Thinking Financial Planning

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!

Fiduciary Standards of Financial Advisors Part of Proposed Regulatory Reforms

This week, the U.S. Treasury unveiled their vision and recommendations for regulatory reform in the securities industry in a detailed whitepaper entitled, “Financial Regulatory Reform, a New Foundation: Rebuilding Financial Supervision and Regulation”. (Background: "Fiduciary Standard Part of Sweeping Regulatory Reforms", FA Magazine, June 18, 2009) The most pertinent changes for brokers and financial advisors is the sweeping reforms that make all investment advisors fiduciaries, including registered reps at broker-dealers and all CFP®s. The stated goal is to bring all classes of investment advisors under a common fiduciary standard (the strictest) to avoid confusion among consumers and to ensure the highest degree of integrity when dealing with clients for all professionals throughout the industry. While many brokers and advisors are still taking a wait and see attitude, and take an arms-length view of the whole regulatory alphabet soup, I think these changes will have profound impact on the industry and the way nearly all advisors run their practice, how they market themselves, and the services they offer. Understanding the big picture and preparing for what appears to be inevitable regulatory reform at this juncture is critical.

First, a bit of background: Today, the various certifications and designations of investment advisors are held to different sets of regulatory requirements and guidelines, particularly in the determination of whether the advisor is or is not held to a fiduciary standard. Registered Investment Advisors are held to a fiduciary standard, meaning that they are liable to provide appropriate investment advice for the needs and risks of the clients, but registered reps, insurance agents, and broker-dealer agents are not. CFP®s and financial planners are fiduciaries only if they are RIAs. Most descriptions of fiduciary responsibility focus on the requirement to further divulge how the advisor is compensated and any potential conflicts of interest that arise from the advisors compensation and the client’s needs. In general, a fiduciary needs to put a client’s needs first and foremost, and are held to strong ethical standards, much like a doctor or lawyer. OK, well, doctors anyway, “do no harm”, and all.

Divulging conflicts of interest and compensation schemes is all well and good, but where the fiduciary standard really matters is when the advisor gets sued. And, unfortunately, after down markets and investor losses, clients sue a lot. If the client has suffered losses that will affect their lifestyle or children’s college plans, there is a much greater liability on the part of fiduciary to prove that he considered all downside risks, and to show that the investment plan was clearly in line with the client’s risk tolerance and comprehensive investment needs. The onus falls on the fiduciary when material harm is done.

By comparison, nearly all broker-dealers require clients to agree to binding arbitration in the event of a dispute. They also make no warranties about keeping the client’s needs first and foremost, merely that a particular investment is “suitable”. The onus is on the client to show lack of suitability to the arbitrator, a much more challenging prospect for the uninitiated.

The National Association of Professional Financial Advisors (NAPFA) compares the approach of a fiduciary (which their members are), with that of broker-dealers who provide the following disclaimer in their client agreements:

“Your account is a brokerage account and not an advisory account. Our interests may not always be the same as yours. [My emphasis. – GK] Please ask us questions to make sure you understand your rights and our obligations to you, including the extent of our obligations to disclose conflicts of interest and to act in your best interest.”

Andy Gluck, CEO of Advisor Products, Inc. wrote an impressive blog about the regulatory changes and the impact of all registered reps becoming fiduciaries. He concludes that, “making all advisors say they will act as a fiduciary will water down the meaning of the term… I suspect that advisors who today are fiduciaries are going to have a tough time differentiating the way they give retail advice from the way brokers who are fiduciaries do it.”

Taking another perspective, I’m hopeful that the fiduciary standard will continue to maintain its inherent liability implications, as this is clearly the intent of the regulatory reform: to close loopholes that keep consumers from getting the best, most appropriate advice and standardizing ethical guidelines that alleviate confusion and clarify issues to the public. What I take all this to mean is less that RIAs will now face a marketing challenge, but that brokers won’t be pushing high flying Internet IPOs, and emerging market ETFs on quite so many unsuspecting investors. While they may never give up their binding arbitration clauses, broker-dealers are going to find themselves in court having to defend their investment advice with a whole new level of fervor where there will be much more of a presumption of guilt than innocence. Since there are many more registered reps at broker-dealers than RIAs, I think this reform will have much broader impact than many expect, particularly those that think that the fiduciary and ethical standards are going to be watered down to the least common denominator.

What is a broker-dealer, financial planner, registered rep, or variable annuity agent supposed to do? Well, I’m no lawyer, and I don’t even play one on T.V., but your goal should be that if you ever end up in court that you’ve got all the facts on your side. Have you taken a holistic view of your client’s financial situation in order to ensure that their risk tolerance was in line with your proposed investments? Have you taken into account all their lifestyle needs, goals and factored in an appropriate measure of downside risk commensurate with “doing no harm” according to historical precedents? Have you built an investment strategy that minimizes risk for the anticipated returns according to asset class correlations determined by historical data going back long enough to cover all reasonable market conditions? My guess is that if you are not doing financial planning, or at least are collecting enough data about your client to be in a position to do it, that the answer to most of these questions is “no”. Further, unless you are using asset allocation and portfolio management software to design efficient portfolios, the answer is probably “no”.

We know that the vast majority of RIAs, who have long been held to fiduciary standards, do make comprehensive financial planning an integral part of their practice. The reason is that they need to be in a position to answer “yes” to all the above questions when pressed. We also know that the vast majority of financial advisors at the large broker-dealers don’t do financial planning, or do it only as a marketing gimmick to show a need to sell products and services. Clearly, as these regulatory reforms move forward from the good intention/whitepaper stage to new legislation, this is going to change. Would you want to end up in court needing to prove that you have operated at the highest fiduciary standard possible without the documentation and planning details that justifies your decisions and the design of your portfolios according to the best historical asset correlation and risk management data available? Again, I think the answer is, “no”.

The last question is: will financial planning technology vendors be regulated through technical certifications of their products (sort of an FDA or UL approval for planning apps), with appropriate liabilities for their role in the delivery of advice? Well, AdviceAmerica welcomes being held to an equally high standard, but I wouldn’t expect any real legislation in this area until after they sort out the next great crash around 2050.

Fiduciary Advisors to Come Under FINRA Compliance Requirements?

There's a great post at the Financial Planning magazine web site by Bob Veres regarding the appointment of Mary Schapiro as head of the SEC in the new administration. Schapiro was most recently the head of FINRA (Financial Industry Regulatory Authority, but you knew that, didn't you?), the regulatory agency responsible for oversight of the financial securities firms in their dealings with the public. Seems like a reasonable appointment, athough Veres has some very legitimate insights and concerns. The trend, claims Veres, is extremely ominous for financial planners and, as the title of his post indicates, is really in the wrong direction for what the public needs to restore trust in the industry, and for what independent advisors and planners really need for their business.

The crux of the issue is that independent RIA's generally have to conform to fiduciary standards, taking on the liability risks of not always putting their clients best interests ahead of their own. This is a fairly simple concept in design, with lofty expectations for ethical behavior and easy to implement and adhere to in practice, with conscientious self-oversight. The alternative approach is for the advisor and/or the advisor's firm to operate in their own self-interest (well, not being held liable for doing so), but working tightly within the regulated environment and compliance constraints established by FINRA, the SEC, and other federal, state, and industry regulatory bodies.

For years the major firms have pushed back against holding their advisors to the higher fiduciary standard (their primary objective has to be to make money for shareholders, no?). We've seen how well this has been working out. Now, bringing Schapiro from FINRA to the SEC seems to imply, consistently with her remarks over the past year or so, that FINRA compliance requirements may be increasingly applied to independent RIAs in lieu of a fiduciary standard. Clearly this is bad news for consumers who again have to go back to wondering in who's best interest is my advisor operating. As Veres concludes, however, the prognosis is not good for advisors either:

I'm going to go out on a limb and make a few predictions here. I expect that Congress will follow the money and do what the large institutions want them to do: Wrap the RIA world, including fee-only planners, inside the FINRA regulatory scheme. This, I predict, will spark a resurgence in brokerage firm market share, as planners try to adjust to a very different regulatory landscape and are subtly delayed, harassed and generally discouraged. Because of much higher regulatory costs, many fiduciary advisors will sell their practices and retire. {My emphasis - GK}

Then, on the watch of FINRA and the Schapiro-led SEC, there will be a new round of scandals, a new raft of bitter consumer complaints and yet more damage to people who will no longer be able to retire because they were sold the latest hot products by emboldened salespeople posing—with regulatory sanction—as professional dispensers of impartial advice.

The lessons of the recent past could not be more obvious. The large firms and their reckless, greedy executives have made it abundantly, painfully clear what kind of regulation they do not want. If Washington accommodates them now, after they have blown up the global financial system, I really can't see how any future scandal will teach them anything new.

This appointment is a wake-up call to honest RIAs and to the public as well. I would like to see a groundswell of financial planning clients telling their elected representatives something very simple. Instead of bringing in a regulator who is hostile to the fiduciary concept, who believes that more rules and more paperwork will fix what they have clearly not fixed in the past, we should simply do what the repeat malefactors desperately do not want us to do. We should give individual investors the gift of knowing that the person sitting on the far side of the desk must, by regulatory fiat, put the consumer's interests first.

I agree that the public needs to have a stronger voice in the matter, although the specifics of industry regulations are frequently lost on the mainstream investor. If you are an advisor, take the time to educate your clients on the standards you are held to, and how you would like to see the industry evolve, and help give them a voice to our newly elected officials.