Ethical Issues For Financial Advisors

The collapse of Enron and Worldcom brought ethical concerns to the forefront of public scrutiny. Their demise caused thousands of Enron and Worldcom employees to lose all of their retirement savings, and provided a wake-up call to investors across the country who held their entire retirement savings in a single stock. The failure to educate those employees about the importance of diversification was perhaps more than mere corporate or fiduciary oversight.

SEE: Business Owners: Avoid Enron-esque Retirement Plans

These headline-grabbing collapses are just two examples of how our modern maze of business models, methods of practice and investment strategies have substantially blurred traditional ethical boundaries. Even scrupulously honest financial planners can now face real dilemmas when trying to do the right thing for their clients. Read on as we explore some common dilemmas investment professionals face, and help provide guidance on how you can tackle them.

Uncharted Territory
A generation ago, both the tax code and the financial products and services available were simpler than they are today. For example, if someone wanted to buy stock, a stockbroker would place the trade. If someone needed permanent life coverage, a whole life policy was issued. But now, planners must decide if this traditional approach is better, or whether the client would be better off buying any number of the diverse modern products available.

The modern maze means every financial planner faces an ethical dilemma when trying to do the right thing for a client.

Ethics for CFPs®
In light of these dilemmas, the Certified Financial Planner® Board of Standards has issued a substantial revision and upgrade of the ethical requirements that it expects from its certificants. Some of these new requirements include:

  • Putting the client's interests ahead of the CFP® certificant's interests at all times and in all situations. This is conceptually a step up from the previous standard of "reasonable and prudent professional judgment" that was formerly in the code. The change essentially raises the code of conduct for any issue or situation that is not considered to be within the bounds of financial planning services, per se, to a level just below that of a fiduciary.
  • All financial planning services must be accorded the care of a true fiduciary, as opposed to merely acting in the client's best interest. This also constitutes a major step up in terms of responsibility, as fiduciaries have a strict set of rules and guidelines that must be followed at all times. For clients, this means that their planners are held to a higher legal standard of care than before.

SEE: Meeting Your Fiduciary Responsibility

Fees Vs. Commissions
Regardless of what legal or moral standard they are held to, one of the biggest ethical dilemmas planners face is choosing a method of compensation. The methods of compensation for both sales-driven practitioners and planners are often interchangeable, since each can charge either fees or commissions for their services (provided that they are licensed to do so). However, this flexibility can often present a moral dilemma for planners who must choose one method of compensation over the other.

A fee-based planner, one who charges clients based on a percentage of their assets, will increase his or her compensation simply by making the client's assets grow. If the planner charges the client a fee of 1% of assets under management, then the annual fee collected from a $100,000 portfolio will be $1,000. Therefore, if the planner is able to make the portfolio grow to $150,000, his or her compensation will increase accordingly. This type of compensation could motivate the planner to employ more aggressive investment strategies than a traditional commission-based broker.

A commission-based planner, on the other hand, is compensated for each transaction, regardless of portfolio gains or losses. These brokers face the temptation to generate transactions as a means of revenue, even if they manage to avoid the technical definition of "churning."

SEE: 4 Dishonest Broker Tactics And How To Avoid Them

In this sense, each type of compensation presents its own set of ethical issues. Ultimately, planners will have to be willing to subordinate their own benefit to that of their clients, regardless of what business model is used. Take for example a planner that can work on either an hourly fee or commission basis. If the planner meets with a client that has $2 million earmarked for retirement, then charging by the hour would result in a total fee of perhaps $5,000 - on the very high end. On the other hand, choosing to charge the client a commission-based fee for investing the $2 million in a variable annuity could pay as much as a 7% commission, which would earn the planner $140,000! This extreme variance in compensation could easily sway even the most stalwart planner. The key to remember is that you must act in the best interests of your client, not your wallet.

Sales Vs. Advice
The boundaries between sales and advice in the financial industry are also becoming increasingly blurred as new platforms and methods of doing business continue to emerge. What this usually boils down to is getting clients to do the right thing for the right reason.

Many clients will base their financial decisions on emotions rather than what their planner advises. Suppose a 60-year-old woman has her entire savings of $100,000 in certificates of deposit (CDs), and is terrified of risking her principal. If she lives for another 25 years, her savings will likely be depleted long before she dies, since these low-risk investments pay a tiny rate of return that will be offset by inflation over time.

As a planner, you obviously need to get your client to diversify her holdings with a sensible asset allocation, or perhaps at least consider some sort of immediate annuity option. But how far should you go in encouraging her to do this? Is it OK for you to use aggressive, fear-based sales tactics, or even bend the truth a little, in order to help this client? After all, it clearly is in her best interest to do this. Besides, if no action is taken, you could be held legally liable for failure to provide adequate advice. In this case, the definition of "fear-based" sales tactics is also somewhat subjective; if the planner shows the client a graphic illustration revealing how she will be bankrupt in less than 10 years, is that using fear as a tactic, or is it merely a revelation of reality? The argument can be made that it is both at once.

SEE: Manage Your Clients' Expectations

Luckily, planners do have help in these types of situations. If a client refuses to take your advice, you can present your client with a written disclaimer that states the client or prospect is refusing to follow the recommendations presented by the planner. If your 60-year-old client wants her CDs and she's signed this disclaimer, then you are in the clear.

Problems with the System
The fact is that there is no central ethical resource that is available for all types of financial planners. Commission-based brokers can consult their supervisors or compliance departments on certain matters, but they are likely to get "corporate" answers to many of their questions - answers that may allow the planner to create a profitable transaction without incurring liability, but may not address what is truly best for the client.

CFP® practitioners may consult the CFP® Board with ethical questions, and other accredited planners may have ethical codes of conduct to refer to as well. But non-credentialed planners are essentially on their own for all practical purposes, as the rules imposed by the regulatory agencies are not designed to address many day-to-day issues that planners face in their jobs.

The Bottom Line
Despite the onslaught of legislation and regulations aimed at curbing unethical practices (such as the Sarbanes-Oxley Act of 2002), financial planning in today's world depends more than ever upon understanding a client's individual situation and objectives, and being willing to do the right thing for them. The correct application of ethics in modern financial planning essentially boils down to having the client understand exactly what they are doing and why, with full knowledge of the costs and risks involved. An ethical transaction occurs when a client truly understands the ramifications of the advisor's recommendations and is willing to go forward, assuming that all pertinent laws and regulations are being obeyed. After all is said and done, ethics can still be viewed as simply knowing the right thing to do, and then doing it.

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