Why some financial advisors must show undivided loyalty to you while others can have undisclosed conflicts of interest. How to tell the difference.
In this episode you’ll learn:
- What is the difference between an investment advisor and a financial advisor.
- What are fiduciaries.
- Are robo-advisors fiduciaries.
- Why is the Department of Labor’s new fiduciary rule controversial.
- Things you should ask a financial advisor before hiring him or her.
Show Notes
Who Is An Investment Advisor – SEC
Investment Advisors Are Fiduciaries – SEC
FINRA – What is an investment advisor
2011 Study on Investment Advisers and Broker Dealers – SEC
The Fiduciary Rule and Its Impact on the Wealth Management Industry ATKearney
SEC chief rips into Fiduciary Rule
Thinking Twice Between Throwing Out The Fiduciary Rule – Irwin Stelzer – The Weekly Standard
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Summary Article
Is Your Financial Advisor Loyal To You?
When I was 28, I worked full time as a credit analyst. We had recently bought and moved into our first home after spending the summer applying coat after coat of Kilz primer and paint to get rid of decades of cigarette smoking residue left behind by the former owner.
Our first born son was nearing his second birthday, and we wanted to start saving for his college tuition.
Given we had to sell one of our cars in order to scrape together the down payment to buy the house, we didn’t have much money to start his college fund. Just $200.
This was before 529 Savings Plans and a couple of years before Internet browsers made surfing the web the easiest way to get information on any topic. Instead, I called a financial advisor.
I don’t recall how I found the advisor, but on a weekday evening she came to our house to answer our questions on saving for college.
Keep in mind my undergraduate degree is in Finance, I had recently graduated with an MBA with an emphasis in finance and I worked in finance full time. Yet, I figured there must be some correct, perhaps tax-advantaged way to save for college so I called a financial advisor.
The advisor was glad to help. She opened up a brokerage account in our name and invested the $200 in the Franklin Templeton Growth, a stock mutual fund that has been around since 1948.
I didn’t question her choice, nor her qualifications. After all, she seemed competent, had a business card that said planner or advisor so I just assumed she had our best interests in mind.
We never heard from her again and our $200 sat in the Franklin Growth Fund untouched for the next six years. We never added another dollar to that college savings account.
$20 For Advice
In the late 1990s, I had left corporate finance and had been working for several years as an institutional investment advisor. I opened up my statement for my Franklin Templeton Growth Fund, which by now was worth over $400 dollars, and realized I was invested in the fund’s “A” class shares.
That means we had paid a 5.75% commission when we first invested our $200, and we were paying an additional 0.25% annual 12B-1 fee as ongoing compensation to the advisor who sold us the fund.
I remember being annoyed that we were invested in such an expensive fund with overall annual expenses of close to 1%. So I closed the account and took back our $400.
By my calculations the advisor earned just under $20 over six years for the 45 minutes she spent with us in the early 1990s. Not exactly a windfall.
Did the advisor act in our best interest? Did she charge too much for her advice?
While I don’t know if she acted in our best interest, I do know she didn’t disclose the compensation arrangement she had with the fund company. Although the commission rate was high, the actual dollar amount she received from our investment was small, and we probably would have balked had she wanted to charge us $200 for an hour of her time.
Fiduciaries
A fiduciary relationship is one in which an individual has placed trust and confidence in another person who in turn accepts that trust and seeks to act in the individual’s best interest in giving conflict free advice.
In the U.S., registered investment advisors are fiduciaries in working with their clients, and according to the U.S. Security and Exchange Commission investment advisors owe their “clients a duty of undivided loyalty and utmost good faith.”
Currently, most financial advisors that work for brokerage firms as well as insurance agents do not have a fiduciary relationship with their clients. Instead, they are held to a standard of fairness in making recommendations to their clients that are suitable and consistent with the clients’ interest.
Leveling The Advisor Playing Field
In 2016, the Department of Labor (“DOL”) expanded and clarified who is a fiduciary in regards to working with retirement plans including employer sponsored plans and individual retirement accounts (“IRA”s) that are created when an individual rolls over their balances from an defined contribution plan such as a 401k.
The DOL’s rationale for making the change is that compared to when the original definition as to who is a retirement plan fiduciary was passed in 1975, today the investment landscape is much more complex in terms of the number of investment choices individuals face.
The DOL wrote in the Federal Register where the new rules were published that if some advisors are not fiduciaries then “they may operate with conflicts of interest and have limited liability under federal pension law for any harms resulting from the advice they provide. Non-fiduciaries may give imprudent and disloyal advice; steer plans and IRA owners to investments based on their own, rather than their customers’ financial interests; and act on conflicts of interest in ways that would be prohibited if the same persons were fiduciaries.”
A Very Big Deal
This proposed change is a very big deal as it raises the standard of care and potential liability for broker-dealer representatives and insurance agents in working with employee benefit plans and beneficiaries including retail investors’ individual retirement accounts.
The consulting firm ATKearney estimated that the DOL’s new fiduciary rule would cost the brokerage industry $11 billion in revenue over the next four years as assets shift from more expensive products and solutions to less expensive solutions, such as roboadvisors.
The new rules don’t prohibit commission-based compensation arrangements. Rather, they require a brokerage firm “to acknowledge fiduciary status for itself and its Advisers” and “adhere to basic standards of impartial conduct.” That means giving “prudent advice that is in the customer’s best interest, avoid misleading statements and receiv[ing] no more than reasonable compensation.”
The new fiduciary duty rule was supposed to take effect next month, but in early February President Trump issued an Executive Order delaying implementation out of concern that the new fiduciary rule “may significantly alter the manner in which Americans can receive financial advice, and may not be consistent with the policies of [his] Administration.”
The order directs the Department of Labor to determine whether the new rule has harmed or will likely to harm investors due to a reduction of Americans’ access to certain retirement savings offerings, retirement product structures, retirement savings information, or related financial advice” or will increase the prices investors must pay to gain access to retirement services or cause an increase in litigation.
A Higher Standard
A higher standard and an even playing field for all financial advisors would most likely lead to an increase in litigation. But it would also give individuals more confidence that their financial advisor is acting in good faith and is considering their best interest.
Best interest and undivided loyalty does not always mean that the cheapest product is best or one without a commission. It means the financial advisor should disclose the pros and cons of any strategy and have a frank discussion about costs and benefits rather than just making disclosures in the fine print.
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