Imagine you’re looking for a new pickup, so you decide to stop by the Ford dealership and see what they have in your price range.
Within a minute or two of walking on the lot, a salesperson has found you and is asking what you’re looking for in a pickup. You let him know what kind of power and space you’d prefer and then he pauses for a minute before speaking up.
“I know the perfect truck for you,” he says, “but it’s not here. You should go to the Chevrolet dealership.”
You’re stunned! You’ve never heard of a car salesperson who was willing to send a customer to another dealership. After all, it means he is sacrificing his own commission in favor of you finding the right vehicle.
But what if a car dealership removed commission and just paid their salespeople a steady salary? Our preconceived notion of the “sleazy car salesman” would probably change considerably because they would be free to give us impartial advice, free of potential conflicts of interest.
Salespeople are not untrustworthy as a whole – I’ve met plenty of them who were a great help to me. While the extent that their commission affects their advice depends on the salesperson, you can’t ignore the fact that they get paid based on what you buy.
Advisor standards come in two forms: fiduciary and suitability. One operates on a fee-based scale with little or no commission involved, the other operates on a commission-based scale based on what they sell their clients.
In this post, we will look at the difference between the fiduciary and suitability standards, how to tell the difference when selecting an advisor, and how new rules from the government could change these dynamics in the coming years.
Fiduciary vs. Suitability
Some advisors, like TFS, hold to a fiduciary standard. Among other things, the fiduciary standard includes a duty of loyalty and care that requires advisors to act in the best interest of their clients.
In other words, if you come into our office looking for a pickup, we’ll point you to whichever would be best for you, regardless of whether it’s a Ford or Chevy (or Toyota or Dodge…).
In contrast, advisors operating under the suitability standard are required to make recommendations that would be a suitable for a client. They can recommend products that result in higher commission for them as long as those products could be deemed suitable (which, as you might imagine, is a difficult definition to pin down).
In other words, if they’re selling a Ford, they’re not going to extol the virtues of the new pickup from Chevrolet.
Most investors aren’t aware of the distinction between the fiduciary and suitability standards since some advisors are registered to offer services that fit either standard.
As I’ve said before, “suitability” does not mean “untrustworthy.” I’ve met more than my fair share of advisors under the suitability standard who operate with integrity.
The difference is that we don’t even want to present the appearance of giving conflicted advice, and we feel that the suitability standard allows room for conflict of interest. That’s why we choose the fiduciary standard.
How to Tell the Difference
The easiest way to determine if your financial advisor is following a fiduciary or suitability standard is to simply ask them. Prior to meeting a financial advisor, ask which standard they operate under, and make sure you ask if that standard applies to every area of their services.
It’s not uncommon for advisors to operate under the fiduciary standard in some areas and suitability standard in others. That’s no cause for alarm, but you’ll still want to check.
In addition, FINRA’s BrokerCheck is a great resource to look up any financial advisor to check out their history. This will tell you if they have ever run into problems in the past. If they have a mark on their record, it’s not necessarily reason to bolt – just make sure you speak with them about it and that their answer satisfies you.
New Fiduciary Rules
Congress and the Securities and Exchange Commission understand that many people don’t recognize the distinction between fiduciary and suitability standards, and they are working on solutions. Supporters of stricter standards argue that customers don’t realize that there are conflicts of interest, which could be costing them a lot of money over the long-term. But critics argue that requiring a fiduciary standard across the board would eliminate free financial advice and make financial advisors too expensive for most people.
The Department of Labor introduced new fiduciary rules last year that took partial effect on individual retirement accounts last summer. But the full implementation has been delayed until the summer of 2019 as it reassesses parts of the legislation that would permit investors to sue brokerage firms for violations. Some experts believe that the DOL rule will now rule out the enforcement provisions that would make it so effective.
The SEC is expected to issue its own proposal over the coming months that would require all advisors to adhere to a fiduciary standard for all brokerage accounts – not just retirement accounts. For example, the new rules could prevent a firm’s salespeople from calling themselves financial advisors unless they agree to a fiduciary rule beforehand. But, there’s some concern that the focus will be solely on making disclosures.
The Bottom Line
The financial services industry has some blurred lines when it comes to conflicts of interest. While regulatory bodies are working on solutions, you should be sure that you take the time to understand whether your financial advisor is bound by a fiduciary standard or a suitability standard, and how that affects their advice. There is a time and a place for both types of advisors, but it’s important that everyone knows what they’re buying.