By Patrick Kalbac
Last April, the Department of Labor implemented a new fiduciary rule. The fiduciary rule requires financial advisors to put their client’s interest before their own. This differs from the less stringent suitability standard which only requires that the recommended investment be appropriate for the investor. The fiduciary rule was intended to stop the biased advice that has drained retirement accounts for years. A 2015 study from the White House Council of Economic Advisers reports estimates of annual losses at around $17 billion a year for working and middle class families.
One type of conduct the rule targeted is churning, or excessive trading in order to generate commissions; however, despite regulators’ best efforts to discourage this illegal fee-generating tactic, a new problem has surfaced in the form of reverse churning. Reverse churning is the practice of putting an investor in an advisory or fee-based account which charges either a flat fee or an annual fee (usually around 1-2% of assets in the account), but then does not manage the account in order to earn the fee. In other words, an investor pays an advisor for doing nothing. This is a major concern for the Financial Industry Regulatory Authority (FINRA) and the Securities and Exchange Commission (SEC) as there has been a rise in fee-based accounts over the last decade.
For many investors, fee-based accounts can be beneficial. These account types help to reduce boiler-room tactics and forge better relationships between the investor and the advisor. Customers with fee-based accounts also tend to have access to a wider range of investment options and their accounts tend to be more effectively diversified. Nevertheless, these types of accounts are not appropriate for all investors. Fee-based accounts are more beneficial to those who actively trade and seek financial advice and recommendations. However, for investors that prefer a more passive investment strategy, fee-based accounts might not be the best option. It can create a conflict knowing that advisors are obtaining a fee despite a lack of trading and/or account management. In those cases, it likely would be more beneficial for the investors to sign a best interest contract exemption and put their assets into a traditional brokerage account that requires a commission-fee for each individual trade.
As with all accounts, fee-based accounts need to be monitored and customers need to be aware of the changing market conditions. It is critical that investors understand that there are pros and cons to fee-based accounts. The real benefits are dependent on the individual and the investment strategy that the investor is most comfortable with.