Is Your Financial Advisor Legally Required to Act in Your Best Interests?
Not necessarily. To find out, you must start with understanding exactly who you are dealing with. The terms “financial advisor” and “Financial Planner” are generic terms which carry no special legal responsibility. Both terms can refer to Stockbrokers, Insurance Agents, or Registered Investment Advisors.
Currently, Registered Investment Advisor is the only title that carries a legal responsibility to act in your best interest.
In a survey conducted by TD Ameritrade in 2006, one thousand clients (many of whom were experienced investors) were asked the following question:
Are you aware that stockbrokers and investment advisors offer fee-based financial advice but provide different levels of investor protection?
The 60% who believed Stockbrokers had a fiduciary duty were incorrect. The 90% that believed that investment advisors have a fiduciary duty were correct.
Stockbrokers, Investment Advisors, and Insurance Agents are all required to gather information about your risk tolerance, investment time horizon, and financial goals so they can recommend “suitable” financial products.
What is a suitable financial product?
Suggesting to a senior citizen living on tight budget that they should short the treasury market with an inverse, leveraged ETF would violate the suitability requirement. The client should not be in a high risk investment, and probably should be directed towards a product which produces regular income and has little risk of loss of principal instead.
As the example above shows, the financial product an advisor recommends must make sense from a practical standpoint. There may be thousands of products that meet the suitability requirement for a particular client however, and not all those products are created equal.
A Fiduciary Duty means that the person or firm you are dealing with is required to act in the best interests of their clients, as their top concern. In the senior citizen example above, there might be several investment grade bond funds which are suitable investments for the client. A Financial Advisor with a fiduciary duty would be required to recommend the best fund for the client. This is true even even if they would receive a higher commission or other compensation by steering the client to a different bond fund.
A financial advisor with a suitability requirement only (no fiduciary duty) could refer the client to pretty much any investment grade bond fund they wanted.
Insurance Agents have a suitability requirement and are regulated on a state by state basis. They are paid primarily through commissions.
Registered Investment Advisors have both a suitability requirement and a fiduciary duty. They are regulated by the SEC and are normally paid through a percentage of assets under management or on an hourly basis.
Registered representatives (Stockbrokers) – Currently have a suitability requirement and are regulated by the SEC and FINRA. They are normally paid through commissions.
In addition to their current suitability requirement, Stockbrokers will soon have a fiduciary duty as well.
Because of the differences in compensation methods between Registered Investment Advisors and Stockbrokers, the upcoming change is the source of much debate. Is it possible for a financial advisor to be compensated through commissions and/or other sales related compensation and behave in a way consistent with the Fiduciary obligation?
Congress has recently decided that from a legal perspective at least, the answer to that question is yes.
The Dodd-Frank Wall Street Reform and Consumer Protection Act was signed into law by President Obama on July 21st, 2010. Included in the bill is a requirement that the SEC study the need for a uniform fiduciary standard covering both Stockbrokers and Financial Advisers when providing personalized financial advice. If the SEC determines there is a need, they have a mandate from congress to implement such a standard. As almost everyone believes that implementing a fiduciary standard for Stockbrokers would benefit the individual investor, there is a very high probability that SEC will create such a standard.
Should the fiduciary standard look like the one that is currently in place for Registered Investment Advisors, or should a new one be created? How this question gets resolved will impact the relationship between almost 600,000 Stockbrokers and millions of their clients and will be the topic of our next article.