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Advisor Terms: What’s a Fiduciary?

by | Oct 10, 2018 | Financial Planning

It has been a little more than a year since I decided to shift gears in my career and open my own firm as a financial advisor. In my prior career as an equity analyst, I never had to do “sales.” The only networking I did was amongst fellow analysts and those that worked at the companies I was tasked with analyzing.

Once I officially opened the doors on Honey Lake Advisors, I had to start getting out there to look for new clients. A big part of that effort has been networking with individuals and business owners in my area. It’s always an interesting exercise.

Them: “So what do you do for a living?”

Me: “I’m a financial advisor.”

Them: “Oh….um, I’m going to go get a cup of coffee from over there. See you around!”

I knew that financial advisors had checkered reputations before I decided to become one myself. Still, it’s still eye-opening to see people’s reactions when I tell them I’m an advisor. One of the big reasons why I think the industry has earned this reputation is because the standard of care many advisors are held to sets the bar way too low, resulting in advice that benefits the advisor over the client.

What’s the Standard of Care?

Last week I talked about the various ways “advisors” are compensated. I put the word advisors in quotes because the reality is that many folks who call themselves advisors are nothing more than salespeople.

This week we are going to look at two standards of care that an advisor can have with you: a ‘fiduciary’ standard or a ‘suitability’ standard. When we look at these two standards in the context of how the advisor is paid, my hope is you will better understand what questions you should be asking any prospective advisor.

The Fiduciary Standard

Fiduciary is a word that’s thrown around a lot, but a lot of people don’t really know what it means. According to the Securities & Exchange Commission (SEC), some of the key elements of being a fiduciary are:

  • Act in the best interests of clients
  • Provide advice in the best interest of clients
  • Owe clients undivided loyalty and utmost good faith
  • Avoid conflicts of interest and disclose them where they exist
  • Cannot use client asset for the advisor’s benefit (think Bernie Madoff)

Acting in client’s best interests and being loyal to them would seem to be pretty basic standards that any client would expect from an advisor. Surprisingly many advisors are not held to such standards!

How can you tell if your advisor is being held to a fiduciary standard or not? Ask them! Or ask them this:

  • “Are you an Investment Adviser Representative?”
  • “Is your firm a Registered Investment Adviser (RIA) registered with the SEC or state?”

If they answer “Yes” to those questions then you are almost certainly dealing with an advisor who is being held to a fiduciary standard under SEC or state rules. The fiduciary rules laid out by the SEC are not suggestions…they are the law. The SEC is quite explicit in spelling out this duty for advisors, which you can see here.

The takeaway here is that acting as a fiduciary carry with it legal responsibilities of duty to clients.

The Suitability Standard

While the fiduciary standard for investment advisers is enforced by the SEC, those that are held to a suitability standard are regulated by FINRA, which is the financial industry’s self-regulating body.

The best way to understand the Suitability standard is to read FINRA’s definition of it:
“A member or an associated person must have a reasonable basis to believe that a recommended transaction or investment strategy involving a security or securities is suitable for the customer, based on the information obtained through the reasonable diligence of the member or associated person to ascertain the customer’s investment profile.” [emphasis mine]

The advisor in this scenario will look at the following to determine your “investment profile” by looking at:

  • Age
  • Investments that you currently have
  • Your investment experience
  • Time horizon of the goal you’re trying to achieve
  • Liquidity needs
  • Risk tolerance

Sounds a lot like what any advisor would do, no? In theory, yes. But check out what the definition says about an advisor’s recommendations. They “must have a reasonable basis” for making a recommendation that is “suitable.” I’m no English major but the words “reasonable” and “suitable” imply that there’s a lot of room for interpretation when trying to determine what’s really best for a client.

Contrast that with the Fiduciary standard, where the advisor has a Duty of Loyalty and a Duty of Care. Recommendations that are based on ‘reasonableness’ and ‘duty’ are two very different things.

The difference between a well-fitting suit and Tommy Boy

I like to think about the difference between ‘fiduciary’ and ‘suitability’ in terms of a guy trying to buy a suit.

Remember back to the old Men’s Wearhouse commercials, where the owner always said at the end, “You’re going to like the way you look. I guarantee it.” The promise he was making was that they would work with you to find a stylish suit and then make sure it fits you as best it could. You needed a suit, and they would help you find the best one. This is how a Fiduciary would operate.

On the other side of the coin, if this same guy went to a store operating under the Suitability standard (no pun intended) they might end up with a suit fitting like the one Chris Farley wore in the movie Tommy Boy.

In both examples, the client ended up buying a suit. However, the salesperson from Men’s Wearhouse took much care to make sure the client got just the right suit for his particular style and build. Hence, the client walked out of the store with a nice-looking suit.

Conversely, the guy who sold the suit to Chris Farley sold him whatever suit he had on hand, regardless of whether that was the BEST suit he could have found for him. The client needed a suit so the salesperson sold him a suit regardless of how it looked or how it fit, end of story.

It’s a matter of ADVICE over SALES.

Much like the guy at Men’s Wearhouse, a financial advisor that is a fiduciary will look at your goals and desires, assess your financial position, and then give you ADVICE on what your potential courses of action are. They are looking out for what’s best for YOU, operating under a Duty of Loyalty and Care.

The advisor that operates under a Suitability standard isn’t held to the same standard. If you need help with your investments, they will sell you a mutual fund as long as they can prove it’s a reasonable recommendation for you. It might not be the best mutual fund you can buy, but as long as it’s deemed a reasonable option the advisor will sell it to you. Their primary duty – surprisingly – is to their FIRM, not the client. And big firms are most concerned with generating sales and gathering assets.

Compensation & Standard of Care – What’s the Takeaway?

In discussing advisor compensation last week and standards of care this week, my goal has been to educate you on what motivates financial advisors. As mentioned earlier, I think a lot of people avoid getting the help they need with their finances because they’re worried about getting taken advantage of. Too often, this is what happens.

But there is a new wave of financial advisors coming to market today that are doing what they can to eliminate conflicts of interest and design their businesses around high standards of excellence.

On the compensation side of the ledger, more and more advisors are adopting fee-only compensation structures, moving away from legacy commissions & sales structures. This not only makes pricing much clearer to you – the client – but it removes motivations for the advisor to sell you stuff you don’t need.

When you combine fee-only compensation structures with a Fiduciary standard of care, you are reinforcing the idea that financial advice should be both conflict-free and in the best interest of the client. Radical, huh?!

My #1 desire in opening Honey Lake Advisors has been to create a company that clients can trust. Without trust, what’s the point? Adopting a fee-only compensation structure and being held to a fiduciary standard are important steps, but not the be-all-end-all. It’s really about the heart to do the right thing for clients.

“But the Lord said to Samuel, “Do not look on his appearance or on the height of his stature, because I have rejected him. For the Lord sees not as man sees: man looks on the outward appearance, but the Lord looks on the heart.””

1 Samuel 16:7 (emphasis mine)



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