Why Fees and the Fiduciary Standard Matter to Investors

Buy or sell dice

By Blake Fambrough

Learn more about Blake on NerdWallet’s Ask an Advisor

When you’re working with a financial professional, you should know how your advisor is compensated and any potential conflicts of interest the advisor may have. That’s why a new rule from the Department of Labor is vitally important to investors.

The department’s fiduciary standard rule, which will go into effect in April 2017, addresses sales practices within qualified retirement accounts. Under a fiduciary standard, the advisor is legally required to act in the client’s best interest. To comply with the new rule, the company and individual advisor providing retirement-planning advice must disclose any conflicts of interest, like hidden fees, that may prevent the advisor from providing advice in the client’s best interest.

Generally, registered investment advisors are held to the fiduciary standard or best-interest standard. But after the rule, all professionals who advise on retirement accounts will have to comply. Under the new rule, fiduciaries cannot accept payment that poses a conflict of interest. However, thanks to what’s called a “best interest contract” exemption, firms can continue to charge the same types of fees as long as they disclose those fees, sign the best interest contract and act in the client’s best interest.

Although the rule is complicated and potential loopholes exist, it should go a long way toward making sure investors are not misled by advisors who they assume are acting in their best interests.

Suitability standard

Currently, many other types of financial advisors are held to a less stringent requirement known as the suitability standard. Under this standard an advisor can recommend a product for clients even if there is a less expensive option, so long as the recommended product is suitable for the investors based on their age, risk tolerance and other factors.

For instance, brokers who are affiliated with broker/dealer firms have to fulfill only a suitability obligation, instead of having to place the clients’ interests above their own. But most brokers are compensated by commissions on the products they sell to clients and have a working obligation to their parent company to produce a profit. They may also make more money when they sell particular products. These backdoor payments may incentivize brokers to sell those products over others, creating a conflict of interest in deciding what investments to recommend to the client.

But this fee structure does not have to be disclosed, so clients can’t be certain that the advice they are getting is in their best interest. They may receive financial-planning advice that results in hidden payments to the financial firm. This lack of clarity on how the advisor and his or her firm are compensated is a disservice to clients. Consumers can’t make an educated decision on the benefits of products or advice until they know the true costs associated with them.

Fiduciary standard

The client’s best interest should always come first — no client deserves a financial product that’s just not suitable for that person’s situation — and that’s what the fiduciary standard tries to fix.

However, there are also loopholes regarding the way the fiduciary standard is currently upheld for advisors outside of retirement accounts. If an advisor is working for a registered investment advisors firm but is also affiliated with a broker/dealer, then he or she is a fiduciary but also a broker, adhering to the suitability standard. In other words, these advisors are dually registered — they wear two hats. At times they are fiduciaries and at times they are brokers, so clients don’t always know when they are truly working in their best interest.

This can be very confusing for the client. Investors can protect themselves by working with an independent registered investment advisor (one not affiliated with a broker/dealer). Since these professionals are legally required to uphold the fiduciary standard, fee transparency must be practiced and clients can avoid confusion about potential conflicts of interest. This is especially important if you have a non-retirement brokerage account, because the fiduciary rule will cover only advice on retirement accounts.

Clarity for clients

Working with a financial professional who is required to be on your side is the best course of action for your financial plan. Aside from knowing exactly how much you are paying for your investments, you will also be able to see the value of the financial-planning advice your advisor provides. With fee transparency, you can determine if the benefits outweigh the costs.

President Harry Truman is quoted as saying, “If you can’t convince them, confuse them.” In the financial-planning world we see evidence of this approach as financial products and services become more and more complex at the expense of everyday investors. Fees and an advisor’s potential conflicts of interest are not always made clear to clients and this is precisely why the fiduciary rule matters so much to investors.

Blake Fambrough, CFP, is a financial advisor with Dubots Capital Management in Temecula, California.

The article Why Fees and the Fiduciary Standard Matter to Investors originally appeared onNerdWallet.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.