The Financial Fiduciary Standard Explained

The new buzzword within the financial industry is “fiduciary,” but what does it really mean for an adviser to be a fiduciary?

A fiduciary is someone who acts on behalf of another person, putting their clients' interest ahead of their own. Therefore, being a fiduciary means the adviser is bound both legally and ethically to act in the other's best interests.

This seems pretty straightforward, which leaves one curious as to why this is such a debated topic among advisers, regulators and special interest groups.

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Shouldn’t all advisers act in the client’s best interest? Of course, but like most things, the answer isn’t as straightforward as it appears at first glance.

The Fiduciary Debate

To understand why this is such a debated topic within the industry, you first need to know that the financial industry is divided into two camps of client care:

• The suitability standard is defined as giving recommendations that are “suitable” for their client.
• The fiduciary standard is defined as giving recommendations that are in the client’s best interest.

Yes, they semantically seem like the same thing, but before you spend too much time overthinking these definitions you should know that these definitions are not really what the debate is about. The truth is the entire debate is really about how advisers are compensated. You see, there is an argument among advisers and regulators about whether compensation should be in the form of a commissions, flat fees or a percentage of assets under management.

The debate sounds something like this: Advisers in the fiduciary camp will argue that the suitability camp makes client decisions based on how much commission the adviser is receiving and therefore does not operate as a fiduciary. On the other hand, advisers in the suitability camp will argue that the fiduciary camp is only interested in gathering client assets so they can charge a fee, and they aren’t really operating as a fiduciary.

Yes, it is that petty and has resulted in a divide within the industry as both camps defend their position without recognizing that the client is best served right in the middle.

Personally, I see this as an inconsequential debate, because regardless of the fiduciary label, regulations, disclosures, definitions and compensation methods, how well a client is served will always boil down to the character and motives of the adviser. I own some property a few miles from my home, and like many landowners, I have “No Trespassing” signs up around the perimeter. These signs clearly inform people of the obvious: This is not your property, and you should not trespass. But, do you think these signs keep dishonest people off my property? They don’t.

No label, sign, rule or regulation can stop those who disregard what is right from doing what they want.

Distinguishing One Adviser from Another

Although advisers may all appear to be the same from the public’s view, the reality is that advisers can differ greatly in what products or services they offer the public due to which licenses they hold.

Licenses are issued by FINRA through the passing of an exam “series” that grant the person the ability to practice as a financial adviser. There are a variety of series exams that grant different privileges, but suffice it to say that all of them enable the general use of the title financial adviser. So, even though someone holds themselves out as an adviser, it doesn’t mean they are all offering the same products or services.

For many, advisers will carry one license or another within a limited set of series, such as a Series 65 or Series 7, and whichever license(s) they procure grants them limited authority to offer specific product(s) to the public.

For instance, an adviser who carries a Series 65 license is granted the authority to offer fee-based services under the Investment Advisers Act of 1940 and typically do not receive commissions for securities sales. Besides calling themselves financial advisers, these advisers will often hold themselves out to the public as either a Registered Investment Adviser or as an Investment Adviser Representative. These advisers are regulated by the SEC under The Investment Advisers Act of 1940, which in fact birthed the fiduciary standard.

I mentioned earlier that no label, sign, rule or regulation can stop those who disregard what is right from doing what they want, and Bernard Madoff is the poster child for making my point. Bernard L. Madoff Investment Securities LLC operated under the Investment Advisers Act of 1940, and Bernie himself technically was a “fiduciary.”

Madoff’s story of running the largest Ponzi scheme in history supports the point that no legislation, no amount of rulemaking or regulatory oversight will compensate for a character flaw. Therefore, a label of fiduciary shouldn’t be a blind hall pass for the client to assume that the adviser they are working with is “better” or more “honest” than an adviser who isn’t licensed as a fiduciary. Technically speaking, it just means they have a Series 65 license and are supposed to operate under a code of conduct to make a “best effort” to operate as a fiduciary.

How the Suitability Standard Could Affect Your Service

So, there is more to consider other than just the question, “Are you a fiduciary?” but before getting into that, let’s take a look at the “suitability” camp. For the most part, these advisers carry a Series 7 license and are compensated through commissions. This license is held by brokers who are contracted with dealers that broker products regulated by FINRA (hence the name broker-dealer, or BD).

The broker accesses the products they use through their BD, who is given the authority to grant or deny the broker’s request to use a particular product for a client. The broker is required to provide their BD with a rationalization for how the product is suitable to meet the client’s needs.

The relationship between a broker and their BD could be seen as a conflict — since both benefit financially from the sale of a product — but if you ask any broker, they will likely tell you that the due diligence departments of most BDs are strict and quote FINRA guidelines often. They are strict because FINRA closely monitors transactions, processes and record-keeping, leaving the BD exposed to fines and other legal recourse when the guidelines are not followed.

So, an adviser who is operating under the suitability standard is required to provide suitable recommendations for their clients. But again, while the adviser is legally bound to either the suitability or fiduciary standards, it is ultimately up to the adviser to operate in good faith of the rules they are following.

Lastly, there is a hybrid model where the adviser has both a Series 65 and a Series 7 license that grants them the ability to offer both compensation methods, depending on the type of product or service needed to serve the client.

Where The Lines Blur

To make this topic even more confusing, there are some who claim to be a financial adviser but do not hold any series licenses at all, but instead operate using only an insurance license regulated by state insurance departments.

These so-called advisers are not held to either standard and act as agents of insurance companies solely focused on marketing fixed life insurance or fixed annuity products for a commission.

Here is the point, commission-based products make up the vast majority of options available to advisers, which is why many in the fiduciary camp will carry an insurance license and offer insurance products to their clients for a commission.

The Best of Both Worlds

With over 27 years of industry experience, what I know for certain is that each client is different and requires special attention be given to satisfy their unique needs and preferences.

What we can surmise from the different licenses is that there are pros and cons to each, and in order for an adviser to truly act in the client’s best interest I feel it is necessary for them to hold a Series 7 and 65 license along with an insurance license. This license combination allows the adviser to remain agnostic about which products are ultimately used, as I find it difficult to see how a client can be served without access to the majority of available products or services.

In my day-to-day interactions with clients, it is not uncommon for me to offer a managed account for a fee to one client, an insurance product for a commission to the next and then a private market investment for someone else – all requiring different licenses. (To learn more about how an adviser is compensated, please check out my podcast (opens in new tab).)

Knowing What to Ask

When someone asks me if I am a fiduciary, my response is yes and no. What do I mean by that?

• From a practical standpoint, “yes,” I operate my entire business focused on serving a client’s interest, as I feel all advisers should.
• But from a regulatory and licensing standpoint, “no,” since I operate within both camps of fiduciary and suitability standards.

It is unfortunate for clients to have to navigate the minutiae of industry terms and regulations, but it is necessary to understand given the pressure clients are under to find the right adviser and will often resort to asking, “Are you a fiduciary?”

However, I do believe there is a better line of questioning that can help clients find an adviser who can act both in the client’s best interest while also being able to offer the best of both worlds:

Q1: “What licenses do you hold?” You will want an adviser who holds a series 7 and 65 along with an insurance license.

Q2: “Do you own your own business?” If an adviser works for someone else, they work for that company. If someone owns the company, they tend to be more apt to work for the client.

Q3: “What product or service do you offer?” If an adviser is focused on product sales, they will often lead a conversation with product features, such as rates of return, management style, algorithms, catchy phrases and other bells and whistles. You want an adviser who begins and ends their process focused on you while product features remain in the background only there to carry out your plan’s objective.

An adviser who focuses on their client’s needs understands that a well-rounded financial plan includes things such as cash flow, debt reduction, limiting tax exposure, estate planning, retirement income planning, risk mitigation, and family planning before there is any mention of products, services or asset allocation. (To learn about a family office model, please check out my podcast (opens in new tab).)

The adviser to avoid is the one who leads with portfolio performance and asset allocation techniques or who has a product script that focuses on the bells and whistles of their product.

The bottom line is that a client’s needs should be an adviser’s priority, and a reasonable client understands there is a cost to the advice being given, regardless if a commission is paid or a fee is charged.

It is the adviser’s responsibility to educate clients on their options, be transparent about how they are compensated and place well-suited products that are in the client’s best interest.

For now, I will operate by holding both a Series 7 and Series 65 along with my insurance license to fulfill the obligation that I feel I have to my clients, which is having the ability to offer them the best of both worlds.