President Barack Obama’s recent endorsement of fiduciary standards for financial advisors could have significant implications for the investment industry. Said differently, the president is pushing to require financial advisors to put the client’s needs before their own. That’s right. Your advisor may not have your best interests in mind. As the law currently stands, broker dealers, insurance salespersons and advisors operating under the “suitability standard” are merely required to ensure an investment is suitable for a client at the time of the investment.
This contrasts with the “fiduciary standard” where registered investment advisors, or RIAs, and Employee Retirement Income Security Act-appointed fiduciaries must avoid conflicts of interest and operate with full transparency. In fact, the President’s Council of Economic Advisers estimates that non-fiduciary advice costs Americans 1 percentage point of their return annually, which amounts to $17 billion each year.
To illustrate the difference between these two standards, consider a middle-aged client who is, by their own description, a long-term investor and is not bothered much by market volatility. Under the suitability standard, an advisor can meet with this client to determine what is suitable at that point in time. Based on goals and risk tolerance, the advisor may determine that the majority of savings should go into a stock mutual fund. The advisor typically hands the customer a prospectus that tells the client in deep legalese that the fund they recommend is operated by the bank that employs them, and that they received a perpetual trailing fee on top of the sales commission they pay. Once the client leave’s this advisor’s office, they have little further legal obligation to monitor this client’s investment.
The picture is much different under the fiduciary standard. First, all conflicts of interest must be disclosed. Also, a fiduciary has a “duty to care” and must continually monitor not only a client’s investments, but also their changing financial situation. Maybe this client’s risk tolerance changed after going through a painful bear market. Perhaps there was a tragedy in the family, causing the client’s medical expenses to skyrocket. Under the suitability standard, the financial planning process can begin and end in a single meeting. For fiduciaries, that first client meeting marks only the beginning of the advisor’s legal obligation. It’s time to be more proactive with your advisor. Here is a list of questions to consider.
“How often do you monitor my investments?” Investors don’t ask this question often, because most investors assume the advisor keeps a close eye on their portfolio. A common reason for using an advisor is insufficient time to self-manage. Hopefully, you are not paying an annual fee for an advisor to put your money into passive index funds and not monitor their performance. However, the problem has become so prevalent that the Securities and Exchange Commission is increasing scrutiny of “reverse churning.” As more advisors move their compensation toward annual fees, the incentive has shifted from doing excessive transactions to generate commissions, toward inactivity. If your advisor is not analyzing your portfolio at least quarterly, you may want to discuss the services offered for the annual fee you pay.
“What is your investment philosophy?” Paying careful attention to the advisor’s answer can offer insight into the business model. Although there is no one-size-fits-all approach, all advisors should have a disciplined and repeatable investment approach. Markets fluctuate, and strategies that may have been in favor last year might perform terribly the next year. An advisor who chases performance and lacks an underlying process often generates poor returns. If they are pitching a new “hot” fund every time you meet, they may not have a have a disciplined long-term investment philosophy. The tried-and-true advisor with a transparent fee structure and disciplined approach may not provide fodder for cocktail party gossip, but over time, he or she will reward patient investors.
“How much am I really paying?” Disclosure requirements have improved since the financial crisis, but “hidden” fees remain. Often, when selecting a financial advisor, clients base their decision on the advertised fee. In some cases, there may be no fee referenced at all. Is the advisor working for free? A seemingly very low fee should be scrutinized by an investor. The advisor may be receiving ongoing service fees from the investment they are recommending. This undisclosed compensation is called “soft dollars,” but are basically kickbacks for selling a particular investment product.
Beware, as these fees can become a significant cost over time, compared to the explicit fees of a fiduciary advisor. A typical fee-based advisor has a tiered structure based on account size that is discussed and disclosed to a client upon entering into an advisory agreement. The average is about 1.3 percent, which does not include fund expenses, another meaningful cost to consider when choosing an advisor. Selecting an advisor with a reasonable fee is important, but what you get for that fee is equally relevant. If one advisor is a fiduciary and the other is only held to the suitability standard, the difference in fees may not paint the full picture. Investing in an advisor who has your best interests at heart could pay handsomely over time.
In summary, when it comes to selecting a financial advisor, take nothing for granted. In an environment where the first question is, “Do you have my best interests in mind?” assumptions should be verified. Regardless of which advisor you choose, ask if they are held to the fiduciary standard. Know what you are paying for. A good advisor will have a customized plan to fit your lifestyle. Finally, make sure your advisor is grounded by a solid philosophy and has experience consistently applying it throughout market cycles. Only after finding advisors who exemplify these attributes should you concern yourself with fees. Remember, a discount broker focused on his or her next commission could cause you financial ruin.
Advisory services offered through CWM, LLC, a Registered Investment Advisor. This material is for general information only and is not intended to provide specific advice or recommendations for any individual. To determine what is appropriate for you, consult a qualified professional. International and emerging market investing involves special risks such as currency fluctuations and political instability and may not be suitable for all investors. The prices of small cap stocks are generally more volatile than large cap stocks. No strategy assures success or protects against loss.
Brett Carson , CFA, is the director of research for Carson Institutional Alliance where, as portfolio manager, he is directly responsible for managing several strategies, including perennial growth, long-term trend and write income. Additionally, the Omaha-based research department conducts thorough analyses of companies to identify undervalued stocks that carry attractive upside potential.
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Is Your Financial Advisor a Fiduciary? originally appeared on usnews.com
