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People often turn to professional advisers to help them understand the complexities of personal finance. Unfortunately, advisers don't always act in the best interests of their clients. Like any profession, financial advising has some bad apples that steer customers toward inappropriate products or even engage in outright fraud.
Last year, the Obama administration passed a new regulation designed to deal with this problem by raising the ethical standards that govern the industry. They were particularly concerned that financial advisors were steering clients toward investments that pay the largest commissions, rather than the ones that are in the client's best interest. So Obama's rule would have required advisors to put clients' interests first, a rule that could open them up to lawsuits if they continued to engage in ethically dubious sales tactics.
The new rule was supposed to take effect in April. But now the Wall Street Journal is reporting that Trump is planning to reverse this rule. Trump advisor Gary Cohn says the rule "limits consumer choice."
Cohn says it's "like putting only healthy food on the menu, because unhealthy food tastes good but you still shouldn't eat it because you might die younger."
So to the extent that you find plowing your savings into low-return investments as enjoyable as a plate of french fries, you will enjoy this blow for freedom. But recent research demonstrates the potential downside of reversing Obama's rule. Under current rules, advisers who engage in misconduct aren't necessarily forced out of the industry. Instead, after being fired from their previous firm, they are often able to find jobs at new firms that make it a habit of hiring ethically challenged advisers. And these firms are more likely to be located in areas with a lot of elderly and less-educated workers.
The study suggests that some firms prey on unsophisticated customers
Business school professors Mark Egan, Gregor Matvos, and Amit Seru were able to assemble a huge database containing information about every financial adviser registered to work in the United States over the last decade. The data is drawn from BrokerCheck, a website operated by the Financial Industry Regulatory Authority that allows consumers to check the professional histories of advisers — as well as from other sources.
The researchers found that only about half of financial advisers who engage in misconduct lose their jobs — and of those who do lose their jobs, 44 percent are able to find another job within a year or two.
Why would a firm risk its reputation by rehiring someone with a past record of misconduct? The researchers found that rehiring wasn't common across the board; a subset of shadier firms tended to hire lots of fired advisers, while other firms hired few if any.
Unsurprisingly, firms that hired these unscrupulous advisers tended to be less prestigious and to pay less well. The researchers write that "firms that employ advisers with prior offenses are also less likely to fire advisers for new offenses." In other words, while some firms work hard to hire reputable advisers, others seem to specialize in employing unscrupulous advisers.
The really alarming thing about this is who these firms serve. The firms employing the most unscrupulous advisers were concentrated in states like Florida, Arizona, and California. According to the authors, "counties with a smaller share of college graduates and a larger share of retirees experience more misconduct, and employ more advisers with past misconduct records. Overall, these results suggest that financial misconduct is more prevalent in areas with a less financially sophisticated, older population and less educated individuals."
These less sophisticated investors are in greatest need of good financial advice. But they're also the most vulnerable to an incompetent or unscrupulous adviser steering them into financial products that won't serve their needs.
Fewer advisers wouldn't necessarily be a bad thing
Obama's regulation requires financial advisers to follow the fiduciary rule, a legal standard that means advisers have to always offer advice that's in the best interests of their clients.
Right now, it's completely legal for an adviser to steer clients toward financial products that pay big commissions to the adviser — even if that means that the client will enjoy a lower rate of return on his or her investment. The Labor Department's new rule will require advisers to disclose this kind of conflict of interest and open them up to lawsuits if they took a commission after giving bad advice. So many firms may shift to a model where they charge customers directly rather than taking commissions from mutual fund companies.
Of course, the industry hates this proposal, and a common argument has been that it would result in many middle-class consumers being unable to get financial advice at all. The Trump administration has picked up this banner, suggesting that getting possibly conflicted advice is better than getting no advice at all.
This new study on financial advisers' misconduct suggests two strong counterarguments. For one thing, it makes clear that bad financial advice isn't just useless — it can cost unsophisticated investors tens of thousands of dollars in losses. According to the study, "the median settlement for misconduct is $40,000, and a quarter of damages exceed $120,000."
The study also highlights the fact that the victims of bad financial advice are not random. Unscrupulous financial advisers are concentrated in areas with the most vulnerable populations: the elderly and people without much education.
In short, if you live in a Florida county with a lot of retirees, the Obama rule will probably make it harder to find a financial adviser. You may have to pay for the advice out of your own pocket instead of getting free advice funded by commissions on the investment products you buy. But that's not an argument against higher standards — it's an argument for them. The least sophisticated investors are the ones who can least afford to work with advisers who don't have their best interests at heart.
