Jargon is wonderful when it applies to your profession but is not so enduring when it applies to someone else’s. I am surrounded in my family by medical professionals and engineers. So, one can only imagine the conversations around my house flying over the head of a financial planner. However, my industry jargon can confuse clients of financial services. In this blog, I will shed some light on a significant word that gets used quite often but remains shrouded in mystery for some: fiduciary.
What is a fiduciary?
Investopedia defines a fiduciary as: “A person or organization that acts on behalf of another person or persons, putting their clients' interest ahead of their own, with a duty to preserve good faith and trust. Being a fiduciary thus requires being bound both legally and ethically to act in the other's best interests.” Therefore, "fiduciary" can be applied to various relationships: board members and shareholders, trustee and beneficiary, legal guardian and child, and executors and legatees. However, the one we’ll be focusing on is financial advisor and client.
What is a fiduciary financial advisor?
True fiduciary financial advisors are designated “Registered Investment Advisors (RIAs)” by the Securities and Exchange Commission (SEC) and are regulated by state and federal agencies. They are legally and ethically bound to do what’s best for you. Plus, they must buy and sell investments based on what they believe will be the right choice for your unique circumstances considering both efficacy and expense. They must avoid or mitigate potential conflicts of interest to the greatest degree possible. However, not all financial advisors are also fiduciaries, and that causes a lot of confusion.
Which financial advisors are NOT fiduciaries?
Unlike RIAs, broker-dealers (B-Ds) get to govern themselves through the Financial Industry Regulatory Authority (FINRA). Their employees (Registered Representatives) are held to the “best interest” standard, which permits greater leeway regarding conflicts of interest, so long as they are disclosed in the fine print. They don’t have to make the most economical investment options available and may keep them off their platforms altogether. The “best interest” standard does require them to have a reasonable belief that an investment, transaction, or frequency of transactions is suitable for a client. However, the language in the requirement is far more vague than the fiduciary standard, which makes it a whole lot easier for them to recommend an annuity or other product or strategy that is highly profitable to the brokerage firm. The SEC has tried to find ways to apply a true fiduciary standard to B-Ds, but the unavoidable conflict of interest (making a profit at the client’s expense) is the very heart of their business model.
In a nutshell, the fiduciary standard discourages an advisor from being paid for their recommendations by anyone but the client. On the contrary, the“best interest” standard permits the B-D and/or its employees to earn commissions and various fees from third parties based on those recommendations. So, even if the B-D’s client relationship representative is salaried, the B-D itself can control which investments are available to best serve its interest. It can lend client securities out and collect fees for itself for doing so and it can exclude mutual funds and ETFs that are not profitable enough for itself. Plus, it can sell its own mutual funds and ETFs and earn management fees from them.
That being said, B-Ds are not evil geniuses. They serve a purpose by making securities available to both the general public and to clients of professional RIAs. The difference may be most profound in the motivation, or lack thereof, to minimize client expenses. The bottom line is that registered fiduciary financial advisors benefit in no way from their clients experiencing higher expenses, however, B-Ds do. Use that information at your discretion.