Saturday’s Wall Street Journal carried a column by Jason Zweig, Brokers Win, Investors Lose Key Reform which lamented the loss of a provision in a bill now "oozing" through the Senate that would have made stockbrokers, insurance agents, and certain other financial salesmen into fiduciaries.
On the remote chance that the term fiduciary does not ring any bells, let me explain. Investment advisors and managers, including, for example, mutual fund companies, are fiduciaries. They are required to put their clients’ interests first, which basically means watching over client money as they would their own. Of course, there are limits to this, nobody would expect a mutual fund company to lower fees out of fiduciary responsibility, but by and large this works and consumers get what they expect from the relationship.
At the opposite end of the trust spectrum are ordinary salesmen and the ordinary profit-maximizing companies for which they work. Of course, the great majority of people and firms we do business with fall into this category. We know this and think nothing of it. When the waiter suggests dessert, nobody indignantly objects he is not putting the interests of the diners ahead of that of his employer. Ditto for the salesgirl at the mall who says you look great in those pants. Again, this system works and consumers get what they expect.
Stockbrokers, for several reasons, fall somewhere in the middle. They are not fiduciaries, but are expected to temper their own desire for profit with that of their clients. The legal requirement is that the investments they sell must be "suitable." They need not be the single most ideal investment for each client, but they do need to be at least plausibly appropriate. If this was the rule at the mall, the salesgirl could sell a middle-aged guy a pair of raspberry corduroy pants, but would be breaking the law if she sold him a pair of pink leather shorts.
It would be tempting to say that stockbrokers are held this modestly higher standard because with investing the stakes are so obviously greater than with a pair of pants. But it is not the amount of money involved that makes us expect a little more than ruthless salesmanship from stockbrokers. We expect nothing more from car salesmen and real estate brokers, for example, and they deal in large transactions too.
What makes stockbrokers different than most other salesmen is that selling what is suitable is, generally, in their own interest as well as that of the client. Unless they are incompetent or criminal, their goal is to build a long-term relationship. Successful brokers commonly keep clients for decades and even serve multiple generations of the same family. Selling something that the buyer will soon realize was inappropriate is a poor long-term strategy, even if it is sometimes a profitable short-term one.
This is in contrast to the salesgirl pushing the leather shorts or the real estate broker extolling the virtues of a view of the interstate. Both of these people can reasonably assume that the customer is unlikely to do business with them again whatever happens, so they might as well cash in now.
So we expect stockbrokers to give advice that is at least approximately sound partially because most of them do it anyway. But there is another reason why consumers yearn to have stockbrokers held to a higher standard than other salesmen. Investments are complicated things that are difficult for non-professionals to understand and make decisions about.
Other professions that help ordinary folks navigate technical and arcane fields, such as lawyers, doctors, and accountants, are expected to put their clients interests before their own without exception. And those professions have elaborate rules that govern and help avoid conflicts of interest. But in none of those lines of work are the conflicts as common as they are with stockbrokers.
The reason for that is fairly simple. Lawyers, doctors, and accountants charge by the hour. (Well, lawyers and accountants do. How doctors get paid is a little mysterious, often even to them.) At the margin, these professions have some incentive to advise clients to do something that will result in more business, a lawyer could recommend suing somebody, for example, but in general they do not need to talk their clients into things in order to get paid.
On the other hand, under the traditional and still typical model, stockbrokers need to talk their clients into transactions in order to put food on the table. If the broker will make $1000 if the client buys a certain mutual fund, and nothing if he does not, how candid can we really expect his opinion on that fund to be?
That’s a significant and fundamental conflict of interest that can’t be legislated away by declaring stockbrokers to be fiduciaries. In fact, I think that the conflict is so large that making brokers fiduciaries would put them in an untenable position.
Paying financial advisors via commissions on transactions is widely considered to be an anachronism and there has been a slow, multi-decade movement away from it. Fee based financial planners, who generally charge like lawyers and doctors and who are often legally fiduciaries, have become relatively common in the past generation or so. And some brokerages have started offering accounts with fees based on assets under management rather than transactions.
These are encouraging trends. Perhaps in ten or twenty years most financial advisors will be fiduciaries, with incentives that are closely, if not perfectly, aligned with those of their clients.
In the meantime, we still have quite a few traditional brokers who are essentially salesmen working on commission. Although less than ideal, that ought not to be a crisis that needs fixing. We deal with people who make their living selling stuff every day. In fact, perhaps the worst thing that we could do would be to obscure the nature of that relationship. Relabeling stockbrokers without changing the underlying nature of their incentives introduces the danger that consumers will forget how the broker makes his living. Despite what he says, you may look ridiculous in those pants.