The Evolution of Financial Advice: Transitioning to Fee-Based and Index Funds

“For every complex problem, there is an answer that is clear, simple, and wrong.”
— H. L. Mencken

Over the past decade, the financial advice industry has undergone a significant transformation. Previously, most financial professionals were incentivized by commissions to sell financial products, often from their employers’ proprietary offerings. The industry has moved toward a fee-based model.

Overview of the Fiduciary Rule in 2015 for Retirement Plans and IRAs

In 2015, the Obama administration introduced a game-changing regulation known as the Fiduciary Rule, which was intended to ensure that most financial professionals offering advice on retirement plans, including IRAs, were fiduciaries. A fiduciary, as we know, manages assets on behalf of someone else and is required to put the client’s interests ahead of their own. This rule, in essence, was designed to reduce or eliminate any conflicts of interest. Many financial companies and professionals were compelled to switch to a fee-only compensation model to comply with this regulation. 

Biden Administration Introduces an Updated Fiduciary Rule

The courts eventually overturned the Obama administration’s 2015 Fiduciary Rule. Despite this, the Trump administration implemented most of it, though it did exclude the requirement that advisors provide a level fee cost structure for their clients. In April 2024, The Biden administration introduced its own Fiduciary Rule, building on the previous two administrations’ work and incorporating the Best Interest Standard promulgated by the SEC. The Best Interest Standard requires non-fiduciary financial professionals to act in the client’s best interest.

The Biden administration’s rule requires financial products not covered by the previous incarnations of the Best Interest Standard, such as fixed annuities, to be sold under a fiduciary standard. This applies mainly to any plan participant thinking of rolling their 401k or 403b into a fixed annuity.

The new rule also requires insurance companies to eliminate potential conflicts of interest. For example, financial professionals cannot be given special treatment—such as the employer paying more of their health plan’s premiums or providing better retirement plan matches—just because they sell more of a company’s proprietary products. A broad interpretation of the statutory employee classification has facilitated this practice.

The Rise of Index Funds

Index investing, a strategy that involves owning a fund that tracks a particular index like the well-known S&P 500, has gained significant traction in recent years. At the end of 2014, index funds (including ETFs) held $4.2 trillion in assets, but this number skyrocketed to $13 trillion by 2023, surpassing the assets held in active management.

The beauty of index investing lies in its simplicity: There’s no stock or bond picking involved. Instead, the fund owns the same stocks in the same proportion as the index, based on the company’s market capitalization. For instance, Microsoft stock represents 7% of the S&P 500 index. This index is dominated mainly by six stocks, namely Microsoft, Apple, NVIDIA, Amazon, Meta (Facebook), and Alphabet (Google), which account for 26% of the index.

The Impact of the Fiduciary Rule on Index Fund Growth

It’s worth noting that the growth of index funds saw a significant boost after the introduction of the 2015 Fiduciary Rule. Since this rule encouraged financial professionals to be licensed as investment advisor representatives to provide fee-based accounts to clients, it led to a shift in investment strategies. Advisors and consultants to retirement plan fiduciaries started recommending the elimination of active management funds with 12b1 fees (fees paid out of mutual fund or ETF assets to cover the costs of distribution) from their plans and the addition of more index funds. This change meant that any compensation to advisors or consultants remained the same regardless of the funds that plan participants used.

Financial professionals also started shifting from commission accounts to fee-based accounts for IRA rollovers. This is because they believe fee-based accounts align more with the spirit of the Fiduciary Rule. In a fee account, advisors charge clients a fee, usually around 1%, but many balance that fee by investing in low-cost index funds.

Fee-Only Advisory vs. Mutual Fund Direct Accounts: Benefits and Challenges

The theory behind a level fee for financial professionals was that if advisors were paid the same regardless of what product they offered a client, the advice a client relied on would be better. Much of the government’s angst was caused by financial professionals recommending that retirement plan participants roll over their 401k accounts into annuities, which happened to pay high commissions and weren’t suitable for retirement money.

Fee-only advisory accounts and index funds have benefited from the Fiduciary Rule. In contrast, mutual fund direct accounts have faced some challenges. In a direct mutual fund account, investors could transfer their 401k to an IRA directly. For example, American Funds offers an excellent range of actively managed funds with an expense ratio of around 0.60 and a tiny administrative fee of $10. If the rollover account is substantial, the commission can be as low as 0% or 2.5%, depending on the rollover size. At 2.5%, it would take only a few years for the IRA holder to pay thousands less in costs than in an advisory account with a 1% advisor fee, even if funded with low-cost index funds.

The Tragedy of the Commons: The Rise of Index Investing and Market Efficiency

If a small group decides to start commuting to work at 5 a.m., they will benefit from less traffic. However, if everyone starts doing the same, nobody will benefit. This is an example of what’s called the tragedy of the commons.

The concept of index investing originated when active management was at its peak. Skilled portfolio managers—such as Peter Lynch at Fidelity, John Neff at Wellington, and John Templeton—analyzed companies and selected stocks for their funds’ portfolios based on fundamentals. This resulted in a more efficient market with fewer mispriced stocks. Indexing then took advantage of this efficient market by providing investors with lower investment costs. However, as more and more people turn to indexing for investing, the question arises: Who will keep the market efficient?

Are Advisor Fees Negating the Low-Cost Advantage of Index Funds?

The main benefits of index funds are low cost and market efficiency. However, does the additional fee charged in fee-based accounts reduce or eliminate much of that low-cost advantage, and does the proliferation of index investing eventually make the market less efficient?

About one-third of active managers outperform their indexes. However, it would be interesting to see what percentage of index funds outperform active managers after the advisor fees are taken into account. Are active managers with lower expense ratios, such as American Funds and Dimensional Funds, more likely to outperform index funds, especially net of an advisor fee?

Conclusion

Almost ten years into this transition, my guess is there are fewer IRA rollovers from 401ks into variable annuities. If the Biden administration is successful, the same will hold for fixed annuities. Fees to retirement plan participants have probably come down as more plans have introduced institutional share classes and index funds. For IRA rollovers funded with mutual funds and ETFs, there are a lot more fees and a lot fewer commissions paid, and time will tell if that ends up being a good thing.

About Tim

I am registered under the 1934 Securities Act and the 1940 Advisors Act, allowing me to operate either fee or commission accounts. A fee account is a brokerage account with a fee wrapper, while a commission account using mutual funds is typically held directly at the fund company, often American Funds.

In a fee account, fund fees, when using index funds, may be around 0.05%, plus an advisory fee paid to the advisor that is typically around 1%, totaling roughly 1.05%. In a commission account, the client pays a commission upfront and then fund fees, which average around 0.60% in the case of American Funds. Most mutual fund direct companies use actively managed funds. At the same time, advisory accounts use more index funds to offset the advisory fee.

These are the opinions of Financial Advisor Tim Hayes and not necessarily those of Cambridge Investment Research. They are for informational purposes only and should not be construed or acted upon as individualized investment advice. Content provided via links to third-party sites should not be considered an endorsement of content that we cannot verify completeness or accuracy of.

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