The Fiduciary Standard, Why It Matters

03.21.2016 - Gail E. Cohen

The fiduciary standard has become less clear to investors over the past several decades as different types of financial professionals are providing various forms of advice to clients. Gail E. Cohen, chair of Fiduciary Trust's board of directors and general trust counsel, examines the distinctions of the fiduciary standard and why it matters. 

Q. How can a fiduciary relationship be described? 

GAIL: Fundamentally, a fiduciary relationship is one where an advisor or trustee is required always to act in the best interest of the client. This means fiduciaries are required to act with loyalty and care and, most importantly, avoid conflicts of interest by never putting their own interests above the interests of their clients. Justice Benjamin Cardozo, in the widely-cited case Meinhard v. Salmon famously defined a fiduciary standard of behavior as follows: 

“A trustee is held to something stricter than the morals of the market place. Not honesty alone, but the punctilio of an honor the most sensitive, is then the standard of behavior…the level of conduct for fiduciaries has been kept at a level higher than that trodden by the crowd.” 

Q. What types of business practices are required by fiduciaries? 

GAIL: The foundation of a fiduciary relationship is the avoidance of any potential conflicts of interest. For example, investment fiduciaries operate as “buy-side only firms,” meaning they buy securities for client portfolios directly from the marketplace. Such firms do not hold their own inventory of securities for the purposes of selling to clients on a commission basis or lending them to short-sellers. 

Fiduciaries are also not permitted to comingle client assets with the assets of the firm. This way, there is never a question about which funds belong to the firm and which belong to the client. Comingling can be a particular risk in the case of bankruptcy or insolvency, where there could be a source of conflict over repayment of funds. We saw this happen to some brokerage firms during the financial crisis of 2008–2009. 

Q. How do the standards governing investment advice differ between fiduciaries and non-fiduciaries? 

GAIL: In the laws that govern investment advice, there are two competing standards for advisors versus brokers. Generally, registered investment advisors and trustees are held to the fiduciary standard, while broker-dealers are regulated under a “suitability” standard. The suitability standard means the investment recommendations must be appropriate for the client in terms of the client’s financial goals and risk tolerance. However, the recommendations do not necessarily need to represent the best solution for the client when all factors are considered. 

Q. Why has the distinction between these different forms of advice been blurred? 

GAIL: Over the past several decades, the term “advisor” has taken on a broader meaning in the eyes of investors, leading to some confusion. With full-service brokers, financial planners, online brokers, insurance agents, attorneys, registered investment advisors, trust companies and banks all offering some form of financial advice, the distinction between who a fiduciary is and who is not is often not clear to the investor. 

In fact, a recent study of high net-worth investors found that 72% of those surveyed said the titles “advisor,” “consultant” and “planner” imply a fiduciary relationship exists. However, the study estimated that the largest percentage of individuals identified by these investors as financial advisors may not actually be subject to the fiduciary standard.1 

Q. How may working with a fiduciary versus a nonfiduciary differ in terms of investment decisions? 

GAIL: Let me answer that by giving an example. From a suitability perspective, the recommended investment must fit a client’s investment profile. For example, it would probably be suitable to recommend a bond investment to an 80-year-old client who is interested primarily in income and wealth preservation. There are lots of similar fixed income solutions in the marketplace that an investment professional could recommend to his or her client to meet the suitability requirement. Which investment will be recommended? This is where the differences in the standards come into play. 

An investment fiduciary is legally bound to make a recommendation that is prudent, uses good professional judgment and is free from conflicts—meaning he or she puts the interests of the client before his or her own interests or the interests of the firm. So, given a choice between an investment vehicle with a higher fee structure that may provide a greater benefit to the investment professional and/ or the firm, or a similar investment with a lower fee, an investment professional working under the fiduciary standard could not recommend the higher-fee vehicle solely because it would be most profitable for the advisor, all other things being equal. 

Q. Why is the Prudent Investor Rule important? 

GAIL: The Prudent Investor Rule was adopted by almost every state during the 1990s. It is the law that governs how fiduciaries must invest assets entrusted to their care. Fiduciaries consider questions such as how does the investment fit into the client’s overall portfolio? Will it meet the needs of the beneficiaries? Portfolio analysis should include the client’s short-term and longterm investment strategy and consider factors such as whether the asset allocation strategy meets performance objectives, how to manage any concentrated positions and an assessment of historical total return, yield and risks. Only based on a thorough and holistic evaluation can a fiduciary make an investment recommendation that satisfies this higher standard. 

Q. How do requirements for continuous oversight differ? 

GAIL: A fiduciary is required to provide continuous monitoring of a client’s investments whereas non-fiduciaries generally provide advice only up to the point of purchase. Fiduciaries are not selling anything other than their knowledge, experience, loyalty and care. So unlike non-fiduciaries who usually may charge commissions based on products they sell, fiduciaries typically earn an ongoing advisory fee.

1. Source: Spectrem Group; 2014 Millionaire Q3 Report. 

This communication is intended solely to provide general information. The information and opinions stated are as of March 2016, and may change without notice. The information and opinions do not represent a complete analysis of every material fact regarding any market, industry, sector or security. Statements of fact have been obtained from sources deemed reliable, but no representation is made as to their completeness or accuracy. The opinions expressed are not intended as individual investment, tax or estate planning advice or as a recommendation of any particular security, strategy or investment product. Please consult your personal advisor to determine whether this information may be appropriate for you. This information is provided solely for insight into our general management philosophy and process. Historical performance does not guarantee future results and results may differ over future time periods.

IRS Circular 230 Notice: Pursuant to relevant U.S. Treasury regulations, we inform you that any tax advice contained in this communication is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein. You should seek advice based on your particular circumstances from your tax advisor


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