The American financial services sector is going to thrive under a Trump presidency. The big problem is that the chances are this will come at the expense of savers and investors – like you and me – all around the world.
As the world leader in financial services – for better or for worse – American policies often set the tone for the rest of the world. So Asia isn’t immune to what will likely be an increasingly lenient and looser regulatory environment for financial services.
Already, investors are anticipating that under Trump, banks, insurers and investment firms will enjoy a more benign regulatory environment – and greater profits. Since Trump’s victory in the U.S. elections on November 8, the S&P 500 Financials index is up 18 percent (compared to a rise of 5.8 percent for the index as a whole, and 3.9 percent for the MSCI World index).
Fiduciary versus suitability
Most immediately, the live-and-let-live approach to financial sector regulation in the U.S. means that the “fiduciary rule,” which is set to take effect April 10, 2017, could be delayed, changed or repealed.
The fiduciary rule is designed to bring investment advisors overseeing retirement accounts (but not other investment accounts) under the “fiduciary” umbrella.
A fiduciary is a professional who is legally required to put the interests of the customer first, like a lawyer or doctor. Right now in the U.S. (and similar to Singapore and Hong Kong – see below), most financial advisors are not fiduciaries – that is, they have no legal obligation to put the customer’s interests first.
Although many U.S. investors assume that their investment advisor has a fiduciary responsibility, most investment advisors are governed only by “suitability” rules. The exception to the suitability rules are certain financial planners and registered investment advisors who must adhere to fiduciary standards to keep their planning designation. (If you’re not sure if your advisor has a fiduciary duty, ask.)
The suitability rule implies that a financial advisor has to have some evidence that a particular investment is “suitable” for the client. But the advisor isn’t legally obliged to do what’s best for that client. This means that the advisor can recommend investment products that pay him higher commissions – but may not be in the best interest of the client – if he can show that the product is “suitable” for the client.
The vagueness of “suitability” allows a lot of leeway for investors to be taken advantage of. As a result, they are often sold investments they don’t need or understand because the advisor earns big commissions from selling them.
The “fiduciary rule” that (for now) is set to go into effect in April 2017 aims to eliminate these potential conflicts of interest – but just for retirement accounts. The Obama administration claims that conflicted advice is costing Americans US$17 billion a year. And that annual returns on their retirement savings are 1 percent lower because of conflicted advice.
How advisors get paid
The investment industry disputes these figures, of course. They have also been fighting the new fiduciary regulation. They say it will mean that clients with smaller accounts will end up paying more fees, and receiving limited investment advice.
This is because the fiduciary rule would mean more advisors in the U.S. would switch to a fee-based business model, instead of a commission-based model.
Advisors who rely on commissions make money on transactions – that is, buying and selling. If they sell investment funds, they may charge a fee, and then get paid a trailing commission from the fund company for as long as the client owns the fund. Commissions depend on the size of the trade. Under this system, even smaller clients making smaller investments can get advice at a reasonable cost – if the advisor isn’t “churning” their account by making lots of unnecessary trades.
Under a fee-based model, clients don’t pay commissions, and advisors are usually not paid a trailer fee by fund companies. Instead, the advisor charges a flat annual fee – either as a dollar amount, or as a percentage of the value of the assets he manages.
For instance, a fee-based advisor might charge an annual fee of 1 percent of a customer’s assets. So an advisor who manages $500,000 for a client would earn $5,000 in fees for the year.
But let’s say an advisor aims to earn a minimum of $5,000 a year per client. That would mean a reasonable 1 percent fee for the client with a $500,000 account. But if another client only has a $50,000 portfolio, that would mean his annual fee would (in theory) be a ridiculous 10 percent.
As a result, that smaller client would be cut loose by the advisor, or else he’d get tired of the fees and look elsewhere for advice.
And a November report by CoreData Research, an investment research firm, shows this is probably what will happen. In a survey of 552 U.S. financial advisors, 71 percent said they will stop serving some “mass-market”, or smaller, clients. Sixty-four percent think the rule will negatively impact mass-market investors, and 39 percent feel that financial advice will become too expensive for the majority of investors.
Where will these orphaned investors go? Well, 94 percent of the advisors surveyed believe these clients will turn to robo-advisors.
How the fiduciary rule would affect the industry
At least this is the financial industry’s argument about why the proposed fiduciary rule will harm smaller investors. But the interests of the finance industry aren’t necessarily aligned with those of the small investor.
Instead, the bigger worry for the financial industry is the stricter disclosure rules that would come with retirement accounts under the fiduciary rule. It would mean that the advisor would have to prove that the investment he’s recommending is in the best interests of the client. And he would have to be more up front about the commissions he will earn selling it.
The investment recommendation conversation gets a lot harder when the advisor also has to tell you he will be making hundreds or thousands of dollars selling this investment to you. It would also see the number of investment products that make investment firms a lot of money (but are usually bad for investors) dry up. Both would hurt investment firms’ bottom lines.
The situation in Singapore and Hong Kong
Financial advisors in Singapore and Hong Kong don’t have a fiduciary duty either. But as we’ve explained before, the local regulatory authorities have made some new rules to help reign in rogue brokers and advisors.
The Monetary Authority of Singapore (MAS), Singapore’s financial regulator, announced earlier this year that advisors “need to meet key performance indicators that are not related to sales, such as providing suitable product recommendations and making proper disclosure of material information to customers.”
If they do not make “suitable” recommendations, their commissions can be clawed back. This would mean that if it were proven that the investment product they recommended was not suitable for the client, their commissions would be withheld or taken back. The goal is to make sure advisors’ goals are more in line with their clients’ goals.
Hong Kong’s Securities and Futures Commission (SFC) also made some changes to their rules this year. As of the end of March, advisors have had a contractual obligation to recommend suitable investments.
Before, financial advisors in Hong Kong had a “regulatory duty.” That meant that if the advisor recommended something unsuitable and the client complained, the broker could receive a warning or be disciplined in some other way.
But the main difference now is that if an investor feels his advisor recommended an unsuitable investment, the advisor has broken the contract. This means the advisor and his firm could be forced to pay back money to the client if found guilty. Hong Kong’s regulators are thinking that the best way to keep advisors in line is to hit them in the pocketbook.
The bottom line
What all this means is that investors need to stay informed – about their investments and their advisor’s responsibilities toward them. While some changes have been made in Singapore and Hong Kong, and changes are on the radar in the U.S., none of these governments have made fiduciary duty a legal obligation for advisors.
In the meantime, make sure to keep your advisor on his toes. Ask lots of questions about any recommendation and how much he stands to earn from it. High quality, professional advisors will not hesitate to give you a clear, straightforward answer.
Another way for individual investors to protect themselves is to learn more about finance. One of the key objectives of Truewealth Publishing is to help individual investors help themselves. For example, see our personal finance section, and our investment glossary.
And if you’re ready to step up, click here to become a charter subscriber to our exclusive investment research product, the Asia Alpha Advisory.