Research Highlights Podcast
December 17, 2024
Service quality in the financial advisory industry
Mark Egan discusses the extent of misconduct among financial advisers and the reasons for its persistence in the industry.
Source: monkeybusinessimages
A growing number of US households hire advisers to assist with major financial decisions, such as planning life events or making portfolio choices for retirement. But some advisers exploit the inherent complexity of these decisions and the lack of sophistication of their clients to benefit themselves.
In a paper in the Journal of Economic Perspectives, Mark Egan, Gregor Matvos, and Amit Seru show that about 7 percent of financial advisers have serious misconduct records, with rates reaching nearly 30 percent in some regions and firms. The authors explain why misconduct clusters in certain firms and geographic areas, particularly those with wealthy but less financially sophisticated populations.
Importantly, the researchers also show that widely publicizing the names of the firms with the highest misconduct rates can lead to a substantial reduction in misconduct.
Egan recently spoke with Tyler Smith about how the complex regulatory landscape of financial advising creates potential confusion for consumers and the best ways to clean up the industry.
The edited highlights of that conversation are below, and the full interview can be heard using the podcast player.
Tyler Smith: I think it's fair to say that financial advisers are mistrusted by many Americans. And, yet, the share of households using them has only really increased in recent decades. So, why do so many households continue to rely on them?
Mark Egan: Finance is hard. Some of the most basic savings decisions and portfolio choice decisions are hard problems to solve even for financial experts. If you're working outside of finance, you may have some education in high school and college on these issues. But these are hard and really important decisions.
Smith: What are some examples of how financial advisers help households?
Egan: They do a number of different things. First and foremost is portfolio choice. Thinking about different types of stocks, bonds, and mutual funds you might buy but also savings in general. If I'm planning for retirement or I want to buy a vacation house in a few years or I'm planning for my children's tuition, how much money should I be setting aside? What does my financial picture look like going forward? I think another big component they play is really building trust. There's a lot of fluctuations in markets and they help by holding households’ hands and helping them understand what's going on. What should they be worried about? What should they be less worried about?
Smith: Can you walk me through some of the main ways that the phrase “financial adviser” is used in the industry and explain what the most important differences between these roles are?
Egan: What is tricky is there's no legal definition of a financial adviser, but there are many people who call themselves financial advisers. Most people that say they're a financial adviser would really be brokers or technically registered reps with FINRA. I think for various reasons over the past 20 years, the name “broker” fell out of fashion and their role evolved a little bit when they adopted the name “financial adviser.” However, there's another group of people called investment adviser representatives, who also may call themselves financial advisers. These are people that are registered with the SEC. A broker will help you provide transaction services, but providing advice is incidental to their business. Investment adviser representatives are really about providing financial advice, less about transactions. What makes it even more confusing is about half of brokers are also registered as investment adviser representatives. They have different legal responsibilities depending on whether or not they're acting as a broker or as an investment adviser representative. For example, an investment adviser representative is held to a fiduciary standard, which means they're legally obligated to look out for their client's best financial interests. Brokers are not held to that same standard.
Smith: What is the problem with financial advisers?
Egan: Most households that are investing in markets use some sort of financial adviser, and they're using financial advisers because finance is hard; they don't understand it. They need an expert to help them make these decisions. The tricky part is when you hire an expert because you don't understand these decisions, it gives advisers potential scope to engage in deceptive practices. We think that maybe market competition and efficient institutional legal design could prevent advisers from engaging in deceptive practices or misconduct, but that’s not the case.
Smith: What kind of misconduct are you able to look at in this paper?
Egan: A nice feature of the financial advisory industry is that FINRA operates a website called Brokercheck, which is a great resource for everyone. You can look up any financial adviser who has worked in the industry in the past ten years. Basically, you can see whether or not an adviser has any disclosures on those records. There's 23 different types of disclosures you could have. We look at six that we identify as adviser misconduct. And I would say this is a pretty conservative definition of misconduct. These would be any sort of customer disputes or related civil cases that resulted in a settlement, any sort of regulatory offenses that the adviser was involved in, any criminal offenses, and any cases where the adviser was fired for cause. We find that roughly 7 percent of financial advisers in the United States have a past record of misconduct. The other thing I want to add is that the misconduct rate varies drastically across different firms and regions. The number can be as high as 20 percent or 30 percent of advisers at certain firms or in certain counties in the United States.
The reason misconduct persists is a lack of information and transparency as well as a lack of consumer sophistication.
Mark Egan
Smith: One obvious approach to decrease misconduct rates would be to raise fiduciary standards. But you point out in the paper that doing this might not be enough to really address the misconduct issue. Why not?
Egan: Financial advisers often face conflicts of interest; they're incentivized to sell potentially high commission products that are worse for their customers. There's been a number of proposals to try to limit these conflicts of interests and hold all advisers to a fiduciary duty. I have some work showing that that could be very good and effective in eliminating conflicts of interest and improving investment outcomes more generally. In the paper, one of the things we highlight is that it's not obvious that that's going to actually make a big impact on misconduct, because misconduct really involves violations of a lower legal standard than a fiduciary standard. It's not that holding advisers to a fiduciary duty is a bad thing. It's just not obvious to me that holding them to a higher standard is going to address problems when they're already breaching a lower standard as is.
Smith: Are there other options for trying to reduce misconduct rates?
Egan: An obvious potential starting point is thinking about disclosure. The reason misconduct persists is a lack of information and transparency as well as a lack of consumer sophistication. Things like FINRA's Brokercheck website are a step in the right direction. One of the things we find in our paper is that disclosure has pretty big effects. To give you some context, my coauthors and I started working on these issues back in 2015. And in 2016, we listed the 20 firms with the highest rates of misconduct in a different paper. We listed 20 for page constraints, but we really could have listed 40 firms with elevated rates of misconduct. After that paper was released, I was encouraged by one of the firms that had the highest rates of misconduct. They were very upfront when speaking to financial media outlets, saying that they knew it was a problem and that they were actively trying to address it by getting rid of some of their recidivist advisers that have engaged in misconduct in the past. Building on that anecdotal evidence, we decided to look at the data a couple of years later and see if this firm actually did anything. And so, to test this, we compared how the rates of misconduct vary between the 20 firms we listed with the highest rates of misconduct in 2016 and the next 20 highest firms with the high rates of misconduct that we didn't list. Was it actually the case that these firms with high rates of misconduct actually cleaned up their practices? What we see in the data, using this difference-in-differences analysis, is that they seemed to. If you look at the firms we listed in the original paper, their share of advisers with a past record of misconduct fell by 1.3 percentage points, or about 10 percent, from about 12.3 percent to 11 percent. Whereas, if you look at the firms we didn't list in the paper, there's really no change in their share of advisers with the past record of misconduct. This suggests that this “naming and shaming”—or just providing more information—can have an impact on the rates of misconduct.
♦
“The Problem of Good Conduct among Financial Advisers” appears in the Fall 2024 issue of the Journal of Economic Perspectives. Music in the audio is by Podington Bear.