Should We Trust Financial Advisers?

In the wake of the financial crisis, many have grown to dislike and mistrust Wall Street and the financial services industry. Well, a new working paper may validate some of those feelings, particularly when it comes to financial advisers.

Researchers from the University of Chicago and the University of Minnesota found that roughly 7 percent of financial advisers have a misconduct record–ranging from selling their clients unsuitable investments to fraudulent behavior. But the paper’s most striking findings relate to what happens after a financial adviser commits misconduct and how that shapes the industry as a whole. The researchers used the BrokerCheck database to look at the disclosure records of financial advisers from 2005 to 2015.

For most young people, the thought of hiring a financial adviser seems as foreign as hiring a lawyer to write your will; figuring out how to file your taxes may be much more pressing than making a plan for retirement. But the report’s findings offer some important insight into the role of financial advisers as well as customers who tend to fall victim to misconduct.

The researchers looked at only six of the 25 disclosure categories in order to focus specifically on fraud and misconduct. They also included pending disputes in order to avoid including disclosures that may be dismissed in the future. While the range of misconduct varies, it does tend to be significant. According to the data they analyzed, the median settlement for misconduct was $40,000.

The paper has four major findings altogether:

1. Roughly 7 percent of nearly 650 thousand registered financial advisers have misconduct records based on data from 2005 to 2015.
2. Advisers with a record of misconduct are more than five times as likely to commit future misconduct than the average adviser.
3. While about half of advisers who commit misconduct lose their jobs afterward, 44 percent are reemployed within a year and firms that tend  to hire these offenders also have high rates of previous misconduct. The researchers go on to note that these firms may even “specialize in misconduct.”
4. These firms also tend to serve people who have relatively low levels of education, high incomes, and the elderly. Existing research indicates that these individuals have lower levels of financial literacy and may have a harder time identifying misconduct or fraud.

When unpacking these findings two important points emerge. First, companies can be surprisingly strict when it comes to misconduct, often firing employees who commit abuses. But at the same time, those who do lose their jobs often manage to stay in the industry, though on average they go to less prestigious companies and take a pay cut. The firms that tend to hire people with a misconduct record also have issues with misconduct themselves.

FINRA created the disclosure system and the BrokerCheck database to improve transparency for customers looking for financial advisers, but the researchers found that despite consumers’ ability to look up the record of potential advisers, misconduct continues at higher levels than you might expect. They argue that this is likely because some customers are less sophisticated than others and may not know how to find or interpret certain disclosures.

Researchers compared the locations of these advisers with Census Bureau data. They found, “Misconduct is more common in wealthy, elderly, and less educated counties… The latter two categories have generally been associated with low levels of financial sophistication.” While these findings are not definitive and don’t prove causation, the connection between where fraud happens and those vulnerable to it is particularly striking. Ultimately, the researchers concluded:

Our findings suggest that a natural policy response to lowering misconduct is an increase in market transparency and in policies helping unsophisticated consumers access more information. Several recent efforts by regulators, such as the establishment and promotion of FINRA’s BrokerCheck website, have been along these lines.

FINRA, the independent regulatory authority that oversees financial advisers and much of the financial industry, has been taking steps to improve transparency and the industry’s culture, but these findings suggest that misconduct and fraud remains a significant problem for the financial advice industry.

The financial crisis was a formative period for most Millennials, so it’s clear why many young adults have moved away from more traditional financial advisors. Millennials tend to gravitate toward different, often tech-based, solutions for financial planning rather than hiring someone for advice. That, coupled with the unique financial burden placed on new adults, puts Millennials in a notably different financial situation with different goals than what their parents and grandparents might have. Based on the findings of this working paper, that skepticism may be warranted.

Kevin Rizzo

Kevin Rizzo is the Crime in America Editor at Law Street Media. An Ohio Native, the George Washington University graduate is a founding member of the company. Contact Kevin at krizzo@LawStreetMedia.com.