On Your Own: Investing in An Era of Irrelevant Regulation
Speech by Edward Siedle at Sage Advisory Services "Perspectives on the Future" conference, Austin, Texas, September 2009.
Since the 1980s the financial services industry has experienced explosive growth. Over the decades dealing with brokers, money managers and other financial advisers ceased to be limited to the wealthy few. As a result of shifting responsibility for retirement planning onto workers and financial product innovation, virtually all Americans (and foreign investors for that matter) that had accumulated any degree of wealth turned to financial services firms for expert, independent investment advice and investment products.
As banks and boring CDs were left behind, brokerages and registered investment advisers proliferated.
1. For decades, the advice investors got from Wall Street was hardly independent and the products marketed were generally high cost, as well as poor performing. This massive transfer of assets to brokers and money managers was good for them; not so good for investors.
The investigations my firm has undertaken on behalf of institutional investors over the years reveal that when you scrutinize financial products and services and identify conflicts of interest and hidden financial dealings, you can predict poor performance. We've investigated investment consultants; 401k, 403b and 457 defined contribution plans; variable annuities; hedge funds and funds of funds and funds of funds of funds. Our investigations reveal that:
2. The harm to investors that resulted from Wall Street's products and services was both foreseeable and preventable.
Less transparency, greater conflicts, results in poorer performance. This should come as no surprise.
Here's the irony of where we are today:
3. In 2009, investors bailed out the very firms that profited for decades providing conflicted or bad advice to Americans on how to invest.
In 2009 hard-working, financially unsophisticated Americans provided financial assistance to the very same highly compensated, financially sophisticated people they had relied upon for decades for advice!
I would submit that when your trusted financial advisor comes to you to borrow money on the brink of bankruptcy, this should be a wake-up call. It's time to closely review the advice this so-called "expert" been giving you over the years.
Many of the most commonplace products Wall Street firms foisted upon the American public over the decades caused devastation. For many Wall Street professionals, their worst financial troubles may be behind them. They have survived and the money they gambled and lost has been replenished by taxpayers.
4. We can debate whether the government bailout of Wall Street was right or wrong; however, there is no question that there will be no massive bail-out of taxpayers. Taxpayers will carry the scars of the financial industry's excesses and regulatory failures for some time to come. Residential real estate and 401k accounts that have fallen 50% in value will not recover quickly. Any taxpayer recovery will likely take a decade.
For older Americans and the nation's millions of aging Baby Boomers, the situation is grave. Those who can continue to work will do so; some will delay retirement and others may never be able to retire. Those who are sick or can't find work or health insurance may join the ranks of the elderly poor.
5. We have just experienced the cruelest blow or breach of trust dealt a generation since the Great Depression. Again, most of this was foreseeable and preventable.
What will happen next?
6. Wall Street will seek to re-invent itself.
You can see it happening already. Wall Street will come up with new products and services to convince investors to hand over their money for "better advice."
One firm has taken out ads saying, "You've re-thought wealth management ... so have we." Of course what's left unsaid is that the firm had it wrong before.
The industry will say, "This time you can trust us" or "This time we'll treat you better-we'll agree to a higher standard now-a fiduciary standard instead of suitability."
Whether Wall Street's new sales pitches will succeed or not, I don't know.
The greatest obstacle Wall Street must overcome is its horrific track record. Investors have been burned and want to see change. Change or the illusion of change is required at this time.
7. Investors want "change." They'll get the "illusion of change."
Some right-wing pundits and financial services insiders are grumbling that the new administration will impose new regulations and come down too hard on Wall Street. That is not about to happen and if you look behind the rhetoric the very opposite seems more likely.
8. Why the SEC has become irrelevant.
In 2006, I was invited by forbes magazine to share my views about why I believed the SEC was on the verge of becoming irrelevant to investors. I opined in the column that in the future investors would have to turn to the private sector for any meaningful protection. I regard the Madoff case, a few years later, as the moment in time when my prediction of SEC irrelevancy was confirmed.
Ironically, this agency founded upon the premise that compelling disclosure is the best means to ensure investor protection, e.g. "sunshine is the best disinfectant," now opposes almost every meaningful effort to enhance disclosure to investors. Now that computers and the internet have accelerated the speed at which information may be provided to investors and the depth of such information, the SEC, siding with industry, has sought to limit the information available to investors to the statutory minimums. For example, 98% of information about the money management industry collected by the SEC is not available to investors.
Leadership at the SEC is a mess. For example, the former head of the brokerage industry's self-regulator, FINRA, is now head of the SEC. Self-regulation is chocked full of inherent conflicts of interest and has proved contrary to investor protection in the brokerage industry.
While it would make a great deal of sense for FINRA to seek to enhance its regulatory credentials by hiring the former head of the SEC, a true regulator, to head-up its operations, it makes no sense for an already discredited SEC to turn over the reins to a conflicted self-regulator. Indeed, FINRA has a history of being sued by the SEC for failing to adequately enforce the securities laws.
At the time of her nomination as Chairman, Schapiro and FINRA were being sued in a class action on behalf of all FINRA members for issuing a misleading proxy statement in connection with the merger of the NASD and NYSE.
My firm is the lead plaintiff in a related case and I can't tell you how ironic it is that I, as a former SEC attorney, am suing Schapiro and FINRA for violating the federal securities laws. When I began my career at the SEC 25 years ago I would never have imagined it.
9. Brokerage industry mandatory arbitration eliminated? Not likely.
The brokerage industry and FINRA wants to see mandatory arbitration remain the rule and you can guess how Schapiro and the SEC will come out on that issue. For decades the brokerage industry has argued that mandatory arbitration is good for investors-so good that, for some reason, it has to be made mandatory. Go figure.
10. Self-regulation of Money Managers? Coming soon.
FINRA will seek to expand into the world of money management as all brokers become investment advisers or subject to the same fiduciary standards. Given that the barriers to entry to the world of money management are far less than the brokerage industry; the ongoing compliance burden is less; and the assets under management compensation scheme is more lucrative, it's hard to imagine that many brokerages will fail to register as money managers in the future. On the other hand, it seems likely that the number of stand-alone brokerages will shrink.
FINRA has long dreamed of becoming the self-regulatory organization for money managers and I think it looks like that dream will likely come true. With its membership dwindling and having lost credibility with investors, FINRA needs to expand or risk losing influence.
11. Why FINRA now supports a fiduciary standard for brokers.
FINRA will lead the effort to make brokers appear as reputable as money managers by lobbying for a watered-down federal fiduciary standard, as opposed to the stricter state fiduciary standards supported by state securities regulators and consumer groups.
When FINRA, an organization that has consistently opposed fiduciary standards for brokers suddenly starts supporting such standards, there's got to be a reason and that reason has nothing to do with what's good for investors and everything to do with what's good for the brokerage industry.
Again, having lost credibility with investors and aware of the growing influence of investment advisers that have always been subject to fiduciary standards, FINRA and the brokerage industry have no choice but to embrace change. Will it be change or the "illusion of change?" It will be, must be, for a variety of legal reasons, the illusion of change.
12. State securities regulators offer investors little protection.
Aside from Massachusetts and New York, there are no state securities regulators seeking to follow in Spitzer's footsteps. By that I mean state regulators generally are not interested in challenging the federal regulators to provide the investor protection that is lacking.
I was recently involved with a retirement plan that had a problem the state securities regulator investigated; now the state AG has taken the case away from the state regulator.
We've been asked to contact the SEC to bring the matter to the Commission's attention.
In summary, the state and federal securities regulators have failed to provide investor protection; a private sector firm must be interjected into the process to force a satisfactory outcome.
13. DOL Still AWOL.
The DOL, throughout the disastrous 401ks "experiment" of the past decades, did nothing but enable financial vendors to fleece plan participant by granting prohibited transaction exemption after exemption from the statutory provisions of ERISA, based upon misleading representations by the industry. Conflicts of interest of every variety, lack of adequate disclosure of fees and revenue sharing have all been "blessed."
Recent action by DOL reveals that the new administration still fails to grasp that the agency's purpose is to protect retirement funds, not respond to industry special interests.
Today DOL positions and judicial interpretations of ERISA often prevent plan participants from seeking meaningful redress. In my opinion, 401k plan participants would be better off without the so-called protections offered by ERISA. ERISA has been so narrowly construed (and whatever it fails to specifically address presumed acceptable) that it more of an impediment than a safeguard. State fiduciary standards are far more straight-forward and less compromised.
But if ever there was an indictment of the DOL, it's got to be the demise of 401ks.
In March we issued a 28 page research report entitled, Secrets of the 401k Industry: How Employers and Mutual Fund Advisers Prospered as Workers' Dreams of Retirement Security Evaporated. Our conclusion will sound familiar at this point: the recent 401k meltdown was foreseeable and preventable.
My firm recently drafted a 401k advertisement that read: 401k: That's no retirement plan. Below it read, "With only $10,000 in the median 401k account invested in high cost retail mutual funds earning 5% annually, you'll have less than $50.00 a month in retirement. You and the boss need to talk.
14. In conclusion, there will be no meaningful regulatory crackdown.
The very fact that Washington is debating creating new agencies, as opposed to improving leadership at the existing agencies, suggests to me that this is an effort to distract attention and there is no serious intention to fix the problems. We don't need any new agencies or regulations to improve the integrity of the financial markets. All we need is the political conviction to enforce the rules. Therefore any regulatory reforms will change little other than perception.
15. The sales-repair-return cycle.
America is entering into what will be a protracted period of close examination of what went wrong over the past 30 years.
Think in terms of the sales-repair-return cycle. In the past financial product sales was the place to be. That is, selling standardized financial products that held the promise of outstanding returns was where the easy money was to be made. These products almost universally disappointed buyers.
Now we are in a repair-return mode. Some investments can be "tweaked" to improve net performance, such as through lowering fees. What cannot be repaired may be returned under warranty theory, i.e. lawsuits.
16. Today investors go it alone.
It's critical now that investors (and financial services firms for that matter) take the time to understand what went wrong over the past decades. Investors must take matters into their own hands.
The bad news is that regulators, law enforcement and others cannot be relied upon or looked to for guidance. There are too many conflicts, too many secret financial arrangements, too many political compromises involving regulators.
We are living in a new world now, very different from the 1930s or 1940s when our regulatory scheme was created.
The good news is that in the new world order, where information flows freely and quickly, intelligent affluent investors can prosper, i.e. access greater information and resources than regulators could provide-if they wanted to.
Get used to living in this new world where the old rules no longer apply.
17. Public pension investigations of money management wrongdoing are here to stay.
This new scrutiny is as a result of (a) public pension benefits exceeding private pensions; (b) the market melt-down exacerbating underfunding of public pension funds and exposing mismanagement of these funds; © the erosion of taxpayer wealth; (d) state Attorneys General investigations of certain investment industry practices related to these pensions. There is not a single public pension fund in this country which doesn't have some arrangement that should be investigated more fully.
There is only one reason why investigations and negative revelations regarding public pensions have not been commonplace:
The problem has been that there is no one who has legal "standing" to compel an investigation: the participants in these plans have no right to do so because, no matter how poorly the plan is run, the taxpayers are on the hook to pay the benefits. Therefore, the participant has suffered no loss. Taxpayers have no standing because they only have a remote relationship with the plan. The Boards of these funds generally resist for their own reasons. The very fact that public pensions almost never seek an independent review of the integrity of their investment process should tell you something. Therefore it's up to law enforcement and other investigators to tackle the problem. The SEC is not interested in getting involved in thorny public pension matters. DOL doesn't have jurisdiction. Until now law enforcement has been reluctant to pursue these cases. Now that the taxpayer monies have run out and the market will continue to underperform the assumptions the plans operate under, criminal investigations may become more common. So widespread is public pension investment management wrongdoing that the threads law enforcement is pursuing around the country today could yield results for the next 10 years.