Redefining “Suitable” Financial Advice

Posted in Projects

Conflicts of interest in the investment industry

Investing is complicated. The average consumer often lacks the time and expertise to make optimal investing decisions which is why many turn to financial advisors for assistance. However, extensive academic research reveals that the conflict of interest in the financial investment industry costs Americans $17 billion a year, with consumers’ returns averaging 1% lower at the individual level.

When we look closer at this context, we find that advisors are incentivized not to maximize returns for clients, but to steer them toward funds with more expensive fees and commissions. And while investment brokers are required by law to provide “suitable” investment advice, this guideline is defined vaguely.

In 2008, along with researchers Sendhil Mullainathan, Markus Noeth, and Antoinette Schoar, we set out to understand whether this inherent conflict of interest prompts financial advisors to provide investment recommendations based either on their potential to earn commissions for themselves or to yield the highest return for the consumer. To do this, we set up an audit study to review the quality of financial advice provided.

The guidance that financial advisors provided to the people of different income levels, ages, and portfolio sizes that were hired to portray customers did not educate clients or help them overcome their perceptual biases. In fact, the advice given may even have a negative impact on the client’s returns. Actively managed funds (which involve more frequent buying and selling and therefore generate more fee income for advisors) were recommended to almost half of the customers, even for those customers with an already well-diversified index fund—a superior and beneficial option for most people’s needs. Additionally, fees associated with managed funds were routinely downplayed during the meetings, obscuring the advisor’s financial incentive to the customer. By comparison, only 7.5% of financial professionals in the audit encouraged low-fee investment strategies such as index funds. The financial professionals in the audit were not doing anything illegal or violating existing regulations. In fact, their advice could be considered “suitable,” even if it didn’t maximize returns for clients.

It seemed that had the potential to change when a new regulation  introduced by the U.S. Department of Labor became partially effective in June 2017. The fiduciary rule, as it is known, requires a larger group of investment professionals to act as fiduciaries, meaning that they legally must put their customer’s interests first and the firms must disclose any conflicts of interest on their website. While this rule is currently active, and many firms have already changed their internal guidance to advisors in anticipation of full enactment of the rule, the Department of Labor is expected to stop its enforcement at an unspecified future date.

While the fiduciary rule applies only to retirement accounts, its enactment was a step in the right direction. Despite the fiduciary rule’s uncertain fate, it could someday serve as a foundation for additional regulations across different investment accounts to reduce conflicts of interest between financial professionals and customers.