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For some time now, consumer advocates have been urging legislators to do more to protect consumers against excessive fees charged by a few rogue financial planners for biased financial planning advice that is often “not in the best interests of their clients”—just so these advisors can rake in higher fees and commissions—in a manner that essentially steals from their clients’ retirement contributions and fills their own pockets. Not good!
After much deliberation with the financial services industry, the Obama Administration enacted new rules on April 6, 2016, to protect more Americans from being ripped off. These rules are controversial, but I think there’s some merit to them because when you’re planning for retirement, your advisor should be focused first on what makes sense for your finances, not theirs.
The new rules are designed to prevent consumers from being steered toward IRAs and other retirement investments with “higher fees or lower returns” that disproportionately benefit the advisors who are recommending or selling them and are against the consumer’s best financial interest. In justifying this new legislation, the White House estimates that such conflicts of interest cost Americans $17 billion a year in lost retirement savings. The White House also estimated that the rules would save a 45-year-old worker with $100,000 in retirement savings about $37,000 over two decades before turning 65. That’s a fair amount of money for one household.
But, on the downside, these rules are fairly complex and complying with them could drive up the cost of investments, making it a bit more difficult for average Americans to get retirement advice. So let’s see how this all plays out over the next few decades.
In the meantime, here are the top five things you need to know about the new rules, which will be phased in over an 8-month period beginning in April 2017:
- Your nest egg takes precedent.
For decades, many investment advisors have been required— under federal law—to put the best interest of their clients first. Such advisors usually earn a flat fee and are known as fiduciaries. But other retirement advisors, such as brokers and insurance agents, have been held to a lower standard and were only required to make sure investments were suitable for their clients, which is a much broader standard and quite open to interpretation. This gave brokers and agents the leeway to recommend investments that provided nice commissions and sometimes benefited the agent’s bottom line even more than the client’s.
These commissions are paid by companies that offer mutual funds or other investments that can have higher fees or lower returns, benefiting the company and harming the client. And this has become a bigger issue as Americans have shifted from pension plans administered by their employer to 401K and other retirement plans that they manage themselves.
So the new rules make all retirement investment advisors into fiduciaries, meaning they must put the client’s best interests above their own.
- The biggest impact will be on IRAs.
While a 401(k) plan is administered by a fiduciary who selects and monitors the investment options available to participants in the plan, such is not the case with IRAs, which can be sold by a host of financial advisors.
The conflict-of-interest is greater with IRAs. IRAs are purchased individually and have higher costs while 401K plans are run by companies that pool the investments of their employees and get better rates. So when you’re with all the other employees in a company-administered 401K, you have more buying power. To mitigate this conflict of interest, the new rules require that advisors who sell or help manage IRAs act as fiduciaries.
- Financial advisors can still accept commissions… with a caveat.
The government has also stipulated that being a fiduciary means an advisor must provide impartial advice in his or her client’s best interest and cannot accept any payments (such as commissions) that would create conflicts of interest.
Even so, there’s a way for advisors to continue receiving commissions from retirement products. Here’s how: Under the new rules, advisors can sign a contract that promises to charge only reasonable compensation, discloses conflicts of interest, and commits to adopting policies to ensure they are acting in their client’s best interests.
But this so-called best interest contract comes with a catch—it allows for class-action lawsuits if violated, rather than the binding arbitration that many financial firms require of clients. While arbitration can be required for individual claims, under the new law, class-action suits must be allowed if a group of people is harmed, which dramatically tilts the balance to a more favorable playing field.
- More financial advisors could switch from commission to upfront fees.
The new regulatory requirements will likely result in a shift from the world of commissions to hourly rates charged by advisors. Fee-only advisors advertise themselves as such and charge a flat, upfront fee for their work, so there is comlete transparency, without any conflict of interest.
As a result, financial advisory businesses will switch to a fee-for-service model from a commission model.
- The rules could make it more difficult for some people to get financial advice.
As the financial industry cautioned, these new rules could shut many Americans out of receiving sound financial advice, especially those in lower income categories. Why? Because upfront fees could be more than $100 per hour, which might be difficult for average Americans to afford. So while fee-only advice has its benefits, the higher cost factor puts it out of reach for many who simply cannot afford those fees.
While there is the potential for conflicts of interest, commission-based advisors don’t require the customer to pay upfront for the service. That’s part of the reason opponents of the rules have argued that retirement investing could become more difficult.
While policymakers should do everything they can to help Americans be more prepared for retirement, they also need to make sure there isn’t too much red tape that makes investing for retirement more difficult. We’ll just have to see how all this plays out.