It seems like these days nearly everybody in the financial world claims to be an “advisor.” But can there a difference from one advisor to the next? You betcha, and you need to be aware of the differences and how you may be.
Financial advisors are held to one of two main standards: fiduciary standard or suitability standard.
First are advisors who are held to the Investment Advisors Act of 1940. These types of advisors are usually known as Registered Investment Advisors and are supervised by the Securities Exchange Commission or their state securities commission (if they have less than $100 million in assets under management). This type of advisor must act as fiduciary. To act as a fiduciary means an advisor is legally obligated to act in their clients’ best interest, not their own.
The second type of advisor is held to a suitability standard. Suitability means the advisor is not required to put your interest ahead of their own, and the transaction only has to be suitable for the situation.
These advisors are regulated by the Financial Industry Regulatory Authority (FINRA) and are generally known as retail brokers. The first type of retail brokers can include insurance agents and traditional brokerage accounts in which the agent is licensed to sell you a financial product. The second type of brokerage account is called a managed account. In this type of account, the advisor is compensated by a fee and is subject to the Investment Advisor Act of 1940. However, the advisor is limited to the list of investment products approved by their firm. It’s possible the products on the list are there because they are more profitable to the company, which also means they are more costly to you.
UNDERSTANDING ADVISOR COMPENSATION
Commission-based. If the way your advisor is compensated is by commission, then their solution for you may be motivated by the sale of a financial product (a transaction). This could lead to what is known in the financial world as a conflict of interest. In other words, the sale of a product may or may not be the best solution for your particular needs.
The legal obligation for the broker is only that the transaction be “suitable” for you.
Fee-Only or Fee-Based. In contrast a Registered Investment Advisor is usually compensated via an hourly fee or percentage of assets under management. A Registered Investment Advisor is required to disclose how they are compensated, whereas a broker is not obligated to disclose how they are compensated. An RIA is required to be transparent about their fees.
By definition, the RIA firm is built around a relationship in which advice is offered for a known fee. In addition, the RIA’s list of investment options is not there because it is another profit stream for the firm because the firm is compensated for advice, and that advice must be in your best interest. That’s why many RIAs use low cost index funds and ETF’s that are less costly to own than more expensive products that may not produce any better return.
AN EXAMPLE OF THE DIFFERENCE BETWEEN A FIDUCIARY ADVISOR VS SUITABILITY ADVISOR:
To help illustrate the difference between the fiduciary standard certain financial advisors are held to and the suitability standard of other types of financial advisors, I’ll share with you an analogy written by Peter Lazaroff, an online contributor to Forbes magazine:
Imagine you need a new car, but you don’t know much about different options. You head to the closest car dealer, which happens to be a Ford dealership. The dealer asks you to describe what kind of car you need, and you begin listing features and attributes that are best described as a Toyota Highlander.
Under the suitability standard, the dealer could say, “A Ford Explorer would meet all of your needs and we have some of those right over here.” The dealer makes the sale and gets the commission. You have a car that is suitable for your needs, but it isn’t necessarily what’s best for you. Since you don’t have a great deal of knowledge about the auto market, you are in the dark.
Under the fiduciary standard, the dealer would be obligated to say, “It sounds like you are describing a Toyota Highlander. We don’t sell those. In order to get exactly what you described, you would have to do down the street to Toyota and ask for a Highlander. I can sell you a similar model called a Ford Explorer. It’s more expensive, and it isn’t exactly what you described.”
In this scenario you have more information about your options and the conflicts driving the dealer. The Ford dealer has a clear conflict of interest in this situation. He can only sell Fords and will lose the opportunity to earn a commission if you buy a Toyota Highlander. Under the suitability standard, you end up with a product (Ford Explorer) that isn’t the best fit given your situation, and it costs more than the better-fitting product (Toyota Highlander). Worst of all, you probably wouldn’t know that the dealership wasn’t putting your interests first.
By now, I hope you see that financial advisors are held to two distinct and different responsibilities to you: fiduciary or suitability. It may seem a little confusing trying to distinguish between the two, but there is a way to know. Simply ask your financial advisor if they are a registered representative. If they answer yes, then you know they are a broker, and not completely independent.
If your financial professional has accepted the higher responsibility of being a fiduciary to you, then they have set out with the expressed goal of always acting in your best interest. For the financial advisor, it’s the road less traveled, but it can make all the difference to you, the client, receiving financial advice.
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