Fiduciary Standard and Financial Reform
June 21, 2010
When working with your financial advisor, do you assume that he/she is always working in your best interest? Unfortunately, the fiduciary standard is not a legal requirement for all advisors. Without its inclusion in the current financial reform package, it remains “buyer beware”.
Financial Reform and the Fiduciary Standard for Investment Professionals
Congress is in the final phases of reconciling the financial reform legislation. The ultimate goal is to protect market participants from the systemic risks that led to the colossal market declines in 2008 after the fall of Lehman Brothers. While one can debate the benefits and cost of additional regulations, we do feel that a healthy market needs fairness and transparency. This is why we were sorely disappointed when the Senate version of the bill lessened the House language to hold all investment professionals to the same fiduciary standard. While the final bill may still include this language, it seems unlikely at the time of this writing that there will be enough supporters in Congress who feel strongly enough to fight for the tougher standards.
Uneven Terrain - Fiduciary versus Suitability Standard
Independent registered investment advisors (RIAs) are required by the Securities and Exchange Commission (SEC) to adhere to the fiduciary standard. As a fiduciary, an advisor has a legal obligation to put the client’s interest first, rather than their own. This fiduciary standard is also part of the Code of Ethics for all CFP® certificants.
Presently, broker-dealers operate under a standard of “suitability” versus the higher standard of operating as a “fiduciary”. Broker-dealer firms argue that the fiduciary standard is too strict as they, by their very nature, must sell proprietary products that may or may not be the best financial instrument available. Under the suitability standard, the investment should be considered appropriate for the client (e.g. funds that are needed within a couple of years should not be invested in volatile stocks), but beyond that, a client must rely upon their own due diligence to ensure that they are receiving the best advice.
This does not mean that broker-dealers always act in a way that is bad for their clients, but it is important to note that not everyone who provides you with advice is required to put your interests first. Unfortunately, in an industry in which trust is critical, this dual standard also makes it easy for investors, who put their personal trust in the hands of an investment professional, to be sold products where the interest of the person who is selling the product is not fully aligned with that of the investor.
Hidden and Undisclosed Fees versus Personal Relationships
Given the number of scandals we have survived, we often take for granted that investors have an understanding of the “hidden” fees that can be found within mutual funds and annuities. Unfortunately, this is not the case. Swayed by investment jargon, smooth sales pitches, and personal relationships, investors still place their money into products that may on the surface sound great, but also have tremendous fees. Because the fees are hidden within the financial instrument, the investor may never even know the extent of the damage until much later, if ever. Following are just a few of the investment fees that can be hidden in seemingly simple and harmless investments, in this case - mutual funds:
· Front-End Sales Loads – Sales charges that are taken when a fund is purchased. These charges are particularly dangerous because they may be as much as 5% of the amount invested. If you are thinking, “Well, that’s not too bad”, consider how would you feel if your portfolio dropped 5% the day you started investing? That is the impact of a front-end load.
· Back-End Sales Loads - Sales charge taken when you decide to sell a fund. Again, these can be significant and typically start at 5%.
· 12b-1 Fees – Marketing or distribution fees that are paid to the broker or third party for selling shares to the public, usually 0.25% annually.
Each of these fees can be mitigated or eliminated. There are thousands of high-quality mutual funds that do not charge any of the fees noted above.
Questions for Yourself and Your Advisor
Do you understand the investments that you own and the fees associated with them? If not, make sure to ask your investment advisor to fully and completely disclose these to you. If you have any doubts, ask for a disclosure in writing. Make sure you understand how your advisor gets paid from these fees. Is it commission based? Does your advisor hold the CFP® or CFA designations, where you are required to adhere to a professional code of conduct? Are there any conflicts of interest that should be disclosed?
Finally, ask your advisor if he or she is held to a fiduciary standard.
Summary
While we feel strongly that all investment professionals should be held to the same high standard of care, it could be some time before this is the case. In the meantime, it is important for you as an investor to understand the differences and to ask as many questions as necessary to ensure the investment advice you are receiving is in your best interest.
