Who's Protecting Investors?

The financial services industry is choosing up sides in an epic battle over what new regulations should be created to protect individual investors. The Securities and Exchange Commission, which has the overall responsibility of protecting investors, has been dithering about offering new rules. And the agency lost much of its credibility in the wake of the Bernard Madoff scandal. So the U.S. Department of Labor (DOL) has stepped in, under its responsibility for protecting retirement plan investors under the ERISA law passed 40 years ago.

A huge re-write of the investor protection rules is now being debated at the department, under the proposed "fiduciary standard rule." It has generated great debate in the industry.
Here are the DOL's key investor protection issues:

Requirement to be a Fiduciary: Current securities industries laws that apply to stockbrokers require only that the salesperson must recommend "suitable" investments for the client. There is no strict definition of the term, except for precedents in previous securities arbitration cases. But a "fiduciary" has far more stringent responsibility.

A fiduciary must put his client's interest before his or her own -- and must fully disclose any conflicts of interest. Thus, while a certain investment offered by a broker might be "suitable," it might not be in the very best interest of the client, and the broker might be motivated by a hefty hidden commission.

The DOL's actual proposal to deal with this issue is a rather twisted sop to the brokerage industry. It creates an exemption for "conflicted advice" -- if the conflict is disclosed and considered to be in the "best interest" of the client! That's not logical, so don't try to make sense out of it. But it does bring up the issue of who would enforce this "best interest" rule.

Prohibition of Broker Commissions on Retirement Account Investments: This issue is widely opposed by the securities industry, as you might imagine. Sellers of annuities, real estate investments and other securities would be required to charge a "fee" that is fully disclosed and can only be a flat percentage of the investment account or a fee based on the adviser's hours. (An exception would be granted for listed securities.)

Prohibition of Advice by Service Providers: Fidelity has publicly commented on the proposed changes, noting that despite the good intentions of the proposal it would completely prohibit them from helping small businesses set up retirement plans for their employees! And it would effectively prohibit their phone representatives from answering questions to those who do not have a signed "contract" for advice. Fidelity says the "best interests" aspect of the rule is unworkable, stating: "Labor's proposal effectively prohibits access to affordable financial help - even when it is in the investor's best interest."

Prohibition of Listed Options in Retirement Accounts: It's hard to imagine the logic of this rule, since options provide investors with the ability to protect their gains and limit their losses in their investment accounts. Sophisticated investors know that they can write call options, taking in premium as insurance against a decline in the stock price. Or investors can choose to risk a smaller amount of money in a stock investment by purchasing a call option to "own" the stock for a limited period of time.

But a portion of the DOL proposal, intended to protect investors against conflicts of interest, would effectively prohibit options transactions. That's because listed options are not included in the "best interest exemption" section of the law as written by the DOL. The Options Clearing Corporation (OCC), which clears $4 billion options contracts each year, is aggressively working to change this provision.

The Regulation Pretzel

The proposed DOL regulations are currently being debated by industry experts, lobbyists and politicians. In the middle of it all, the true interests of the average investor are being twisted and forgotten.

There is big money involved in these changes. When the proposed rule was first unveiled for comment in April 2015, the DOL estimated costs to financial services firms could total between $2.4 billion and $5.7 billion over the next 10 years. But a recent study commissioned by the Financial Services Institute, an industry lobbying group, projects costs could be four times higher than the DOL estimates. And it says costs would hit smaller firms harder, putting many out of business -- and leaving the small investor with fewer sources of advice.

Somewhere between this governmental attempt to protect the small investor and the industry's claims that the cost of the protection would leave the investor more vulnerable lies an important middle ground: honest advice at a reasonable price.

While the financial services industry spends millions lobbying the provisions, the robo-advisers (technology based advice providers) are growing by leaps and bounds -- providing unbiased, low-cost advice to retirement plan investors. Companies like Betterment, Wealthfront, GuidedChoice and NextCapital are attracting a rush of both investment capital and investor accounts.

If this technology moves as fast as Uber did to disrupt the taxi industry, or Amazon did to disrupt the department store industry, or Quicken Loans and Guaranteed Rate did to disrupt the mortgage industry, the securities industry will have little left to squabble over. And that's The Savage Truth.