Nick Rossolillo, President, Concinnus Financial
March 3, 2015
On February 23, 2015, President Obama made comments about the “fiduciary standard” while speaking about retirement savings and investments at AARP’s offices in Washington, D.C. The comments were a call on the Department of Labor to draft new laws requiring financial professionals working with retirement assets to put client interests before their own. “Wait,” you may be saying, “How can such a thing be enforced? And how can I tell if my financial professional is working in my best interests?” You are not alone. The debate has been going on for quite some time within the financial industry, and was brought into the public’s awareness especially after the financial crisis.
Why the debate? What is the fiduciary standard? And how can you make informed decisions as an investor and saver?
History of the Fiduciary Standard
In the wake of the Great Depression, a slew of new regulations emerged in an attempt to crack down on sales practices in the financial world. Two such acts, which are relevant to our particular discussion, were the Maloney Act of 1938 (an amendment to the Securities Exchange Act of 1934), and the Investment Advisors Act of 1940.
The Maloney Act established the NASD, which has since morphed into what we now call the Financial Industry Regulatory Authority (or FINRA). Among other duties, FINRA regulates broker-dealers, or individuals or companies who charge a commission to clients for selling stocks, bonds, mutual funds, etc.
The Investment Advisors Act of 1940 authorized the Securities and Exchange Commission (or SEC) to regulate investment advisors. An investment advisor charges a fee (either an hourly rate, a flat annual fee, or a percentage fee based on total account value) to clients rather than a commission.
Ok, are you completely bored yet, or are you still with me? What is the debate about exactly?
Commissions vs. Fees
In the aftermath of the world’s most recent economic crisis, heated debate has surfaced about the charging of commissions versus the charging of a fee. Many financial professionals who charge a commission (are a broker-dealer and are regulated by FINRA) have to reasonably believe that a recommended investment is “suitable” for the client. In contrast, professionals who charge a fee (are an investment advisor and are regulated by the SEC) are held to the “fiduciary standard.” Basically, the fiduciary standard is this:
- Investment advisors must make reasonable investment recommendations independent of outside influences.
- They must always place client’s best interests ahead of their own.
This is not to say that professionals who charge a commission do not follow this standard. However, only investment advisors regulated by the SEC are held to this fiduciary standard by law. At this point you are no doubt asking, “How do I know if my advisor is really acting in my best interests? I don’t read minds.”
The most recent proposal, brought up again on the 23rd of February, would enforce a fiduciary standard on all financial professionals handling retirement assets. This would be done by eliminating commissions and only allowing a fee to be charged for the handling of retirement assets. This would, in theory, eliminate conflicts of interest arising from the high commission investment products many financial companies offer.
Arguments For and Against Commissions-Based Investing
Those in favor of keeping commission based investments argue a few main points:
- Eliminating commissions would reduce the investment options investors have, since some investment types are offered mainly on this basis.
- Over the long-term, paying a commission instead of an ongoing fee is cheaper for clients.
- Enforcing a fiduciary standard will raise costs for financial firms, which will be passed on to clients in the form of higher fees.
There are a few assumptions this argument is making. First is that some investment vehicles only work if they are high cost on the front end (or that a commission is charged and paid). Second is that once a commission is paid, there are no additional client charges that occur within the investment vehicle. Third, an assumption is made that clients will hold, and be encouraged to hold, investments over the long-term, thus not incurring additional commissions.
Arguments For and Against Fee-Based Investing
Those in favor of fee-based standards argue this:
- Conflicts of interest arising from investment products being offered with a higher commission are eliminated.
- Client and financial professional interests are aligned when the financial professional’s pay is tied to investment performance.
- Investment decision making and advice is improved and becomes more objective.
Some of the arguments from the opposite angle arise here as well, specifically the ongoing cost argument. Why would a client interested in buying ‘investment XYZ’ and holding it indefinitely continue paying a fee every year for investment advice they don’t need? Also, a fee-based advisor faces a conflict of interest in that they may not offer other types of products (such as insurance) that is based off of a commission. Obviously, the two sides of the argument are not perfect.
What Can You Do?
Until some concrete decisions are made surrounding the debate, you as an investor have some decisions to make. Start by asking yourself a few questions such as this:
‘How knowledgeable and comfortable am I managing my own investments?’
‘What type of investment am I looking to make?’
‘Do I need financial advice outside of the decision making that goes on inside my investment portfolio?’
‘What exactly am I looking for in a financial professional? Is it product driven (i.e. you are investing for a future need, you currently require income, or you need a specific product like insurance) or relationship driven (you need someone who can answer your financial questions and provide education)?’
Also bear in mind that many professionals have a foot on both sides of the line. As an example, they may offer fee-based investment management but also offer insurance products that pay them a commission. When consulting a financial professional, make sure you know exactly what you are getting from them and how they are going to be paid.
Simply put, do your own homework! Make sure you understand costs, the nature of the costs you are being charged, and what you are getting in return.
Nick Rossolillo is the president and founder of Concinnus Financial, based in Spokane, WA. He works with individuals and small businesses creating personalized investment portfolios and helping with financial planning. To contact Nick, visit www.concinnusfin.com, email him at email@example.com, or call (509) 220-1895.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. Investing in securities is subject to risk and may involve loss of principal.
Over the past couple of months, it seems that my engagement in small talk has been revolving around cheap gas prices. In fact, it seems that I cannot escape the discussion, be it at work, running errands, watching the news, etc. (I realize by writing this post, I am contributing to my problem.) No doubt your experience has been the same. Perhaps you have heard comments like this:
“Can you believe gas is under $2 a gallon again?”
“I filled up my SUV for $25 last week!”
“I’ve been thinking about buying a new SUV myself.”
“My family is planning a cross country road trip this spring break in our new SUV we just purchased.”
Such conversations have typically ended on a comment like, “I wonder how long it will last.” In light of such comments, I wanted to take a moment to re-hash how we got here, some possible expectations going forward, and actions we as consumers and investors can take. (If you are not interested in analysis, skip to the last heading for the short version!)
Oil Supply and Demand
Let’s begin with June of 2014, when oil prices last peaked at over $110 a barrel here in the US. Since then, prices have been down as much as 60%, and the price of gas has followed suit. What is the reason for this dramatic drop?
In simple terms, the price of oil is very sensitive to changes in supply and demand. If you recall from your incredibly interesting and engaging economics professor’s lectures, an increase in supply of ‘product x’ will decrease the price, and a decrease in demand of ‘product x’ will also decrease the price. This relationship between supply and demand is especially dramatic with oil; small changes in supply and demand can have great impacts on price.
An increase in US oil production, a surprise announcement from OPEC in November that they would not cut their production, and an apparent global slowdown in demand have all contributed to the precipitous fall of oil and gas prices since last summer. It seems, then, that the real driver behind the recent fall is a price war. In other words, businesses are vying for dominance in a smaller global market and attempting to push competitors out of the business. Simple enough right?
So… What’s Next?
It can be quite difficult to forecast, in the near term, where commodity prices are headed. As a result, a slew of opinions have surfaced stating that oil is headed as low as $20 a barrel, and others just as adamantly declaring it’s going back up to $100 a barrel. This article is not an attempt to add my voice to the chorus, but what is one to believe at this current juncture?
Let’s consider a few current assumptions:
- According to a November report from Citi’s Ed Morse*, around half of the worldwide drilling projects are losing money at the time of this writing. At the very least, margins are quite tight for many drilling projects. Furthermore, any continued drop in price is likely to push more companies towards operating losses and thus cutting production.
- Oil consumption has been on the rise for a long time. The last 30 years have seen increases in consumption coming largely from the developing world (think China, India, Brazil, Russia, etc). Any disruption in demand from developing countries caused by political and economic issues will likely be short-term. The growth in demand from these regions will no doubt pick up again. Even if demand were to begin to taper, the world is unlikely to cure its dependence on fossil fuels overnight.
- On the other hand, oil prices have been historically quite volatile, with dramatic swings in price that are seemingly unrelated to actual events. Basically, extremes in either direction are often followed by an extreme move the opposite direction. Expect more volatility going forward.
With the unpredictability of oil prices in mind, it seems reasonable to say that even if we see some extra drop in the near future, it is likely to snap back quite quickly. In other words, this is a roller coaster. Surprises will abound. Am I being sufficiently obscure?
Actions We Can Take As Consumers and Investors
The point is this: while it feels uncustomarily good to fill up at the gas station right now, do not be lulled into a false sense of security. The prudent and wise will assume cost savings at the pump to be a short-term bonus, and will use the opportunity to strengthen personal savings and budgets. Others will no doubt get stung when the trend eventually reverses or normalizes, as they take the opportunity to add to their monthly obligations. Come out of this glut stronger than when you entered it.
As an investor, consider putting some money to work in the energy sector. Markets tend to overreact to these little events, leaving plenty of opportunities for those able to keep their wits about them. Make sure to do your due diligence and also consult with your investment advisor when making decisions on this.
Enough said for now on this topic. Enjoy your next visit to your local gas pump!
*Udland, Myles. (2014, November 28). Here Are the Breakeven Oil Prices For Every Drilling Project In the World. Retrieved from http://www.businessinsider.com/citi-breakeven-oil-production-prices-2014-11