A fiduciary is an individual or entity that acts on behalf of another person or group. Whether they are financial advisors, lawyers, trustees and more, fiduciaries assume a legal and ethical responsibility to act in the best interests of a specific person. It’s important to understand what makes a person a fiduciary, especially when searching for a financial advisor to manage your investments or provide financial advice.
Understanding Fiduciary Duty
While financial advisors are not the only professionals who can act as fiduciaries, the Investment Advisers Act of 1940 first introduced the concept of fiduciary duty or the legal obligation that advisors have to their clients.
However, the 1940 law did not clearly define fiduciary duty, prompting the U.S. Securities and Exchange Commission to issue an official interpretation of the term in 2010. The SEC stated that when an advisor is bound by fiduciary duty, they must “adopt the principal’s goals, objectives, or ends,” and exercise what’s known as “duty of care” and “duty of loyalty.”
In simplest terms, fiduciary duty is the responsibility to act in a client’s best interests at all times. “In our view, an investment adviser’s obligation to act in the best interest of its client is an overarching principle that encompasses both the duty of care and the duty of loyalty.”
What Is a Fiduciary Financial Advisor?
All investment advisors registered with the SEC or a state regulatory agency are required to act as fiduciaries. To meet the duty of care component of the fiduciary standard, advisors must fulfill these three primary requirements:
- Act in the best interest of the client: To truly act in the client’s best interest, a fiduciary advisor must have a “reasonable” understanding of their objectives. This means comprehending the investment profile (risk tolerance, time horizon, etc.) of a retail client and the investment mandate of an institutional client, like a pension or retirement plan.
- Seek the best execution of transactions for the client: Duty of care also includes an advisor’s obligation to execute transactions in a way that maximizes proceeds and minimizes costs. In seeking the best execution of transactions, an advisor must consider a broker-dealer’s commission rate, the value of their research, as well as the brokerage’s financial responsibility and responsiveness.
- Provide advice and monitoring: Over the course of an ongoing relationship with a client, a fiduciary advisor has a duty to provide monitoring and advice, especially when he or she is compensated through periodic asset-based fee.
Meanwhile, for a financial advisor to fulfill their duty of loyalty, an advisor must put the client’s interests ahead of their own. This means when a potential conflict of interest exists, the advisor has a responsibility to disclose it.
For instance, some financial advisors are also licensed insurance agents or broker-dealer representatives who can earn commissions when recommending certain policies or products to advisory clients. This creates a conflict of interest, as the advisor has a financial incentive to recommend specific products or services, despite more suitable alternatives possibly existing. By having “full and fair disclosure” of the conflicts of interest that could consciously or unconsciously impact the advice they receive from an advisor, clients can better evaluate their advisory relationships, the SEC wrote in 2019.
Fiduciary Duty vs. Suitability Standard
It’s important to note that SEC-registered financial advisors are held to a higher standard than stockbrokers. While advisors must abide by fiduciary duty, brokers must follow the suitability standard, a Financial Industry Regulatory Authority (FINRA) requirement that investments need only be suitable to an investor’s circumstances. This standard may allow a broker to recommend investments that generate higher commissions than similar low-priced options.
However, the suitability standard was overhauled in 2020 when the SEC began requiring brokers to follow a best interest standard. While it does raise the standards that stock brokers and investment dealers must meet, it does not protect investors as well as the fiduciary standard.
Other Types of Fiduciary Relationships
The term fiduciary often refers to the financial best interests of a person or entity. However, there are many kinds of fiduciary relationships beyond that of a financial advisor and their clients. A fiduciary duty exists whenever a consumer places their financial or legal trust in another person.
For instance, an attorney has a fiduciary obligation to serve his or her client’s best legal and financial interests. In real estate, an agent must disclose all relevant facts to their client, present all offers to the client and abstain from representing both parties in a transaction.
A person who is appointed as a trustee (someone responsible for managing a trust) also has a fiduciary duty to the needs of the trust’s beneficiaries ahead of his or her own interests. Meanwhile, the board of a company has a similar obligation to steer the direction of the company in a way that benefits the shareholders, not themselves.
A fiduciary is a person or group that acts on behalf of another person or entity. Financial advisors who are registered with the SEC or state regulators are bound by fiduciary duty, meaning they’re required to put their clients’ interests before their own and disclose any potential conflicts of interest.
Financial advisors aren’t the only kind of fiduciary, though. Lawyers, real estate agents, trustees and company boards all have fiduciary relationships with their clients or beneficiaries.
Tips for Hiring a Financial Advisor
- Finding a qualified financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three financial advisors in your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- Familiarize yourself with the differences between fee-only and fee-based advisors. While fee-only advisors make money solely from the advisory fees they charge their clients, fee-based advisors may earn commissions for recommending products and services in addition to asset-based advisory fees. Commission-based compensation can create a conflict of interest, so it’s worthwhile finding out whether an advisor works on a fee-only basis or can earn commissions.
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