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A great debate is raging on in the financial services industry regarding the concept of suitability and fiduciaries. In fact, many firms in the financial services industry are lobbying hard with millions of dollars to keep suitability as the “law of the land”. What is the difference even? Does it make a difference in the investments and asset allocation strategy recommended to you? Well, the financial services industry does not want to change the status quo away from suitability; I can assure you of that. In order to answer that question better, I will provide an analogy below to try to explain the concept more clearly.
Imagine that you have a son or daughter who is finishing up his or her senior year in high school. He or she has done remarkably well academically and has participated in many extracurricular activities. Your child is interesting in pursuing a degree in engineering and is not quite sure what school to go to and if mechanical or biological engineering might be the right path. A sensible and perfectly natural approach would be to consult the high school guidance counselor to get some insight. The guidance counselor may recommend the local university in town. The guidance counselor knows that they offer a degree in engineering. Let’s say your son or daughter report back with excitement at the prospect of going off to college and starting on the path to a career in engineering.
After you have that conversation, you run into a friend who you “brag” to about the news. However, that friend is an engineer and mentions that there is a well-respected engineering program only 75 miles away. That university is known as one of the best in, not only in the state, but in the region. You are still very proud of your son or daughter but cannot understand why the guidance counselor did not mention that option. You decide to go to the guidance counselor and ask what his process was when he talked to your son or daughter. The guidance counselor simply states that your child mentioned that he/she wanted to go into an engineering program. The local university offers an engineering program, and it is accredited as well. When you ask why the other university was not mentioned, the guidance counselor replies that his job was only to find a school that had the degree your son or daughter needed. It was not his job to find the best option. Needless to say, you would be extremely perturbed or worse.
That little story can serve as the backdrop for the issue of suitability and fiduciaries. There are some financial professionals that offer advice based upon suitability. Other financial professionals are considered to be fiduciaries. Suitability is more akin to the way in which the guidance counselor handled the meeting with your son or daughter. The job was only to find a school that fit the needs. Finding a better option was not really thought of or necessary. The friend actually put you on the path to how a fiduciary approaches things. A fiduciary would find the best option given all the information about your son and daughter and his/her future plans.
Now the definition of suitability and how a fiduciary must act are really complex from a legal standpoint and the corresponding requirements needed to follow either. A fiduciary has additional legal responsibilities to you as a client. In order to be a fiduciary, there are strict rules on compensation, products that meet your financial goals, investment expenses, and conflicts of interest. What might a conflict of interest be? Well, a good example is that many financial services firms have proprietary asset management arms and investment products. If that firm manages your recommended portfolio components, additional revenue goes to that firm. Another example might be that many mutual fund offerings provide the financial professional with lucrative 12b-1 fees that are referred to in the industry as trails. A trail simply means that the financial professional receives an annual amount based upon a specified percentage applied to the client accounts that he/she has with the mutual fund company. Another favorite offering is variable annuities. These types of products offer extremely high payouts which are applied to the face value of the insurance policy. It can be very tempting to offer the variable annuity with the highest payout as long as the underlying investments are acceptable (i.e. they invest in large cap stocks that were one portion of your proposed portfolio allocation).
Now I am not saying that anyone who only has to adhere to suitability requirements will automatically place you into investments that have higher fees for you or are better for his/her year-end bonus. My point is that a fiduciary must adhere to higher standards of conduct and act truly independent. A fiduciary runs the risk of additional liability if they breach their duty to you as a client. A financial professional that only has to recommend suitable products has a much lower hurdle to get over. As long as he or she recommends a mix of stocks, bonds, and alternative investments that meets your financial goals, that is all they have to do. Of course, that financial professional may suggest the exact same products that a fiduciary would. However, they are not required to recommend offerings that are the best in terms of investment fees and the best financial product available given your circumstances.
The important thing to remember is to always ask your financial professional whether or not he/she is a fiduciary. If not, you want to ask them how they come up with solutions that are suitable for you. You can even ask them if there are other options available. If you see recommendations that are heavy on the mutual funds of the firm you are dealing with or life insurance products with large amounts of legalize and complicated forms, you should delve deeper into that financial professional’s logic. You definitely should ask what form of compensation and amount he/she will receive and if any revenue goes to the firm from that financial product. Additionally, I would ask them why a more low cost, passive approach might achieve the same objective but be less expensive for you. Some of the responses might surprise you. If the answers seem to sound more like the guidance counselor, I would urge you to seek a second opinion before you choose that financial professional and start an account with that investment portfolio.