Building Better Brokers

I have long been extremely wary of investment brokers, for much the same reason I don't go to psychics: I don't believe anyone has a very accurate crystal ball. I have also never really trusted their motives. Many are just out for their commissions. As a result, I was intrigued by an article today in the New York Times addressing the question of whether brokers should have a fiduciary duty to always have their clients' best interest in mind. Such a standard might seem obviously good, but I wonder if there's an even better solution.

Some have argued that the financial overhaul bill should include a provision to require all brokers -- whether peddling stocks, bonds, insurance products, etc. -- to put their client's interests before their own. The NY Times article explains:

At issue is whether brokers should be required to put their clients' interest first -- what is known as fiduciary duty. The professionals known as investment advisers already hold to that standard. But brokers at firms like Merrill Lynch and Morgan Stanley Smith Barney, or those who sell variable annuities, are often held to a lesser standard, one that requires them only to steer their clients to investments that are considered "suitable." Those investments may be lucrative for the broker at the clients' expense.

Over the years, it has become more difficult for consumers to understand where their advisers' loyalties lie, especially as the traditional stock-peddling brokers have started to look and act more like financial advisers. The fact that some brokers can wear two hats with the same client -- that is, provide advice as a fiduciary in one moment, but recommend only "suitable" investments in the next -- only adds to the confusion, experts said.

Indeed, there is a fine line between what is suitable for a client and what's in his best interest. And I'd imagine that most Americans have no clue what the difference is between those distinctions. After all, can something be suitable, but not in a client's best interest? Unfortunately, sometimes the answer is "yes."

So should there be a law that makes this distinction clearer? Perhaps. But I worry about how it's enforced. For example, there's a huge spectrum of investment opportunities out there. As long as a broker is sure that an investment is "suitable" for a client, how can she ever be certain that it's the very best product for her client? There's a fair amount of subjectivity involved.

And what if a broker really was legitimately working for a client's best interest, but an investment didn't do as well as anticipated? We're talking about predicting the future here. Would more of these customers sue their advisors? If I lose money, couldn't I argue that it would have been in my best interest to have made money, so my broker failed her fiduciary duty?

I think that gets messy. So I'd prefer a more market-based solution. These investment houses should reward brokers, not based on commission for selling products or getting more trades, but for performance. Specifically, that could be measured in three ways. First, did the client get a positive return? Second, did that performance adhere to the particular goals set forth by that client? Third, is the client satisfied with the broker's performance?

If I was looking for a broker, but I understood the vast majority of her pay to be structured in that way, it would go a long way in convincing me that she would ultimately care most about what's best for me. This should also weed out brokers who aren't out for their client's best interest -- they wouldn't make very much money or retain their clients. Meanwhile, the firms who have policies like this should benefit greatly, because they would attract those looking for sound investment advice.

But in order to make this effective, legislation that I would unequivocally support is that which would require firms to disclose to clients the basis for its brokers' pay prior to any investment being sold to that customer.