When you are figuring out how to manage your finances, it’s important to know not only about the different strategies for financial planning but also how the money management industry works. When you are entrusting your savings and income to someone, you want to be confident that this individual is responsible for acting in your best interests. Unfortunately, this is often not the case. Therefore, it’s crucial to vet financial advisors carefully to see if they are the right fit for your financial situation and goals.
The word fiduciary acquired a much deeper meaning in April of 2016 when the Department of Labor released their Fiduciary Rule. It was vacated later, but a newer version was approved by the Biden administration in February of 2021.
The new rule basically separated the world of financial advisors into two different categories: fiduciaries and nonfiduciaries. If anything, this just added to the confusion and risk for investors. The problem stems from the fact that there is no legal definition of the term financial advisor. In other words, basically anyone and everyone can use the term. And yet, most clients are not aware that the term financial advisor does not stipulate the ethical standards under which the advisor must operate.
A 2019 survey by wealth manager Personal Capital revealed that almost 50% of Americans incorrectly believe that all advisors are legally bound to act in their clients’ best interest. Unfortunately, this creates a situation in which many clients unknowingly pay for financial advice from advisors who are free to put their own interests in front of their clients. In actuality, only financial advisors who are fiduciaries are obligated to act in their clients’ best interests.
What Is a Fiduciary?
A fiduciary is a person or entity that has the power to act on behalf of someone or something else. Essentially, a fiduciary must act as if they are who they represent and make decisions that are in that person’s best interest.
The most well-known example of a fiduciary is a trustee of a trust. In this case, the trustee or fiduciary has discretionary authority over the assets in the trust. Similarly, a fiduciary financial advisor has the authority to buy and sell securities in an account on the client’s behalf without their express consent. For this reason, fiduciaries are held to a higher standard than nonfiduciary advisors.
What’s the Difference Between a Fiduciary and a Financial Advisor?
The difference between fiduciary and financial advisor lies in the definition of the terms. A person who advises others regarding their finances can be either a can be either a fiduciary financial advisor or a nonfiduciary financial advisor. A fiduciary, however, must act in their client’s best interest. And they don’t have to be financial advisors. They can also be attorneys or guardians or trustees or other professionals.
What’s the Difference Between the Fiduciary Standard and the Suitability Standard?
On account of the Department of Labor ruling, we now have two different standards in the financial industry: the fiduciary standard and the suitability standard. The problem becomes even more pronounced when brokerage firms fail to mention which standard they are working under.
The main difference separating the fiduciary standard and the suitability standard lies in how an advisor makes his or her decisions. Prior to making a recommendation, a fiduciary must go through a thorough process to determine a client’s best interest. They must also explain the recommendation in detail to their client, so there’s no misunderstanding about it and the reason for the fiduciary to suggest it.
For financial advice to meet the suitability standard, the advisor need only have sufficient reason to think that it meets the client’s financial needs. Basically, the advisor would only need adequate information regarding the investment and his or her customer’s finances prior to making the recommendation.
Suitability Standard and Conflicts of Interest
Clearly, the suitability standard doesn’t require the same level of discussion as the fiduciary standard. Moreover, it does not ensure that advisors put their clients’ best interests ahead of their own; it also does not preclude any conflicts of interest.
A nonfiduciary can direct clients towards products that line his pocket, as long as they could be suitable for them. A fiduciary, on the other hand, can’t recommend a higher commission product because paying more in fees wouldn’t be in the client’s best interest.
Although not every advisor under the suitability standard is putting their needs before their clients, it’s critical to know that they are allowed to legally. Furthermore, the compensation structure and incentives at their firm may result in conflicts of interest.
Anytime you involve someone in your personal finances, you are placing a great deal of trust in them. Thus, it’s important to know the type of financial services you need and to find the right type of financial professional to provide them. Regardless of the type of financial advisor you choose, you need to be clear about how they make their money and the value they offer for what you pay them.