Is the Fiduciary Duty Enough? The Disclosure Loophole

The Department of Labor has recently delayed its fiduciary duty rule for retirement advisers.

I wrote favorably about the proposed rule because it puts investors’ interests first and not the profit interest of the advisor. A financial advisor without a conflict of interest seemed right to me because people are on their own to secure their retirement. And many folks, if not most, don’t have the skill set to do so appropriately.

I have come to learn that even if the fiduciary rule were not suspended, it wouldn’t always serve the best interests of the client. Although it certainly is better than not having it.

Let me explain why one current loophole – the disclosure loophole – can swallow the entire duty even if your advisor is a fiduciary.

This blog (Part I) describes the disclosure loophole in the current fiduciary duty standard. Part II describes one way you can protect yourself if you are working with an advisor who is a fiduciary.

Background on the Fiduciary Duty Rule

Financial advisors, such as stock brokers and annuity sales persons, offer advice about and sell financial products that may only be “suitable” for consumers. Current compensation practices incentivize advisors to place their own interests ahead of the investor’s interests. Advisors can recommend products that pay them more but are more expensive and provide lower earnings to investors.

The recently suspended rule sought to change this regulatory scheme for retirement investors.

A fiduciary duty requires that the advisor put the client’s interest before their own profit interest. A fiduciary acts as the “purchaser’s representative” on behalf of the client. The duty requires the person to have loyalty to the client because of the potential for abuse. The advisor does not represent the financial product provider.

Advisors that are Certified Financial Planner™ professionals have a fiduciary duty to their clients. The DoL rule was not a change for them. You can verify a CFP®’s their credentials here. Registered investment advisers (“RIAs”) regulated by the Securities and Exchange Commission (SEC) also have a fiduciary duty. You can check their credentials here. And their fiduciary duty doesn’t just apply to retirement advice, but to all investment advice.

Securities brokers, sellers of annuity products, and insurance agents do not have this duty if they aren’t CFPs® or RIAs. The rule would have affected them the most.

SEC Fiduciary Duty and the Disclosure Loophole

According the SEC, a RIA must act in the best interests of their clients and offer investment advice in their best interests. The advisor should not engage in any activity in conflict with the interest of any client. He or she should take steps reasonably necessary to fulfill his or her obligations.

But there is a loophole.

The advisor must at least disclose all conflicts of interest that might incline him or her — consciously or unconsciously — to give advice that is not disinterested. If the advisor does not avoid a conflict of interest that could impact their impartiality, the advisor must make full and frank disclosure of the conflict.

This requirement allows the advisor to disclose his or her duty away. And most of these disclosures are hidden or contained in volumes of overwhelming written materials that investors don’t understand.

Let me give one example that I have run across many times.

Many investment advisors and their firms benefit from “revenue sharing fees” from mutual fund companies. The investment firm requires that the mutual fund “share” some of their fees in order for their advisors to recommend the funds to investors.

Yes, these firms disclose these fees. But it takes a diligent investor to find the disclosure and to understand its implications.

For example, Morgan Stanley discloses that although they try to charge the same rate to mutual fund companies, the fact is they receive more revenue from fund companies with the largest client share holdings.

Morgan Stanley recognizes that these differential rates create an incentive to promote those products with the largest revenue sharing rate. Their disclosure implausibly suggests although this conflict occurs at the firm level, their branch offices managers and financial advisors do not receive more compensation as a result of this revenue. Thus, they believe they have fulfilled their fiduciary duty.

I beg to differ.

Yes, the financial advisor doesn’t get a bonus for pushing the mutual funds with the largest revenue sharing rate, but the entire system is set up so that the advisor sells those funds.

Not surprisingly, the Morgan Stanley accounts I have reviewed are concentrated in the funds that Morgan Stanley receives the most money as listed in their disclosure.

Yes, the conflict is disclosed, but the investor is still harmed. Investors have no idea this occurs.

This example is not to pick on Morgan Stanley but to say that even with a fiduciary duty, there are loopholes that certainly don’t put the client’s interest first.

Now I know the savvy reader is saying so what? They get fees, but aren’t the products they recommend superior? Ah, but there lies the rub.

The next part of this blog will show why they aren’t. And, more important, how you can protect yourself even if your advisor is a fiduciary.


No comments yet.

Leave a Reply