Today, we present a guest post written by Jeffrey Frankel, Harpel Professor at Harvard’s Kennedy School of Government, and formerly a member of the White House Council of Economic Advisers. A shorter version appeared on February 21st in Project Syndicate.
Those who favor financial deregulation as well as those who want to increase the level of financial regulation often spend too much time talking about the quantity of regulation and not enough time talking about the quality. It is important to get the details right. The case of the US “fiduciary rule” strongly suggests that President Trump will not get the details right.
Earlier this month, amid the flurry of tweets and executive orders, the new occupant of the White House issued an executive order directing a comprehensive rethinking of the Dodd-Frank financial reform of 2010.
Could Dodd-Frank be improved?
One can imagine various ways to improve the current legislation. The most straightforward would be to restore many of the worthwhile features of the original plan that Republicans have undermined or negated over the last seven years. (Most recently, the House this month voted to repeal a Dodd-Frank provision called “Publish What You Pay,” designed to discourage oil and mining companies from paying bribes abroad. Score one for the natural resource curse.)
In theory, yes, one might attempt the difficult and delicate task of modifying the Volcker Rule to improve the efficiency tradeoff between compliance costs for banks and other financial institutions, on the one hand, and the danger of instability in the system, on the other hand. Some in the business community are acting as if they believe that Trump will get this tradeoff right.
I see no grounds whatsoever for thinking so. In particular, the financial system has been strengthened substantially by such features of Dodd-Frank as higher capital requirements for banks, the establishment of the Consumer Financial Protection Bureau, the designation of Systemically Important Financial Institutions, tough stress tests on banks, and enhanced transparency for derivatives. If they were undermined or reversed, it would raise the odds of a damaging repeat of the 2007-08 financial crisis down the road.
The assault on the fiduciary rule
Even before the review of Dodd-Frank gets going, Trump has gotten financial policy badly wrong. At the same time as issuing the executive order, he also took a step toward canceling the fiduciary rule for financial advisors that is scheduled to go into effect in April. The fiduciary rule says that professional financial advisers, in return for their fees, must put their clients’ interests first when advising them on assets invested through retirement plans (such as Individual Retirement Accounts and 401(k) plans). The motive behind its cancellation could not be to help the average American family, because it would so clearly have the opposite effect — like a number of other Trump policies.
The fiduciary rule was adopted, after extensive review and preparation during the last years of the Obama Administration, for good reason: many investment advisors and brokers have a conflict of interest that incentivizes them not to act in the best interests of their clients. Typically they recommend a stock or bond or fund that is not quite as good as others, but for which the adviser receives a hidden commission or de facto “kickback” for recommending [e.g., because it the firm’s own product]. Many investors don’t realize that the adviser is not legally obligated to do otherwise. The end result is underperformance of the savers’ retirement accounts. They have no recourse when they discover the truth too late, e.g., when they are ready to retire.
What is the main argument against the fiduciary rule, beyond an apparent desire to maximize profits for financial institutions? It is a claim that the rule is a case of government over-reach, because it deprives families of some choices that they would otherwise have. But this argument disregards the reasons that savers seek a financial advisor in the first place.
How do savers approach their investment strategy?
There are, broadly speaking, three approaches to allocating one’s assets. First, if one believes that one has judgment superior to that of the average investor in the marketplace, one can actively choose which individual assets or which actively managed funds to buy and sell. Such investors distill information on their own and have no need for a retirement savings advisor. There is a huge variety of financial assets, products, and funds that they can freely partake of if they wish, especially in the Anglo-American countries. (The category of investors who in fact merit the belief that they have systematically superior judgment consists only of one person, Warren Buffett, so far as I know.)
Second, one can put one’s money in broadly diversified low-cost funds, such as the index funds offered by Vanguard, and leave it there. This is the approach most economists recommend, because it delivers higher returns than the first approach. Most investors who follow the first approach buy and sell too often, eat up a lot of money in cumulative transactions costs, and are unrealistically optimistic about their abilities to pick winners or to time the market. Regardless, under the second approach there is again no need for an advisor, unless one counts the advice one gets from reading a paragraph like this one, which is free. (Recommended allocation shares within the person’s total financial wealth are something like 60% in equities, 30% in bonds, and 10% in money. That last number depends on the individual’s preferences, particularly his or her degree of risk-aversion and the likelihood of needing cash for a major upcoming expense. Within equities, perhaps one-third should be foreign.)
The superior track record of the index funds has gradually attracted more and more investment dollars over the years. Still, many small investors just can’t bring themselves to believe that the second approach is the best they can do, and yet they recognize that they don’t have the time or skills or interest to pursue the first approach. These are the people who seek an investment advisor. They want someone they can talk to about their portfolios, and they want it to be someone they can trust. The word “fiduciary,” like “fidelity,” comes from the Latin for “trust.” The advisor is of little use to them if he or she cannot be trusted to give advice in the investors’ best interests.
Leveling the playing field for ethical financial advisors
Not all financial advisors act contrary to their clients’ interests. Some already apply a fiduciary standard in practice, to earn their clients’ trust, even though the law does not yet require them to do it. Truly ethical advisors tend to want the Obama rule to go into effect in April as planned, because the removal of unscrupulous competitors is good for their business. It is like an auto dealer who favors the laws preventing auto dealers from turning back the odometer on a used car, because he would not do that anyway but knows that some others are not as ethical. How foolish it would be to oppose such laws because they “deprive consumers of their free choice” to buy a used car under fraudulent terms!
It is in the interest of ordinary Americans for the fiduciary rule to go into effect in April as planned. And for the Trump Administration to keep its hands off of other Obama financial reforms as well.
This post written by Jeffrey Frankel.