Nathan Geraci is President of The ETF Store, Inc. and host of the weekly radio show “The ETF Store Show“.
If you work with a financial advisor, you might be surprised to learn they may not have a legal obligation to place your interests ahead of their own. Let me repeat that. Your financial advisor may not have to act in your best interests!
As it turns out, many “financial advisors” are simply brokers who get paid commissions based on the investments they recommend to you. These brokers can legally steer you into expensive investments that pay them big dollars, but may end-up costing you big dollars. Furthermore, they do not have to disclose this fact to you.
Surprised? The issue comes down to the difference between a fiduciary standard and a suitability requirement. Luckily, you do not need a law degree to understand the differences here. A fiduciary standard requires an advisor to put your interests ahead of their own – they have a duty of care and duty of loyalty. Registered investment advisors, or RIAs, operate under the fiduciary standard which means they must avoid conflicts of interest and ensure they are always acting in your best interests. Meanwhile, a broker simply adheres to a suitability requirement, which means the investments they recommend must be suitable given your general risk profile.
Why might this be an issue? The potential problem with suitability is that a broker can satisfy this requirement by actually recommending the least advantageous of all the suitable options. Consider a situation where a broker believes that a growth stock mutual fund is suitable for you and they have two funds they are considering recommending. The first one charges you 1.3% annually and it pays the broker a commission (or load) of 5% of your total investment. Remember, this load is coming directly out of your pocket. The second fund only charges 0.3% annually – so it is a full percentage point cheaper – but it only pays the broker a commission of 2%. Both of these funds do the exact same thing from an investment standpoint. They both have the same benchmark index. Can you see the potential conflict here?
A broker might be tempted to invest you in the more expensive fund that pays them a bigger commission, even though the less expensive fund would likely be a much better option for you. There is another issue as well. Once a broker recommends a suitable investment to you and they receive their commission, they may have little incentive (or legal obligation) to continue monitoring that investment. If the investment is underperforming or perhaps your situation has changed, the broker might not be all that concerned. Unfortunately, the next time you hear from the broker could be when they are ready for another commission check and they need to sell you another lucrative (for them) investment.
If you are surprised or even confused by this, you are not alone. Unfortunately, the financial services industry has made it difficult for investors to discern what type of advisor they are working with. A broker will often refer to themselves as a financial advisor, investment advisor, retirement planner, or some other similar title. It can be very challenging for you as an investor to know exactly who you are dealing with. The financial services industry is even spending millions of dollars lobbying to keep this arrangement intact!
So what can you do as an investor? There are a two very simple steps you can take to protect yourself:
- Ask your advisor if they are a fiduciary and if so, to put it in writing. If your advisor is unwilling to do so, it is highly likely they are a broker. Look for Registered Investment Advisors (RIAs), who are required by law to operate as fiduciaries.
- Ask your advisor how they get paid and how much they get paid (and again, ask for it in writing). Unlike other walks of life, it is not taboo to ask your advisor how much they make. After all, it is money coming straight out of your pocket. A fee-based advisor charging a small percentage of the investments they are managing is likely a fiduciary. If you hear words like “commissions” or “12b-1 fees”, you are likely working with a broker. Also, ask your advisor where their compensation is coming from. If they receive compensation from anyone other than you, you are likely working with a broker (i.e. if mutual fund companies are paying kickbacks or other incentives to the advisor). Follow the money trail.
There are other steps you can take including asking about the types of investments your advisor uses (for example, ETFs do not pay brokers commissions and therefore, they are less likely to use them) and asking about their investment philosophy (an advisor constantly churning positions is likely doing so to rack up commissions). However, the two steps above will weed out most brokers.
It is important to note that just because an advisor gets paid commissions and operates as a broker, that does not automatically make them a bad advisor. Consider an advisor who puts together an individual bond portfolio for you where the bonds are going to be held until maturity and no changes will ever be made to the portfolio. It would likely make more sense to work with a commission-based broker for these bond transactions rather than pay an on-going asset-based fee. The key is that you as the client should be aware that the broker is receiving these commissions and how much they are receiving – because, again, this is money coming out of your pocket. There are other situations where a broker may make sense, but the key is this: there needs to be transparency and disclosure.
A recent report released by the White House indicated there is currently an estimated $1.7 trillion dollars in individual retirement accounts that are invested in products that pay fees or commissions to brokers. The report also said investors who receive investment recommendations from advisors who may have potential conflicts of interest had a 1% lower return annually. That equates to $17 billion dollars a year – and that is without adding in any effects of compounding year-over-year. This is real money that can make a significant difference in your retirement. The lesson here is to make sure your advisor is working for your retirement, and not theirs.
