What is a fiduciary and who is held to fiduciary standards?

What is a fiduciary and who is held to fiduciary standards?

Many investors may not realize that financial advisors are held to different standards when it comes to the recommendations they make to clients and prospects.

What a financial or investment advisor recommends largely depends on whether that professional is held to a fiduciary or suitability standard.

What is a fiduciary?
A fiduciary, a word derived from a Latin root meaning “trust,” is a person or institution given the authority to act on behalf of others in situations that require trust, honesty, and loyalty.

The U.S. Department of Labor (DOL), under The Employee Retirement Income Security Act of 1974 (ERISA), defines a fiduciary to include anyone who gives investment advice for a fee or other compensation with respect to any moneys or other property of a plan, or has any authority or responsibility to do so.

In 1975, the DOL issued a five-part regulatory test to clarify under what circumstances an adviser was held to fiduciary standards. This test still applies today. Advice that is held to a fiduciary standard is:

A recommendation on investing in, purchasing or selling securities or other property, or advice on a property’s or investment’s value

Made “on a regular basis”

Pursuant to a mutual agreement or understanding

Serves as the primary basis for investment decisions

Individualized to the particular needs of the plan

An investment advisor is not treated as a fiduciary unless each of the five elements is satisfied for each instance of advice.

The difference between fiduciary and suitability
Advisors held to a fiduciary standard are required by law to put clients’ interests ahead of their own. This means they cannot recommend securities or products just to earn a higher commission or other benefit. Common fiduciaries include attorneys, accountants, business advisors, estate executors, trustees, and bankers.

Those who give investment advice that have fiduciary responsibilities typically fall under the category of fee-only financial advisors and registered investment advisors. They are typically compensated by ongoing asset management fees instead of receiving a commission for each transaction.

Advisors governed by suitability standards must only make recommendations that are suitable for their clients’ profiles. That means an advisor can recommend a product over another to earn a higher fee as long as it doesn’t conflict with the client’s financial needs or objectives. Examples of those held to suitability standards include stock brokers, broker-dealers, and insurance agents.

An example of a transaction that could violate suitability standards is selling a deferred annuity to an older individual with a lengthy surrender period, or recommending a replacement for an annuity that is still in the surrender period.

Whether an advisor is governed by fiduciary or suitability standards depends on which agency he or she is registered or licensed with. Investment advisors registered with the Securities and Exchange Commission (SEC) and/or state securities regulators must follow the fiduciary standard.

If the professional is a stock broker or insurance agent licensed by a state insurance department or by the private-sector Financial Industry Regulatory Authority (FINRA), he or she is subject to a suitability standard.

How to determine if an advisor is a fiduciary
To know for sure which standard a professional is working under, you can ask how they get compensated. If it’s an asset management fee, it’s likely the person is a fiduciary; if it’s by transactional commission, the professional is probably under suitability standards. You should also ask about any and all fees that apply to a product or service being recommended.

Also look for certain disclosures on the advisor’s website, emails, brochures, business cards and other advertising. A registered investment advisor is required to have a disclosure on all advertising material that states something to the effect of: [NAME OF ADVISOR] is a Registered Investment Adviser in the state of [STATE OF REGISTRATION]. You can also do an Internet search for SEC-registered advisors on the agency’s website, www.adviserinfo.sec.gov. Advisors licensed by FINRA are required to state that on their advertising materials as well.

Just because you receive professional services from a non-fiduciary doesn’t necessarily mean you’re getting poor advice. But you should be aware that the advisor does not have to offer the absolute best recommendation for your particular circumstances. Many advisors will make unbiased recommendations that they believe are in the client’s best interest regardless of not being a fiduciary. But some will choose a suitable option that pays a higher commission or other incentives.

Another reason to be cautious of using a non-fiduciary is if you are considering the roll-over of 401(k), IRA or other investment assets into an annuity or life insurance product. The insurance agent selling the annuity, working under a suitability standard, is only required to recommend and/or sell a suitable annuity product. He or she does not have to be concerned about whether moving money out of the 401(k) or IRA is a good option for you. A fiduciary, on the other hand, must take a more holistic approach.

Under a proposal by the Department of Labor, fiduciary standards may be expanded to more advisors. A proposed rule change would remove the “on a regular basis” requirement from the five-part test, meaning that any one-time recommendations, such as an annuity purchase, would fall under the DOL’s fiduciary definition.