Retirement, IRAs, and the Fiduciary Standard

fiduciary standard DOL

Question:  I’ve been reading about a new fiduciary standard for financial advisors. It requires retirement plan advisors to put the client's best interest ahead of their own.  Hasn’t this always been the case?  What’s new?

Answer:  Stockbrokers and registered representatives of brokerage firms are paid commissions for sales and are not currently held to a fiduciary standard.  The Dodd-Frank Wall Street Reform Act of 2010 gave the Securities and Exchange Commission (S.E.C) authority to require advisors who sell securities for commission to act in the best interest of their client.  That never happened, probably due to the obvious conflict between what’s best for the client and what’s best for the salesperson.

Because the SEC failed to act, the Department of Labor, who overseas retirement plans under the authority of the Employee Retirement Income Security act of 1974, issued a rule last week that requires all financial advisors to act in a fiduciary capacity when selling investments and giving advice to retirement plans, plan participants, and IRA owners. The rule also covers advisors when they are providing advice to a plan participant about rollovers to IRAs and other plans.  

There are three different categories of financial advisors.

1) Fee-only Registered Investment Advisors (RIAs) have always been required to follow the fiduciary standard, which, in simplest terms, says that the fee-only advisor must put the client’s best interest first – ahead of the fee-only advisor’s own best interest.

2) Commission-based advisors, AKA stockbrokers and registered representatives of securities firms, operate under a somewhat lessor standard.  They are required to recommend investment products that are suitable for a client, but not necessarily in the client’s best interest. 

3) The third category, fee-based (as opposed to fee-only) advisors, can receive fees and/or commissions. They wear two hats.  They can manage a client’s portfolio for a fee under the fiduciary standard, and sell the client an investment and earn a commission under the suitability standard. 

Why does the DOL care about what standard an advisor is bound by?  The sale of mutual funds offers a good example.  Say the broker/advisor recommends a U.S. Large Cap stock fund.  The suitability rule states that broker/advisors “must have a reasonable basis to believe” that a transaction or investment strategy involving securities that they recommend is suitable for the customer.  This reasonable belief must be based the customer’s age, other investments, financial situation, tax status, investment objectives, investment experience, investment time horizon, liquidity needs, and risk tolerance. Now assume that the broker/advisor can recommend several similar U.S. stock funds that are suitable.  One pays a 5% commission, one pays a 3% commission, and one pays no commission. Under the suitability standard, the broker/advisor can sell his customer the fund that pays him the most, even though the higher commission is not in the customer’s best interest.

This obvious conflict of interest raises the question: how can you apply a fiduciary standard to a sales transaction without diluting that standard’s meaning and worth?  Well, the Department of Labor just did it by decree, declaring that if a sales commission is “reasonable” then it satisfies the fiduciary standard.  How that rule removes the conflict of interest remains to be seen. Using the above example, what’s a reasonable commission? 5%, 3%, or 0%?

 

Kenneth B. Petersen CFP®, EA, MBA, AIFA® is an investment advisor and Principal of Monterey Private Wealth, Inc., a Wealth Management Firm in Monterey.   He welcomes questions that you may have concerning investing, taxes, retirement, or estate planning.  Send your questions to: Ken Petersen, 2340 Garden Road Suite 202, Monterey, CA93940 or email them to ken@montereypw.com.