The Department of Labor (DoL) has put forth a proposal that would substantially impact the business models of thousands of brokers, advisors and insurance agents nationwide. This legislation has been created in an effort to update and overhaul the current set of rules that govern the financial marketplace. The crux of the matter lies in the distinction between operating under the suitability standard versus being required to act in a fiduciary capacity for clients.
How They Differ
Most brokers, insurance agents and financial planners who are paid commissions for the transactions that they place are held to a standard of suitability on a per-transaction basis. This standard maintains that any transaction that can be deemed to be “suitable” for a given client is permissible, provided that it is based upon the facts that the advisor is able to gather regarding the client’s financial situation, tax status, investment objectives, risk tolerance and time horizon.
The broker or planner is required to understand the risks and technical characteristics of any investment or program that he or she recommends to clients, and failure to do so results in a violation of this standard. But suitability is only applicable at the time of the transaction and not afterwards. A broker can recommend a stock to a client that may be suitable for him or her according to the definition. But if that stock tanks two months later, the broker cannot be held liable because it met the suitability requirements at the time of purchase. (For more, read Meeting Your Fiduciary Responsibility.)
Registered investment advisors (RIAs) are by contrast held to a higher standard of conduct known as a fiduciary standard. This standard was established by the Investment Advisors Act of 1940 and requires advisors to always act in the best interests of their clients irrespective of all other factors, regardless of the consequences to their compensation or any conflicts of interest that they may have. An example of how this works compared to the suitability standard is given in the following example:
Frank goes to his stockbroker for an investment recommendation. His broker finds several stocks that technically fit Frank’s investment objectives, but his investment firm will pay him a higher commission for selling one of them. The broker tells him to buy that stock as a result. Frank buys 1,000 shares and the stock rises quickly, then drops substantially below its par value several weeks later. Frank goes back to his broker to complain, and his broker reminds him that his recommendation fit Frank’s goals and risk tolerance at the time of purchase. (For more, see: How to Create a Client Investment Policy Statement.)
Frank sells his stock at a loss and takes the proceeds to a RIA. The RIA crafts an investment policy statement for Frank that will dictate how his portfolio will be managed. The RIA charges Frank a quarterly fee for his services. When Frank’s portfolio declines in value, so does his advisor’s fee. The advisor also discloses to Frank that he is also registered with a broker-dealer so that he can use variable annuity contracts if the need arises. The advisor also comes up with approximately the same list of stocks as the stockbroker, but the RIA digs deeper into the financials of these companies to see which ones really have the most growth potential.
The important difference in these two scenarios is that Frank’s RIA works for him, the client, while Frank’s broker works for an investment company.
Although the line between broker, agent, planner and fiduciary can sometimes become blurred, the legislation being proposed by the DOL will bring some fairly substantial changes to the financial marketplace. If this becomes law, it may spell the beginning of the end for the suitability standard in its present form. It will require all brokers and planners everywhere to disclose any possible conflicts of interest to their clients and also find the absolute best product for them in all situations.
The new law will classify anyone who provides any type of recommendation or advice pertaining to retirement savings, qualified plans or IRAs as a fiduciary, regardless of what licenses they do or do not hold or their method of compensation. (For more, see: 401(k) Investment Policy Statement Example.)
But this law is also careful to exempt certain types of actions from this definition. Those who provide pure education without any type of sales pitch or bias are not considered fiduciaries, and those who make sales pitches to other fiduciaries or potential plan sponsors who are financially sophisticated themselves are not bound by fiduciary standards. Brokers and traders who simply take orders from retirement plan clients without providing any type of advice or recommendations are likewise exempted from this definition.
The Bottom Line
The financial industry currently employs two separate levels of care to its customers. The suitability standard is only applicable on a per-transaction basis while fiduciaries must unconditionally put their clients’ best interests ahead of their own in all situations. The Department of Labor has responded to ongoing public dissatisfaction with many of the products and services being offered by the commission-based element of the industry by proposing legislation that will confer fiduciary status on anyone who works with individual clients in an advisory capacity. (For more, see: Fiduciary Designations for Financial Advisors.)
If this law passes, then the DOL will also have the power to monitor and enforce this rule along with the Internal Revenue Service (IRS). But while proponents maintain that this change will force many brokers to start recommending investment choices that have lower fees, some critics feel that this action will remove the incentive for planners to seek out investors with lower accounts balances because they will not generate sufficient revenue to be worth pursuing. Assuming that this legislation is passed by Congress, its ultimate effects are yet to be seen. (For more, see: What the DoL’s Fiduciary Policy Means for Advisors.)