The United States Department of Labor’s (DOL) recommendation to require financial advisors to adhere to a fiduciary standard received a lot of attention and reaction by financial institutions.
While the financial services industry understood the requirements imposed by the proposed DOL fiduciary rule, many consumers did not fully understand the importance of a fiduciary standard and limitations of the proposed rule as it applied to advice provided by financial advisors. This article provides an explanation of a fiduciary standard, when it applies, and why it should be important when selecting a financial advisor.
Fiduciary Standard
The National Association of Personal Financial Advisors (NAPFA) defines a fiduciary as “a person or organization that owes to another the duties of good faith, trust, confidence and candor. When acting in a fiduciary capacity, the advisor is legally obligated to maintain an allegiance of confidentiality, trust, loyalty, disclosure, obedience and accounting to his or her clients.” A fiduciary should be a person who holds a legal or ethical relationship of trust to act prudently and act in the client’s best interest. (1)
Suitability Standard
Prior to the proposed DOL fiduciary rule, financial advisors who received commissions on sale of investment products and annuities were subject to a suitability standard which required recommendations to be suitable based on a client’s financial objectives, risk tolerance, and other factors. A suitability standard does not require financial advisors to consider costs the consumer might incur in following a financial advisor’s recommendations; therefore, it is difficult for consumers to discern if the advice is being influenced by commission income the advisor might receive.
DOL Fiduciary Rule
The proposed DOL fiduciary rule required financial advisors to follow a fiduciary standard; however, it is important to note that the proposed rule only applied to qualified retirement accounts such as 401(k) plans and individual retirement accounts. The reason for the limited application of the proposed rule is that retirement accounts are subject to The Employee Retirement Income Security Act of 1974 (ERISA) which established minimum standards for most pension and retirement plans to provide protection for individuals. The proposed fiduciary rule did not apply to commission based advisors who recommended products in non-retirement accounts.
Advisor Compensation
Financial advisors can receive compensation in one of three ways: sales commissions, combination of sales commissions and fees, or fee only. Financial advisors who receive commissions are supposed to ensure that product recommendations are suitable for a client; however, commission-based advisors are not required to offer less expensive alternatives which may also satisfy a consumer’s financial objectives. Since sales commissions on some products can be 8% or more of the investment amount, financial advisors who receive sales commissions may have strong incentive to recommend certain products.
It is important to understand the difference between financial advisors who are “fee-based” and those who are “fee-only.” A fee-based advisor can be compensated by sales commissions or by a fee for service, depending on the product or service. As the title suggests, a fee-only advisor is only compensated by a fee and does not receive commissions based on product recommendations. While fees should be disclosed in writing, sales commissions are not always disclosed and may make it difficult for a consumer to determine the underlying cost of the product they are purchasing.
Conclusion
While a fiduciary standard creates a better alignment of interests between the financial advisor and consumer, the fee-only model offers a higher level of transparency regarding compensation compared to sales commission and fee-based compensation models. Additionally, a fee-only model creates a better alignment of advisor compensation to the intent of the fiduciary standard.
(1) www.napfa.org