Most segments of our economy have their own sets of words, abbreviations, and phrases that “outsiders” to that industry don’t understand. The financial services industry is no exception and may have some of the best examples. Financial professionals use jargon like “tranche,” “CMO,” and “disintermediation” which often leaves others scratching their heads.
If asked to identify the most important word in finance, the answer would be “fiduciary.” Essentially, there are two different standards in the investment and planning field. One standard holds that financial professionals make suitable recommendations to clients, meaning the financial professional merely has to “come close” to a good recommendation. The other standard is a legal obligation to adhere to what is objectively in the client’s best interest. The latter standard is called a “fiduciary duty,” and it is the standard that everyone who pays for professional advice should demand.
How does a person know the difference between a fiduciary and everyone else?
A financial advisor can fall into either category, so the important distinction is whether their firm is a registered investment adviser (RIA) or a broker-dealer (BD). RIA firms are regulated by either their state financial division or the Securities and Exchange Commission (SEC) depending on the amount of money they manage. RIAs and their advisors are fiduciaries who are held to the highest standard of care for their clients. Broker-dealers adhere to the suitability standard and often manufacture proprietary products that potentially introduce conflicts of interest and can compromise objectivity in the advice they render. Conflicts of interest are particularly prevalent among advisors employed by insurance companies and their affiliated broker-dealer, so be on your guard if you meet with such advisors.
I’ll mention a third category, the hybrid advisor. This type of advisor conducts business with clients on both a fee-based and commission-based compensation structure. Hybrid advisors are registered with both the Financial Industry Regulation Authority (FINRA) and the SEC. The critical thing to note is that because hybrid advisors can charge commissions, there is still a potential conflict of interest since it leaves them the option of making recommendations that could generate higher compensation at greater cost to the client. Additionally, a hybrid advisor may or may not be a fiduciary.
When deciding which type of financial advisor to choose, the primary consideration is whether you want to receive advice that’s objective and free from conflicts that put your interests against the advisor. Who would want advice that may be motivated by how much money the advisor will make based on the recommendations?
The only way to ensure that the recommendations you receive from your advisor are totally unbiased is to work with a fee-only (not fee-based), Registered Investment Advisor. As a fiduciary, an RIA is legally obligated to offer financial advice that is centered on your best interest to the exclusion of all other interests, including and especially the advisor’s. With a Registered Investment Advisor, your interests will always take precedence over the advisor’s interests — specifically, how much money he or she makes — and that’s the best scenario for you! Always ask a financial advisor in what capacity they’re providing their advice.
If you have questions about RIAs and broker-dealers, please give us a call to schedule a time to talk.