The Fiduciary Rule - A Wolf In Sheep's Clothing (2024)

President Obama's fiduciary rule is set to go into effect June 9. Actually, it goes into partial effect June 9, and into full effect next January. The rule requires financial professionals to act as fiduciaries when managing money individual retirement accounts or 401(k) accounts.

It seems like a commonsense rule. Who wouldn't want their investment advisor to have their best interests at heart? Yet there is a dark side to the fiduciary rule that few are talking about.

The problem is two-fold.

First, fee-only fiduciaries are very expensive and struggle with significant conflicts of interest. Second, on the surface, they don't appear to be expensive or to confront conflicts of interest.

They typically charge about one percent of the money they manage, which doesn't sound like a large sum of money. Given that they must act as fiduciaries, it would seem impossible for a fee-only advisor to have a conflict.

The result is that some consumers blindly walk into a treacherous arrangement. Here's why.

Fee-Only Advisors Have Conflicts of Interest

A fiduciary must put his or her clients' interests first. Given this, it may seem odd that a fiduciary could have a conflict of interest. In the world of investing, however, fiduciary, fee-only advisors wrestle with conflicts.

To understand why we need to follow the money. Fee-only advisors typically charge a fee based on the amount of assets under management. The more money they manage, the more they make. I should note that this compensation structure is not universal. There are some advisors that charge a fixed fee. I interviewed one on my podcast recently, which you can listen to here.

A conflict arises when a client has a choice that would affect the advisor's compensation. Here are two common examples:

• Should the client pay off their mortgage or invest the money with the fee-only advisor;
• Should the client roll over a 401(k) to an IRA managed by the advisor.

It's impossible for a fee-only advisor to give conflict-free advice on these important questions. That's not to say their advice will be bad. It just won't be conflict-free. The same is true, by the way, with a commissioned broker. They cannot offer conflict-free investment advice. That's not to say their advice is bad. It's just not conflict-free.

The problem with fee-only arrangements is that they can appear to be free of conflicts. Fee-only advisors will tout their role as a fiduciary, which is fine to a point. Just be mindful that even fiduciaries in the investment world have conflicts of interest.

Fee-Only Advisors Charge Enormous Fees

A typical fee-only advisor charges one percent of the money he or she manages annually. One percent doesn't seem like a lot. There are cash back credit cards that pay more than that. The loss of even one percent each year, however, once we factor in compounding, is enormous.

Let's look at an example.

We'll assume we invest $1,000 a month during our working years from age 25 to 65. If we earn an 8% return, our $1,000 monthly investment grows to about $3.5 million.

Now let's assume an advisor takes one percent each year. Rather than earning 8%, we earn 7% after the fee is taken out. The result is that our investments grow to just over $2.6 million. That "small" one percent cost us 25% of our wealth, or almost $900,000.

Of course, not all advisors charge one percent. Some charge a lot more than that. Some charge less.

Vanguard, for example, charges just 0.30% for its advisory services. Given enough time, even 30 basis points add up. Using our example above, a 30 basis point fee would still cost us nearly $300,000 over 40 years of investing. For those needing help, however, this is far better than the results of a one percent fee. And that assumes the investment results are the same, which brings me to the next key point.

Fee-Only Advisors Can Be Terrible Investors

Imagine a fee-only advisor invested a client's assets in a total of three index mutual funds. These funds tracked the U.S. stock market, the international stock markets, and the U.S. bond market. The goal was to use low-cost funds that tracked the market as a whole. At some point, the client may start to wonder just why she was paying the advisor 1% or more each year. With such a simple portfolio, she would reason, why doesn't she do it herself and save the fee?

It's a good question. Unfortunately, it's also one that many fee-only advisors have anticipated. Their response to this potential loss of business reveals a very dark side of the fee-only advisory business.

They complicate a client's investment portfolio. Instead of serving their clients well with a few low-cost index funds, the create portfolios with dozens of investments. Many of these investments are expensive, actively managed funds and exotic ETFs.In one case, a listener to my podcast reported that a very well known financial firm had invested $500,000 of his money in 87 different investments. And the firm was acting as a fee-only fiduciary.

To be clear, not all fee-only advisors behave this way. In my experience, however, many advisors place their client's money in far more investments than necessary, many of which are expensive, actively managed funds. They claim either that their approach will beat the market (it won't) or that it will perform better during a bear market (it probably won't, and even if it does, not by much).

The result is an expensive investment portfolio. Between the advisor's fees and the mutual fund fees, total costs can easily top 2%. And all of this can happenwhile they are acting in their client's "best" interests.

It Gets Worse In Retirement

In retirement, the effect of fees and conflicts really hit home. I've seen countless advisors talk clients into rolling over their 401k into an IRA that the advisor manages for one percent or more. Some even employ scare tactics.

I've seen advisors convince unsuspecting retirees to transfer their retirement out of the government's Thrift Savings Plan (TSP) to a high-cost IRA. It breaks my heart.That's not to say that a 401(k) rollover at retirement is always a bad choice. Rather, retirees should seek competent advice from a professional who will not benefit based on the decision a retiree makes.

Here's the problem. The general rule of retirement spending is that a retiree can spend 4% of their investments the first year. After that, they can increase the amount they take out each year by the rate of inflation without a significant risk of running out of money. Any earnings above 4% in a given year remain invested to account for inflation.

Now let's imagine a retiree with $1 million. A 4% withdrawal rate the first year would give them $40,000. The 4% rule, however, doesn't account for advisor fees. If an advisor takes one percent, that leaves the retiree with just $30,000 the first year. The advisor has taken 25% of the retiree's spending money.

The point is not that fee-only advisors are universally bad. Far from it. The point is that the reality of the business model doesn't favor the investor. It favors the advisor. As for the Fiduciary Rule, it appears to solve a problem that, in fact, it doesn't really solve.

As you consider how to manage your investments, keep the following in mind:

• A 1% advisory fee is huge;
• There are fee-only advisors that charge a lot less; and
• Fee-only advisors are not free of conflicts.

Let's be careful out there.