Author: Steven Fox
Even though the Department of Labor’s new fiduciary rule for financial advisors has not yet been implemented, it has already been effective in increasing consumer awareness of and interest in the concept of fiduciary duty. In general, the term “fiduciary” simply means somebody who has a legal and/or ethical obligation to put the interests of another in front of their own interests.
Some common examples of fiduciary duty include the duties of attorneys to their clients, corporate board members to their shareholders, the trustee of an estate to the beneficiaries, or court-appointed guardians to minor children. Many people would presume that financial advisors also have a fiduciary duty to their clients, but that is not necessarily the case! In fact, the far majority of financial advisors do not currently have a legal responsibility to put their clients’ best interests before their own. Most financial advisors are subject to a lower standard called “suitability”, and there are others who are only required to act as a fiduciary for certain aspects of their relationship with clients.
There are two basic components to fiduciary duty: a “duty of loyalty” and a “duty of care”. Having a duty of loyalty means that a fiduciary has a responsibility to do what’s best for their client, rather than for themselves. Having a duty of care means that a fiduciary is knowledgeable and competent in their profession.
In the context of fiduciary financial advisors, fulfilling a duty of loyalty could mean advising clients to buy lower-cost financial products rather than another product that pays a higher commission rate for the advisor. Even better, they could follow a business model that seeks to avoid such commissions altogether. Financial advisors who receive variable compensation depending on the advice that they give will always have an inherent conflict of interest, which creates the potential for them to abuse the trust that clients should be able to have in their advice.
An example of a financial advisor fulfilling their fiduciary duty of care could be the advisor pursuing professional designations that challenge them to learn as much as possible about the topic areas within financial planning. Completing advanced education increases their ability to provide the best possible advice to clients, passing exams serves as a way to demonstrate their expertise, and keeping up with continuing education requirements helps to maintain or further enhance that knowledge.
Within the financial planning industry, there are a variety of types of fiduciary standards. Though they all require financial advisors to put their clients first, there are important differences in how these standards are applied. Not all fiduciaries have to act in the best interest of their clients at all times and in all ways, nor are all fiduciary standards enforceable by law, nor do all of them include both a duty of loyalty and a duty of care. This is true even if they (perhaps rightfully) call themselves a fiduciary!
There are three general types of fiduciary standards that a financial advisor may fall under:
- An SEC fiduciary under the Investment Advisors Act of 1940 (called “Registered Investment Advisors”)
- A fiduciary under the new Department of Labor rule about retirement accounts
- Voluntary fiduciary standards
SEC Fiduciaries (Registered Investment Advisors)
Whenever you’re working with a financial advisor who is with a firm called a “Registered Investment Advisor” (often abbreviated “RIA”), it means that they fall under a regulatory structure defined by the Investment Advisers Act of 1940. RIAs are required to go through a registration process with either the Securities and Exchange Commission or (for smaller firms) state securities authorities.
All RIAs are required to act in the best interest of their clients, whether they are registered with the SEC or their state. The RIA version of fiduciary, though, is more about disclosing conflicts of interests than it is about necessarily removing them. Some RIAs still receive commissions for various financial products that they sell to clients, which is permissible as long as they properly disclose the arrangement.
One of the biggest limitations of the RIA fiduciary standard is that it only applies to RIAs, not broker-dealers. RIAs currently make up only a small portion of the financial services industry. In addition, it only applies while the financial advisor is giving investment advice. It is irrelevant when discussing other areas of financial planning.
If you’re interested in learning more, see Section 206 of the Investment Advisors Act of 1940.
For many years now, the Department of Labor has been trying to institute a required fiduciary standard for anybody who provides advice about retirement accounts. A new rule was finally passed last year and was set to take effect in April of 2017, but it has been delayed and there is some doubt over its future with the new administration in the White House. As of this writing, it looks likely that the rule will be taking effect in June of 2017.
The DoL fiduciary rule is important because it prohibits some types of transactions that are not in the best interest of consumers, such as variable compensation. It also requires additional disclosures. In general, it is more restrictive than the fiduciary definition applied to RIAs.
Another major factor with the DoL rule is that it will apply to anybody giving advice to retirement investors, not only RIAs. So for the first time, financial advisors working at broker-dealers and insurance companies will be required to follow a fiduciary standard. They can still receive commissions for investment or insurance products that they sell, but there will be more regulatory scrutiny.
An important limitation to understand about the DoL fiduciary rule is that it only applies to retirement accounts. It has no bearing on advice regarding nonretirement accounts or financial advice outside of investing. This creates odd situations where a financial advisor could be required to act as a fiduciary when giving you advice about your IRA or 401(k), but not when discussing your taxable investment accounts or other areas outside of investing.
Voluntary Fiduciary Standards
The third category of fiduciary standards for financial advisors is made up of a variety of voluntary professional certifications and oaths. These standards are created by organizations seeking to improve the financial advice given to consumers. They generally tend to be stricter than the RIA and DoL definitions of fiduciary, focus on avoidance of conflicts of interest rather than disclosure, and have no legal consequences for financial advisors breaching their fiduciary duty. There is no legal enforcement of these standards, and nobody is ever required to adhere to them unless they voluntarily choose to do so.
One of the most common voluntary fiduciary standards is that applied to Certified Financial Planners, who are all required to follow the CFP® Board’s Code of Ethics and Practice Standards. All CFP® professionals must agree to act in the best interest of their clients any time that they are advising on “material elements of financial planning.” This fills in a big gap left by the RIA and DoL standards, which only apply to investment advice.
The CFP® fiduciary standard focuses primarily on the duty of care element, and only lightly addresses the duty of loyalty. Becoming a CFP® requires advanced education, passing a challenging exam, several years of experience, and the completion of ongoing continuing education requirements.
The biggest limitations of the CFP® fiduciary standard are that it only applies to CFP® professionals (a purely voluntary certification), there are no restrictions on commissions for investment or insurance products, the lack of a legal foundation means that the only punishment for breaches comes from the CFP® Board, and it only applies while the financial advisor is doing financial planning. This creates a potential problem when CFP® professionals can complete a financial plan for a client and then “switch hats” and become a salesperson collecting commissions for selling the products that they recommended.
Besides CFP® certification, there are a few other voluntary fiduciary standards that financial advisors may choose to adhere to. Many of them are established by membership organizations, such as the National Association of Personal Financial Advisors or the XY Planning Network. Interest groups such as the Institute for the Fiduciary Standard create their own versions. Some financial advisory firms also create their own fiduciary agreements that they sign with the client at the beginning of every relationship.
These other voluntary fiduciary arrangements often focus on avoiding conflicts of interest, not just disclosing them. Like the CFP® fiduciary standard, there are generally no legal consequences for breaches, though some of these organizations may require financial advisors to sign an agreement with their clients that they’ll abide by a fiduciary arrangement. Breaching those agreements may give clients the ability to sue.
Finding a fiduciary financial advisor
Most people searching for a financial advisor to work with would expect (and want) a professional who is both competent and puts clients first. It’s important to keep in mind that the far majority of financial advisors are not currently subject to any of these fiduciary standards. And because there are different types of fiduciaries, saying that they’re a fiduciary does not necessarily mean that they are required to act in your best interest at all times and in all the ways you engage with them. Know the differences between different types.
Don’t be too shy to ask questions! It’s entirely reasonable and fair to ask your financial advisor how they get paid and what conflicts of interest they may have when giving advice. Some people believe that conflicts aren’t always a bad thing, as long as clients are aware of the arrangement and understand that it may impact the advice they receive. Others think that financial advice should be completely separate from the sale of financial products. You can decide for yourself, there are a wide variety of financial advisors to choose from.
Consider working with a financial advisor who adheres to several different fiduciary standards. If they bring up the subject before you ask about it, then it’s probably something that they believe to be an important part of the way that they serve clients.
Keep in mind that all members of the San Diego Financial Advisors Network adhere to at least one (often, multiple) versions of the fiduciary standard. All of us firmly believe in putting clients first!