U.S. Secretary of Labor Thomas Perez and White House National Economic Council Director Jeff Zients recently wrote an insightful article for CNN about the “conflicted advice” that many people receive from their financial advisors. Advisors who provide such conflicted advice to their clients, they point out, cost Americans $17 billion a year. This is money that could be helping hard-working Americans achieve their financial and retirement goals, but instead it is paying for what are often excessive and unnecessary expenses.
Conflicted advice takes place when a financial advisor recommends a product or service for a client that is better for the advisor than it is the client, and it almost always centers around the way in which an advisor is compensated. As an example, when confronted with the option of investing a client’s money in an annuity product with expensive fees, or a no-load investment with zero sales fees and minimal ongoing expenses, an advisor might be tempted to place a client’s funds in an annuity on account of the fact that the annuity provider will pay the advisor a generous front-end sales commission. What is more, as Perez and Zients correctly point out, advisors are often awarded “perks and bonuses—a trip to Hawaii for example—for meeting sales goals for particular products.”
Perez and Zients are also right to note that “This is not a case of bad people doing bad things”, but rather, “It is about good people working in a structurally flawed system.” The system is flawed because, from a legislative perspective, not all advisors are held to the same standard of fiduciary responsibility. As a fiduciary, an advisor is always obligated to place a client’s best interest above his own. CERTIFIED FINANCIAL PLANNER™ practitioners and Registered Investment Advisors are considered fiduciaries, but the way in which they are held accountable can get a little complicated. CERTIFIED FINANCIAL PLANNER™ practitioners, for example, are held accountable as fiduciaries by the non-profit CFP Board, whereas Registered Investment Advisors are held accountable to a fiduciary level of care by the Investment Advisors Act of 1940. What is more, many CFP® practitioners are also Registered Investment Advisors, so they are doubly held to a fiduciary level of care.
But further complicating matters is the fact that CFP® practitioners and Registered Investment Advisors can be fiduciaries on some parts of their businesses while still maintaining other parts of their practices that are not held to the same fiduciary standard. If an advisor, whether a CFP™ practitioner or a Registered Investment Advisor, receives sales commissions on any part of her business, then that advisor must be registered with a broker/dealer that is regulated by Financial Industry Regulatory Authority (FINRA), and it is this registration that allows the advisor to receive sales commissions. And, for any part of an advisor’s business that pays sales commissions, the advisor does not have to demonstrate a fiduciary level of responsibility, but only a sales “suitability” standard of responsibility as outlined by FINRA. That is, as long as the advisor can demonstrate to regulators that a product was a suitable sales recommendation, even though it may not have been the best recommendation for the client out of a given set of possible recommendations, then this is all that regulators are concerned with.
But what if a client wants to ensure that a financial advisor is always placing her best interest above the advisor’s? How does one make sense of such a flawed system with inherent conflicts of interest? Since the crux of the matter ultimately centers around the conflicts of interest vis-à-vis an advisor’s compensation, there’s a simple way to do this: Simply ask the advisor how he or she gets paid. If an advisor receives sales commissions in any form, then the advisor has at least some of his or her business that is not held to a fiduciary level of responsibility. On the other hand, if an advisor receives compensation solely in the form of fees—what is known as a “fee-only” advisor—then the advisor is solely regulated by the Investment Advisor Act of 1940 and is taking pains to ensure that no aspect of his or her business is conflicted with the best interest of the client. A fee-only advisor removes such conflicts from the client-planner relationship by making it impossible for the advisor to be placed in a position where he or she has to decide whether or not to recommend a product that is better for the advisor or the client.