Jun
27

The Fiduciary Rule And Investment Advisers: Why It Matters

fiduciary_rule_investmentadvisers_alphaflow

 

Recently, there’s been a lot of discussion and media attention around President Trump’s order to the Department of Labor (DOL) to review what’s known as the “Fiduciary Rule”. The amount of information and conflicting arguments about the Fiduciary Rule can cause confusion.  This post is meant to help clarify the rule, who it applies to, and when it applies.  It will also help to define and clarify some terms that being written or talked about in the investment management and financial services industries.  

What Is The Fiduciary Rule?

The Fiduciary Rule clarifies how persons (usually brokers, investment advisers, financial advisers) selling retirement-related products or offering retirement-related investment advice must interact with their clients.  More specifically, it means that they must act as a fiduciary for their clients.  Acting as a fiduciary means that the broker or adviser must put their client’s interests ahead of their own, and disclose all conflicts of interest when offering advice or products for a retirement related account.

Distinguishing Fiduciary Advisers

The distinction between someone who does or does not act as a fiduciary is important when we define the roles that different ‘advisers’ play in an investor’s financial life. The term adviser is sometimes used loosely to describe any number of people with various roles related to personal investments. From giving advice to soliciting the sale of a security, many investment professionals are referred to as advisers, when in fact, they may not be registered as such. And this matters because if they are not held to a fiduciary standard, they are not bound to hold the client’s best interests above their own.

Registered Representative or Investment Adviser Representative?

How then, do we understand someone is a fiduciary? In part, it comes down to a distinction between someone registered as a representative of a broker-dealer (RR – registered representative) and someone registered as a representative of an investment adviser (IAR – investment adviser representative).  

Usually, an RR is someone employed by a brokerage company licensed by the SEC.  They have usually passed the series 7 and either 63 or 66 exams and are registered to do business in one or more states and with one or more self-regulatory organizations (like FINRA).  

An IAR is employed by an investment adviser, which means a company that provides securities advice or analysis, as a business, and for compensation.  Generally, this means the IAR has passed their series 65 exam and is registered to do business in one or more states or with the SEC.

 

Investment Adviser & Registered Representative Comparison
PersonExams Passed
Pre-Rule Retirement StandardPost-Rule Retirement Standard
Registered RepresentativeSeries 7 & 63SuitabilityFiduciary
Investment Adviser RepresentativeSeries 65FiduciaryFiduciary
Dual Registered Dual Registered Series 7 & 66
EitherFiduciary

 

Suitability Vs. Fiduciary Duty

One of the most hotly contested aspects of the Fiduciary Rule is around the standard of suitability as a determinant for an investment choice made by a registered representative. Today, a registered representative must only ensure that an investment is ‘suitable’ for a client. This suitability is determined by factors including investment risk tolerance, time frame, and goals. However, there is no determination made as to whether the investment is in the client’s best interests.

To illustrate, let’s say the registered representative (RR) has a choice of offering two different mutual funds to a client. Both invest in similar stocks and have relatively similar returns (before fees), but one charges higher fees and also pays the RR’s firm based on the total dollar investments made into that particular fund.  The RR only offers the client the one for which they get compensated, even though the other mutual fund option may be a better option for the client (because it charges lower fees).  The reason the RR can do this is that both mutual funds are considered “suitable”: meaning as long as the recommendation meets the client’s risk profile and investment goals, then they can offer that product to their client.

In contrast, an investment adviser representative (IAR) must act as a fiduciary.  In the same situation, if the IAR wanted to offer the same mutual fund that the RR did, they would need to disclose to the client that they are getting compensated for sales of that fund and that the lower cost option makes more sense for the client.  So, instead of simply offering a suitable choice for the client, the IAR must: 1) disclose conflicts of interest and, 2) act in the best interest of the client rather than in their own best interest.

What The Fiduciary Rule Would Change

Staying with the scenario above, the Fiduciary Rule would require an RR to act like the IAR in when selling any products related to, or be advising on anything related to retirement.  It would require an RR to only act in the best interest of the client and to disclose conflicts of interest. With our mutual fund scenario, the RR would now be required to disclose that they are being paid commissions to sell the higher fee fund, and they would be required to select the fund that is in the client’s best interest, which would be the fund with the lower fees to the client.

The rule would also apply to anyone dually-registered (meaning they are registered both as an RR and an IAR).  Currently, the dually-registered representative can decide what ‘hat’ they wear (RR or IAR) when suggesting investments for retirement. In other words, they will decide whether they are making a suggestion based on meeting the suitability standard or the fiduciary standard. Under the fiduciary rule, the dually-registered representative must always act as a fiduciary when related to retirement advice.

Application Of The Fiduciary Rule

One point that is worth clarifying, is that the Fiduciary Rule would only apply to retirement-related advice and product sales, not any general investment sales or advice since the rule comes in under the Department of Labor’s ERISA purview, which pertains only to retirement plans and related investments and advice.  If the SEC were to issue a similar rule, it would cover all investments, not just those related to retirement.  

As the Fiduciary Rule’s implementation has been suspended until at least 2018, RR’s still must only meet the suitability standard when suggesting products for retirement accounts.  IAR’s must, as before, continue to act as fiduciaries for their clients.

Further Reading

Here are some other great resources to look at if you’re interested in learning more about the fiduciary rule including commentary both for and against the Fiduciary Rule, as well as information on investment advisers in general:

Department of Labor: Fiduciary Rule

Investopedia: Fiduciary Rule

New York Times: Before You Pay For Financial Advice, Read This Guide

CNBC commentary: Why Obama’s Retirement Advice Rule Is Bad for Investors

NerdWallet Commentary: Why the Fiduciary Rule Is Good for Investors

Bloomberg: Fiduciary Rule Fight

Time: Wall St. Fights Fiduciary Rule

 

About the author:

Nick GiovacchiniNick Giovacchini is the Client Services Director at AlphaFlow. Prior to joining AlphaFlow, Nick worked for Barclays Risk Analytics and Index Solutions team, working with institutional asset managers to analyze risk and performance drivers of their portfolios. He also was an Account Manager for MarketFactory, a leading technology provider for the FX world.

Nick has a BA in Political Science from George Washington University in Washington, DC.