What You Need to Know About Fiduciary and Suitability Standards of Care
Today’s post comes from Per Stirling Director and Portfolio Manager, Robert Phipps.
The financial industry has a long history of employing jargon to confuse the investing public and keep investors ignorant of the fact that there are two different standards of client care that financial professionals are held to: a suitability standard, and a fiduciary standard.
According to law, brokers (financial professionals who work for broker-dealers, i.e. firms that focus on facilitating financial transactions) are salespeople who get paid commissions for successfully making sales. They are bound only by the rules of suitability, which is the less onerous standard of care.
This older and traditional standard of care merely requires that financial professionals make recommendations that are reasonable in light of the objectives, financial status, sophistication and risk tolerance of an investor. On the surface, this seems like a perfectly reasonable means of protecting investors, as it would theoretically, for example, keep a broker from selling riskier investments, such as penny stocks or futures contracts, to clients for whom such risk is inappropriate, like a 95-year old widow living on social security.
But as you may imagine, the suitability standard can be fraught with potential conflicts of interest. A broker could, for example, sell his or her firm’s more expensive proprietary products or recommend mutual funds and annuities with unusually high commissions – rather than similar investments with lower fees – yet still pass the suitability test as long as those products are still “reasonable” with respect to a client’s needs and goals.
By contrast, advisors that provide individual and customized advice through a Registered Investment Advisor are not only compensated purely by fees rather than commissions, but are always held to a fiduciary standard – the highest standard of client care. The fiduciary standard mandates that every single recommendation made must be based solely upon the best interest of the client, and there is no circumstance when an advisor can place their own personal interest above that of the client that they are advising. Not only that, Registered Investment Advisors must disclose any potential conflicts of interest and do not engage in investment banking and underwriting. Brokers do not face similar limitations, as the suitability standard allows them to put their interests above that of their clients.
While it seems self-evident that the fiduciary standard should be the prevailing standard of care, some financial industry groups are making huge lobbying efforts to keep regulators from adopting fiduciary standards across all aspects of the industry in order to protect their profit margin, all while keeping the investing public from fully understanding the difference between the two standards.
Sadly, neither the lobbying efforts nor the purposeful obfuscation are new, as history plainly shows. However, what is new is that politicians and regulators are finally starting to consider this issue in earnest, as evidenced by a new legislative push to require broker dealers to adhere to a higher standard of care when providing advice about investments in retirement accounts. Specifically, the Department of Labor’s proposed change would elevate the standard of care required of brokers from suitability to one that looks closer to a fiduciary level.
Naturally, there are exceptions to these broad definitions. The first is in regard to Certified Financial Planner™ professionals (CFP®s), many of whom adopt fiduciary standards across their entire practice. There are also firms, like Per Stirling, that adopt fiduciary standards across all aspects of their business, even where it is not required by law. There are also financial professionals who will provide their clients with a signed and binding contact that they will always exercise fiduciary standards when making recommendations.
Working with brokers under the traditional suitability model is fine for many clients or even specific needs of clients. Working with investment advisors ensures the fiduciary standards of care, and that the client’s best interest is held above all else. However, not everyone needs the ongoing advice and recommendations provided by an investment advisor. As such, there is no single solution that is right for everyone.
Our intent is not to suggest that all financial professionals who operate under the standards of suitability are somehow unethical or are “bad” people, as there are certainly many brokers who sincerely care about their clients. However, there is nothing in the standard of suitability that keeps a broker from putting their own best interest (or that of their employer) above the best interest of their clients.
At the same time, there is one thing that we think is very clear: that everyone who pays a financial professional owes it to themselves to decipher the jargon in order to understand the standards their advisor is held to, the type of advice they are paying for, and whose best interest is being represented.broker dealerDepartment of LaborfiduciaryRegistered Investment Advisorstandards of caresuitability