Complex is “bad”?
I was one of the invited speakers at a seniors’ luncheon in Charlotte, North Carolina. The host organization picked one professional from each of several areas of service to seniors. There was a Medicare expert from the government, who was very helpful and clear-speaking. There were two different types of safety experts from local firms, and a well-respected annuity salesperson. After the annuity specialist finished, I was to speak on long-term care strategies, and I rose to prepare the projector. The host asked me to wait for an impromptu speaker, a compliance auditor from the North Carolina Insurance Department.
The auditor promptly derided annuities as a category, proclaiming them complex and inferring that this constituted poor consumer value. From my seat, I heard two couples almost immediately decide on certificates of deposit and balanced mutual funds, respectively. I never got to discover whether they passed on annuities, but I also wonder whether they ran out of income years later, since—for all their good and useful purpose—neither category of products offers guarantees of lifelong income, and one can lose substantial market value. That regulator had actually influenced people he had never met to abandon a whole category of products that they likely needed, at least to the degree that guaranteed income could be matched up to guaranteed-to-pay-out expenses. Yes, there is a way to calculate the minimum one should have in an annuity for this specific purpose, matching guaranteed income to guaranteed-to-incur expenses.
To finish the account of this event: the regulator-speaker caused so much worry with his talk that my own presentation was sabotaged. Half of my talk was on a new type of annuity that doubled as a no-more-premiums long-term care insurance policy. This product, which was new at the time, provides several times one’s deposit in long-term care insurance (LTCI), plus new tax and Medicaid qualification advantages, and can be used for regular income if the owner no longer wants theLTCI. But, presumably because of the regulator’s implication that annuities were bad (he knew nothing of this new type, I discovered later), not a single attendee showed the slightest interest on the response cards.
Did the regulator, or anyone who generalizes implied advice, adversely bias consumers to avoid products that they actually needed? Almost certainly so.
Don’t get me wrong here. Without regulation, disclosures and license standards would not exist to protect consumers from the likes of Chester, discussed earlier. But did the vast amount of regulation over the years protect Frank from Chester, anyway? And is it really the case that we can only trust government to be the regulators, or might industry self—regulation work best? As it happens, in North America, industry self-regulation actually does account for most regulation anyway! Let’s explore how that works and how both government and industry self-regulatory bodies work to help consumers. These are things you must know in order to protect yourself and be on the lookout for the rare but real shyster. After all, it’s not that there are more dishonest or incompetent financial professionals per thousand; rather, the problem is that you rely upon these people for far more weighty decisions than most buying decisions you face. This is why the question of “fiduciary status” has become such an issue today. The Department of Labor has issued a directive making fiduciaries of all individual sellers of and advisors on qualified retirement funds and IRAs. A 2017 Executive Order has required a reexamination of the impact of this upon consumer choice, and that reexamination may result in change or discontinuation of the regulation.
A fiduciary is a person or firm that acts—legally or contractually—in the best interest of another. Legally, fiduciaries are in a position of trust and obligation toward the person they agree to serve and must place that person’s best interests above their own. Some have incorrectly interpreted this to mean that their compensation must be “reasonable” in order to do this, but that standard has not been in American law or regulation until recently because, traditionally, market forces set prices, and fiduciary duties are about care owed once the relationship is formed. There is another reason for compensation not being a part of this: Constitutional law clearly forbids government from setting prices, except to deal with monopolies and national crises. Fiduciary duties grew from the development of the Law of Agency (way back in the Elizabethan days of jolly old England), by which an agent owed fidelity to a principal (a client) in defined weighty matters such as realty representation, legal representation, and any contractual agreement that formally established such a relationship. Of course, fair dealing is a legal obligation of agents to all parties involved, regardless of his or her duty to all. For example, a real estate agent, a financial planner contracted to work for a client, and an attorney cannot lie to others in order to advance the best interest of their client. An agent can also represent two or more opposing parties, provided the agent obtains consent from all clients and takes steps to avoid advantaging one at the other’s disadvantage.
Over time, standards of care have developed to enable agents of investment companies or insurance companies to serve their principals (the company, not consumers) with fairness to the consumer. As noted above, the consumer knowingly allows this by acquiescing to the fact that the broker may not have every investment available to evaluate for a given recommendation or assignment to find “the best” for the client. The broker finds the best available. Why? Would you expect a store that offers food to obligate itself to find the very best green beans and offer only that brand? No. But what is at stake is far more important than a so-so meal versus a fantastic meal. So the standard of care has developed to generally mean two things: (1) The product and actions recommended are as optimized for the particular client as humanly possible, and (2) the best available product is sold. Again, not all brokers have the same product mix, and not all brokers have the same analytical tools and talent pools to optimize a client’s finances.
Different advisory and sales functions are regulated by different organizations. These can overlap because advisors have multiple licenses. Investment Advisor Representatives or IARs (fee-only and fee-and-commission advisors) are prohibited by regulation from giving you testimonials of clients (presumed in the law to be misrepresentations). No kidding. Get to know the human being. State insurance departments do not usually publicize discipline history, but all do answer direct inquiries. So check the website or write to them. State and Canadian provincial insurance departments subscribe to a common disciplinary database, so you need not check with multiple insurance regulatory bodies. If you think there may be a problem, check with the professional’s manager and/or compliance department first. You can also use FINRA.org’s complaint or BrokerCheck function for any concerns about securities and hybrid insurance/securities. Fee-advisory firms and individuals are regulated simultaneously at the federal and state level, depending upon the magnitude of the advisory practice, so check at both levels (search for your state’s corporation commission, then find the “investment advisor” link). The federal site is SEC.gov.
How do you maximize your chances of finding the right professional for your needs? A Certified Financial Planner (CFP) is trained to make the right referrals and to work in your best interest, even if not functioning as a member of a firm with Registered Investment Advisor (RIA) designation, because the CFP code requires it, regardless of any state or federal law. It is best to start with a comprehensive examination, similar in concept to a family physician performing an annual physical. If you find, in working with a CFP, that active management of money is needed, that is the service that requires disclosures in writing of the advisor’s history and specialties. That document is a Form ADV Part II, or a brochure containing the same information. Most people just sign to say they’ve read it, but it is important reading, mainly because it does show specialties, licensing, and education. Being regulated as an investment advisor or as a representative of one is not necessarily about fees. It is about advice given on any of three securities management issues:
- Prescribing the selection of money managers
- Acting as a money manager with discretion to adjust the portfolio
- Prescribing (not merely offering or discussing) a specific asset allocation percentage for specific asset classes of securities (if recommendations are limited to a specific allocation to guaranteed non-securities assets, this is not investment advice requiring registration)
Prescribing an asset allocation means defining specific percentage breakdowns in order to attain a specific target return and minimize volatility associated with that target return, or to maximize likely return for a given upper limit of volatility. These two mathematical procedures result in an “efficient portfolio,” but there are many efficient portfolios one could prescribe. The “secret” is to find the efficient portfolio considering your income draw. That additional constraint changes the math. A good IAR will use Monte Carlo simulations (explained later in this chapter), and an expensive database feeding that modeling, to determine the “efficient portfolio” for you, in order to discover the likelihood of exhausting assets during one’s life. This diagnostic procedure is more complex than even the previously described two ways to prescribe a portfolio, but it is the best way to devise an asset allocation. However the portfolio is allocated, with or without Monte Carlo simulation support, it is one of the three services that triggers the requirement for Investment Advisor Registration.
Registration as an RIA or a representative of one was created back in the 1930s because of the variable valuation nature of securities, including bonds. Hence, recommending the purchase of a variable annuity for which the seller merely suggests options for asset allocation, or recommending fixed interest insurance products and suggesting the allocations for interest calculation methods, does not qualify as investment advice. Stockbrokers do recommend specific securities selection and general asset allocations, but they have an exemption in the law.
Stockbrokers may or may not be Investment Advisor Representatives, as their specialty is to inform you of appropriate securities for your goals and enable you to buy or liquidate them. This may sound like investment advice, but it is exempted because the selection of active managers, rather than merely asset allocation or selection of mutual funds, is the service that an IAR provides. Likewise, an insurance agent may recommend less risk because of some analysis, and suggest that a portion of your portfolio be liquidated and put into products that offer some forms of guarantees, but that does not involve the ongoing active management of a portfolio nor the selection of a money manager; it may seem so, but the insurance agent is really giving general advice as to asset allocation and then touting the merits of managers available for the client to select in a variable annuity or a variable life product.
Is it “bad” if an advisor is not an Investment Advisor Representative? No—it simply means that the services offered do not include active management of securities (keeping in mind the stockbroker exemption) or advising on specific asset allocation by asset class (see the accumulation planning chapter). In fact, the IAR registration merely means that the advisor has passed a test that measures understanding of investment advisor regulations and law and a bit about basic portfolio theory. Some IARs might tout their registration as a qualification. If you read that in an IAR’s literature, then you do have important information: it means the advisor has distorted the meaning of his or her registration, which in turn could indicate that the representative may exaggerate other things, such as product features and benefits. You only need an IAR if there is reason to believe you need active money management. Financial planning is about much more than this.
This excerpt is taken from “The Secrets of Successful Financial Planning: Inside Tips From an Expert,” by Dan Gallagher.
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