Sadly, we hear the stories too often. A novice investor entrusts their retirement assets to a financial advisor or investment broker. They receive advice that seems to fit their objectives and risk profiles. But as they begin to receive their statements, they notice that their profits are being eaten up by constant trading fees or steadily eroded by high-commission packaged products. Furthermore, their advisor frequently encourages them to make trades into products or securities that they don’t necessarily understand.
But who can the novice investor trust? The relationship between a financial advisor and their client is, or should be, based on trust. In the last couple of years, this has brought an obscure term into the mainstream: fiduciary. The definition of the term fiduciary is the topic of this article. We’ll discuss what a fiduciary is, including the ways a financial or investment advisor has to meet their fiduciary duty. We’ll also contrast the fiduciary standard with the suitability standard, explain the fiduciary rule, and explain why there is opposition to the fiduciary rule, including in some cases by the people it’s designed to protect.
What is a fiduciary?
The word “fiduciary” comes from a Latin word that means “trust”. A fiduciary is a person held to the highest standard of care as it relates to or involves a confidence or trust. Although we don’t hear the word fiduciary used much in a medical context, if you have ever had to be under the care of a doctor or have had a surgery, you are hoping that the doctor is bound by a fiduciary duty. In the doctor-patient relationship, this duty goes beyond doctor-patient confidentiality to include:
- A Duty of Care– they are legally required to be educated and informed about the laws and issues regarding the procedures, conditions, and surgeries they are administering.
- A Duty of Competence– it’s why every doctor has his medical degree and other licensing prominently displayed.
- A Duty of Good Faith and Fair Dealing– you expect the doctor to charge fair market prices and not order unnecessary procedures.
- A Duty of Loyalty– you don’t want them to prescribe any procedures or medications that are not in your best interests
- A Duty to Avoid Conflicts of Interest
Many a malpractice suit has been awarded because of a physician's failure to meet one or more of these fiduciary standards.
In the context of investing, a fiduciary is someone who has a legal responsibility to put your needs above their own. A broker or financial planner working under a fiduciary standard is ethically bound to act in his or her client’s best interests. Some of the ways an investment advisor may meet their fiduciary duty include:
- They cannot buy securities for their own accounts before buying them for a client.
- They cannot make trades that result in higher commissions for them or their investment firm.
- They must do their best (i.e. meet a standard of care) to ensure that any investment advice they dole out is based on the thorough and accurate analysis so as to provide recommendations based on the complete and accurate information.
- They must avoid any conflicts of interest in their fiduciary relationship.
- They must place trades using a “best execution” standard that strives to combine low cost with efficient execution.
Are all financial advisors bound by the fiduciary duty?
The short answer is no. A more nuanced answer is not yet, but things are trending in that direction. A brief history lesson will help explain this.
Prior to the 1970s, the role of investment advisors and financial planners was shrouded in mystery to the vast majority of Americans. Along came the Individual Retirement Account (IRA), which encouraged investment by granting tax advantages for retirement savings, and quickly hundreds of thousands of Americans from all walks of life and income levels had become “investors”.
Foreseeing the problem that could come from uninformed investors entrusting their retirement savings to investment firms, Congress enacted the Employee Retirement Income Security Act (ERISA). This act ensured that the fiduciaries of an investment firm’s retirement plan had to protect retirement assets by implementing rules that ensured the plan assets would not be mismanaged. It also required that plans should provide participants with information about plan features, how plans are funded, and provide regular information about the plan free of charge.
However, the ERISA only covered plan fiduciaries. This protected an investor's retirement assets once they were in the plan, much like saying your deposits at a bank are FDIC insured. However, it didn't prevent or discourage the practice of advisors offering investment products that they received commissions on or products that may be offered by their own firm. To better understand this, you need to understand the difference between the fiduciary standard and the suitability standard.
How is the fiduciary standard and suitability standard different?
When you go to a brand name insurance agent, they are going to recommend policies from their companies that they feel are suitable for your budget and needs. In the best case scenario, an agent may follow up with you periodically to see if your circumstances or needs have changed, but even in that case, they are still going to sell you products that are from their company (and for which they receive commissions).
For an investment advisor, the suitability standard means that if, after talking to a client to determine their goals and needs, they have adequate reason to believe a security they recommend will help achieve those goals, they can present that option. They do not have to disclose any commissions that they receive or any underlying motivation behind directing them to that security.
The suitability standard requires that an advisor does the following:
- Execute orders promptly and use “reasonable diligence” to determine the most favorable terms.
- Inform their client of any material information.
- Charge fees that are reasonably related to “market prices.”
- Fully disclose any conflicts of interest.
Another way to understand the difference between the fiduciary standard and the suitability standard is in the way advisors are paid. Most advisors are paid either by a fee-only arrangement, a commission-based arrangement, or a combination of fees and commissions.
A fiduciary advisor can only be fee-based. This fee is either a flat or hourly rate, a fee based on a per-service basis, or a fee that reflects a percentage of the client’s assets that they manage.
A non-fiduciary advisor can collect commissions. These advisors:
- Are paid from the sale of investments. This may mean they discourage buyers from buying and holding.
- In some cases, they receive a separate commission from their company for selling a particular product or security.
- They can charge a client a percentage of their invested assets.
- They can charge per transaction.
To be fair, many non-fiduciary financial advisors act in the best interest of their client each and every day, including some that may diligently make efforts to follow-up with their clients and track the performance of their investments. However, the suitability standard does not legally require them to put the clients’ best interests ahead of their own. This means that they can direct clients to securities that are profitable for themselves as long as that recommendation meets the client’s objectives.
The fiduciary standard means that if an advisor has two comparable investments to recommend to a client, they cannot recommend the more expensive option because for a client to pay higher fees is not in the client’s best interest.
What is the fiduciary rule?
Today’s investors are seeking more financial advice for their retirement savings, particularly as employees are changing jobs more frequently, and needing to make decisions regarding rollovers. A report from President Obama’s Council of Economic Advisers estimated that IRA investors who received advice based on conflicting incentives lost a total of $17 billion per year and earned a 1% lower return each year. The report went on to conclude that receiving non-fiduciary advice when rolling over a 401k into an IRA could cost an investor up to 12% of their savings over a 30-year period and therefore see their savings run out five years earlier.
This was the catalyst for the U.S. Department of Labor created the fiduciary rule in 2016. This rule created a fiduciary standard for financial advisors. It stated that any financial advisor or investment advisor who work with retirement plans, including those who dispense retirement planning advice, would automatically become a fiduciary: someone who is bound legally and ethically to provide a standard of care that comes with that status.
The new rule was scheduled to be fully implemented during 2018, but on March 15, 2018, the U.S. 5thCircuit Court of Appeals ruled that the Department of Labor did not have the authority to make such a law. On June 21, 2018, they confirmed that the rule was “vacated,” or canceled.
Why is there opposition to the fiduciary rule?
Frequently things like the fiduciary rule, while seeming to be simple, unmask many complexities. Such was the case for financial advisors and investment advisors started to determine how they could change their structure to meet the fiduciary rule.
The easiest way was to move any clients who were in a commission-based account to a fee-based account. In this way, the advisor would get a fee for the total value of the portfolio at the end of the year. This presents a couple of problems.
First, many investors were accustomed to only paying a commission on their trades. If they were now assessed a fee it meant that money that they had already paid a commission on would now be assessed a fee which, according to the Financial Industry Regulatory Authority, is capped at five percent. For example, a client with an existing commission-based Roth IRA could be forced into the unsavory choice. The could keep the Roth IRA, but lose the ability to make changes to it. Or they could shift it into a fee-based account where they would pay a yearly fee based on the value of their assets and have an advisor actively manage their assets – an option they may not need or want.
However, even if the fee was as low as 1%, a client that has not traded any of the assets inside their IRA in many years would now actually face higher costs.
Second, the industry stood to lose an estimated $2.4 billion per year by eliminating fees such as front-end load commissions and mutual fund 12b-1 fees. Meanwhile, some of the larger investment advisory firms argued that by eliminating commissions and shifting the industry to flat fee structures, the fiduciary rule would actually price many less-wealthy investors out of the market for investment advice.
The third reason for the opposition that was unrelated to the fee structure was the ability of smaller firms to meet all the stipulations for compliance. This would result in a consolidation within the industry as small firms would dissolve or be acquired. Even some of the larger firms such as MetLife and AIG preemptively sold their brokerage operations to assure they could be in compliance with the rules and their related costs.
The bottom line on the fiduciary standard
Even though the fiduciary rule is not the law of the land, the fact that it almost did become law(and that parts of the rule may still become law in the future) caused changes in the financial services industry. To begin with, fees are coming down and will probably continue to do so. In addition, many firms have made fees more transparent and removed high-fee, low-cost mutual funds. In turn, investors are now finding that they have a range of higher-quality investments and their selection process is easier.
Furthermore, now that the conversation about the fiduciary standard has become familiar to investors, there will be more scrutiny placed upon brokers and advisors as their clients demand that they adhere to a fiduciary standard.
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