In March, the Fifth Circuit Court of Appeals killed the Obama administration’s “fiduciary rule,” a prime example of the “bureaucrats know best” type of regulation that tries to override individual choice. The rule was based on the false premise that most holders of 401(k) and individual retirement accounts (IRAs) lacked the ability, in the regulators’ words in the proposed regulation, to “prudently manage retirement assets on their own” and “distinguish … good investment results from bad.”
The rule was also a power grab by the Obama-era Department of Labor (DOL), stretching the limited authority Congress had given the DOL over traditional pensions in the Employee Retirement Income Security Act (ERISA) of 1974 to encompass a broad swath of financial professionals who service 401(k)s and IRAs. The Fifth Circuit rightly threw out this regulation as “arbitrary and capricious,” and the Trump administration did not appeal the ruling. At the time of the ruling, I stated, “Any new fiduciary standard should be issued, as Congress intended, by the Securities and Exchange Commission (SEC) and should preserve and enhance investor choice and access to financial advice.”
The SEC has now proposed its own broker-dealer conduct standard called “Regulation Best Interest.” It mandates that broker-dealers only serve the “best interest” of their customers, as investment advisers registered with the SEC and deemed “fiduciaries” are required to do. Currently, broker-dealers must meet a standard of “suitablility,” meaning that the investments must be suitable for a customer’s income and assets. While the “suitability” standard requires extensive documentation and other compliance measures, it still leaves open a variety of “suitable” options.
In contrast to the Obama DOL, the SEC exercised a degree of care and diligence in drafting these rules, and there are a number of important differences that cut in favor of all concerned. Whereas the DOL rule stretched beyond its reach to include every type of financial professional—including insurance agents and even possibly radio hosts that broadcast financial advice—the SEC proposal appears to be limited to broker-dealers under clearly under its jurisdiction.
The SEC rule also contains none of the DOL’s condescending language about ordinary investors, and states the importance of investor choice. On page 8, the SEC states:
We recognize the benefits of retail investors having access to diverse business models and of preserving investor choice among brokerage services, advisory services, or both. We also believe that retail investors need clear and sufficient information in order to understand the differences and key characteristics of each type of service. Providing this clarity is intended to assist investors in making an informed choice when choosing an investment firm and professional, and type of account to help to ensure they receive services that meet their needs and expectations.
Nevertheless, I am skeptical of any mandate that puts the government in charge of deciding what option is in the “best interest” of an autonomous adult. As SEC Commissioner Hester Peirce asked rhetorically in a recent speech, “Regardless of how nice it sounds, what does ‘best interest’ actually mean?”
To its credit, the SEC rule doesn’t try to define “best interest,” recognizing it will be different in individual circumstances. Still, mandating this as the standard could give SEC bureaucrats the power to punish broker-dealers merely because a recommendation isn’t as good—in the regulator’s eye—as another alternative. Taken literally, the term means that there can only be one right answer for an investor’s needs.
And too often that answer is conflated with “conventional wisdom.” The Obama DOL’s prescriptive “fiduciary” mandate explicitly favored passive index funds that followed the market over actively managed funds. Yet following the market can be a prescription for disaster if there is a fundamental weakness in a certain industry sector—say, the financial sector 10 years ago this month, about a month before it would implode. And since no financial professional has yet been shown to have perfect ability to predict the future, the investing strategy that is really in the best, bottom-line interest of the customer isn’t always known until after the fact.
Also, as Peirce noted, a “best interest” mandate could give investors a false sense of security. “Just as ‘fiduciary’ has been used to lull investors into not asking questions about their financial professional, so ‘best interest’ runs the risk of becoming a term that encourages investors simply to rely on the fact that their best interest is being taken care of,” she said. “If we retain the term, we—as regulators—and you—as advisers and brokers—ought to make an effort to encourage investors to look beyond nice terms to the substance of what their financial professional is doing—or not doing—for them and how much she is charging.”
Indeed, the SEC’s granting of “fiduciary” title to registered investment advisers (RIAs) has been far from bulletproof in preventing scams involving these advisers. For instance, Bernard Madoff, currently serving a 150-year jail sentence for concocting a multi-billion dollar Ponzi scheme, was in fact an SEC-registered investment adviser and fiduciary. It should go without saying that fraud should be swiftly prosecuted whether authorities find it among broker-dealers of RIAs.
The SEC should protect investors from fraud and deception, but not prevent them from making the choice of which type of financial professional they wish to deal with. To its credit, the SEC’s proposed disclosure forms could make it easier for investors to make informed choices. That is, if other red tape is cleared away.
Though not nearly as burdensome and costly as the DOL’s rule would have been to ordinary investors and financial professionals, the SEC’s proposed regulation is also flawed in that it doesn’t find any outdated rules to repeal. Though President Trump’s order for 1-in and 2-out on regulations only applies to executive agencies under his direct control, independent agencies such as the SEC should adhere to the spirit of that directive.
In that vein, if the SEC wants to update disclosures that broker-dealers give to investors, it should get rid of some of the other paperwork it requires brokers to bombard their customers with. Former Republican SEC Commissioner Paul Atkins and former Democratic SEC chair Mary Jo White (appointed by President Obama) have both issued warning about the information overload investors are mandated to receive, and how this volume of paperwork could distract them from the most important info that they need to know.
And needless to say, the SEC should discount any advice it receives to make its rule more like the paternalistic DOL regulation. Limiting investor choice and foreclosing options due to cost is certainly not in Main Street investors’ “best interest.”