After a long wait, the Department of Labor has announced it is ready to finalize its fiduciary duty rule as early as this week.  Under this rule, brokers will be considered fiduciaries of their clients, meaning that they will be legally bound to act in their best interests.  The proposed rule has been extremely controversial.  At first blush, it’s difficult to see why.  After all, its proponents argue, don’t you want your broker acting in your best interest?   

But the reality is not so simple.  There is a difference between a broker choosing to act in a client’s best interest and being legally obliged to do so.  And the difference will likely mean that many investors, in particular low- and middle-income investors, will lose out. 

Under existing rules, brokers are bound to a suitability standard.  This means that if they offer you a product it must be suitable for your needs.  If you’re an 80 year old retiree, a fund full of high-risk equities is probably not suitable for you.  But as long as the products are suitable, a broker is free to recommend one fund over another, even if the broker’s reason for making the recommendation is that the recommended fund will provide a better commission, not because it’s a better investment for you.

Since many brokers already put their clients’ interests first, isn’t this just holding everyone to the practices of the best brokers?

No because the rule doesn’t simply change business practices; it changes how the law views brokers.  A fiduciary duty standard is a very high duty of care.  Lawyers, for example, owe a fiduciary duty to their clients, and board members owe a fiduciary duty to their corporations.  There is a well-developed body of law that defines what qualifies as fulfilling a fiduciary duty and most brokers will likely seek out legal counsel for help in understanding what the law means, and how to ensure they are in compliance.  Additionally, holding brokers to a fiduciary duty standard opens the door to litigation.  If the broker deviates from how the law defines adherence to the fiduciary duty standard – or if an unhappy client simply believes that the broker has – the broker now faces the risk of a law suit.

More importantly, the rule will also change the way brokers earn their money.  Most brokers currently made their money through commissions on trades, although they often provide advice and information to their clients as a perk.  To continue using this type of structure under the new rules, brokerage firms would be required to complete and have clients sign new disclosures and paperwork.  Many in the industry have indicated that compliance not be feasible and that they would opt not to continue to use commissions.

Changing this compensation structure is one of the implicit goals of the new rule.  In early 2015, the White House issued a report finding that “conflicted advice” – advice from brokers who were paid through commissions – cost Americans $17 billion in lost retirement savings.  Despite the fact that the analysis supporting this figure has been roundly criticized, it has served as a rallying point for support of the new rule.  What supporters have not addressed, however, is the loss of services the new rule will likely cause, especially for low- and middle-income investors.

While average investors often rely on brokers who work for commissions, wealthy investors often use an investment advisor.  Instead of earning fees for making trades, advisors earn a flat fee, typically a percent of assets under management (one percent is a common rate).  These advisors often qualify as investment advisers under SEC rules and therefore are already held to a fiduciary duty standard.  These advisers face higher compliance costs and litigation risks than brokers, and consequently tend to serve only the wealthy since the fee they earn is worth the cost.  Such a fee structure is unlikely to work for lower net-worth investors, however.  The work involved in managing a portfolio is not much more for a $1 million investment than for a $30,000 investment.  Therefore it is rarely cost-effective for an adviser to take on a client with only $30,000 to invest (which is itself well above average).

Under the new rule, brokers will have no cost-effective way to provide advice to less wealthy investors.  The compliance costs for continuing to use commissions will likely be too expensive, and using a flat fee is inefficient for smaller investments.  Many members of congress from both parties have expressed concern about the impact of the rule on their constituents. 

There is an alternative to broker-provided advice, but many Americans may find it to be a poor substitute.  Many firms have begun using computer algorithms to make investment recommendations.  This algorithms, dubbed “robo-advisors,” use accepted portfolio theory to create appropriate diversification and allocation for investors.  While the investments recommended by the algorithms may not differ from those provided by human brokers, some investors may nonetheless prefer to talk with a real person.  Older Americans in particular may be uncomfortable having a computer make their investment decisions and may prefer the familiarity of speaking with a broker, especially one they may know personally.

None of this is to say that there are not problems with the current system.  Some reports suggest that investors may believe erroneously that anyone who gives them investment advice is already held to a fiduciary duty standard.  The solution, however, is not to implement a new rule that will leave them with reduced access to advice, but simply to provide better information about brokers compensation structures.  The concept of commissions and sales is one that permeates many transactions Americans conduct every day.  From buying a car to buying shoes to choosing a new computer, Americans frequently interact with salespeople, gleaning information from them while retaining proper skepticism given the fact that the salespeople work for commissions.   If any new regulation is needed, a simple disclosure rule, requiring brokers to explain their compensation structure to investors, would go a long way toward solving the problem without reducing average Americans’ options when it comes to receiving needed investment advice.