Fiduciary standards of care

January 25, 2017

One word has caused much angst among lawmakers, financial advisors, brokers, and those seeking advice. And that word is fiduciary. A very general definition of fiduciary is a person who has an ethical or legal relationship of trust with one or more parties. There are several professions that necessitate a fiduciary standard of care, not limited to attorneys, doctors, real estate agents, bankers, and even executives of publicly traded companies. These individuals are always obliged to act ethically, and may even be legally responsible to act in the best interests of those who they serve. Each profession has varying degrees of fiduciary standards of care, but nonetheless there is still an element of trust involved, and trust is an absolute concept; it’s either existent or it’s not.

 

The legislative debate around the fiduciary rule is complex, nuanced to a fault, and boring enough to make our readership fall asleep on the spot. But it does deserve a brief mention, if only to grasp the issues of contention. 

 

Under the Obama administration, last year the Department of Labor approved a law set to go into effect this April that will make financial institutions and advisors legally and ethically accountable to provide advice that is “at the time of recommendation, in the best interest of the retirement investor.”1 The salient word in this statement is retirement. But another interesting phrase within the law is “at the time of recommendation.” Several questions follow with regard to these two points, by no means limited to: 

 

  • Are investors between the ages of 20 and 30 so-called “retirement” investors, or are they merely saving for some other goal like a college education for their children?

  • Are baby boomers who have no intention of ever retiring—by choice—considered retirement investors?

  • Is any credence given to monitoring the investments that were implemented based on the initial advice at “the time of recommendation,” or is it simply a one-time transaction with no follow-up?

  • How long does the investment outlook period cover when a recommendation is made? Who decides? And how is this monitored?

 

The ambiguity in the DoLs statement above is enough to make your head spin. And although we believe that the law has good intentions, sometimes the unintended consequences can exacerbate the problem even more. Make no mistake, there is a problem with the system, the terminology, and ultimately the outcomes that investors have been subjected to for decades. But that doesn’t mean a half-baked law will suddenly fix all of that. 

 

Difficult to define

 

Semantics, believe it or not, is an enormous problem within the investment industry, as we just witnessed when trying to define what a retirement investor actually means. Take it a step further and questions arise about what it means to be an advisor or a broker or even a financial planner. Can Certified Financial Planners be brokers? Can brokers be advisors? How do you even know if your investment professional is qualified, and what designations are required for each? For example, just to highlight how absurd some of the naming conventions are in the industry, at first glance it would appear that Registered Investment Advisors (RIA) and Registered Representatives (RR) could be used interchangeably. But the two are far from synonymous. RIAs work under a fiduciary standard of care as prescribed under the Securities Act of 1940. They are legally obligated to put their clients’ interests ahead of their own. Registered Representatives abide by no such standard, operating in a sales capacity as brokers. This is not to say that RRs can’t serve their clients in an ethical and beneficial manner, however. All it means is that they’re being compensated to sell an investment product, rather than being paid to advise the client on a continuous basis. This example is meant to shed light on the ambiguity of the language used in the industry. It gets even more confusing once the terms “wealth manager” or “financial advisor” or “investment advisor” are used to describe what may or may not be someone operating in a fiduciary capacity.

 

The answers investors seek are as convoluted as the questions, which does nothing but harm investors in the long run. Confusion has killed investors’ returns.

 

Two standards within the investment world currently dictate how advice is given: the fiduciary standard and the suitability standard. The latter is a much less stringent rule that basically says advice and/or an investment product must be reasonable based on the client’s needs and profile.2 In other words, the suitability rule, or FINRA Rule 2111, states that at the time of counsel, all that is needed is for the suggestion to be suitable for that individual. Of course, an advisor who is compensated by a flat fee will most likely interpret "suitability" very differently from a broker who is being paid commissions derived from transaction activity. This is not to say, however, that all fee-based advisors are altruistic fiduciaries, while all brokers are self-serving and only concerned with the commissions they generate. Plenty of advisors have been indicted for bilking investors out of money, and many brokers serve to bring buyers and sellers together, albeit at prices that (hopefully) make sense for both. 

 

Sifting through the rubble

 

Much has been written about the way investment advice is communicated to the public. Opponents of the new fiduciary rule argue that it will harm investors and cost more to comply with regulations. Proponents say it’s a step in the right direction but it doesn’t go far enough. Lawmakers can’t seem to articulate exactly how the law will impact the general public, let alone keep various investment professionals from using titles that clearly deviate from how they actually operate. But there’s one very basic concept that most seem to be missing and that’s the issue around conflicts of interest. 

 

Michael Kitces, an advisor and author who has written extensively on the subject, summarizes the new rule quite well: “the essence of the new rule is the idea that when a fiduciary provides advice, it must be in the ‘best interests’ of the client (not for the benefit of the advisor and his/her own compensation), and advisors must manage and mitigate their conflicts of interest that may taint their client-centric advice.”3 

 

Kitces is right, the heart of the matter deals with conflicts of interest, and nothing more. Consider the following questions:

 

  • Is your financial advisor or broker doing their due diligence to find the funds with the lowest costs? And how do you know?

  • Are the fund recommendations with their institution or a third-party institution? And who has actual custody of your money? (note: a third-party custodian should always be used to hold your assets)

  • Is the institution that offers the funds publicly traded or is it operating at-cost for the benefit of its fund shareholders? (More on this later)

  • Is your advisor selling a product or are they simply providing advice for a fee?

 

Every investor ought to ask their potential investment professional these questions to determine whether they’re operating as a fiduciary or not. 

 

We want to touch on one last point with regard to the topic. Much has been said about individuals and the standards that they’re obliged to operate within. But what about institutions? Are institutions often operating under suitability or fiduciary standards? Do institutions as a whole have your best interests in mind, or are they attempting to serve two masters? 

 

A tale of two masters

 

To highlight one conflict of interest that the investment industry needs to confront, we’ll compare two fund companies: Vanguard and BlackRock (NYSE:BLK). Both organizations have assets under management (AUM) in the trillions, making them among the largest and most successful fund companies on the planet. But there’s a stark contrast between the two. Vanguard is a privately held company that operates without a profit motive, whereas BlackRock is a publicly traded corporation looking to maximize profits for its shareholders, which must come at the expense of the investors in its funds.

 

BlackRock is attempting to serve both its shareholders (those who own the stock) and its investors (those who invest in its funds), but in order to increase the profits of the former, the company must extract fees from the latter, essentially robbing Peter to pay Paul. This is a massive conflict of interest and one that often goes unnoticed. Vanguard has no such arrangement and operates “at-cost,” charging fees only enough to cover its operational expenses. Therefore, the company does not try to maximize profits for one group at the expense of another. Vanguard’s average fund expense ratio was a mere 0.18%, nearly 85 basis points less than the industry average of 1.01%.4 This translates into real savings for investors who avoid fund companies that serve two masters.

 

Vanguard highlights this with an appropriate statement on its website that reads: “We never have to weigh what's best for clients against what's best for the company's owners, because they are one and the same.” The fiduciary standard of care applies just as much to institutions as it does to individuals, and investors would be better served if they were the only master that mattered.

 

 

 

1. http://www.dolfiduciaryrule.com/

2. http://www.finra.org/industry/suitability

3. https://www.kitces.com/blog/best-interests-contract-exemption-bice-and-dol-fiduciary-bic-requirements/

4. https://about.vanguard.com/what-sets-vanguard-apart/why-ownership-matters/

 

 

 

 

 

 

 

 

 

 

 

 

 

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