In April 2016, a new word entered many investors’ vocabularies: fiduciary. Even for those who’d heard it before, the term took on a whole new meaning when the Department of Labor’s Fiduciary Rule was released. The rule was officially vacated by the Fifth Circuit Court of Appeals in June 2018, but resurfaced in a less restrictive form in 2020. The latest version was approved by President Joe Biden’s administration and went into effect on Feb. 16, 2021.
With the rule, financial advisors fall into two camps: fiduciaries and nonfiduciaries, adding a new level of confusion — and risk — to the advisor-client relationship for many investors. Not only are there fiduciaries and nonfiduciaries, but also true fiduciaries and pretend fiduciaries, which present even bigger risks to investors.
“Pretend fiduciaries talk like fiduciaries to sound trusting, then they act like salesmen,” says Knut Rostad, founder and president of the Institute for the Fiduciary Standard, a nonprofit that advocates for the fiduciary standard in McLean, Virginia. They can say things that mislead and confuse investors who don’t understand the full scope of the rule and their rights.
This is the crux of the issue, he says. To call both sales brokers and fiduciary advisors “advisors” only creates confusion. “We don’t confuse dietitians with butchers or medical doctors with drug companies,” he says. But the financial industry appears happy to perpetuate such confusion.
A 2019 Financial Trust Report by digital wealth manager Personal Capital found that nearly half of Americans falsely believe all advisors are legally required to always act in their clients’ best interests. Not only is this inaccurate, but it can also be detrimental to investors who unwittingly expose themselves to biased and potentially costly advice from advisors who put their own interests before investors’ interests.
“Not all advisors are required to put you first,” says Jay Shah, president of Personal Capital. “Only financial advisors who are fiduciaries are required to act in the best interests of their clients.”
Here’s what you should know about fiduciary financial advisors:
— What is a fiduciary?
— Examples of fiduciary-client relationships.
— Is there a difference between a fiduciary and a financial advisor?
— The fiduciary duty is the highest standard of care.
— Fiduciary standard vs. suitability standard.
— How advisors are compensated.
— The DOL’s 2021 fiduciary rule.
— Do I need a fiduciary advisor?
— How to find a fiduciary advisor.
— Are robo advisors fiduciaries?
What Is a Fiduciary?
A fiduciary is a person or legal entity, such as a bank or financial firm, that has the power and responsibility of acting for another (usually called the beneficiary or principal) in situations requiring total trust, good faith and honesty.
The most common example of a fiduciary is a trustee of a trust, but anyone can be a fiduciary. If you undertake to assist someone in a situation where they place total confidence and trust in you, you have a fiduciary duty to that person. Corporate officers are fiduciaries for their shareholders, as are attorneys and real estate agents for their clients. Some, but not all, financial advisors are fiduciaries.
When you’re the beneficiary of a fiduciary relationship, you give that fiduciary discretionary authority over your assets. So a fiduciary financial advisor can buy and sell securities in your account on your behalf without needing your express consent before each trade. Because fiduciaries have this discretionary authority, they’re held to a higher standard than nonfiduciary advisors.
Examples of Fiduciary-Client Relationships
These are some common examples of fiduciary relationships:
— Fiduciary financial advisor-client
— Corporate officer-shareholder
— Real estate agent-client
Is There a Difference Between a Fiduciary and a Financial Advisor?
There is a difference between a fiduciary and a financial advisor — but the difference lies is what these terms actually mean. A financial advisor is a job description, which can include fiduciary and nonfiduciary advisors. A fiduciary is any professional who is upheld to a fiduciary standard — meaning the person must act in your best interest — and can include financial advisors, attorneys, guardians and other professionals.
The Fiduciary Duty Is the Highest Standard of Care
According to the Cornell Law Dictionary, “A fiduciary duty is the highest standard of care.” It entails always acting in your beneficiary’s best interest, even if doing so is contrary to yours. For a financial advisor, this may mean recommending a product that results in reduced or no compensation because it’s the best option for the client.
“A fiduciary cannot recommend an investment that doesn’t benefit you or carries higher fees than a virtually identical investment,” Shah says.
According to the Securities and Exchange Commission, which regulates registered investment advisors as fiduciaries, the fiduciary duty also entails:
— Acting with undivided loyalty and utmost good faith
— Providing full and fair disclosure of all material facts, defined as those “a reasonable investor would consider to be important”
— Not misleading clients
— Avoiding conflicts of interest (such as when the advisor profits more if a client uses one investment instead of another or trades frequently) and disclosing any potential conflicts of interest
— Not using a client’s assets for the advisor’s own benefit or the benefit of other clients
What Happens if a Fiduciary Duty Is Breached?
The SEC concludes by stating that “departure from this fiduciary standard may constitute ‘fraud’ upon your clients,” which could result in revoking the firm’s or investment advisor’s registration, the advisor’s barring from the industry or a multimillion dollar disgorgement, among other penalties.
“A fiduciary’s responsibilities are both ethical and legal,” Shah says. “If a fiduciary violates his or her duty, you have an avenue for legal action.”
Shah says, common examples of breaches of fiduciary duty include these:
— Acting negligently
— Making unauthorized trades in your account
— Churning your account by trading excessively to generate commissions
— Misrepresentation through false statements about a security or transaction
Fiduciary obligations extend beyond the first meeting. A fiduciary will continually monitor a client’s investments and financial situation and adhere to best practices of conduct for the duration of the relationship. If they follow this prudent practice in vetting and screening investments, advisors cannot be held liable for how the investment performs, other factors being equal, Rostad says.
“I think most investors would expect their advisors are doing that anyway, but that’s not always the case,” says Shelby George, senior vice president of advisor services at Manning & Napier, an investment manager in Fairport, New York. Nonfiduciaries are held to the suitability standard, a lower standard of care.
Fiduciary Standard vs. Suitability Standard
For advice to be considered merely “suitable,” the financial professional must only have an adequate reason to believe a recommendation fits the client’s financial situation, needs and other investments. For that to be the case, an advisor must obtain adequate information about the investment as well as the customer’s financial situation before making the recommendation.
The most common difference between a fiduciary and an advisor acting under a suitability standard is the decision-making process, George says. Before making a recommendation, fiduciaries undergo a prudent process designed to determine their client’s best interest. After making a recommendation, they discuss it thoroughly with the client to ensure there’s no misunderstanding about the recommendation and the fiduciary’s rationale for making it.
“Advisors acting under the suitability standard may, but are not required, to have the same depth of discussion,” George says. As a result, their duty to a client’s investments and financial situation ends once the trade is placed. These advisors aren’t obligated to monitor client accounts or financial situations on an ongoing basis.
Instead, the suitability standard only calls for fair dealing and best execution, which means the advisor must do the following:
— Execute orders promptly and at the most favorable terms available, determined through “reasonable diligence”
— Disclose material information
— Charge prices reasonably related to the prevailing market
— Fully disclose any conflicts of interest
The suitability standard does not require advisors to put their clients’ best interests before their own, nor must they avoid conflicts of interest.
“If your advisor isn’t a fiduciary, he can steer you into products that put more money into his pocket, as long as they’re considered suitable for you,” Shah says. For instance, when faced with two comparable investments, one of which has a higher commission, a fiduciary couldn’t recommend the pricier investment because paying more in fees isn’t in the client’s best interest. An advisor held to the suitability standard, however, could recommend the more expensive product, provided it’s “suitable” for the client.
“Of course, not all nonfiduciaries are bad guys hoping to eat your financial lunch, but it’s important to understand that, legally, they can,” Shah says. “What’s more, their compensation structure could inherently make it difficult for them to act without conflicts of interests.”
How Advisors Are Compensated
Generally, you pay for financial advice in one of three ways: advisory fees for fee-only advisors, commissions, or a combination of fees and commissions for fee-based advisors.
Fee-only advisors charge either a flat or hourly rate, on a per-service basis or as a percentage of assets under management. They do not earn commissions or trading fees, so their compensation is independent of the investments they recommend.
With fee-only advisors, “all fees are completely transparent,” Rostad says.
Commission-based advisors are paid from the sale of investments. They may also receive a fee from their financial institution for selling a particular product, collect a percentage of the assets a client invests or be paid per transaction.
Here, most of the fees earned by the firm or broker are not transparent, Rostad says.
The Financial Industry Regulatory Authority requires that commissions and fees be “reasonable” and disclosed at or before the time of investment. The organization’s 5% guideline considers any markup at or above 5% seldom reasonable and any commission near that threshold is subject to regulatory scrutiny and must be justified.
An advisor who receives both a flat fee and commissions is considered fee-based. Fiduciaries must be fee-only or fee-based. Nonfiduciaries can be commission-based or fee-based.
The commission structure opens the door to conflicts of interest between advisors and their clients. An advisor who is paid based on the products recommended would have an incentive to steer clients toward investments that generate a higher commission. If an advisor is compensated per transaction, clients may be encouraged to trade excessively, a practice known as churning accounts.
“Many advisers do not provide biased advice, but the harm to investors from those that do can be large,” writes the Department of Labor in the Federal Register Vol. 81, No. 68. The administration of former President Barack Obama’s Council of Economic Advisers estimated that advice from advisors with conflicting incentives costs individual retirement account investors about $17 billion per year. The council estimated that recipients of conflicted advice earned 1% lower returns each year.
If conflicted advice is given when a 401(k) is rolled over into an individual retirement account, or IRA, it can cost the investor an estimated 12% of his savings over 30 years, with those savings running out more than five years sooner as a result.
These findings, coupled with investors increasingly seeking investment guidance for retirement savings outside of an employer-sponsored plan, particularly with rollovers, provided the impetus for the Department of Labor’s Fiduciary Rule.
The DOL’s 2021 Fiduciary Rule
The goal of the original rule was “to encourage more transparency of fees, close certain payment loopholes, simplify retirement advice and improve investor education,” says Jason Schwarz, president of Wilshire Funds Management and Wilshire Analytics in Santa Monica, California. But the Fifth Circuit Court of Appeals found the original rule “inconsistent with governing statutes” and said the department was “overreaching to regulate services and providers beyond its authority.”
The rule was essentially tabled but resurfaced again in mid-2020 with the DOL’s latest version. In it, advisors giving guidance on retirement plan rollovers and distributions would be considered giving investment advice and thus be governed by the fiduciary standard. The rule also allows investment advice fiduciaries to receive compensation, such as sales loads, certain commissions and revenue-sharing arrangements from investment product providers, as long as the fiduciary discloses such arrangements. Proponents of this latter element say it will help prevent participants from having to pay for advice, while contenders argue it may create conflicts of interest.
The latest version of the rule went into effect on Feb. 16, 2021, with an enforcement grace period until Dec. 20, 2021. In response to the first proposed rule, many firms removed products that don’t meet the fiduciary standard, Schwarz says. The result for investors is higher-quality investments and an easier investment selection process. “It’s not unreasonable to expect the fees advisors charge will come down along with the fees of the underlying products they use,” he says.
Investors are demanding more objective, transparent advice and fee structures. “Smart advisors will realize this change is coming and that advice that is ‘good enough’ is no longer good enough for today’s investor,” Shah says.
Do I Need a Fiduciary Advisor?
The main message for investors now is don’t get too caught up in the technical language of the fiduciary definition, but instead think about what services you want from a financial professional and ensure you get them, George says. Not all investors need fiduciary guidance.
Knowing the type of investor you are will help identify the best financial advisor for you. At one end of the spectrum, you have investors who love researching investments and know exactly how they want to invest. These investors may only need help placing trades, which doesn’t require fiduciary expertise.
“A competent and ethical broker can offer any important product information,” Rostad says.
At the other end of the spectrum are investors looking for more guidance on topics such as where and how much to save for various financial goals. An investor in this situation would do well with the diligent care and broader range of services a fiduciary provides.
“No matter what type of advisor you choose to work with, it’s important that you understand how they make money and what value they’re providing for what you pay them,” Shah says.
How to Find a Fiduciary Advisor
“One of the first and best questions investors can ask advisors is how do you get paid?” Schwarz says. “Often, the answer to that question will lead to a better understanding of (whether) that advisor is a fiduciary.” Any fee-only advisor is almost certainly a fiduciary while one that is commission-based is not.
Fiduciaries provide “independent, conflict-free investment advice, and they’re paid as such,” he says.
The easiest way to determine if an advisor is a fiduciary is to simply ask, “Are you a fiduciary?”
“A true fiduciary will be able to answer yes,” Shah says. If so, get that answer in writing, then confirm the advisor’s claim by searching the SEC’s advisor information database, he says.
Getting it in writing is essential, Rostad says. “Tell the financial (representative) to put in writing she is a fiduciary at all times. Tell her to be completely transparent about all conflicts and put all-in fees and costs in writing. Tell her to put important agreements, disclosure and consents in writing.” This is the only way to ensure you’re working with a true fiduciary and not someone pretending to be one.
Also verify whether the advisor acts as a fiduciary at all times or only under certain circumstances, such as when advising on retirement accounts. Rostad suggests investors seeking fiduciary guidance insist that any advisor they hire meet the institute’s best practices for standards of conduct. He says these advisors will, among other things:
— Be a fiduciary at all times
— Put agreements and disclosures in writing
— Show clients what they pay and if the firm receives fees from third parties for their recommendations
— Doggedly avoid conflicts of interest — or mitigate them
— Be fee-only; avoid commissions
— Have baseline knowledge, education and competence
— Use an investment policy statement that, at a minimum, expresses assumptions about objectives, risk and performance
— Minimize investment expenses
“Real fiduciary advisors will affirm compliance of best practices in writing and to regulators without a problem,” he says.
Other questions to ask a financial advisor include:
— What financial services do you provide?
— How often will you monitor my investments?
— How often will I meet with you? Is this a one-time meeting or will we meet regularly?
— Is it up to me to contact you when I have questions or to schedule a meeting?
“Questions like (these) set expectations of what this relationship will be,” George says. They go beyond the simple yes-or-no question of if an advisor is a fiduciary to better define the level of service investors can expect from an advisor, including robo advisors.
In its guidance for investors on robo advisors, the SEC advises conducting the same due diligence you would with any investment advisor by asking the following:
— How often does it follow up with clients?
— Do you have to contact the robo advisor with updates about your financial situation?
— How does it take into account your relevant personal information such as your risk tolerance and other investments?
— What types of accounts does it manage?
— What is its approach to investing?
— What range of investments does it offer?
— How often does it rebalance your account?
— What are the associated fees and how is the robo advisor compensated?
Are Robo Advisors Fiduciaries?
According to the SEC, robo advisors can be fiduciaries.
It declared that “robo advisers, as registered investment advisers, are subject to the substantive and fiduciary obligations of the (Investment) Advisers Act (of 1940).” The staff of the Division of Investment Management and the Office of Compliance Inspections and Examinations at the SEC monitors robo advisors for compliance with the act and said it will implement safeguards as needed.
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Update 04/15/21: This story was published at an earlier date and has been updated with new information.