This article was first published by Truewealth Publishing.
In investing – maybe even more so than other parts of life – small words can have big financial implications.
We recently wrote about how to not become a victim of so-called market “experts” who are more concerned with their commissions than they are with their customers’ investment success. One small – but really not so small – rule change could put an end to this and protect a lot of investors.
The U.S. Department of Labor last week announced the final version of a “fiduciary rule.” This rule will bring investment advisers overseeing retirement accounts (but not all investment accounts) under the “fiduciary” umbrella.
A fiduciary is any professional who is legally required to put the interests of the customer first, like a lawyer or doctor. Right now in the U.S., most financial advisers are not fiduciaries – that is, they have no legal obligation to put the customer’s interests first.
For the most part, the financial industry – in the U.S. and elsewhere – is governed by “suitability” rules, rather than fiduciary rules. That means that, at a minimum, a financial advisor would need only to explain to a judge why he felt an investment he recommended wassuitable for a particular investor. He has no legal obligation to dowhat’s best for the client. (Of course, he should be doing what’s in his clients’ best interests anyway… but it often doesn’t work out that way).
That’s why when you meet with a financial adviser to open an investment account, he asks you some questions about your risk tolerance, your investment time horizon, your investment experience, and so forth.
This scorecard, or “know your client” form (often shortened just to “KYC”), is what he hides behind if an investment doesn’t work out. He will use your answers to explain why he suggested each investment to you.
Sometimes, if you want to buy a certain stock or other investment, or if he thinks you should buy something different, he will ask you to fill in a new scorecard. This is so the latest KYC information can justify this new investment being in your account.
He may even say, “If you don’t say you have a high tolerance for risk, you can’t buy this investment.” Or something to that effect.
So the suitability rule is quite flexible and is a legal grey area. Sneaky advisers take advantage of its flexibility to recommend products that pay them the highest commissions – whether they’re suitable or not.
But with a fiduciary rule, the conflict of interest would be reduced, even if something so subjective can’t be completely eliminated. It would mean that the financial adviser would legally have to do what is best for the client, regardless of commissions. So even if a client requested an investment product that paid a huge commission, the fiduciary rule would say that the adviser could not allow it if it wasn’t in the client’s best interests to own it.
Unfortunately, many people think their financial adviser already has a fiduciary duty toward them. A recent survey in the U.S. found that 46 percent of Americans believe that advisers already “are legally required to put the best interests of their clients first.”
Having a fiduciary duty would mean a lot of financial advisers would have to make the way they earn their fees more transparent. They may have to switch to a fee-only model, rather than one that’s more focused on commissions. That would mean their compensation wouldn’t depend on the products they sold. Instead (as is already the case for many financial advisers) they’d be paid a flat fee based on the size of the customer’s assets, or an hourly fee.
In Singapore, investment advisers do not have a fiduciary duty towards clients. But the Monetary Authority of Singapore (MAS), Singapore’s financial regulator, announced earlier this year that advisers “need to meet key performance indicators that are not related to sales, such as providing suitable product recommendations and making proper disclosure of material information to customers.”
If they do not make “suitable” recommendations, their commissions can be clawed back. This would mean that if it were proven that the investment product they recommended was not suitable for the client, their commissions would be withheld or taken back. The goal is to make sure advisers’ goals are more in line with their clients’ goals.
Hong Kong’s Securities and Futures Commission (SFC) also made some changes to their rules this year. As of the end of March, advisers now have a contractual obligation to recommend suitable investments.
Before, financial advisors in Hong Kong were constrained by what’s called a regulatory duty. That meant that if the adviser recommended something unsuitable and the client complained, the broker could receive a warning or be disciplined in some other way.
But the main difference now is that if an investor feels his adviser recommended an unsuitable investment, the adviser has broken the contract. This means the adviser and his firm could be forced to pay back money to the client if found guilty. The regulators are thinking that the best way to keep advisers in line is to hit them in the pocketbook.
These are both good changes that will help clients. The next step will be to go beyond “suitability” to make sure that advisers have a fiduciary duty, as is slowly happening in the U.S.
Until then – and even after these kinds of changes – investors should always be cautious when dealing with a financial adviser. Don’t be afraid to ask your advisor how he gets paid, and why they are recommending you buy any investment or investment product. And if you don’t understand something, just say no. Regardless of legal protections, a well-educated customer is the best defense against abuse by an adviser.
If you feel you have been sold something that is not suitable, or in your best interests, bring it up with your adviser, their manager and the financial services regulator in your country. For Singapore, that’s the MAS, and in Hong Kong, it’s the SFC.
This article was first published by Kim Iskyan at Truewealth Publishing, an independent investment research firm focused on taking the mystery out of finance and investing. We want to empower investors to make better and more profitable investment decisions on their own.
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