Who Does Your Financial Advisor Work For?
If you use a financial advisor, you probably trust him or her to give you objective advice. That's why you're paying him. But until recently, not all advisors were required to act in your best interests or to disclose conflicts of interest.
As explained by the Department of Labor:
While many advisers do act in their customers' best interest, not everyone is legally obligated to do so and some do not. Many investment professionals, consultants, brokers, insurance agents and other advisers operate within compensation structures that are misaligned with their customers' interests and often create strong incentives to steer customers into particular investment products. These conflicts of interest do not always have to be disclosed and advisers have limited liability under federal pension law for any harms resulting from the advice they provide to plan sponsors and retirement investors. These harms include the loss of billions of dollars a year for retirement investors in the form of eroded plan and IRA investment results, often after rollovers out of ERISA-protected plans and into IRAs.
In order to combat this problem, the Department of Labor issued a new "fiduciary rule" on April 16, 2016, to be effective April 10, 2017. Not everyone is a fan of the fiduciary rule. In May the Senate voted to repeal the fiduciary rule. However, President Obama has promised to veto any legislation that would do so. As with so many things, the November election will probably determine its fate.
Under the law a fiduciary is a person who is required to put another's interest over his own. Examples of fiduciaries are trustees and executors. A trustee is required to put the interests of the trust beneficiaries over his own interests. Likewise, the fiduciary rule requires advisors to act in the best interests of their clients.
Currently, registered investment advisors are held to a fiduciary standard, but brokers are judged by a lower standard of "suitability," i.e., whether or not an investment is "suitable" versus whether or not it is the best investment for a client. Therefore, an advisor could steer a client to a mutual fund that paid the broker a higher commission versus a similar fund with a lower commission. As long as the recommended fund was a "suitable" investment, the broker would not be liable.
Under the fiduciary rule, all "recommendations" must be in the best interests of the client. "A 'recommendation' is a communication that, based on its content, context, and presentation, would reasonably be viewed as a suggestion that the advice recipient engage in or refrain from taking a particular course of action." It is what you are looking to your advisor to provide – what to buy, what to sell, when to buy or sell, etc. There are certain communications, however, that will not constitute "recommendations." Educational materials and general communications such as newsletters will not be deemed recommendations. Nor will providing an investment platform. A platform is a selection of investments offered to plan participants without advice regarding those options. For example, your 401(k) offers you ten mutual funds. You can choose among the ten funds, but the platform provider does not offer you any advice on which fund(s) to pick.
The Department of Labor anticipates that the fiduciary rule will have the greatest impact on brokers and insurers since they have not been subject to a fiduciary standard in the past. The fiduciary rule will likely reduce their income while also imposing new compliance requirements, including reporting, disclosure and record keeping.
Several brokerage firms have been loudly protesting the fiduciary rule saying that small investors will suffer because brokers will no longer be able to afford to manage small accounts. Or, instead of dropping small accounts, they may change their fee structure. Many advisors are now charging flat fees. You pay the advisor for his or her advice regardless of what investments are recommended or whether or not you purchase them. The advisor does not get an additional commission on your purchases. Depending on the size of your account, a flat fee may increase the amount you are paying your broker.
There is also an option under the fiduciary rule to continue more or less maintain the status quo. The exemption is called the Best Interest Contract Exemption. If a client signs a contract wherein the broker promises to (1) attempt to act in the client's best interest, (2) disclose all potential conflicts of interest and (3) provide a detailed report of his commissions, then the broker will not be bound to the fiduciary standard. If you choose to operate under a business interest contract exemption, at least you will be aware of the commissions your broker is earning and can make an informed decision based on that information.
A detailed report of commissions may be very eye-opening for some clients, particularly with respect to annuities. Annuities have long been an opportunity for fraud, in part because clients have not known the commission structure and, therefore, their advisor's motivation. Annuity commissions can range from 1% to 10% depending on the length of the annuity, the surrender charges, the types of investments, etc. Many brokers have been convicted of selling annuities in inappropriate circumstances such as to elderly clients. The fiduciary rule may not do anything to reduce this conduct, however, since these advisors are already breaking the current law.
As always, you must be your own advocate. It is important to note that the fiduciary rule only applies to retirement plans such as 401(k)s, IRAs and certain annuities. It does not apply to non-retirement investment accounts. For these accounts, it is your responsibility to ask the right questions about fees and alternative investments to make sure you are getting the best advice for you, not your broker.