What Is The Fiduciary Rule?

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If you ever had a niggling thought in the back of your mind that perhaps your financial advisor was charging you too much, or worse, not acting in your best interests, the Fiduciary Rule is designed to better protect you.

The idea behind the Fiduciary Rule is simple: advisors should act in the best interests of clients.

You might naturally assume it is the duty of your financial advisor to act in your best interests already but the reality is financial advisors can, if they wish, conceal commissions and fees from clients, leading to conflicts of interest.

The Suitability Standard
For Financial Advisors

Previously, financial advisors, insurance agents and brokers had to abide by the suitability standard which did not preclude them from pocketing hefty commissions. The Fiduciary Rule requires financial professionals to put clients’ best interests first.

Before the fiduciary rule took effect on June 9, 2017 financial advisors were required to meet the suitability standard, a lower level of accountability.

financial advisor meetingAs long as clients’ needs and objectives were being met, financial planners, insurance agents and brokers could declare that the suitability standard for clients had been met.

With the new ruling, financial professionals serving clients must now abide by a higher standard that legally requires them to put their clients’ best interests first.

As opposed to simply finding “suitable” investments that could still earn advisors, brokers or agents sizeable commissions, financial professionals must now choose the best investments for clients – not simply suitable ones that could secretly line their pockets.

Any financial professional who wishes to still earn a commission will be required to disclose to clients any conflicts of interests via an agreement called the Best Interest Contract Exemption, or BICE.

How Financial Advisors
Could Act In The Past

Financial advisors could previously recommend products that met clients needs while simultaneously pocketing large commissions and still remain compliant to the suitability standard. With the Department of Labor’s fiduciary rule, financial advisors must disclose commissions received on financial products, such as annuities and IRA rollovers.

The suitability standard and the new fiduciary rule seem to be similar at first glance. If an investment is suitable for you, surely your financial advisor is acting in your best interest?

They very well might be. But when they had to comply only with the suitability standard they might also be acting largely in their own best interest.

Take the example of a retiree who seeks predictable income forever more. The retiree’s financial advisor recommends an annuity that pays an ongoing fixed monthly amount to the client.

According to the suitability standard, the financial advisor has met the needs and objectives of the client, so why is the fiduciary rule needed?

What the retiree may not have known is that the financial advisor may be taking a large commission and lining his or her own pockets.

A financial advisor who puts a client in a $1,000,000 annuity may pocket as much as $50,000 in sales commissions without the client knowing it.

According to the fiduciary rule, the financial advisor will need to disclose the $50,000 commission prior to the sale of the annuity product.

The financial advisor will be forced to think twice about commission-based products because acting in the best interest of clients is a matter of law.

>> Related: Retirement Planning For Dummies

Which Accounts Does
The Fiduciary Rule Cover?

Retirement accounts are subject to the fiduciary rule but brokerage accounts, even those intended for retirement, are not.

If you have a brokerage and a retirement account managed by a financial advisor, only the retirement account is subject to the fiduciary rule.

The accounts covered by the fiduciary rule, include:

  • Individual Retirement Accounts (IRA)
  • 401(k) Retirement Plans
  • Simplified Employee Pension Plans
  • 403(b) Plans
  • Simple IRA Plans
  • Employee Stock Ownership Plans
  • Defined Benefit Pension Plans

If you request that your financial advisor invests in a specific product on your behalf, the investment selection is not covered by the fiduciary rule.

Any brokerage accounts that you plan to dip into for your retirement are not covered by the fiduciary rule; savings for retirement must be in an actual retirement account to be eligible for fiduciary rule coverage.

Plus, if you happen to call your financial advisor to request information or the advisor educates you on different investments, securities or products, such general advice is not categorized as financial advice subject to the fiduciary rule.

>> More: What Are The Best Brokers For Beginners?

Why The Fiduciary Rule
Is So Important

The fiduciary rule is important in spotlighting obscure fees in addition to transparent fees, such as management fees.

The fiduciary rule shines a light on fees and commissions that may otherwise be concealed from clients.

Most clients pay attention to management fees paid to financial advisors. These fees are generally well disclosed and easy to spot on monthly or quarterly financial reports.

Less apparent to clients are the hidden fees they incur on an ongoing basis. Mutual funds charge fees to fund investors but these fees are taken out at the fund level.

Because the fees are not visible on regular financial statements, it’s easy to miss them. Yet over time, they do stack up.

For example, a client starting with a $100,000 paying total fees of 0.5% on a portfolio earning on average 8% annually will amass over $300,000 more than if they were paying 2% fees annually.

Expense Ratio
YearAnnual Gain (8%)0.50%1.00%1.50%2.00%
0$100,000$100,000$100,000$100,000$100,000
1$108,000$107,500$107,000$106,500$106,000
2$116,640$115,560$114,485$113,415$112,350
3$125,971$124,222$122,488$120,771$119,070
4$136,049$133,529$131,045$128,595$126,180
5$146,933$143,532$140,193$136,917$133,702
6$158,687$154,279$149,974$145,768$141,660
7$171,382$165,828$160,429$155,180$150,078
8$185,093$178,238$171,605$165,187$158,980
9$199,900$191,571$183,551$175,828$168,395
10$215,892$205,897$196,319$187,141$178,350
11$233,164$221,290$209,965$199,168$188,875
12$251,817$237,827$224,550$211,952$200,002
13$271,962$255,594$240,136$225,540$211,763
14$293,719$274,682$256,790$239,981$224,193
15$317,217$295,188$274,587$255,328$237,329
16$342,594$317,217$293,602$271,635$251,209
17$370,002$340,881$313,918$288,962$265,873
18$399,602$366,302$335,622$307,370$281,363
19$431,570$393,608$358,809$326,925$297,725
20$466,096$422,939$383,578$347,697$315,004
21$503,383$454,443$410,035$369,759$333,251
22$543,654$488,282$438,293$393,189$352,516
23$587,146$524,626$468,474$418,070$372,853
24$634,118$563,661$500,705$444,489$394,320
25$684,848$605,583$535,125$472,537$416,976
26$739,635$650,605$571,879$502,313$440,883
27$798,806$698,955$611,124$533,920$466,108
28$862,711$750,878$653,024$567,467$492,718
29$931,727$806,634$697,757$603,069$520,786
30$1,006,266$866,507$745,511$640,848$550,388

So, what seems like a small hike in annual fees can amount to a substantial loss in portfolio wealth over time due to the power of compounding.

Indeed, the Economic Policy Institute claimed that a 60 day delay in enacting the fiduciary rule would cost retirement savers $3,700,000,000 over a thirty year period.

What The Fiduciary Rule Means
For Financial Advisors

Financial advisors must make appropriate disclosures and be especially vigilant to avoid misleading statements.

A temptation for financial advisors is to nudge fees charged to clients a little higher. The magic of compounding means every extra 0.1% charged to clients annually adds up to a large amount over a long time time period. However, such fee hikes directly hurt clients’ investment returns (and have spawned a robo advisor industry intended on disrupting them).

Financial advisors who charge higher fee schedules and deliver low investment returns to clients are at risk of losing retirement accounts and being confined to managing only brokerage accounts.

Financial advisors who have historically enjoyed hefty commissions from rolling over IRAs, selecting high fee mutual funds or selling annuities are especially at risk.

Financial advisors must be especially careful going forward to make appropriate disclosures, such as the Best Interest Contract Exemption, and avoid making misleading statements.

The fiduciary rule is still under scrutiny but since its enactment, financial advisors must comply with the “reasonable compensation” conduct standard.

What The Fiduciary Rule
Means For Clients

The fiduciary rule holds financial advisors, brokers and insurance agents to a higher legal standard, but is no substitute for your own due diligence.

By January 1, 2018, any fiduciary rule exemptions are expected to end. When they do, clients should still be careful when evaluating financial advisors.

Financial advisors generally have different specialties and preferences in how they serve clients.

Some will invest your money in a limited number of model portfolios while others will customize investment portfolios to your needs. Others, such as Betterment, offer you an automated, hands-off approach.

Certified insurance agents may invest client funds in insurance products, while others will lean towards options hedging on stock portfolios.

As a client, you can take comfort in the extra layer of consumer protection afforded by the fiduciary rule but should still be diligent when evaluating financial advisors to ensure their services and specialties match your own financial needs and goals.

Just because the fiduciary rule holds financial professionals to a higher standard does not mean opportunities to earn sales commissions have disappeared. Unscrupulous financial advisors will always be around to capitalize on the naivete of unsuspecting clients, so while the legal provision raises the standard for advisors, it is no substitute for your own due diligence.

If you are not sure where to begin, check out the best robo advisors, who generally have low management fees and choose low-fee index funds.

Have you experienced any fee or commissions conflicts with a financial advisor? How did they resolve themselves? We would love to hear from you in the comments below.

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