The Complexity of Conflict
When sifting through financial advisor marketing, one might encounter a small spotlight on conflicts of interest. Consumers of financial advice should keep their guard up if a firm or advisor claims that they have no conflicts of interest with their clients. All financial relationships have conflicts of interest. Full stop. What’s important is recognition, transparency and mitigation of those conflicts of interest.
Fiduciary is Necessary, not Sufficient
In the world of financial advice, a Fiduciary is one with a legal obligation to put the client’s interest first at all times. Fiduciaries are often found at firms that only sell advice, not products. Seems easy enough, right? We’ll get to that…
The other flavor of financial advice, typically found at firms that sell insurance products or investment products, requires advice to be in the best interest of the client at the time of the recommendation. Isn’t that the same thing? We’ll get to that too…
The requirement for “best interest” is an evolution from “suitability.” Prior to the regulation that drove the minimum standard of “best interest,” purveyors of investments and insurance only had to justify that their recommendations were suitable for the client at the time of the recommendation.
Suitability as a standard is not hard to fault. If a client needs an investment that can be expected to pace inflation, a suitable recommendation can vary from gold to artwork to Class A shares of a proprietary mutual fund to a no-load share of a Treasury Inflation-Protected Security (TIPS). Those recommendations are wildly different from each other and an unsuspecting consumer is automatically on defense trying to sort out which is in their long-term best interest. The salesperson on the other side of the table assuredly knows which provides the best compensation for him/her.
If financial advice were beverages, a client expressing need for a tasty drink could receive a recommendation for anything from iced tap water with a squeeze of lemon to a $5,800 snifter of an aged whiskey. Both could be considered suitable “tasty drinks,” but one lines the pockets of the seller and the other performs the basic task of quenching thirst with some flavor.
Now that financial industry regulations require “best interest” over “suitability” a broker must use reasonable care and diligence to determine that a product recommendation is in the client’s best interest at the time of the recommendation, disclose and mitigate conflicts.
The fiduciary standard goes beyond the weaker “best interest” requirement by acknowledging the subtle but undeniable line between investment advice and sales of investment products.
Yet, even a fiduciary will face conflicts of interest in financial relationships so it’s not enough for consumers to seek a fiduciary. Consumers also need to keep their cross-check going for pop-up conflicts of interest and make sure there are sound mitigations in place.
The anthology of financial conflicts of interest could fill an internet, but this list should arm shoppers against the most likely threats.
Sales-World Conflicts of Interest
This list contains the usual suspects when receiving advice from an agent that also sells products.
- Insurance policy sales. Most insurance policies include handsome commissions. Term life policies still compensate both the sales agent and the providing company, just not as much. If an advisor tells you that you need insurance and offers to sell it to you, how can you be sure this policy is in your best interest?
If an advisor helps you understand that you need insurance and recommends several companies that can provide you quotes without any sort of referral compensation, you’re more likely getting conflict-mitigated advice. But could there be a conflict? Sure.
If your best interest involves purchasing a Whole Life policy that will reduce the billable assets under management with your advisor, the advisor has an incentive to recommend cheaper Term Life insurance. The conflict should be acknowledged and addressed.
- Investment sales. Brokerages and some investment advisory firms earn fees not just for advice, but commissions for selling certain products. If there are hundreds of mutual funds in the market place that could meet your need, but when an advisor recommends the “house brand” that s/he earns a sales fee and transaction commission on, that’s a pretty glaring conflict of interest.
It might be nice to address that conflict of interest up front, not in tiny fine print.
- Referral fees. Advisors are required to disclose compensated referral relationships. Whether it’s a referral to an attorney, CPA, or insurance company, clients should expect to know why they’re getting a particular referral and how that could impact the advice they receive.
- Proprietary investments. Even if a broker-dealer discloses, “This house fund pays me a 10% sales charge but has outperformed its index by 58%…” the prospective buyer should still beware. Switching advisors and custodians is common, but proprietary funds usually don’t transition between custodians—they have to be liquidated to cash first.
If that proprietary fund is in a taxable account, the client incurs a potential capital gains tax just to switch firms. If the investment seller doesn’t disclose this conflict at the sale, how is the potential to pay higher taxes in your best interest? That claimed outperformance would have to account for market conditions and your individual tax situation…
- Trading commissions. Churning is the term for unnecessary buying and selling in a client’s account just to accrue trading commissions. The practice is illegal, and in the 21st century commissions are the exception, not the rule. Yet, it still happens. If you’re paying trading commissions to a broker, you should know it and watch the charges like a hawk!
Advice-World Conflicts of Interest
This list contains considerations that still crop up even though a fiduciary doesn’t sell products, just advice.
- Debt payoff. If an advisor earns fees, say 1% of assets under management (AUM), then selling $500K of stock to payoff the mortgage costs that advisor $5K per year. The advisor has a clear incentive to convince you to keep the debt.
- TSP or 401(k) rollover to an IRA. This conflict also pops up in the AUM model. Advisors usually don’t bill on assets they don’t directly manage. The solution is to recommend that the client consolidate accounts by rolling over funds from the TSP or a 401(k) to an IRA that the advisor can bill on. This could increase advisory fees and potentially custodian charges if they’re higher than the old TSP or 401(k).
- Assets Under Management fees. The AUM model encourages an advisor to devote time to asset-gathering. It’s the size of the asset pool that ultimately determines the advisor’s compensation. An advisor may have more of an incentive to find new assets than provide contracted services to current clients.
- Hourly rates. If an investment advisor charges an hourly rate for advice, analysis, or research, the advisor has an incentive to bloat the time tasks take.
- One-time project charges. One-time financial plans are a desirable offering for hard-core DIY’ers. Clients get professional advice and a vector check but keep their hands on the throttle and stick. The advisor has an incentive to minimize the time investment in building out the one-time plan.
- Subscription. This newer fee model allows clients to pay a flat annual or monthly fee for financial advice. The actual services provided vary, but often the client will maintain hands on the throttle and stick for investment management. The advisor has the incentive to minimize hours per client.
Cleared to Rejoin
It’s understandable if you’re not optimistic about getting sound, fairly-priced financial advice after reading this far. But the reality is that the world of financial advice is changing, and generally for the positive. Professional organizations such as the CFP® board require members to take a fiduciary oath, identify, and mitigate conflicts of interest in order to keep their certification. More and more advisors are departing “wire house” brokerages to become independent advisors and provide fiduciary advice.
The democratization of financial information via the internet gives consumers newfound ability to (or, to at least try to) achieve information parity with an advisor or salesperson. Thus, the buyer has a lot more tools available in the effort to beware.
So, while even the best advisor has conflicts of interest, s/he is diligently transparent about them the mitigations s/he uses.
If this article has you wondering about your financial advisor relationship, try answering these questions and see where it takes you?
- “Each year I pay my advisor _________.
- His/her compensation comes from clients / non-clients / I don’t know. (circle one).
- For the services I receive, I get more value than I pay for. (True / False – circle one)
- My advisor and I are both tracking and even talk about the conflicts of interest that arise in our relationship. (True / False—circle one)
If you’re happy with the results, then you likely have a good relationship with your advisor. If not, you deserve one. Just remember that conflicts of interest are always present and they have to be managed on both sides of the table!
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