W. Scott Simon
As noted in last month’s column, the new fiduciary rule promulgated in April by the U.S. Department of Labor (DOL) runs 1,023 pages in length. All the commentary that I’ve read over the last two months about that rule may be approaching the word output generated by the DOL in its issuance of the rule itself. I’m hopeful that next month I’ll be able to offer some useful observations about the new rule that likely will take effect before we know it.
In the meantime, something crossed my desk recently that caught my eye for its egregiousness. What made me really stop and pause, however, was the question of whether this kind of abuse would still be allowed to continue under the new DOL fiduciary rule or whether such behavior and practices will eventually go by the wayside.
What caught my attention was the case of new clients–a married couple–retained by our registered investment advisory firm. Theirs is a sad story that has been brought to us courtesy of their financial advisor. The names have been changed to protect the innocent (and the guilty, given that this is a family-oriented column).
Henrik Stanislaus is a decent, hard-working family man. He is 67 years old and, with his wife Wilhelmina, owns a small family-operated business employing six family- member employees and three others.
In 2015, Mr. and Mrs. Stanislaus generated income of $475,000 on which they paid $120,000 in taxes. The couple has about $1.5 million in investments, not including owning (free and clear) the commercial building their business occupies. Their business pays rent to them for the use of this building. The couple has no plans to sell their business or retire, but they don’t want to significantly expand the business, either. They own their home free and clear, a vacation home, as well as some raw land valued at about $750,000. They would now like to re-establish a company retirement plan primarily for tax deferral purposes. So they require some retirement planning.
In 2010, the couple’s company had a 401(k) plan, but they shut it down on the advice of their advisor. Mr. and Mrs. Stanislaus had $1.382 million of investable assets. They needed some planning done in this area as well which includes reducing their tax bill as much as legally possible. They turned to their “financial advisor” (more exactly, a hybrid registered investment advisor/registered representative and more colloquially, an insurance agent/broker) who proceeded to advise them to shut down the company retirement plan and invest the couple’s money in four annuities (two variable and two indexed) and one account managed by the broker in five individual retirement accounts (IRA).
The period involved here (nearly six years from June 2010 to March 2016) exhibited very strong growth in financial markets. In fact, the S&P 500 Index more than doubled in value, but unfortunately, the five accounts were unable to share in the healthy returns provided by world financial markets during this period. In fact, each account significantly underperformed market averages. Perhaps it was because the advisor had created a conservative asset allocation due to the couple’s age and relative success at saving money and paying off their debts.
However, the asset allocations of the various IRA accounts invested in by the couple ranged from 80% to 100% in stocks. The two X variable annuity accounts are linked to a 100% allocation to stocks while the two Y indexed annuity accounts have an 80% allocation to stocks. The managed account has a 91% allocation to stocks.
In the nearly six-year period when the S&P 500 Index returned a total of 114%–in comparison (1) the two X variable annuity accounts invested 100% in stocks returned only 14% and 16%, (2) the managed account invested 90% in stocks returned a staggering -3%, and (3) the two Y indexed annuity accounts invested 80% in stocks returned only 27% and 31%. The suboptimal returns earned by the five accounts reveal fundamentally shocking disconnects from the returns readily provided by financial markets.
In summary, the couple invested $1.382 million in May 2010 with this unnamed financial advisor. Since then, the market–with the S&P 500 Index representing the “market” since the great bulk of the total assets in this case are pegged to the S&P 500–has doubled in value. In comparison, the investment returns of this couple in these five accounts have been, in a word, abysmal. Had the accounts grown in value in the same amount as their market benchmarks, this couple’s accounts would have grown to nearly $2.8 million instead of only $1.5 million.
The financial advisor here maneuvered the couple into missing out on the doubling in value of their accounts. The annuity companies did outperform their advisor, who actually lost money for his clients while managing one of the accounts over the nearly six-year period in question. By the way, the asset allocation of the managed account the advisor implemented was 91% in stocks. This for a couple entering their late 60s.
Why did this scenario produce such a terrible outcome when there was such a bull market in stocks? Mr. and Mrs. Stanislaus said that they had been lured into these insurance products based on the marketing promises offered by their financial advisor. The allure of participating in upward movements in the stock market–while avoiding losses–is a powerful inducement in purchasing insurance products like those at hand here.
In reality, though, the couple’s annuities in this situation not only limited their downside but less obviously–based on the written marketing materials involved as well as the oral representations made by the financial advisor, which is where virtually all such sales are clinched (i.e., the ear is much more powerful than they eye)–were the significant limits and conditions on the upside. The fine print in annuity contracts clearly spells out the details of the downside but equally clearly, purchasers of such products are simply not qualified to read them and knowingly understand them. They need a true fiduciary on their side who will protect them to do that. This leaves purchasers at the mercy of insurance agents–with powerful financial motivations but no fiduciary duty–to explain the disclosures to them and their myriad ramifications thereof.
In this case, disclosures were not enough to save the couple from the lure of false non- fiduciary promises, high fees, and terrible advice. Will the new fiduciary rule promulgated by the DOL do a better job? Only time will tell.
W. Scott Simon is an expert on the Uniform Prudent Investor Act, Restatement (Third) of Trusts and Title I of ERISA. He provides services as a consultant and expert witness on fiduciary investment issues in depositions, arbitrations and trials as well as in written opinions. Simon is the author of two books including The Prudent Investor Act: A Guide to Understanding. He is a member of the State Bar of California, a Certified Financial Planner® and an Accredited Investment Fiduciary Analyst™. Simon received the 2012 Tamar Frankel Fiduciary of the Year Award for his “contributions to advancing the vital role of the fiduciary standard to investors, capital markets and to society.” The author’s views expressed in this article do not necessarily reflect the views of Morningstar.