Disclaimer: This is meant to be an informational guide, nothing in this post should be interpreted as individualized advice.
Let's start by answering this question: What is a fiduciary? By simple definition, a fiduciary is a person who has an obligation (either legal or ethical) to another person to act in their best interest at all times. This seems like a pretty cut and dry explanation. One would think that it would be easy to identify if their adviser was acting in a fiduciary manner. Unfortunately, in today's financial services industry there is a lot of grey area when it comes to identifying whether or not the decisions an adviser makes are in the best interest of the client. This grey area comes from the underlying compensation structure for the adviser and the standards that adviser is held to. Thus, to effectively answer the original question, it seems best to give some insight into how advisers/planners/managers/etc. can be compensated and how that pertains to their obligation to the client.
- Commission-based Compensation: This kind of compensation can come in many different forms. You'll often see advisers that receive this method of compensation offer "free" financial plans to their clients. Those plans more often than not turn into a sales pitch for whatever product fits the situation. Sometimes it is hard to tell whether or not an adviser is leading with a commission-based product. Most often you will see commissions associated with the following products: Insurance products (life, disability, long-term care), annuities (fixed, variable, indexed, etc.), or investments with a sales charge (mutual funds, unit-investment trusts, REIT's, etc.). When these type of commission-based products are involved, there is an increased chance that the fiduciary relationship is not present. The reason for this is that when selling commission products, advisers must recommend products based off of the "suitability standard" not the "fiduciary standard". The suitability standard is met so long as the recommended product fits the general profile of the client's goals. This means that when an adviser is comparing the options available to the client, they are not obligated to choose what they feel is the best option. In fact, they don't even have to get close to the best option so long as the client signs on the dotted line and it passes the suitability test. This puts the burden on the client to know what is best for them, which is extremely difficult with today's financial products.
- Fee-Only Compensation: This is the completely opposite end of the spectrum when compared to commission-based compensation. Advisers that work under this structure do not use or accept any product that pays a commission. It is common that the only means for compensation for these advisers is through financial planning fees and investment management fees. Occasionally they may offer some form of non-commission-able insurance products, but it is more common that they refer their clients to insurance brokers to cover insurance needs. The fiduciary relationship is very difficult to break with this kind of a compensation structure as there is no incentive for the adviser to act outside of the client's best interest. The client pays the adviser directly so there is no outside influence to sway the adviser's decisions.
- Fee-based Compensation: The middle ground between fee-only and commission based advisers. This is the most common scenario to see in the industry today and also the hardest to identify. The reason it is so difficult to identify is because most fee-based advisers can use a mix of commission-based products and also work on a fee-basis. The tricky part is knowing when they are operating on one side or the other. It is the discretion of the adviser to choose how they earn their compensation. Some "fee-based" advisers operate almost identically to that of a commission-based adviser. They can call themselves "fee-based" because they have the ability to operate on a fee-basis and they can choose not to. Others will operate more similarly to a fee-only adviser and use commission-based products only on occasions when it best suits the client. Due to this, clients must be very aware of how their adviser is choosing to receive their compensation and what implications that has for the service they receive.
To wrap up, the easiest way to find out if your adviser is acting in your best interest is to ask if they are operating as a fiduciary. If you feel that their answer isn't clear, ask them how they are compensated for helping you.
As always, I hope you gained some insight from reading this post. You are welcome to reach out to me directly if you have any further questions or comments. Email deanbarda@appleandassociates.com or call (530) 272-1345.