About Those Hidden Fees Investors Pay

The Department of Labor is soon expected to issue its much-ballyhooed, much-anticipated, and, in some circles, much-loathed “fiduciary rule.”

This rule will require brokers who work with retirement accounts to act as, well, fiduciaries -– in other words, to put their clients’ interests ahead of their own. (Registered investment advisers are already held to a fiduciary standard.)

What could be simpler or less objectionable?

Yet brokers have fought the DOL’s fiduciary rule since it was first proposed last April. The rule is a small part of a larger sea change underway in financial services that will ultimately improve the quality and reduce the cost of investment advice, and brokers who are attempting to buck the trend will end up on the losing side of history.

How we got here is instructive. According to the DOL, its fiduciary rule is primarily for the benefit of middle-class and working-class investors. Why those folks in particular? Their retirement accounts tend to be smaller and therefore well suited to mutual funds, and with just one mutual fund a modest retirement account can be transformed into a diversified portfolio of hundreds of stocks and/or bonds.

There’s just one dirty little secret at work here: Some mutual fund companies pay brokers a fee for selling their mutual funds to investors. Brokers aren’t required to disclose these fees, so, surprise, surprise, they don’t. Investors are left with the impression that brokers are recommending the best funds, when in reality brokers are likely pushing funds that pay them a fee.

This isn’t just a harmless sleight of hand. The DOL estimates that these pay-to-play fees cost investors roughly 1 percent annually in forgone investment returns. This performance drag is a two-headed monster. For starters, the funds that pay these fees are generally more expensive than those that don’t. Someone has to pay for the fees to brokers and that someone, of course, is the investor.

Wait, it gets better. Part of the fee is an annual commission that is paid to the broker for as long as the investor owns the fund. So not only are brokers incented to recommend unnecessarily expensive funds to begin with, but they are then incented to keep investors in those funds for as long as possible so they can keep their fee stream flowing.

Brokers would no doubt protest that these hidden fees don’t influence their investment recommendations. Maybe so, but there is overwhelming evidence that expensive, actively-managed mutual funds favored by brokers are highly likely to underperform low-cost index funds. In just the latest in a long string of unflattering results, S&P’s biannual SPIVA U.S. Scorecard reports that as of December 2015, 82 percent of large-cap mutual fund managers, 88 percent of mid-cap managers, and 88 percent of small-cap managers underperformed their benchmarks over the last ten years.

Given these odds, why would anyone recommend expensive actively-managed mutual funds? Ah, yes, pay-to-play fees.

This is a suboptimal state of affairs in any context, but even more so when investors’ retirement funds are at stake. Brokers could have forestalled the coming fiduciary rule by voluntarily disclosing pay-to-play fees to investors or — better yet — ending the practice altogether. But brokers clearly have no intention of doing either one of those things.

Instead, brokers have been content to push back with old-fashioned fear mongering. The fiduciary rule, they argue, will leave retirement investors worse off because brokers will either: 1) stop providing retirement advice to middle-class and working-class investors, or 2) charge investors higher fees for retirement advice to compensate for the greater burden imposed by the rule.

That’s a false dilemma, my friends. There are already many financial companies that provide fiduciary retirement services with little or no investment minimums for a fraction of the cost of a high-priced, actively-managed mutual fund — and more are coming to market all the time. They include discount brokerages, investor-friendly mutual fund companies such as Vanguard, and online financial advisers known as robo-advisers.

That development alone should be a wake-up call for traditional brokerage firms. There is a new generation of financial companies that already lives up to the DOL’s proposed standard. Moreover, they all are eager to efficiently and effectively serve the investors who traditional brokerages appear to be so cavalierly gouging or waving away.

Source: Bloomberg Gadfly, https://bloom.bg/2zYapDv