Why no one should use brokerage accounts

Social Security rules are complicated and change often. For the most recent “Ask Larry” columns, check out maximizemysocialsecurity.com/ask-larry.

Editor’s Note: Our regular Social Security columnist Laurence Kotlikoff, professor of economics at Boston University, often offers his thoughts on personal finance — beyond Social Security — for Making Sen$e readers, most recently, suggesting “10 ways the class of 2014 can beat the economic odds” and explaining how to use your standard of living as the basis for all of your financial planning. Today, a sharp warning about brokerage accounts.

— Simone Pathe, Making Sen$e Editor

Financial fraud, in its multiple forms, is a plague that can be temporarily suppressed, but not eradicated. Some of the worst financial actors were exposed in the Great Recession. But every day brings fresh reports of gross misconduct on Wall Streets at home and abroad.

The fact that our regulators, with very limited resources, uncover some 700 fraud cases annually is testimony to the large number of swindlers still at large “managing” our money.

The malfeasants come in all sizes, including extra large. Last week, France’s biggest bank, BNP Paribas, was accused of money laundering. Two weeks ago, Credit Suisse pleaded guilty to tax evasion. In October, JP Morgan paid massive fines for overlooking the London Whale. In September, Goldman Sachs was heavily penalized for selling fraudulent mortgages. And …

As I summarized in Forbes, with so much financial fraud, we all need to worry where our money is parked. In a checking account, it’s guaranteed up to $250,000 by a government agency — the Federal Deposit Insurance Corporation (FDIC). If it’s invested in a mutual fund and, if there is an independent custodian holding the fund’s securities, then the only risk is that the independent custodian is dishonest. But if it’s invested with any of our nation’s 4,000 brokerage firms, our money is “protected” by a Wall Street agency — the Securities Investors Protection Corporation (SIPC).

SIPC was established pursuant to a 1970 act of Congress with the purpose of protecting investors. But asking Wall Street to protect us from Wall Street was and is asking for trouble.

SIPC’s website says, “SIPC protects customers if their brokerage firm fails.” Nothing could be farther from the truth. Investors in brokerage accounts that fail due to fraud can be forced to pay back to a SIPC-appointed trustee huge sums, indeed far more than what they contributed to their accounts.

Wall Street pays SIPC’s bills. So when a SIPC-appointed trustee sues innocent victims​, every dollar the trustee takes ​in is a dollar less Wall Street has to pay out. Thus, Wall Street uses SIPC to further defraud people it’s already defrauded.

To see this mechanism, take Frank and Sally, who invested $40,000 in 1991 in a brokerage account to fund college tuition for their newborn daughter Sarah. Frank and Sally knew about the miracle of compound interest and realized that saving early and letting capital markets work for them was the smart approach. Sure enough, their money grew, leaving a $160,000 account balance in 2010 — just enough to cover Sarah’s tuition.

Sarah graduated last Sunday. But yesterday Frank and Sally learned that their brokerage firm had been shut down due to fraud, with not a penny left. Frank and Sally were totally shocked, but thanked God they hadn’t lost their investment.

That was yesterday. Today, Frank and Sally learned the truth about SIPC “protection” from their accountant, Sam. They owe the SIPC-appointed trustee $80,000 and will be sued if they don’t pay.

Here’s how SIPC’s swindle works. When a brokerage firm steals your money, SIPC claims the firm went bankrupt. But since the broker was a crook, the customers are not entitled to any appreciation on their money – even though they paid taxes on the appreciation and would have earned similar returns in honest brokerages! The fact that Frank and Sally knew nothing about the fraud doesn’t matter. They are assumed to have known because they withdrew funds within two years of its discovery. As a result, they are treated as if they are the criminals and are forced to pay back money to SIPC (i.e., to Wall Street).

Under current law, the SIPC-appointed trustee (much to SIPC’s distress) can only sue to recover withdrawals for the last two years. Thus, in Frank and Sally’s case, they took out $80,000 in the past two years, so they owe $80,000. Had Sarah started college two years earlier, Frank and Sally would be in the clear. They’d also be in the clear if the fraud weren’t discovered for two more years.

Also, had Frank and Sally’s withdrawals, over the entire history of their account net of their original $40,000 contribution, been less than $80,000, their obligation to the SIPC trustee would have been limited to that amount (or zero if the amount were negative). But their net withdrawal amount was $120,000, which exceeds $80,000. Therefore, Frank and Sally are stuck paying the full $80,000.

And now for the rest of the horror story.

SPIC also tells Frank and Sally that because their “net equity” — the difference between their contributions and withdrawals — is negative, they can never recover a single penny of their lost savings through SIPC insurance, even if SPIC is able to recover funds from the true criminals — the broker dealers who conducted the fraud.

Yes, this is complicated — for a reason. It keeps people with brokerage accounts from understanding the risks they face in actually spending their accumulated savings.

​And the notion that savers who withdraw the proceeds of their investments — something every IRA brokerage-account holder over 70-and-a-half is legally required to do — should be criminalized for spending those withdrawals is as antithetical to capitalism as it gets.

A bipartisan bill before Congress – HR3482 and S1725 – would change SIPC’s definition of “net equity” and prevent SIPC from persecuting Frank and Sally and other victims of financial fraud. Until that law is passed, the best way to avoid the SIPC threat is simply not to invest in brokerage accounts, period. Had Frank and Sally, for example, invested their original $40,000 directly in a mutual fund with a reputable third-party custodian, they would never have faced this madness.

What if you already have money in a brokerage account whose account balance exceeds the amount contributed? Move your money out of your brokerage account — today. Invest it in a safely custodied mutual fund, and don’t spend any of it for two years. Only after that time period will you be able to spend the full amount without facing the risk of being branded a criminal by the real criminals.

Editor’s Note: Variations of this post have appeared in Forbes and the Huffington Post.

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