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Retail financial advisors looking out for themselves?

(MoneyWatch) Would you be surprised to hear that retail financial advisors often recommend the portfolio that makes the most money for them, not their customers, even if their recommendations result in less money for their clients or make their client's current situation worse? That's the damning conclusion of a recent working paper published by the National Bureau of Economic Research (NBER), reporting on an audit conducted by the Consumer Financial Protection Bureau (CFPB) of the quality of financial advice.

The CFPB put together a clever undercover operation in which trained auditors visited numerous retail financial advisors whom the average citizen can access via their bank, independent brokerage, or independent advisory firm. These advisors are usually paid based on the commissions and fees they generate from transactions and not on the assets under management. The audit was carried out in the Boston area in 2008.

The auditors impersonated regular customers who were seeking advice on how to invest their non-401(k) plan retirement savings. The auditors represented two different wealth levels, either those with savings between $45,000 and $55,000 or those with savings between $95,000 and $105,000. The auditors' goal was to have a savings amount that was representative of that of the average U.S. household in different age ranges. The audit didn't address the situation of people in the higher end of the wealth spectrum, who usually have access to private wealth managers or fee-based advisors who don't accept commissions.

The goal of the audit was to determine if the financial advisors would attempt to correct mistakes that individual investors might be making or if they would exploit those mistakes and move their customers toward funds that generate high fees. An important goal of the audit was to estimate the extent to which advisors gave "good advice," defined as moving investors towards low-cost, diversified index funds, a strategy suggested by many textbooks on investments and one often recommended by my fellow CBS MoneyWatch bloggers Allan Roth and Larry Swedroe.

The auditors presented the advisors with one of four scenarios:

Scenario #1. The auditor expressed a desire to chase returns -- that is, to invest in an industry sector fund that had performed well during the previous year.

Scenario #2. The auditor held 30 percent of his or her portfolio in the company stock of their imaginary employer.

Scenario #3. The auditor held a diversified, low-fee portfolio consisting of index funds and bonds -- in effect, an efficient portfolio often suggested by textbook theory.

Scenario #4. The auditor held all of his or her investments in CDs and simply expressed a willingness to increase risk for higher returns.

The audit compiled all the financial advisors' responses and recommendations to the above scenarios. Here are four key findings:

Finding #1. There was a significant bias towards actively managed funds that generate higher fees. In nearly 50 percent of the interviews, the financial advisor encouraged the client to invest in an actively managed fund. Index funds were recommended in just 7.5 percent of the visits. When advisors mentioned fees, they often did so in a way that downplayed them without lying. For example, they would make statements such as "This fund has a 2 percent fee, but that's not much above the industry average."

Finding #2. There were differences in the advisors' level of support for the investment strategy presented by the auditors. Particularly troubling was what happened if the auditor presented the diversified, low-cost portfolio scenario: In 85 percent of the cases, the advisor suggested changing the investment strategy. In just 2.4 percent of these visits did the financial advisor support the low-cost portfolio. Since having a low-cost portfolio has been repeatedly demonstrated to be the most efficient way to invest, the advisors' suggestions would most likely result in lower accumulations for their customers. In effect, the advisors were willing to make a change that could leave their clients worse off.

Finding #3. Advisors were most supportive of the current strategy when the scenario presented was the willingness to chase returns. In more than 19 percent of these visits, the advisor supported this strategy. The cynical interpretation is that this scenario presents an opportunity for the advisor to churn the account, directing the customer to high-cost sector funds. The advisors supported the scenario to hold employer stock in about 10 percent of the visits and, as mentioned previously, almost never supported the low-cost index approach.

Finding #4. One more interesting finding: In almost one-third of the visits (30 percent), the advisors refused to offer any advice until the "customer" actually transferred money to the advisor. While it's understandable that advisors may not want to offer "free" advice, this situation presents a screening problem for the customers -- with no information to go by, it's hard to judge the value of an advisor before having to commit to the advisor.

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While it's possible that advisors can produce better results for their customers than those customers can produce when making decisions on their own, this study shows there's a lot of room for improvement at the retail level of financial advice. Hopefully we wouldn't see these kinds of results from financial planners who are paid only on a fee basis.

Based on the results of this study, here's my take-away for individual investors:

Ask your financial advisor how they are paid. Only use financial advisors who aren't paid on a commission basis. These type of advisors are available to customers with average wealth levels, although you may need to do some hunting to find them.

Learn as much as you can about investing on your own. Even if you work with a financial advisor, knowing as much as you can about investing will help more easily choose a financial advisor. And when you select one who has your best interests at heart, you'll be able to have more informed conversations with them.

This may sound like a lot of hard work, but you'll thank yourself later when you're able to make sound investment decisions and have enough money to enjoy your retirement.

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