NEW YORK – A financial-services firestorm has been set off by a controversial proposal advanced by U.S. Secretary of Labor Thomas Perez that would redefine and dramatically limit the commission a financial adviser can charge clients, even regarding advice on mutual fund investments for an IRA or a 401(k).
At the core of the debate is the assertion that the prevailing commission model in the mutual-fund industry induces financial advisers to make self-serving recommendations at the expense of customers, who assume they are receiving unbiased investment advice.
The Obama administration contends many financial advisers are promoting mutual funds that pay them the most rather than funds suitable to the customer’s risk tolerance.
As the debate spills over from the federal courts into executive branch agencies such as the Department of Labor, an innovative, patented decision technology is positioned to fill the gap by establishing objective standards to answer the question at the heart of the controversy: What mutual fund is best for the customer?
Over the past several months, a working relationship has developed between WND and Decision Technology Corporation, an information-technology company headquartered in Troy, Michigan.
The company has developed a patented decision technology custom-designed to address the questions raised by the Obama administration.
Agreements are in place that will enable WND, beginning this fall, to report exclusively the “winners” and “losers” in a variety of mutual fund categories.
The DTC analytic will rank the mutual funds in each category, from the top performer to the worst.
The technology has been successfully utilized for the past decade in its original application, empowering CPAs and attorneys to give to their clients investment advice designed to be “compensation blind.”
The patented DTC technology enables CPAs and lawyers to identify and select on the basis of investment performance the best mutual funds, money managers and even life insurance products that meet a customer’s self-defined investment needs. It operates under a licensing affiliation model created by Consulting Services Support Corporation, or CSSC, of which DTC is a wholly-owned subsidiary.
“The DTC analytic results published by WND starting this fall will cause a firestorm in the mutual fund industry,” Eric Smith, the founder and CEO of DTC, predicts.
Smith is the co-inventor of the DTC analytic with Joseph Simko, the company’s chief technology officer.
“Inevitably, individual mutual funds of some of the largest, best-known and most extensively advertised and promoted mutual fund companies are going to be named as poor performers in the various asset ‘investor suitability’ mutual fund categories that will be reported on,” Smith said.
Smith said it will “soon be obvious to WND readers that many better-performing but lesser well-known mutual funds will be shown to be the winners in investment performance objectively analyzed than many better-known, highly-compensated and heavily-advertised mutual fund alternatives, including some of the bigger names in the mutual fund industry.”
‘Thieves exploiting investors’
For months, Secretary of Labor Perez has been raising in congressional hearings the same issues of mutual fund compensation-induced bias that led Smith and DTC to begin developing their now-patented technology some 10 years ago.
A widely read editorial in the Wall Street Journal published Thursday, “Obama Targets Financial Advisors,” opposed the rule change, saying Perez sees the commission model that brokers and financial advisers have used for decades as “thieves exploiting investors.”
The editorial argued that while Perez maintains “the rule is needed to protect Americans from advisers who are pushing stocks and mutual funds to gain fat commissions,” it would “raise costs and limit choices for people of modest means who need financial advice.”
The Wall Street Journal editorial staff insisted the new rule will kill the commission model financial planners depend upon to service middle-income retirement savers.
Customers “will need to sign a complicated contract before they receive any advice, which some say will make giving financial advice over the phone unworkable,” the Wall Street Journal editorial staff warned
Smith disagrees.
He argued that the patented decision technology his company is taking to market “was specifically designed to score and rank literally thousands of investment managers and mutual funds from ‘best’ to ‘worst’ utilizing customizable, composite blends of objective performance criteria.”
Smith detailed how the new analytic driven by DTC’s decision technology can’t be “gamed” in that it “filters out all undue influence that compensation advantages may exert on the financial planner’s recommendations and ensures that the client investor gets what’s best for him or her and not what’s best for the broker or adviser.”
The technology, he said “ensures that regulatory investor ‘suitability’ standards set by financial services regulators like the Financial Industry Regulatory Authority (FINRA) are met.”
“Regulatory compliance issues involving FINRA suitability requirements are ‘baked into the process’ with the standards set by the DTC decision technology,” Smith said.
In layman’s terms, the DTC technology first requires the user to set a number of “filters” that test an investor’s tolerance for loss. Various classes of mutual funds can be self-defined by investors who determine their own risk tolerance before the analytic scores and ranks mutual funds that fit their criteria.
“Then, for instance, blue-chip mutual funds may fit a retirement customer’s self-defined risk-averse investment criteria,” Smith said. “The DTC sorts out the universe of mutual funds fitting the ‘blue-chip’ criteria, such that for that retirement customer only ‘blue-chip mutual funds’ are scored and ranked from best performing to worst performing.”
Factors such as whether compensation is “front-end loaded” as a sales charge or “back-end loaded” with withdrawal fees are weighed by the decision technology to determine the fund’s performance.
“No fees or pricing considerations escape the DTC decision technology,” he said, “not even the hidden administration and transaction costs many mutual fund companies build into their operating costs to enhance a fund’s profitability to its manufacturer.”
Smith said that if a particular mutual fund with large sales charges and heavy internal administrative and transaction costs performs less well because of those costs, it can be expected to end up lower on the ranking scale.
“The question the DTC decision technology answers is the same question the Department of Labor is asking, namely, ‘What mutual fund is best for the customer?’” he stressed.
Poor financial advice
Perez’s determination to change the rules for financial advisers was apparent in the testimony he gave the House Health, Employment, Labor and Pensions Subcommittee on June 17. Perez told the story of an employee, “Phil,” who was offered a buyout from the company where he had worked for 30 years.
According to Perez, Phil was presented with three choices. He could ignore the offer and keep working; he could take the company’s pension and receive a monthly check of $1,500 for life; or he could take a lump sum of $355,000 – money he had earned.
Phil and his wife brought in a financial planner recommended by the company to help them make the decision.
“But [the financial adviser] didn’t do what was in their best interest,” Perez continued. “Instead, she put Phil’s money in investments that weren’t appropriate for him, and she misled him about how much monthly income he could safely withdraw. Today, Phil and his wife have lost nearly all of their savings.”
The couple lives on a strict budget and shops at thrift stores, Perez said.
“They’re at risk of losing the home they’ve lived in for more than 40 years. They won’t have anything to leave for their kids or grandkids.”
Perez further testified that “the proposed regulatory package would save investors more than $40 billion over 10 years, even if one focuses on just the one subset of transactions that have been the most studied.”
The labor secretary and the Obama administration can look to the Supreme Court to receive support for implementing financial services regulations aimed at taking compensation considerations out of financial planning recommendations made to retirement clients.
Supreme Court disciplines financial planner
As WND reported, a unanimous Supreme Court ruling May 18 in the Tibble v. Edison case, provided Perez with the legal arguments needed to drive a wedge between the compensation that financial advisers receive from fund managers and the investment advice given to pension clients.
The Supreme Court ruled that the individual pensioners in a 401(k) retirement savings plan maintained by their employer, the California-based Edison International, had the right to sue the plan’s trustees. The company had offered six higher-priced retail-class mutual funds as investment options while “materially identical” but lower-priced, institutional-class mutual funds were available.
The Supreme Court ruled that by offering only the higher-priced version of the six mutual funds, the plan trustees had breached a fiduciary duty under the Employee Retirement Income Security Act, ERISA. At the district court level, the trustees defended their actions by claiming that they were simply relying on their investment adviser’s advice. But the judge found the defense insufficient.
The Supreme Court clearly agreed with the conclusion that the investments recommended were “imprudent” because lower-priced, materially equivalent mutual funds were available but not recommended.
“Under trust law, a trustee has a continuing duty to monitor trust investments and remove imprudent ones. This continuing duty exists separate and apart from the trustee’s duty to exercise prudence in selecting investments at the outset,” wrote Justice Stephen Breyer, who delivered the opinion for the unanimous Supreme Court.
The case is also noteworthy in that the Supreme Court extended the responsibility of 401(k) trustees beyond the six-year limitation applied to employers and plan representatives under ERISA. The fiduciaries of the Edison 401(k) plan had picked some of the retail-class mutual fund investment options in 1999, and the case was filed in 2007, more than six years after the mutual funds had been selected.
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