The Fiduciary Rule and Conflict of Interest

The U.S. Fifth Circuit Court of Appeals recently vacated an Obama‐​era rule that applied the “fiduciary rule” to Individual Retirement Account advisers, and struck the final blow to a regulation that has faced legal challenges since President Trump initiated a review of the rule last year. The Court determined that the rule constituted an overreach of the Department of Labor’s authority to regulate employee benefit plans.


Though the rule is now dead, its genesis is in a decades long fight over how financial advisers and brokers are regulated. Advisers who provide financial advice for a fee, but do not sell financial products, are required to recommend the “best” financial product to clients. But brokers who buy and sell stocks and bonds for investors are only required to recommend “suitable” products if their advice is “solely incidental” to their service as a broker. The Department of Labor’s rule would have elevated all professionals who work with retirement plans, including brokers, to the level of a fiduciary.


Supporters of the rule argue that brokers, and other financial professionals working for commissions, have a conflict of interest with their clients. For example, advising clients to purchase investments that yield higher fees and commissions may benefit the broker at the expense of their clients. The rule’s proponents contend that without it investors cannot be sure that their interests align with those of their broker. As the New York Times recently declared, “Retirement investors, you’re back on your own.”


However, in the current issue of Regulation I review a working paper that undermines this perception. In their December 2017 paper “The Misguided Beliefs of Financial Advisors,” economists Juhani T. Linnainmaa, Brian T. Melzer, and Allessandro Previtero analyze trading and portfolio information for advisers and clients in Canada who are not subject to fiduciary duty. If the “conflict‐​of‐​interest” perception of financial advisers is correct, the analysis would show systemic differences between advisers’ accounts and their clients’ accounts.


Instead, the authors found that the advisers personal investments are similar to their clients. Both groups of accounts have net returns that are about 3 percent less than the market. And the advisers actually have less diversified portfolios and pay more in fees for their accounts relative to their clients. In fact, the authors argue that advisers are not steering their clients wrong because of a conflict interest, but instead are simply misguided: contrary to the evidence, advisers believe that active management is a better strategy than passive management.


Perhaps investors should be worried about the advice they receive from financial advisers, but not because they are trying to dupe you. Requiring advisers to provide their clients with the “best” recommendations achieves nothing if the adviser’s own perceptions are misguided.