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Toward a Workable Fiduciary Standard for Brokers: The 7 Questions

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I frequently hear industry “horror stories” from advisors who have taken on new clients, only to discover unsuitable—and very expensive—investments that had been recommended to said clients by a broker.

One recent case involves an elderly widow who was sold a ridiculously expensive whole life policy, seemingly for no good reason: her portfolio was more than sufficient to cover her retirement needs even if she lived to be 100, and her children’s inheritance had already been funded. But she was locked in to paying thousands of dollars each month into the policy, and thanks to documents the broker had her sign, even the state insurance commissioner couldn’t do anything about it. 

Part of the current conversation about a fiduciary standard for brokers revolves around whether brokers can act in the best interests of their clients within a brokerage environment. Although many brokerage firms are very good at creating substantial financial incentives to sell excessively expensive and/or unnecessary products (as in the above example), and creating very reasonable sounding rationales for doing so (“suitability,” for instance), I still believe that some brokers can—and do—buck the system and act in the best interests of their clients.

But how are clients to know whether their broker is really acting in their best interest when he/she doesn’t have a legal responsibility to do so (at least not at all times)? And should the SEC step up and actually establish a fiduciary standard for brokers, how will they, FINRA or a third-party credentialing organization (such as the CFP Board) determine whether brokers are meeting that standard?

These are difficult questions in that the existing fiduciary standard at least is “principles based”: meaning that there is no set of rules to follow (such as FINRA’s safe harbors for sales practices). Instead, RIAs are simply required to act in the best interests of their clients at all times, and should client complaints arise, the SEC, FINRA, FINRA arbitration or the courts use the facts and circumstances to determine whether that standard was met in each case.

This isn’t a great deal of help for brokers trying to do right by their clients, or for third-party credentialing bodies and clients trying to determine whether a particular broker is truly client centered. 

These questions got me to thinking about how fiduciary advisors themselves recognize cases of broker abuses in the portfolios of their new clients. Based on the stories that I’ve heard over the years, I’ve come up with what I hope is a simple solution for evaluating the behavior of any advisor/adviser: focusing on what’s in client portfolios.

The following is a modest suggestion for how client portfolios might be reviewed: Seven questions that don’t necessarily reveal whether the fiduciary standard has been breached, but rather, raises red flags that then require very good explanations as to why each item was sold to the client. 

The Seven Quetions

Has the broker or advisor/adviser recommended any of the following:

  1. Investment vehicles other than low cost ETFs or indexed funds?
    Now, before your blood pressure tops out, I agree that managed funds often have a place in a well-diversified portfolio. But because there are some many good low-cost alternatives today, and the cost differential is so great, it should be incumbent upon the advisor to document why a higher-cost choice was made. The answer might be as simple as “the client requested this fund,” or “there was no index for this asset class,” etc. But to satisfy the duty to minimize client costs, there has to be a reason.
  2. Retirement products other than IRAs or 401ks?
    Yes, I’m talking about annuities and/or whole life policies. I think most advisors agree that there are circumstances under which these products make financial sense. Yet their costs and loads are so high compared to other available solutions that they should be among the last resorts, not the first choice. Which means there should be a good reason for using them, rather than the alternatives.
  3. Investments proprietary to their employer BD or its affiliates?
    I trust this doesn’t require much explanation. In my experience, proprietary products tend to be more expensive than third-party alternatives. And even if they aren’t, there’s the obvious conflict of interest. I’m not saying brokers should or shouldn’t recommend them: only that if they do, they should have a really good reason why it is in the client’s best interest.
  4. Investment products or insurance products upon which they or their BD receives remuneration from the product manufacturer or distributor?
    Again, this is a question of conflict of interest. To overcome those conflicts the broker should have a very good reason why this investment is, indeed, in the client’s best interest.
  5. Any loan vehicles or borrowing accounts?
    I don’t think I need to explain why having clients borrow to invest in commission-generating products creates a few conflicts. Not saying it isn’t a good idea in some cases, but the onus should be on the broker.
  6. Lower than industry-standard cash positions in client portfolios?
    Last time I checked, professional financial planners were recommending at least six months of household overhead to be held in cash, for emergencies. You can quibble over how much and for how long, but the point is that sound financial advice includes a contingency cash fund. This creates an obvious conflict with both brokers and RIAs who manage assets for a fee, which requires an explanation if the fund is too low.
  7. Excessive turnover in client portfolios?
    This seems like a no-brainer, especially as it’s a FINRA red flag as well.

Armed with the answers to these questions, any client (and/or regulator) should be able to determine whether a broker or advisor/adviser is truly acting in their best interest, and hopefully, increase the quality of investment advice. But, hey, that’s just my opinion: I could be wrong.

I’d love to hear from advisors who regularly see client abuses, and from brokers themselves, on my proposed seven rules.