Updated: Nov 5, 2020
Nick Rossolillo, President, Concinnus Financial
March 3, 2015
On February 23, 2015, President Obama made comments about the “fiduciary standard” while speaking about retirement savings and investments at AARP’s offices in Washington, D.C. The comments were a call on the Department of Labor to draft new laws requiring financial professionals working with retirement assets to put client interests before their own. “Wait,” you may be saying, “How can such a thing be enforced? And how can I tell if my financial professional is working in my best interests?” You are not alone. The debate has been going on for quite some time within the financial industry, and was brought into the public’s awareness especially after the financial crisis.
Why the debate? What is the fiduciary standard? And how can you make informed decisions as an investor and saver?
History of the Fiduciary Standard
In the wake of the Great Depression, a slew of new regulations emerged in an attempt to crack down on sales practices in the financial world. Two such acts, which are relevant to our particular discussion, were the Maloney Act of 1938 (an amendment to the Securities Exchange Act of 1934), and the Investment Advisors Act of 1940.
The Maloney Act established the NASD, which has since morphed into what we now call the Financial Industry Regulatory Authority (or FINRA). Among other duties, FINRA regulates broker-dealers, or individuals or companies who charge a commission to clients for selling stocks, bonds, mutual funds, etc.
The Investment Advisors Act of 1940 authorized the Securities and Exchange Commission (or SEC) to regulate investment advisors. An investment advisor charges a fee (either an hourly rate, a flat annual fee, or a percentage fee based on total account value) to clients rather than a commission.
Ok, are you completely bored yet, or are you still with me? What is the debate about exactly?
Commissions vs. Fees
In the aftermath of the world’s most recent economic crisis, heated debate has surfaced about the charging of commissions versus the charging of a fee. Many financial professionals who charge a commission (are a broker-dealer and are regulated by FINRA) have to reasonably believe that a recommended investment is “suitable” for the client. In contrast, professionals who charge a fee (are an investment advisor and are regulated by the SEC) are held to the “fiduciary standard.” Basically, the fiduciary standard is this:
Investment advisors must make reasonable investment recommendations independent of outside influences.
They must always place client’s best interests ahead of their own.
This is not to say that professionals who charge a commission do not follow this standard. However, only investment advisors regulated by the SEC are held to this fiduciary standard by law. At this point you are no doubt asking, “How do I know if my advisor is really acting in my best interests? I don’t read minds.”
The most recent proposal, brought up again on the 23rd of February, would enforce a fiduciary standard on all financial professionals handling retirement assets. This would be done by eliminating commissions and only allowing a fee to be charged for the handling of retirement assets. This would, in theory, eliminate conflicts of interest arising from the high commission investment products many financial companies offer.
Arguments For and Against Commissions-Based Investing
Those in favor of keeping commission based investments argue a few main points:
Eliminating commissions would reduce the investment options investors have, since some investment types are offered mainly on this basis.
Over the long-term, paying a commission instead of an ongoing fee is cheaper for clients.
Enforcing a fiduciary standard will raise costs for financial firms, which will be passed on to clients in the form of higher fees.
There are a few assumptions this argument is making. First is that some investment vehicles only work if they are high cost on the front end (or that a commission is charged and paid). Second is that once a commission is paid, there are no additional client charges that occur within the investment vehicle. Third, an assumption is made that clients will hold, and be encouraged to hold, investments over the long-term, thus not incurring additional commissions.
Arguments For and Against Fee-Based Investing
Those in favor of fee-based standards argue this:
Conflicts of interest arising from investment products being offered with a higher commission are eliminated.
Client and financial professional interests are aligned when the financial professional’s pay is tied to investment performance.
Investment decision making and advice is improved and becomes more objective.
Some of the arguments from the opposite angle arise here as well, specifically the ongoing cost argument. Why would a client interested in buying ‘investment XYZ’ and holding it indefinitely continue paying a fee every year for investment advice they don’t need? Also, a fee-based advisor faces a conflict of interest in that they may not offer other types of products (such as insurance) that is based off of a commission. Obviously, the two sides of the argument are not perfect.
What Can You Do?
Until some concrete decisions are made surrounding the debate, you as an investor have some decisions to make. Start by asking yourself a few questions such as this:
‘How knowledgeable and comfortable am I managing my own investments?’
‘What type of investment am I looking to make?’
‘Do I need financial advice outside of the decision making that goes on inside my investment portfolio?’
‘What exactly am I looking for in a financial professional? Is it product driven (i.e. you are investing for a future need, you currently require income, or you need a specific product like insurance) or relationship driven (you need someone who can answer your financial questions and provide education)?’
Also bear in mind that many professionals have a foot on both sides of the line. As an example, they may offer fee-based investment management but also offer insurance products that pay them a commission. When consulting a financial professional, make sure you know exactly what you are getting from them and how they are going to be paid.
Simply put, do your own homework! Make sure you understand costs, the nature of the costs you are being charged, and what you are getting in return.
Nick Rossolillo is the president and founder of Concinnus Financial, based in Spokane, WA. He works with individuals and small businesses creating personalized investment portfolios and helping with financial planning. To contact Nick, visit www.concinnusfin.com, email him at firstname.lastname@example.org, or call (509) 220-1895.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. Investing in securities is subject to risk and may involve loss of principal.