Obama Administration Makes Strong Case for Outlawing “Backdoor Payments” to Financial Advisers

On February 23, US President Barack Obama announced:

“Today, I’m calling on the Department of Labor to update the rules and requirements that retirement advisors put the best interests of their clients above their own financial interests. It’s a very simple principle: You want to give financial advice, you’ve got to put your client’s interests first.  You can’t have a conflict of interest.

Department of Labor officials have denied that commissions will be banned, but Obama’s choice of words (“you can’t have a conflict of interest”) suggests the opposite. The first draft of the new rules will be released in a few months.

Explaining the motivations behind the reforms, Obama cited some very disturbing statistics and academic studies. He also gave a powerful moral argument. Referring to the practice of some fund managers and insurance companies using secret “backdoor payments” to induce financial advisers to recommend their inferior products, he said, “It offends our basic values of honesty and fair play.”

Council of Economic Advisers Publishes a Must-Read Report

On the same day that Obama gave his speech, the White House Council of Economic Advisers (CEA) issued a report, titled, The Effects of Conflicted Investment Advice on Retirement Savings.

The report surveys the academic literature on the topic of conflicted investment advice. The research overwhelming concludes that commissions have a serious corrupting influence on financial advisers and a colossal negative impact on the retirement savings of Americans. The CEA estimates that investors are being bilked out of tens of billions of dollars every year—just in retirement accounts alone.

CEA Debunks the Investment Industry’s Insidious Propaganda

In defense of its deceptive practices, the investment industry never tires of repeating the same ludicrous, self-serving arguments, many of which have no factual or logical basis.

The CEA debunked some of these arguments in its report:

“Some observers have asserted that advising structures using conflicted payments are the only way that savers with lower balances can obtain advice and that without such advice the adequacy of their retirement savings would suffer. This argument, however, falls short in multiple ways and overlooks channels that could provide high-quality, conflict-free advice to moderate-income savers at the same cost as conflicted advising structures.

First, advisers can provide the same quality of advice while receiving non-conflict-based payments as they can when receiving a payment of equal amount based in conflict. The cost of advice depends primarily on the resources necessary to provide it—the adviser’s time, IT infrastructure, and other inputs—rather than the form of the adviser’s compensation. Thus, an adviser receiving payment through non-conflicted structures should be able to provide advice at the same cost as an adviser receiving conflicted payments, as long as the inputs in time and infrastructure are equal. If advisers serving moderate-income Americans can remain profitable regardless of whether they receive conflicted or non-conflicted compensation, one would expect the number of advisers working with lower-balance savers to remain the same regardless of whether conflict-based payment systems remain in use. 

Second, the prevalence of conflicted payments today may actually interfere with low-balance savers’ ability to get advice. Ongoing developments in the financial industry are sharply reducing the cost of advice, but it may be difficult for new entrants providing quality, unconflicted, low-cost advice to compete on price when other advice erroneously appears to be free. Therefore the prevalence of hidden fees and conflicted payments may make it more difficult for low-cost, high-quality alternatives to compete on a level playing field, reducing moderate-income Americans’ available options for inexpensive advice. As just one example, new approaches to advice that exploit technological advances are allowing firms to offer personalized advice at costs well below those of traditional advice.

Finally, savers with modest balances today tend to become savers with larger balances tomorrow. According to the Employee Benefit Research Institute, more than 60 percent of IRA contributors in 2010 contributed in at least one of the next two years and nearly 40 percent contributed in every year from 2010 to 2012 (Copeland 2014). A significant motivator for the services provided to low-balance customers today is likely their potential to become higher balance customers in the future. Financial advisers have strong incentives to work with lower-balance savers regardless of whether using conflicted or non-conflicted payment structures.”

CEA Finds that Mandatory Disclosure of Conflicted Payments Is, by Itself, an Inadequate Solution

Although transparency is desperately needed in the investment industry, the CEA cites academic research that suggests transparency often “backfires” in the case of conflicted payments, resulting in weaker consumer protections and less ethical behavior on the part of financial advisers:

Mandatory Disclosure Is Not a Solution

CEA Concludes Its Report by Highlighting the UK and Australia’s Ban on Conflicted Payments, Implying that this Is the Best Way Forward

After arguing that disclosure of conflicted payments would not effectively reduce exploitation of investors, the CEA introduced some better ideas. The CEA specifically mentioned the United Kingdom and Australia’s ban on conflicted payments:

International Policy Changes to Mitigate Conflicted Advice

US Department of Labor Says, “We Can Fix This”

On Feb. 23, the same day as Obama’s speech, the US Department of Labor released the below video, which summarizes the problem of conflicted investment advice. The video concludes by saying, “We can fix this.”

Coalition of Consumer Groups Petition US Government to End Legalized Corruption on Wall Street

Several organizations, such as the Americans for Financial Reform, the Pension Rights Center, and the Consumer Federation of America, have joined together to support the new reforms being proposed by the Obama administration. The organizations have set up a website, SaveOurRetirement.com, and have created a petition which can be signed HERE.

Petitioning US Government

US Initiative Will Inspire More Countries to Follow

The United States is the most influential country in the world when it comes to finance. If the US implements significant regulatory reforms—such as a ban on conflicted payments—it will put increased pressure on other countries to follow.

Obama’s latest speech and the White House CEA report are undoubtedly already having international influence, simply by raising awareness of the enormous harm caused by conflicted investment advice and the urgent need for reform.

Useful Links

Obama’s Speech on C-SPAN (with Transcript)

Council of Economic Advisers: Report on the Effects of Conflicted Investment Advice

US Department of Labor: Protect Your Savings

US Department of Labor: FAQ on the New Rules

US Consumer Groups for Financial Reform

Petition: Tell Washington to Stand Up to Wall Street

Post-Implementation Review of the United Kingdom’s Ban on Conflicted Payments (1)

Post-Implementation Review of the United Kingdom’s Ban on Conflicted Payments (2)

Information about Australia’s Ban on Conflicted Payments

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