Suitability vs. Fiduciary Standards: An Overview
Investment advisers and investment brokers, who work for broker-dealers, both offer investment advice to individuals and institutional clients, such as pension funds, nonprofit organizations, and corporations. However, they are not governed by the same standards. Investment advisers work directly for clients and must place clients' interests ahead of their own, according to the Investment Advisers Act of 1940. Brokers, however, serve the broker-dealers they work for and must only believe that recommendations are suitable for clients. This suitability standard is set by the Financial Industry Regulatory Authority (FINRA).
Investment advisers are bound to a fiduciary standard that is regulated by the Securities and Exchange Commission (SEC) or state securities regulators, both of which hold advisers to a fiduciary standard that requires them to put their client's interests above their own. The act is pretty specific in defining what a fiduciary means, and it stipulates that advisers must place their interests below that of their clients. It consists of a duty of loyalty and care. For example, advisers cannot buy securities for their accounts prior to buying them for clients and are prohibited from making trades that may result in higher commissions for themselves or their investment firms.
It also means advisers must do their best to make sure investment advice is made using accurate and complete information and that the analysis is thorough and as accurate as possible. Avoiding conflicts of interest is important when acting as a fiduciary, and it means that advisers must disclose any potential conflicts. Additionally, advisers need to place trades under a "best execution" standard, meaning they must strive to trade securities with the best combination of low cost and efficient execution.
According to the SEC, investment advisers assist individuals and institutions in making financial decisions pertaining to planning for retirement, saving for a child's college education, or planning and developing investment strategies to manage assets and portfolios. They can charge fees for their services, which can be on an hourly basis, a percentage of the assets they manage for clients, or a commission on trades they make for their customers. They may manage individual portfolios, divided up by separate clients, or pooled investments, such as hedge funds, pension funds, and other related commingled assets.
Broker-dealers have to fulfill a suitability obligation, which is defined as making recommendations that are consistent with the best interests of underlying customers. Instead of having to place interests below that of the client, the suitability standard requires only that broker-dealers must reasonably believe that any recommendations made are suitable for clients, in terms of their financial needs, objectives, and unique circumstances. A key distinction in terms of loyalty also is important, in that brokers serve the broker-dealers they work for and not necessarily their clients.
Suitability also includes making sure transaction costs are not excessive and that recommendations are not unsuitable for clients. Examples that may violate suitability include excessive trading, churning the account simply to generate more commissions, or frequently switching account assets to generate transaction income for broker-dealers. Also, the need to disclose potential conflicts of interest is not as strict a requirement for brokers. An investment must only be suitable; it doesn't necessarily have to be consistent with clients' objectives and profiles.
The SEC considers broker-dealers to be financial intermediaries who help connect investors to individual investments. They play a key role in enhancing market liquidity and efficiency by linking the capital with investment products that range from common stocks, mutual funds, and other more complex vehicles, such as variable annuities, futures, and options.
[Important: The SEC defines a broker as someone who acts as an agent for someone else, and a dealer as someone who acts as a principal for their own account.]
One activity a dealer may carry out is selling a bond out of his or her firm's inventory of fixed-income securities. The primary income for a broker-dealer comes from commissions earned from making transactions for the underlying customer.
The suitability standard can end up causing conflicts between broker-dealers and underlying clients. Under a fiduciary standard, investment advisers are strictly prohibited from buying a mutual fund or other investment because it would garner him or her a higher fee or commission. Under the suitability requirement, this isn't necessarily the case, because as long as the investment is suitable for the client, it can be purchased for the client. This also can incentivize brokers to sell their own products ahead of competing products that may be at a lower cost.
- Investment advisers are bound by a fiduciary standard that places their clients' interests ahead of their own.
- Brokers work for broker-dealers, whose interests they serve. They follow a suitability standard, which means only that transactions must be suitable for clients' needs.