Brokers and the Fiduciary Standard

Question: Should I be concerned about President Trump’s executive order last week that repeals the fiduciary rule for brokers? Sounded like a good thing to me that brokers should put client’s needs ahead of their own! 

Answer:  Last Friday, President Trump signed an executive order instructing the Department of Labor (DOL)  to review (not repeal) the previous administration’s order that was due to take effect April 10th.  The rule requires registered representatives of brokerage firms (brokers) who are paid commissions for sales to adhere to a fiduciary standard when giving advice on retirement plans, including IRAs. The DOL may postpone the effective date while it reviews the rule.

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 confliction 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 oversees retirement plans under the authority of the Employee Retirement Income Security act of 1974, issued a rule last year requiring all financial advisors to act in a fiduciary capacity when selling investments and giving advice to retirement plans, plan participants, and IRA owners.

There are three different categories of financial advisors. Fee-only Registered Investment Advisors (RIAs) don’t sell investments and are 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.  Commission-based advisors, AKA brokers, stockbrokers, and registered representatives of securities firms, operate under a somewhat lessor “suitability standard.”  They are required to recommend investment products that are suitable for a client, but not necessarily in the client’s best interest.  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. 

The DOL is concerned about conflicts of interest and high fees in retirement accounts.  The suitability standard of care only requires that a broker/advisor “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. Let’s say the broker recommends a mutual fund with three different share classes, one that pays a 5% commission, one that pays a 3% commission, and one with no commission. Under the suitability standard, the broker/advisor can sell his customer the fund that pays him the highest commission even though it is not in the customer’s best interest.  This conflict of interest raises the question: How can you apply a fiduciary standard to a commissionable sales transaction without diluting that standard’s meaning and worth?    Well, the Department of Labor is making the argument that if a sales commission is “reasonable” then it satisfies the fiduciary standard.  How that rule removes the conflict of interest is questionable and now under review.

 

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.