Personal Finance: What is a fiduciary and why should I care?

Christopher Hopkins
Christopher Hopkins

Last week, the U.S. Department of Labor issued new rules that will impact millions of retirement savers and thousands of financial service providers. These new regulations substantially expanded the array of client relationships to which a financial professional owes a fiduciary duty, mandating that the client's interest be placed ahead of the interest of the representative.

photo Christopher Hopkins

Although many investors may assume this is already the case, the fact is financial services are offered under two distinctly different models. Registered Investment Advisors are regulated by the Securities and Exchange Commission or state authorities and owe a fiduciary duty to put their clients' interests ahead of their own. "Fiduciary" derives from the same root as "fidelity," and simply means "trust." Advisers under this standard operate under a stringent legal responsibility to act in the best interests of their customers regardless of compensation. Typically, fiduciary advisers collect fees based upon assets under management unrelated to transaction volume or frequency.

Other financial providers, including brokers and insurance agents, generally operate under a less stringent "suitability" standard. This less rigorous regimen requires that advice and products be suitable but not necessary optimal, and leaves considerable room for conflicts of interest as well as the potential for inferior long-term returns due to higher costs and hidden fees.

The Labor Department began crafting updated fiduciary standards in 2010, and just rolled out the final version last week. As one would expect from a massive government regulatory edict, the new rule is unnecessarily complex and quite imperfect, but late modifications in response to industry feedback improved the final product. On balance it advances the interest of individual retirement investors and injects much-needed transparency into compensation arrangements.

The change was required because the ground has shifted from under retirees in the last 40 years.

Traditional pension plans arose in the post-war industrial boom as a recruiting incentive to attract qualified employees. However, many companies over-promised and under-delivered, offering rich benefits but failing to fund their plans adequately. A wave of high profile pension collapses culminating with Studebaker in 1963 pointed to the need for reform. The 1974 ERISA Act imposed standards for management of employee pension plans, including the responsibility to adhere to a fiduciary duty in managing investments or dispensing advice.

This was great as far as it went. But in 1974, the 401(k) and the rollover IRA did not exist. Fast forward to today, with nearly 60 percent of all retirement assets in self-directed vehicles and traditional pensions in decline. ERISA excluded self-directed accounts from the fiduciary requirements since their eventual importance was unforeseen.

The latest DOL action addresses this insufficiency. With limited exceptions, anyone providing investment advice or products with regard to retirement assets including IRA accounts for a fee or other compensation, direct or indirect, is now required to place their clients' interests first.

In a reasonable concession to commission-based consultants, the new standard allows clients to sign a "best interest contract exemption" that warrants impartial advice but allows the sale of more complex and costly products like variable and fixed indexed annuities that often were inappropriate for retirement accounts but generated substantial compensation. If these products are truly in the clients' best interests, they may still be sold under the BICE with adequate disclosures.

As the saying goes, to a hammer every problem looks like a nail, and the Labor Department is a sledge. A one page, nearly costless solution would have been a simple rule requiring anyone using the title "advisor" (or adviser) to be a fiduciary; otherwise representatives would identify as brokers, salespeople, or agents.

Still, the abundant confusion among many retirement investors and their increased reliance upon defined contribution plans and IRAs made action imperative. Not perfect, but better.

Christopher A. Hopkins, CFA, is a vice president and portfolio manager for Barnett & Co. in Chattanooga.

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