The fiduciary standard of care requires that a financial adviser act solely in the client’s best interest when offering personalized financial advice
The definition of the fiduciary standard. In this article will compare the fiduciary to the suitability standard, and raise points where the fiduciary standard does not go far enough.
The legal description of the suitability standard can be read in-depth on FINRA's website. In sum, all investment professionals are legally required to provide a recommendation suitable to the client's needs. Using a car purchase as an example, if a customer goes to a Ford dealership and asks for a vehicle for their four person family, they could be shown a Ford F-350 crew cab truck. The salesman will not be motivated in suggesting they go to the Honda dealership to look at a Honda Accord, but instead show what is available on the Ford lot. If the salesman suggests a F-350 Super Duty truck, this would be a "suitable" recommendation as long as the truck has four seats. Let's assume the customer is not from Texas where the F-350 is a popular everyday vehicle!
In the financial products industry, commissions and kickbacks abound. With the suitability standard, the advisor/broker can receive significant fees that undermine client portfolios, as they may recommend products based on fees, commissions, or kickbacks received instead of what is in the best interest of the client.
To solve this, a stronger standard in which many advisors, and one required by CFP advisors, hold to is the fiduciary standard. As a fiduciary, one must provide a recommendation in the client's best interest. A recommendation cannot be made influenced on sales fees, commissions, or any other kickback. But is this enough? Advisors are influenced in other ways - primarily ease of work, consistent compensation, and non-disclosure of outside options. Let's look into each of these:
Ease of work for the advisor
Everyone wants passive income. To be able to receive income with no or minimal work can be the ultimate goal. In the finance industry, if an advisor is paid to manage assets, are they truly spending time on the client's portfolio based on the given compensation, and is the compensation in-line with the work output? Compensation style is key here - advisors who market themselves as fiduciaries may provide recommendations in the client's best interest, however their fees are not. For more information on this, see my article on why I am opposed to AUM compensation. Most methods of advisor compensation do not encourage advisor to work for their clients, if anything they are setup to not have to do any work! Once an advisory firm has a client's assets, are they encouraged to spend more time with the client if their fee is based on a percentage of assets under management or sales-fee/commission style? Definitely no. In practice clients who come to me from AUM or sales based advisors
For the purpose of this article, I will not cover the issue of advisor's doing counter-productive work; this will be covered in a future article.
Similar to ease of work, financial professionals want consistent income. I've been an entrepreneur since 2008 - and the ideal business model is one that retains customers/clients for the long run, and where these clients pay consistently. Ideally this would be increase each year (to adjust for inflation and increase profits). The finance industry is based on this - obtain management and custodianship of client's assets, and charge annual fees to manage these assets. As the portfolio increases, the fees will increase accordingly.
As a comparison, hourly-based advisors do not have conflict of interests of compensation; fees are based on hours worked. I often have clients who often decrease fees in future years, as fees are not based on portfolio size. I have clients who are consistent, however I also have many others who need my advice once or once every few years. If an advisor does not put the client's best interest based on compensation, do they meet the fiduciary standard? I suggest not, and why I am an hourly planning only advisor.
Non-Disclosure of Outside Options
If a client could be better served by someone else, are you obligated to tell them? This is a question for all, not only financial professionals. Should the car salesman tell the customer Ford does not have sedans, and before deciding on the available F-350 look at the Honda dealership for an Accord? Is the insurance agent obligated to inform the customer of their fees, and mention a non-commission based insurance company that would provide the same product without commissions? Of course not. The question remains - if a fiduciary acts solely in the best interest of a client, should they recommend a service that has lower fees than their own?
I think these three elements needs to be part of the fiduciary standard. Without them, the standard leans on shaky ground. The fiduciary, if truly acting in the client's best interest, needs to tell the client their compensation method may not be in line with the amount of fees collected based on ease of work and consistent returns, and they should tell the client if a better option is available.