Tax ID Number ITIN: The Real Cost of the Fiduciary Rule

Increasingly, investors are asking questions of their advisers. Simply put, investors want to know the motivations behind the advice they’re getting. Is the adviser trying to do what’s in the best interests of the client, or trying to sell the client products, or both?

The differences between RIAs, IARs and registered representatives

Many advisers in the U.S. already operate under the fiduciary standard, and have for years. Nothing would change that status under the new law, if enacted. They are licensed as registered investment advisers (RIAs), having passed the Series 65 securities exam. Investment adviser representatives (IARs) work under the supervision of registered investment advisers. RIAs typically work on a fee basis only, but may accept commissions on insurance-based products like life insurance and annuities when fully disclosed.

Registered representatives, on the other hand, owe their first allegiance to a licensed broker dealer. It is important for you as a consumer to be aware that the registered rep is not necessarily acting with a fiduciary duty. They are required to sell products to the consumer that are “suitable” to the customer, although not necessarily in the customer’s best interests. Buyer beware.

The distinctions between fiduciary rules and suitability rules are important to understand, however, the smart consumer will seek both when making large and significant financial decisions. Especially key are decisions related to retirement.

How clients’ ages play a role in fiduciary decisions

Financial choices in retirement have an element of finality due to shortened time horizons. There should be a clear distinction between proper advice for younger working individuals with 20 or more years before retirement, and advice for individuals in the “red zone” — 10 years before retirement and 10 years after.

What may pass as stellar financial advice for a 35-year-old investor contributing to a 401(k), could be disastrous for a recently retired 66-year-old investor who now is taking withdrawals necessary to retire.

The 35-year-old investor may welcome market crashes since he or she will be “buying on the dips,” accumulating more shares, taking advantage of dollar-cost-averaging. The retired person is no longer contributing but rather is withdrawing from the pile. This can lead to “reverse dollar cost averaging,” and selling on the dips.

If severe losses hit a retirement portfolio in the early years after retirement when necessary withdrawals have begun, the fiduciary rule may be of little help to a retiree. The damage has been done.

Adviser bias also comes into play

Although advisers want to be objective, each has a bias based on experience and world view. The retiree may be working with an adviser who is an excellent accumulation specialist, working under the assumption that “the market always comes back.” That fiduciary’s bias may be different from a fiduciary who specializes more in the “decumulation” phase, focusing on fixed-income and preservation strategies.

If the fiduciary rule is all about what is best for the client and customer, adviser bias and client risk tolerance may be more of an issue than how the adviser is compensated.

A hypothetical retiree’s journey following a fiduciary’s advice

Consider Sarah, age 66, who retired in 2007 with $30,000 a year coming in from Social Security but no pension. Her 401(k) rollover totals $300,000. She has monthly expenses of $4,000, including rent for an apartment where she hopes to stay for as many years as possible. Her key financial objective has shifted from accumulation to preservation and income.

Her plan for funding her $48,000 a year in expenses is fairly cut and dried: She starts with her $30,000 income from Social Security, and takes 6% per year in withdrawals from her 401(k) (rolled to an IRA) to make up the $18,000 income gap. The combined $48,000 annual cash flow from these two sources will be tight, but should cover things.

Hopefully, inflation adjustments from Social Security would cover any rent and insurance increases in the future. Sarah has been told by her fee-based adviser that she can be confident. The adviser said she can expect a 6% to 8% return over time from her portfolio, therefore she “should be fine” taking 6%.

Market downturn throws a wrench into the plan

Then 2008 and the market meltdown comes along. She watches her portfolio of mutual funds fall more than 40% from October of 2008 through March of 2009. All the while she continues to withdraw her necessary $18,000 annually.

Her account falls from $300,000 at the beginning of 2007 to $180,000 by the beginning of 2008. Sarah still needs her $18,000 a year. Suddenly, simple math shifts from being her friend to being her adversary. The $18,000 withdrawal is now 10% of her remaining balance, and she still is paying fees to the fiduciary adviser.

Even though rates of return would begin turning around by the summer of 2009, this poor sequence and her ongoing fees serve to put her at a severe disadvantage. She is suddenly in great danger of running out of money at some point during her lifetime if another “2008” comes along.

Although her first adviser — a fiduciary — was not a fan of annuities and was fee-based, an annuity in this situation from a commission-based fiduciary agent would have preserved her $18,000 of income for life. Her income would be guaranteed. The agent would have been compensated by the insurance company, with no deductions to Sarah.

The question for the Department of Labor: Which was the superior fiduciary advice for Sarah — staying in the market, or choosing a guaranteed lifetime annuity with liquidity privileges?