Suitability is Costly

Posted in: Economics, General, Stock Market, Thought of the Week

One of the most fundamental principles in economics is that we are all “self-interested” and will act in ways that will better our lives over time. Let’s consider a very common scenario that will most likely resonate with investors and explain this concept in greater detail.

Assume for a moment that you were at a department store shopping for a pair of jeans and asked a salesperson for assistance as you decided between two options. Both jeans fit and look identical, but one is from Italy and 4x more expensive than the other pair made in the U.S.

More than likely, the sales associate will push you to buy the Italian jeans for the sole reason that the commission is much higher than the cheaper pair. Furthermore, the store will also want the Italian pair sold because their margin on the sale is most likely higher.

Try not to act too surprised but this exact form of salesmanship occurs daily at large brokerages when brokers sell overly expensive products to clients in order to get paid higher commissions.

According to a recent White House report, those Americans who receive conflicted advice, similar to the jeans purchase above, earn approximately 1% lower each year. Although this may sound like a small amount, a percentage point can be incredibly important over a multi-year timespan (especially in low interest rate environments).

Furthermore, an estimated $1.7 trillion of IRA assets are invested in products that provide payments that generate conflict of interest. Therefore, the White House estimates that the aggregate annual cost of conflicted advice is about 1 percent of $1.7 trillion, or $17 billion, each year!

The reason for such a big number is due to the fact that the SEC only requires brokers to sell investment products that are deemed “suitable” for an investor.

The suitability standard states that a broker only needs to check the suitability of a prospective buyer, based primarily upon financial objectives, current income level and age, in order to complete a commissionable sale of a financial product.

In a way, when a broker checks the suitability of a potential buyer, they are measuring how much financial product can be sold, not the needs of the investor. What makes matters worse for investors is that no disclosure of possible conflicts of interest is required.

Hence, most major brokerages encourage their brokers to put their clients into funds run by the brokerages and push other products that brokers receive larger commissions to sell. Simply put, the brokers at these firms are incentivized to put their wallet ahead of their clients’ best interests.

Over the past few months, the SEC has finally made steps to close the loophole by requiring brokers and advisers to uphold a “fiduciary duty.” This move would require brokers to put their clients’ interests above their own, which is ironically what they should already be doing!

Here’s a simple question that you can ask a broker to determine if their interests align with yours. Ask how he/she is paid for services rendered. If he/she receives a commission for each sale of an investment product, then proceed with extreme caution because your interests are no longer aligned with theirs.

If your advisor charges a fee on assets managed, then you know that their incentive is to grow your investment account over time because your interests are aligned. Picking poor investment products that reduces the size of your account will lead to a reduction in their fee.

The bottom line is that conflicted advice is expensive with only the broker assured to profit. While it’s encouraging to see politicians finally addressing these issues, we seriously doubt anything will happen anytime soon that will protect individual investors from these incredibly unethical business practices from Wall Street. Therefore, we strongly urge investors to only work with those advisors who adhere to the fiduciary standard.

Read this week’s Thought of the Week to learn more about the fiduciary standards within the financial industry.

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As an Investment Advisory Representative working in conjunction with Global Financial Private Capital (GFPC) we are provided weekly thoughts on what is happening in the economy and the market. Written by our investment committee at GFPC we find these thoughts to be informative and interesting.