This is a story about what the Department of Labor’s (DOL) Fiduciary Rule and the book Freakonomics have in common. As it turns out, it’s quite a lot.
Freakonomics, published in 2005, was both entertaining and surprising because it upended some of our beliefs about how people conduct themselves. The authors, Steven D. Levitt, a Ph.D. economist at University of Chicago and Stephen Dubner, an American journalist, demonstrated that economics is really all about the study of incentives.
Incentives are also at the core of why every investor should prefer an advisor who is a fiduciary. The DOL rule (currently on hold until June 2017 at least) would hold brokers and advisors who work with IRAs, 401(k), and other tax-advantaged retirement savings plans to a fiduciary standard. In other words, advisors must work in the best interest of their clients and generally avoid conflicts of interest; when conflicts exist, they must explicitly be disclosed.
Brokers, insurance agents and fee-based advisors receive significant amounts of their compensation from sources other than their clients’ fees. Could these outside sources of compensation prove to be incentives – consciously or subconsciously?
Freakonomics chronicled the impact that incentives have on many common economic transactions. Here’s an example involving realtors.
You hire a realtor to help you sell your house and you expect them to negotiate for the highest price. But Levitt’s study of the data showed that the realtor’s focus is more on reaching a faster deal than pushing for a higher price. Realtors make more money by selling more homes, not by getting an extra 3% on the price of your home.
The underlying incentive may not be obvious at first. But once you hear it and absorb it, it makes sense. Nevertheless, most of us still hire a realtor expecting them to get us the best price.
Critics claim Levitt and Dubner wander away from economics and into sociology. Daniel Kahneman, a Ph.D. psychologist also wandered outside his field when he won the Nobel prize in economics. His work in behavioral economics showed the impact that emotions and psychology (and incentives) have on financial and economic decisions.
Sometimes incentives are carrots: Do this and you’ll get free coffee.
Does anyone doubt that Starbucks offers us incentives to join their rewards program because they know they’ll get more business from us?
Free coffee for your birthday! Free coffee when you earn 125 points!
But in the meantime, we are prompted by the app to visit more often than we would have otherwise.
Sometime incentives are sticks: Do this or lose the promotion.
In September 2016, we learned that Wells Fargo employees had opened around 2 million unauthorized accounts on behalf of customers, without their knowledge or permission. It was a routine practice at the bank that employees referred to as “sandbagging.” Those employees who had not met the onerous, bank-imposed sales goals were not considered for promotions. In this case, the incentive didn’t work out for around 5,300 employees who were fired, nor for the bank, which paid a $185 million fine. The consumer banking chief of Wells Fargo left because of the scandal, claiming it was a “personal decision to retire after 27 years with the bank.”
While we are often motivated by the incentives around us, being a fiduciary mitigates their lure. The loudest objections to the DOL Fiduciary Rule came from brokerage firms and the insurance industry that employ professionals who are not fiduciaries and who receive the majority of their compensation from selling products.
Brokers are subject to a suitability standard that falls short of being a fiduciary. It requires a broker to make recommendations that are suitable, based on a client’s personal situation. But the standard does not require the advice to be in the client’s best interest.
Financial advice also comes from a myriad of fee-based advisors, insurance representatives and those with industry-designed titles and credentials. They receive a meaningful amount of their compensation from sources other than the client. Fees, commissions, and compensation might be disclosed, but if so, the disclosure is so obfuscated, it is of no value and provides no transparency.
It is often difficult to tell whether a financial advisor is a fiduciary. Here are two ways to find out:
Ask them if they can provide independent certification that they are fiduciaries. RCG has been certified by the Centre for Fiduciary Excellence (CEFEX) since January 2008.
Ask them if they have a Client Bill of Rights or will sign one stating they will act as a fiduciary. An example would be RCG’s Client Bill of Rights.
The DOL Fiduciary Rule may never become law. The issue has been in the national and political news frequently over the past year, but most investors still do not recognize or appreciate the difference. We encourage you to share this information with family and friends so they’ll be on the lookout for these incentives and minimize the chance that they will accept advice that is not in their best interest.
And, while we’re at it, in addition to being a fiduciary, we think it is just as important that your advisor is fee-ONLY and a Certified Financial Planner® professional. Consider it the trifecta standard for wealth advisors. There are enough uncertainties in reaching financial independence. Why add the uncertainty of having a financial advisor who may be rewarded with incentives that are not in your highest interest.
PAST PERFORMANCE IS NO GUARANTEE OF FUTURE RESULTS. This information is for educational purposes only and should not be considered investment advice or an offer of any security for sale.