Economists Mark Egan, Gregor Matvos and Amit Seru have an eye-opening new academic research paper on the “market for financial adviser misconduct.” They use data on all 1.2 million people who registered as financial advisers between 2005 and 2015 and come up with some startling results.
Many, many financial advisers have been disciplined for misconduct, some repeatedly. These advisers are more likely to be fired — but many of them go on to find jobs at other firms.
Egan, Matvos and Seru’s data suggest that there are two very different employment markets for financial advisers. One of them provides legitimate advice (although there are arguments — see below — that this advice usually isn’t as good as it ought to be). This market is far less likely to employ people who have been disciplined for misconduct. The other market employs advisers who are then matched with unsophisticated consumers who often may not realize that they are getting bad advice. Here’s how it works.
There are plenty of bad apples in the financial advice industry
Egan, Matvos and Seru’s headline finding is stark. Fully 7.28 percent of financial advisers have been disciplined for misconduct. This figure is substantially higher in some parts of the United States. In many counties in Florida and California, about 1 in 5 financial advisers have been found to have engaged in misconduct. In Madison County, N.Y., 1 in 3 have been disciplined for misconduct.
In the aggregate, the wealthier, the more elderly and the less educated a county is, the higher the likelihood that financial advisers have engaged in misconduct. While one has to be careful in interpreting aggregate results like this, they match with what you might expect. The more rich people there are, the more lucrative opportunities there are for misconduct (although it might also be that richer people are more likely to keep track of their money and complain when they believe it is being invested badly). The more elderly and poorly educated people there are, the more “financially unsophisticated investors” (i.e., suckers) there are to prey upon.
Egan, Matvos and Seru also find evidence that advisers who have been disciplined for misconduct once are five times more likely to be disciplined again than other advisers. This could be because they are more likely to be innately dishonest; it could also conceivably be because once they have lost their reputation for honesty, they have no great incentive to behave well in the future.
Firing is not enough
Egan, Matvos and Seru do find evidence that financial advisers lose their jobs for misconduct. Nearly half of advisers who have been disciplined leave their jobs within the next year. These advisers take longer to find new jobs, and when they do find new jobs, they find them in firms that pay $15,000 less.
However, about three-quarters of these disciplined financial advisers stay in the industry. In an idealized market, when advisers were appropriately disciplined for misconduct, they would lose their jobs, generating incentives for honesty. That isn’t the market that this research depicts.
Indeed, advisers who leave their jobs because of misconduct are only slightly less likely to find a new advising job within a year than those who left their jobs without evidence of misconduct.
There is an active job market for dubious financial advisers
Economists working on job markets are very interested in “matching”: how employers look for employees with the right qualifications, and how employees look for appropriate employers. Al Roth, who won a Nobel Prize for his work on matching, has a new book, “Who Gets What — and Why: The New Economics of Matchmaking and Market Design,” that provides an interesting and accessible overview of how matching works.
Egan, Matvos and Seru suggest that there are two different job markets in financial advising, in which employers are looking for quite different kinds of employees.
One job market is dominated by financial advising firms that target sophisticated investors. These firms tend to be highly intolerant of misconduct, and very unlikely to hire advisers who have records of misconduct. For example, two prominent financial industry firms have big advice arms where less than 1 percent of advisers have records of misconduct.
However, Egan, Matvos and Seru find a second job market, dominated by firms that are much more tolerant of misconduct among their employees. Nearly 20 percent of one significant firm’s advisers have been disciplined for misconduct. The research also finds that more than 15 percent of advisers for three other firms have been disciplined for misconduct.
Their data suggest that the problem isn’t simply that certain corporations are more tolerant of misconduct. For example, the article finds that while 15.14 percent of one prominent firm’s advisers have been disciplined for misconduct, only 1.51 percent of the advisers of one of its affiliates been disciplined. One possible explanation is that these two branches of the same organization target different kinds of customers. The first targets retail customers, who are likely to be less discerning. The second targets institutional investors, who are likely to be very demanding indeed. More generally, the research finds that businesses that have had high amounts of misconduct in the past are more likely to have high amounts in the future.
Not all dubious behavior is against the rules
Egan, Matvos and Seru rely on data covering active misconduct in which financial advisers are found to have broken the rules requiring them, for instance, to sell only “suitable” investments to their clients.
However, many observers believe that the rules are far too weak in the first place. Helaine Olen, a financial journalist, and Harold Pollack, the Helen Ross Professor of Social Service Administration at the University of Chicago, note in their excellent new book, “The Index Card: Why Personal Finance Doesn’t Have to Be Complicated,” on sensible financial planning that the suitable investments standard is pretty weak. It doesn’t fully oblige advisers to find you the best deal, or to tell you if they are receiving a bigger commission for selling you one financial product than another.
They say that there is a better alternative: the fiduciary standard, under which every financial adviser would have a “legal and regulatory duty to put your interests ahead of his or her own.”
Unfortunately, it may be very hard to find advisers who are prepared to meet this standard. Furthermore, advisers who do meet the standard are probably going to charge you for their advice (since they will not make the same kinds of money from commission as regular advisers do). Advisers who stick to the suitability standard, but do not disclose their commissions or necessarily offer the best possible advice to their clients, will not appear in Egan, Matvos and Seru’s data. They are fully complying with industry rules, even if their clients might do better from more disinterested advice.
This has led to big political battles over the responsibilities of financial advisers to provide disinterested advice about 401k and other retirement accounts. The Obama administration has been trying to push through a new regulation which would oblige advisers to live up to a fiduciary standard when providing advice on retirement.
The financial planning industry has been ferociously resisting this regulation, with help from Congress, where there is talk of a new bill that would overturn the Obama rule, and put a different (and presumably less onerous) standard in its stead. The ferocity of the battle illustrates the huge financial stakes for both citizens and the financial planning firms that offer them advice for good or ill.