If I asked you the question, “Are all financial advisors legally required to put the best interests of their clients first when providing recommendations?” what would you say?
If you answered, “Yes,” then you’d be in the same boat as 53% of respondents in a survey by Financial Engines, America’s largest independent investment advisor.
You’d also be wrong.
The sad truth is that most financial advisors are not fiduciaries, and therefore not required to put your interests first. This can have a serious impact on your bottom line. Just a 1% change in fees in your portfolio can result in a 25% reduction in returns over a 40-year period. This really matters!
Whether you are on the hunt for a financial advisor or already working with one, it is important to be educated as much as possible when it comes to your personal finances so that your investments work best for you.
Learning the differences between fiduciaries and non-fiduciaries can ease the investing experience and save you from extra costs.
The Big Ideas You’ll Learn
- Not all financial advisors are held to the same standards when giving advice. This means their recommendations could be influenced by kick-backs and commissions they receive from others.
- Working with an advisor who is not bound by fiduciary standards could cost you as much as 2% of your asset value each year.
- When looking for an advisor, seek out “fee-only” advisors who are paid only by their clients. Also seek out those who are regulated by the SEC or CFP Board of Standards, to ensure they are bound by the fiduciary standards.
What Is a Fiduciary?
A fiduciary is a person or legal entity who acts on behalf of another person, accepting an ethical duty to provide the highest level of care, to work in their client’s best interests. The care, loyalty, and trust are referred to as fiduciary duties.
The Investment Advisers Act of 1940 established fiduciary rules related to investment advice. The rules are based on the duty of care and loyalty, ensuring that fiduciary advisers provide investment advice that is accurate, thorough, and free from conflicts of interest.
According to the act, fiduciaries must disclose any potential conflicts and must work to provide financial advice that is both low-cost and efficient. They are legally required to present the best options available for their clients, period, regardless of how much they get paid — or don’t get paid — for the options they recommend.
Financial advisers (different than financial advisors) are fiduciaries that are regulated by the Securities and Exchange Commission (SEC). Certified Financial Planning professionals providing financial planning services also must abide by the fiduciary standard, as defined by CFP Board.
In contrast, individuals with titles such as wealth manager, financial advisor, and broker, are regulated by the Financial Industry Regulatory Authority (FINRA). They are typically employees of banks, brokerage firms, and insurance companies. They are considered salespeople by the Investment Advisers Act and are held to a different standard — the suitability standard. This standard only requires that a financial professional makes suggestions that meet their client’s overall financial objectives.
These non-fiduciary professionals typically focus on selling their firm’s products and services, which often pay the advisor commissions, kickbacks, and fees. These payments could incentivize them to recommend products that may or may not necessarily be in their client’s best interests.
Why Is It Important to Use a Fiduciary?
An example may help clarify why this difference matters.
Let’s say an advisor comes across two investments with nearly identical characteristics (say two broad-based S&P mutual funds), but one of them will pay the advisor a higher commission upon your investment in the fund. (An example of this fee is a 12b-1 fee, which is similar to a kickback for the broker who sells the fund.)
An adviser who is a fiduciary must present the investment with the lower fee structure because, among the two investments, it is the one in the client’s best interest.
An advisor working under the suitability standard, however, can (and often will) recommend the investment option with the higher commission assuming it aligns with the client’s financial objectives (e.g. the client wants a balanced portfolio of ETFs and mutual funds) and does not expose them to unnecessary risk.
So, why does this matter? This can have a huge impact on your bottom line.
The Value of a Fiduciary Adviser
Working with a financial advisor who is a fiduciary can save you real cash over the long term, as much as 2.0%+ of your assets under management. Let’s talk you through the ways they save you dough.
1. No Kick-Backs
Non-fiduciary financial advisors tend to offer mutual funds because they can accept 12b-1 fees as a form of payment. Advisors bound by the fiduciary standard are required to present the client with low- and even no-cost funds available since these are in the client’s best interest. Without these kickbacks, the expense ratio of a mutual fund can be reduced by 25 to 75 basis points.
Outcome: +0.50% to your bottom line for putting you in investments that do not have 12b-1 fees.
2. Lowest-Cost Share Class
Non-fiduciaries are usually required to recommend their firm’s investment funds first, regardless of whether these investments are the lowest-cost or best-performing options.
Fiduciary duty, on the other hand, requires that advisers must make the best possible recommendation for their client. Thus, fiduciaries cannot only offer a proprietary fund. With the duty to act in the clients’ best interest, fiduciary advisers present the lowest-cost share class of any investment. The difference can be another 25 to 75 basis points in cost on each transaction.
Outcome: +0.50% to your bottom line for putting you in the lowest cost investment options.
3. Lowest-Cost Broker, Custodian, or Trustee
Your assets will be traded by the investment broker and custodied at the broker’s firm when working with a non-fiduciary. This may not always be the lowest cost option in the market.
On the other hand, fiduciary advisers can analyze and choose the lowest cost broker, custodian, or trustee possible. This can save you up to 25 to 50 basis points in trading costs and custody fees.
Outcome: +0.25% to your bottom line for cost-efficient trading and custody options.
4. Competitive Investment Adviser Fees
It’s almost impossible to know what you are paying a non-fiduciary financial advisor in fees. Through commissions, base compensation, bonuses, referrals, awards, and reimbursements, they can receive compensation from any one of the mutual fund families, insurance companies, and investment companies they recommend.
Due to this lack of transparency, the total fees that you are paying can be as much as 250 basis points higher than what you’d pay in a transparent and competitive market.
Fiduciary advisers, especially “fee-only” advisers, generally only receive compensation from their clients. As a result, their fees are transparent and they have to charge fees that are competitive in the market.
Outcome: +1.00% to your bottom line for transparency and market-competitive fees.
The Long-Term Impact on Your Bottom Line
By working with a fiduciary advisor, your return on your portfolio could be around 2.25% higher than by working with a non-fiduciary advisor. We’d call this the cost of conflict of interest for working with a non-fiduciary financial advisor.
Investments that do not have 12b-1 fees: 0.50%
Lowest cost investment options: 0.50%
Cost-efficient trading and custody services: 0.25%
Transparency and market-competitive fees: 1.00%
Cost of Conflict of Interest With Non-Fiduciary: 2.25%
That 2.25% can really add up over time. Let’s say you had $250,000 today to invest. If you work with a fiduciary financial advisor that charges a $2,000 fixed fee per year, your total portfolio would be nearly $2.5 million in 30 years. You’d pay $60,000 in total management fees.
In contrast, let’s assume you work with a non-fiduciary advisor that charges 1% based on assets under management. Ignoring the cost of conflict of interest, your portfolio would be a little over $2 million in 30 years and you’d pay $266,000 in total fees. If you bake in the additional cost of working with someone who will not put your interests first, you only have $1 million in your portfolio in 30 years, compared to $2.5 million by working with a fiduciary financial advisor.
How to Know If Your Adviser Is a Fiduciary
Fiduciaries give you the assurance that your assets are in safe hands, however, the tricky part can be qualifying prospective advisers as fiduciaries.
First, we would recommend you seek out fee-only advisers. These advisers are paid only by you the client and not for the investments they recommend. You should also consider working with investment professionals who are Certified Financial Planners. A CFP(R) Professional is bound by the standards of the CFP Board to serve as fiduciary, “One who acts in utmost good faith, in a manner he or she reasonably believes to be in the best interest of the client.”
During your initial consultation, there are three important questions to ask your adviser:
1. What legal standard do you operate under, and what’s your regulatory body?
This question answers if the institution uses the fiduciary or the suitability standard, and how your advisor is working to serve you, the client. If regulated by the SEC, your financial adviser is bound to serve as fiduciary.
2. How are you compensated by the investments you recommend?
This question will help you learn if your financial advisor receives an extra form of compensation for recommending an investment vehicle.
3. If you have dual registrations, does that affect your investment approach?
Larger financial institutions have dual registrations as fiduciaries and broker-dealers. For smaller firms, it is especially important to ask how that dual registration is impacting their investment-making decisions on your behalf. What you want to look out for here is how they answer the question — if they are bound by suitability-only or by fiduciary standards.
Being Informed Is Being Empowered
Choosing the right financial adviser is taking charge of your financial future. It puts you in control of your financial decisions.
Since not all advisors operate as fiduciaries, be direct with them. Ask if they are a fiduciary, and check how they are compensated by the type of investment products they recommend to you. Working with an investment professional who is bound by the fiduciary standard removes any potential conflicts of interest and reduces your costs, allowing your investments to flourish over time.
By asking these direct questions, you can make sure that your adviser is working to put more money in your pockets rather than potentially more in their own.