First of all, what is a fiduciary? The legal definition is that a fiduciary is acting as a trustee on someone else’s behalf, and several legal duties follow from this. Similarly in investing, a fiduciary is someone who is required to put the client’s interest ahead of their own.
The standard for an investment advisor has not always been fiduciary, which is why there is a new fiduciary rule. First the standard was the prudent man rule, which meant that an advisor could only recommend an investment if a prudent man would do so. This is a very lax standard, since being prudent is hard to define. The standard was then upgraded to suitability. Not only did the recommendation have to be prudent, it also had to be suitable for the client. For example, consider a large growth company stock that doesn’t pay dividends. That could be a prudent investment, since buying it could produce an increase in the value of the portfolio. But what if the client is an elderly woman who relies on dividends to help pay her bills? The stock may comply with the prudent man rule, but it is hardly suitable for such a client.
In the early days of personal finance, stockbrokers (some of whom still roam the earth) would call you up and tell you to sell or buy this or that stock. They made their money from commissions on the trade. Commissions were at one time pretty lucrative, but then in 1975 the SEC (Securities & Exchange Commission) allowed firms to set their own rates, and so competition reduced commissions. Buying and selling stocks is much more exciting for both client and stockbroker than buying and holding them, which is what many advisors do now for money intended for the long term. However, brokers get paid to sell you something, so they have an incentive to “churn” or constantly trade. The fees to the client for all this trading can be expensive, and it also encourages buying the new “hot stock” – it’s hot because people are buying it already, so the price is high.
The personal finance industry then moved to more of an advice model, getting paid on assets under management (AUM), which takes away the incentive to churn. There’s no way to eliminate conflicts of interest completely. In the case of charging on AUM, it’s in the advisor’s interest to recommend that all assets be invested into the portfolio. For example, there’s an incentive to advise the client not to pay off their mortgage, because that would reduce the amount of AUM, and therefore the fee being paid. Sometimes this can be the right advice, though, if the numbers show that paying off the mortgage actually doesn’t work and the client would be better off making the monthly mortgage payments. A fiduciary will always point out these inherent conflicts of interest when making a recommendation.
Under the suitability rule, as long as the investment is prudent and suits the client, the advisor can choose whatever security pays them better. There are some firms with in-house funds where the advisor will be paid more for using an internal product, even if there is a better product for the client outside the firm, and with the suitability rule the advisor can choose the internal fund. A fiduciary must recommend the external product that is better for the client, even if they won’t be paid the incentive.
Right now the fiduciary rule discussed in the news is set to include retirement accounts only, but most people in the field believe that it will eventually be extended to other accounts as well.
The retirement aspect adds one more wrinkle to being a fiduciary with this rule. Right now advisors often recommend that their clients “roll over” their employer plan to an individual IRA upon leaving the employer. Advisors can’t manage 401(k) accounts due to the regulations (though they may recommend which investment their client should use or what their asset allocation should be), but once it’s in an IRA, the advisor can manage it. Obviously this adds to the advisor’s AUM and they can then charge for this advice. But with the fiduciary rule, rolling it over may not always be the right answer, as it may be better for the client to leave the money invested in their plan. Often, the mutual funds inside an employer plan are the cheapest share class available, and the client may not have access to them outside the account. The plan may also have some other benefits that an IRA does not. On the other hand, sometimes the investments are poorly chosen and the client would benefit from having access to different products inside an IRA. In addition, these plans cost money to administer and in some cases the cost is borne by the employee, so they might do better with an IRA. For those who often move between employers, consolidating old employer plans inside one IRA may make sense. A fiduciary has to carefully weigh the pros and cons of the plan and an IRA before making a recommendation to roll over the money into her management.
If you want to know if your advisor is a fiduciary, ask them. If they can’t give you a clear answer, then they do not act as a fiduciary. Many Registered Investment Advisory (RIA) firms and CFP® professionals already act as fiduciaries, and for them this rule simply means there will be more paperwork (which is costly, especially for smaller firms.) However, on balance, the new rule clearly benefits the client.