Two key terms that retail investors are likely to run across when looking for an investment expert are “fiduciary” and “suitability.” The terms describe the standard of care and behavior that investment professionals are expected to follow when dealing with investors. Investment experts who follow the fiduciary standard are required to put their clients’ interests ahead of their own. Those who conform to the suitability standard previously had to make sure their recommendations were suitable, given the client’s age, goals, resources and other factors. However, broker-dealers and their representatives now must adhere to a more stringent standard called Regulation Best Interest, which like the fiduciary standard, mandates they act in their clients’ best interests.
A financial advisor can help you create an investment plan for your needs and goals. Connect with your advisor matches today.
What Is Fiduciary Duty?
Fiduciary duty is a legal and ethical obligation requiring financial advisors to act in their clients’ best interests at all times. Under the Securities and Exchange Commission (SEC) guidelines, this duty encompasses two primary components components: duty of care and duty of loyalty.
Duty of care obligates fiduciary advisors to “provide investment advice in the best interest of the client, based on the client’s objectives,” the SEC wrote in its official interpretation of fiduciary duty. This involves conducting detailed due diligence on investment strategies and products to ensure they align with the client’s needs.
Duty of loyalty, meanwhile, requires investment advisors to put the client’s interests ahead of their own. As part of this obligation, advisors must eliminate or make “full and fair disclosure” of conflicts of interest. The SEC notes that duty of loyalty is “particularly relevant for firms or individuals that are dually registered as broker-dealers and investment advisers (sic) and who serve the same client in both an advisory and a brokerage capacity.
This fiduciary duty or standard can’t be waived. Investors are commonly asked to sign agreements with their advisors that describe the terms of their arrangement. However, nothing in one of these agreements is valid if it would allow a fiduciary to follow a lesser standard.
What Is the Suitability Standard?
The suitability standard required financial professionals to recommend investments that are appropriate for a client’s financial needs, goals and circumstances. Unlike the fiduciary standard, it did not mandate that the advisor act in the client’s best interest only that the recommended products meet the client’s suitability criteria at the time of the recommendation. This allowed advisors acting in the capacity as a broker to suggest products that may benefit them through commissions or incentives, as long as they align with the client’s financial profile.
How Regulation Best Interest Changed Suitability
But the suitability standard got an overhaul in 2020 when the Securities and Exchange Commission (SEC) implemented Regulation Best Interest (Reg BI). While it stops short of imposing fiduciary duty, Reg BI introduces stricter obligations, requiring broker-dealers to act in the “best interest” of their clients when recommending investments. This includes mitigating conflicts of interest, providing greater transparency about fees and compensation and ensuring clients are informed about the risks and costs associated with products.
Reg BI bridges some gaps between suitability and fiduciary standards by holding broker-dealers to higher accountability but critics of the rule have argued that it doesn’t go far enough in protecting investors. It remains distinct from fiduciary duty, as it does not require ongoing management or alignment with the client’s best interest beyond the initial recommendation.
Identifying a Fiduciary
Investors attracted by the idea of getting advice from someone who won’t recommend high-priced investments for personal profit motives may prefer to choose a fiduciary. One way is to use a registered investment advisor (RIA). Ever since 1940, when the Investment Advisors Act was passed, investment counsellors registered with the SEC as RIAs have to follow the fiduciary standard.
Part of the 2020 SEC rule change prohibits brokers and dealers, who follow the suitability standard, from advertising themselves as “investment advisors.” So using only an expert who displays that term in marketing materials is one way to increase the chances of getting fiduciary-level service. However, some professionals may be registered as both advisors and brokers, and may follow the less-strict standard in certain circumstances.
Another way to make sure an investor is getting advice from a fiduciary is to see that the advisor has a designation as a Certified Financial Planner™ (CFP®) or chartered financial analyst (CFA). People with these designations are obligated to follow the fiduciary standard.
While it’s not directly related to the fiduciary or suitability standards, another path to reduce conflicts of interest is to choose an advisor who has a fee-only business model. Note that fee-based is not the same as fee-only. This means the advisor doesn’t get commissions for selling investment products. Instead, the advisor charges the client directly through flat fees for such services as preparing a financial plan, through monthly or annual service charges or by charging a percentage of the assets being managed. A fee-based advisor, on the other hand, can earn sales commissions from third-parties such as insurance companies and mutual funds on top of what a fee-only advisor would earn.
Finally, an investor could ask a financial professional to sign a code of ethics requiring the professional to follow the fiduciary standard. The Institute for the Fiduciary Standard has a sample code of ethics that investors could use for this purpose.
Bottom Line
The suitability standard and the fiduciary standard are two requirements placed on different investment professionals. The fiduciary standard requires RIAs and some others to only make recommendations that are in the client’s best interest. The suitability standard requires only that investments be suitable to the investor’s circumstances, and may allow a broker to recommend an investment that is more costly and generates a higher commission than a similar low-priced option.
Tips for Investing
- Any time you are considering making an investment decision, it’s a good idea to talk it over with an experienced financial advisor. Finding the right financial advisor who fits your needs doesn’t have to be hard. SmartAsset’s free tool matches you with up to three financial advisors who serve 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.
- One of the ways to get completely free, unbiased advice about how to put your hard-earning dollars to work is by using an investment calculator and asset allocation calculator.
Photo credit: @iStock/gradyreese, @iStock/EHStock, @iStock/AlexRaths