401ks,  Return on Investment

The Equation Has Changed Part 1

Do you read the newspaper or listen to CDs? When was the last time your heard the dialup tone? Do you know what a dialup tone is? In just the last 20 years, we have experienced exponential change in everything from how we decide what to have for dinner to how we learn the news. The goal of this blog, and of my radio show, About Money, is to put you ahead of the curve so that you can make investing and financial decisions that not only keep up with changes, but outpace them.

I want to spend a couple weeks talking about the changes we’ve seen in the financial industry. The Department of Labor’s Fiduciary Rule has been in the news every day (as of this writing in early 2017), and whatever the outcome, the light it has shined will change an already capricious industry. In this blog, we’ll be looking at how investing has changed in the last century, and where it’s projected to go, in two parts.

We’ll begin with how the structure of the investment industry – and in particular the 401(k) spheres – has changed.

Since the 1960s, the way payment was calculated for financial services (at the time, facilitated by stock brokers) was through a fixed transaction commission. Every time a trade was made, you paid a fixed commission, which had been regulated for 183 years. On May 1st, 1975, the Securities Acts Amendments of 1975 created the option for negotiable commissions. At the time it was a victory for deregulation, but most stock houses chose not to change their income structure – with the notable exception of Charles Schwab, with whom you may be familiar. He introduced the idea of discounted trades, and by 1999, one-third of all investors had at least one “discount” account. Discount accounts proved to be a bigger game-changer than anyone at the time expected.
When I licensed in 1986, 95% of revenue in the industry was generated in big brokerage houses, and they had found success with commissions. In the ‘80s, the average household income was around $43,000; brokers were expected to produce at least $100,000 in revenues. Those who couldn’t were eliminated.

They did not leave the industry, but began their own industry shift by opening small firms. They sold a different product, so to speak. The old Registered Representative (broker-dealer) fell under the Investments and Exchanges Act of 1933, which specified only that an investment be suitable for a client. These new firms chose to license under the Investment Company Act of 1940 – they became Registered Investment Advisors, which required a fiduciary standard. They had to (have to still) make every decision in the best interest of the client.

It created a split between the two groups; the former can sway the client toward the investment that offers the higher commission to the broker, so long as it is “suitable.” The latter must make every decision in the best interest of the client (a topic about which I’ve spoken before). The Department of Labor Fiduciary Rule wants to expand the fiduciary requirement to all advisors who work in the retirement planning spheres.

The trend – leaving brokerage houses to join or start smaller firms – continues to this day. Almost 50% of the revenues created by the financial advising industry are created by the registered investment advisor. From there, they began, too, to move away from commission-based accounts to fee-based accounts, and this payment structure has since made its way back to the brokerage houses.

Fee-based accounts have, for better or for worse, created a culture of relationships; “sell the relationship, not the results.” Make people like you, so they don’t care what the performance is. Dalbar did a study which found that the average stock mutual fund investor, over the last 30 years, has achieved a return of 3.96%. What that means that if you began with $100,000.00 30 years ago, you would have tripled your money. The S&P 500, to compare, was up 11.1% over that same amount of time. Your $100,000.00 would become $2.1 million. With returns consistently so poor, pressure has been put on fees, bringing them down across the industry.

In the 1980s, the average fee was around 3% for the first $100,000.00. Today, it’s down to 1% or even lower. Failure to perform has injured the advisor and the investor.
So, what new innovation will continue to change the equation? Robo Advisors.

Computers can now not only provide financial planning with significantly lower fees than any registered financial advisor I’ve ever met. Today, 46% of investors are aware of the Robo Advisor, and are at least considering opening an account. Why? They can do everything most financial advisors do, except “hold hands” during a down turn,” and the fees are so much lower.

So, ironically, advisors “selling the relationship” may give way to the Robo Advisors, leaving those few of us who really do believe that superior performance is real value. Baseball teams do not pay a .217 hitter the same as they pay a .320 hitter. It is not what is paid that is most important, but how much the client earns in their account.

I’ll continue this conversation next week with more on how your individually managed accounts and 401(k) plans equations have changed. In the meantime, I pose a question:

Why is 10% the new 4%?

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