If one of them passes away, the monthly income check will continue to be delivered to the surviving spouse. They’ve also chosen a product that guarantees their original deposit will be refunded, less the cumulative payments received, if they were both to pass prior to receiving payments equal to their original purchase premium. No one seems to want to pay for an income stream and then have the insurance company keep everything if they were to die too early.
If the client were to purchase lifetime income annuity, and he and his spouse would no longer have to worry about the additional $2,000 a month coming into the household. However, their $1 million portfolio of assets will shrink by $400,000 used to purchase the annuity. That means only $600,000 would be remaining as billable assets for the advisor. That means the advisor would only have about $6,000 worth of income on an annual basis instead of $10,000. The Advisor ‘s annual income would drop by $4,000 on this client, or 40%. Do you see the conflict?
Should I Delay Social Security and Earn Delayed Retirement Credits?
Let’s throw one more wrinkle into this example. The client then asks about whether or not he as the higher wage earner should delay Social Security benefits and receive delayed retirement credits of 8% per year from age 66 to 70. This would ultimately increase their Social Security benefits for the rest of their life, as well as the Cost of Living Adjustments (COLAs) on those inflated benefits, and the survivor benefit likely to be inherited by his younger spouse. They had attended a workshop and the class instructor made a great case for delaying, and got them thinking about doing this strategy.
In order to fill the gap while they delay his Social Security benefits they will need four years of income at $2,500 per month multiplied by 12 months, and then multiplied by four years. To fill the gap created by delaying his Social Security benefits they need cumulatively $120,000 over 4 years.
The advisor now is faced with potentially removing another $30,000 this year from assets that are billable and potentially as much as $120,000 of billable assets because those dollars really can’t be invested in risky investments because the client needs them over the next four years.
On a $1 million portfolio, if we take out $120,000 and set it aside to gap Social Security while the couple earns delayed retirement credits to boost their Social Security benefit for the remainder of their life that will reduce the billable assets down to $880,000. At a 1% fee, the advisor is collecting $8,800 instead of $10,000 annually. Do you see a conflict of interest there?
The Cost of A Comprehensive Plan To A Fee-Only Advisor
What if we add all that up. In the course of drafting a well written comprehensive written retirement plan we do all three? The client wants to pay off your mortgage. Deduct $200,000 from the $1 million portfolio of billable assets. Then they want to buy the income stream that they cannot live to complement Social Security at a cost of $400,000. We have to subtract that from the remaining $800,000 of billable assets in the portfolio. On top of that, we need to set aside $120,000 to be able to gap Social Security in order to optimize the household Social Security benefits for the remainder of the couple’s lives. All in total $720,000 would be carved off of the $1 million portfolio of billable assets.
Originally destined to be managed at a 1% fee totaling a billable net revenue to the advisor of $10,000 per year, that now drops to $280,000 left to be managed as billable assets, or $2,800 worth of annual revenue to the advisor for advice and services rendered. Even if the advisor increased the fee to 1.5% on the remaining assets, or $4,200 annually, this is a far cry from the $10,000 originally billed on the $1 million billable portfolio. Do you see a conflict of interest for a fee-only advisor?
Clear and Present Conflicts
By now the conflicts of interest for both a commissioned based financial professional and a fee-only advisor should be clear. They do exist, for both. Fee-only advisors are not free from giving conflicted advice. The conflicts faced by a fee-only advisor must be managed with the same vigor and passion as conflicts of interest that arise when commission is paid on the sale of a product.
Most advisers strive to act in their client’s best interest. They strive to improve the lives of the folks they serve, and help guide them to take actions that will benefit them.
However, in business there are conflicts when compensation of any type is received. These conflicts must be openly acknowledged, clearly understood, and candidly dealt with in the most prudent manner possible. No one running a financial services business is completely free from all conflicts of interest, and it is up to the financial professional to do his/her best to manage and disclose them for his or her clients.
"Investment Adviser Representative of and advisory services offered through Royal Fund Management, LLC, a SEC registered investment adviser."