Fiduciary Reform: The Crux of the Issue

Activities on the fiduciary reform front heated up this week. According to an article in FA magazine, a group of advisors calling themselves the Committee for the Fiduciary Standard formed to lend a voice to refinement of fiduciary standards for financial advisors, which they characterize as an 'authentic' fiduciary standard. They have laid out five core principles which they believe to be the essence of a fiduciary as outlined in their press release:

1. Putting the client's interests first.
2. Acting with prudence, defined as acting with "skill, care, diligence and good judgment."
3. Not misleading clients and providing "conspicuous, full and fair disclosure of all important facts."
4. Avoiding conflicts of interest.
5. The full disclosure of unavoidable conflicts.

These are noble goals, but further detail is required to really define an issue like "putting the client's interest first". This new group appears to consist of about a dozen otherwise unaffiliated independent advisory firms.

On a parallel front, the Financial Planning Coalition (FPC) released a statement this week both applauding administration efforts, but raising concerns that the focus of regulatory change was aimed mostly at broker-dealers, and would result in a watered-down "fiduciary-lite" standard, and that the changes continued to leave a broad class of finanical planners still unregulated. The FPC is a coordinated group consisting of the CFP Board of Standards, the Financial Planning Association, and the National Assoc. of Personal Financial Advisors (NAPFA).

The FPC stance appears to be similar to the new group mentioned earlier, in that they are both advocating a clear, strong and/or authentic guideline for fiduciaries, and desire to retain the value-added perception of fiduciaries today over non-fiduciary brokers. I'm not sure how many unregulated financial planners there are out there, and how much business they are actually getting, so I'm somewhat skeptical that needs more attention, but OK.

To understand the crux of the issue, I always want to drill into the details, though. What does it really mean to "put your clients interests first"? To me, the big issue here is compensation. Registered reps (brokers), can sell any product that is "suitable" to their clients, and are generally compensated by commissions, or fees that result from the investment products sold. Not being a fiduciary means that you don't have to make sure that your clients are getting the best products at the lowest fees, and that whatever you can get in commissions is a testament to your sales skill.

On the other hand, the fiduciary concept means you as the advisor have to put your client's need to minimize fees as well as risks for the optimal potential return ahead of your need/desire to maximize your compensation. If anyone disagrees with this seldom discussed interpretation, please let me know, because it's often vague and certainly controversial. If you agree with this supposition, how can you be a fiduciary and charge a commission, or even promote loaded mutual funds over no-load funds, or... and the list goes on. Where is the line to be drawn? If you elect to hold yourself out as a fiduciary, do you have to justify the use of mutual funds over index ETFs, which many point to as having a higher liklihood of outperforming a majority of funds net of fees and expenses?

In an earlier blog article I also raised the issue of increased liability for fiduciaries and how that necessarily affects investment advice, especially if lots of investors are losing money in a broad down market like we have seen. Along with the compensation issue, I still think that's an issue (overall investment planning difference, asset allocation models, and risk aversion methods) that these fiduciary groups need to further define.

Andy Gluck has another excellent post on this topic this week, and raises the compensation issue as well. He writes:

"If brokers are fiduciaries but can continue to be compensated on commissions, then the fiduciary standard of care has no teeth. And if the U.S. government bans commission compensation of independent financial advisors, as was done last week by Great Britain’s Financial Services Authority, an extremely unlikely reform, then telling the difference between fiduciaries will be difficult."

So, it's very interesting that Great Britain has now actually gone the route to ban commission compensation for RIAs. And I agree it's unlikely to happen here, even if that's what ultimately holding the client's needs first effectively translates into. This is where these fiduciary advocacy groups need to fill in the details for us and provide us a stance on their "more authentic" definitions of a fiduciary.

The "teeth" of the fiduciary standard of care definition has more to do with the implied liability for investor losses, or what "acceptable" losses are, given the risk tolerance of the client, than whether the advisor is commission-compensated or not. For example, when I was at Smith Barney, we used to push structured investment products that could track a stock or an index and limit the downside risk of the investor through the use of complex option strategies. You might get 85% of any upside in the index, but losses could be limited to 5%, or even less. Just one example, but these might be great products for fiduciaries to promote, because of the risk protection, even if they carried a reasonable up-front fee or commission. Just as long as the commission was clearly identified, and comparable investment vehicles were promoted, if applicable, and all relevant facts were disclosed.

Health care reform, not to change the subject, is such a complex issue because nobody wants to give up their piece of the pie. And it's going to be no different with advisor regulatory reform. Nobody is going to want to give up their revenue stream, or any perceived differences they hold out over the competition that they have today. Expect a long and convoluted battle here as well. And lets hope the advocates on both sides are sincere in their positions, if they really hold the consumer's interests most dear.

Happy Independence Day Everyone!

Comments

[Michelle Boudreau]

Nice post ! the essence is the customer satisfaction is first priority , then is the way for financial stability .

[Ken]

Nice post, keep the info on fiduciary advice coming.

http://www.fiduciary.me