Trust is the most valuable asset a financial advisor has in their arsenal, but are clients giving away their trust too easily? A study by Personal Capital reported in the Financial Advisor Magazine suggests that could be the case.
Their 2019 report found that 48% of respondents believed that all financial advisors were required by law to always act in their client’s best interest. Along these same lines, 65% of people thought that their advisor would only recommend investments that would be best for them.
This study continues to become more fascinating as 30% of respondents felt that a financial advisor would be likely to take advantage of a client, but 97% did not think that about their own advisor. It’s a classic predicament: people know something bad could happen but not to them.
Unfortunately, this happens more than it should. A vast majority of the time it’s because language, standards, laws, and fees are murky. Without proper vetting, a client may assume their advisor operates in their best interests when that isn’t the case.
It’s our goal at TFS to arm you with the information you need to make confident choices about who you decide to work with, which is why we brought you this two-part series. Let’s dive into what you need to know to determine if your advisor is working for you.
Know the true meaning and scope of the word fiduciary
A fiduciary is one of those financial buzzwords that can be sprinkled into conversations or highlighted in marketing collateral, but what does it mean and how does it work?
A fiduciary is a person or entity that acts in the interest of another person in good faith, honesty, and trust. The Cornell dictionary cites a fiduciary duty as “the highest standard of care.” In the financial industry, this relationship carries immense weight. Serving as a fiduciary means that an advisor always acts in the best interest of their client, even if it’s not necessarily what’s best for the advisor.
As a financial advisor, that involves making recommendations that are aligned with the client’s needs and goals. In practice, that might be recommending a product or service that garners little to no compensation for the advisor, because that product best fits into the client’s plan.TFS has been operating as a fiduciary since 2001 when we shifted our practice to a fee-based firm.
The Securities and Exchange Commission (SEC), the regulating body of registered financial advisors, elaborates on the fiduciary standard, and the responsibilities that come with it. They cite that a fiduciary must,
- Act with loyalty.
- Never purposefully mislead a client.
- Actively avoid or disclose any conflicts of interest.
- Provide a complete and comprehensive disclosure about recommendations.
- Never use a client’s asset for the benefit of the advisor or any other party.
The fiduciary standard vs the suitability standard
Remember, not all advisors are fiduciaries. Some operate under the suitability standard, which states that an advisor can only make recommendations that are “suitable” to the client. This definition leaves a grey area and gives more room for advisors to recommend products with higher commissions.
Let’s look at a case study to better illustrate this point.
- Advisor A is a fiduciary. They are legally obligated to act in their client’s best interests.
- Advisor B operates under the suitability standard. They must disclose the proper information and fully discuss the recommendation with the client but they don’t have to ensure each and every recommendation is in the client’s best interest, just that it’s suitable for their portfolio.
Now, consider that there are two equal products on the market that fit the client’s needs. One has a substantially higher commission than the other. What happens next?
Advisor B is free to recommend the product with the higher commission. Since it does fit the client’s needs and they fully disclose the process, it’s good to go.
Advisor A, on the other hand, would only be able to recommend the product with the smaller commission. Why? While the higher paying product still aligns with their needs, it isn’t in the client’s best interest to pay a higher price when there is a near-identical one on the market for a lower rate.
Now, we aren’t saying that advisors who aren’t fiduciaries are bad. What we are saying is that an advisor who acts as a fiduciary has an additional responsibility to advocate for the client throughout each step of the planning process.
The “part-time” fiduciary
Another place where clients can get tripped up is when an advisor markets themselves as a fiduciary, but only acts in that capacity when performing certain tasks. This distinction can get tricky.
Some advisors are affiliated with both a registered investment advisory firm and a broker-dealer firm (like us). That’s not inherently an issue, but the problem occurs when they operate under the fiduciary standard for investment advice and the suitability standard for selling securities or insurance products and aren’t communicating that difference to their clients.
While we are affiliated with both an RIA and a broker-dealer firm, we are upfront and communicate that to our clients. We operate as a fiduciary nearly all the time and when we bring in commissioned products, we do so with heavy disclosure, openness, and transparency.
The bottom line here is that open communication is high on our priority list. We encourage our clients to ask us questions and we are happy to provide them with the answers they need. Again, this opens up the line of communication and gives clients the opportunity to develop a better relationship with their advisor.
Even knowing all the ins and outs of what it means to be a fiduciary, this word can mean different things to different people. To ensure that your advisor operates under the fiduciary standard we outlined for you today, ask them the following questions:
- What does being a fiduciary mean to you?
- Why are you passionate about being a fiduciary?
- Do you always act as a fiduciary in each piece of advice you recommend?
- Can you demonstrate what this looks like in your firm?
Upfront, transparent fees
Fee structures are another fuzzy area for many people when it comes to their financial advisor. The same Personal Capital study from above found that 20% of people didn’t know how their advisor was paid. This information gap presents a significant issue.
It’s a red flag when any advisor can’t clearly articulate three fundamental ideas:
- How they are paid.
- Why they chose their fee-structure.
- The value you get from the fee.
If your advisor can’t give you a clear explanation of how they are paid, odds are they won’t be a good fit for you. It’s vital to know your advisor’s compensation model because it can point to the value and service you can expect from them.
Technically speaking, there are three ways an advisor can be paid.
- Fee-only (flat-fee, service-based, AUM. Advisors don’t receive any commission for selling securities or products.)
- Fee-based (advisors who can receive both a flat fee and commission)
- Commission (paid solely from the sale of products or investments)
Keep in mind that fiduciary advisors can either be fee-only or fee-based. But since these technical terms can be applied in different ways across the industry, it is always best-practice to explicitly ask your advisor how they are paid.
Remember, it’s not only essential to know what an advisor charges and why but also the level of service you can expect for the price they charge.
Stay tuned for part two coming your way next time! Has this post inspired you to ask us any questions? If so, schedule a time to talk with us today.