Previously unknown to most of the investing public, the term fiduciary has become increasingly popular since the Department of Labor (DOL) announced its intentions to tighten the standards by which financial companies are required to adhere in order to conduct business. Yet, even while consumers are growing ever more aware of the term fiduciary, few truly understand the difference between the more broadly practiced suitability standard and that of the increasingly influential fiduciary standard. The goal of this article is to dispel misinterpretations of these two terms and place them into the proper context. Perhaps this is best shown using an analogy.
Let’s say that you are contemplating buying a new car. You tell your friend Tom, and he mentions that his buddy TJ is a salesman over at Acme Auto. You figure any friend of Tom is probably a good guy, and drive over to Acme the following day. After introductions, TJ asks what sort of car you are looking for, and your price range. He also offers to run a credit report to determine how much you can afford to pay, if you’re interested. TJ says that to initiate the credit check, he needs your driver’s license. You hand the license over, and he takes it down to the finance department. He then proceeds to show you several cars over the course of an hour. Afterwards, he tells you to think about which car you might want to buy while he checks to see if the credit report is ready. A few minutes later, TJ returns and says he has some great news. According to the report, you qualify for all of the cars he’s shown you. TJ says it’s now up to you to let him know which one you’d like to own. Based on the suitability standard, all of the vehicles you’ve been shown are suitable. After all, TJ didn’t try to sell you a boat, bus, or airplane. Still, you don’t quite feel ready to buy, and tell TJ you’ll let him know tomorrow.
After going to Acme Auto, you stop at Cars R Us, a dealership which holds itself to the fiduciary standard. Pam, the Cars R Us associate, explains that before she shows you any cars, she needs to know about you and your needs. She says she’s going to ask you several questions. She’ll use the information to determine which cars are most appropriate for your situation, and then make her recommendation. She begins her questioning by asking how many miles you drive to work each day. She knows that if you are buying the car mostly to accommodate a longer commute, you will probably desire a more fuel efficient car. On the other hand, if you have three grade school children and the car is going to be used mostly to shuttle the kids and their gear back and forth to daily extracurricular activities, you may value space and storage over gas mileage. Likewise, if you’re going to be sharing the car with your newly licensed teenager, you probably don’t want him or her behind the wheel of an expensive vehicle. More likely, safety, reliability, and economic considerations are of greater significance. Following her assessment, Pam shows you a couple of automobiles and explains the benefits of each and why each might be appropriate for your needs. Pam also asks what sort of car you already had in mind, and explains why one of the cars you test drove over at Acme auto is likely too expensive for your household income.
In summary, the suitability standard determines just that―suitability. Regardless of each car’s size or cost, all of the cars you were shown at Acme are likely suitable. After all, as a means of conveyance, each gets you from point A to point B, doesn’t it? But, what if TJ had attempted to sell you a boat or airplane? While either of these would probably be considered unsuitable, what if he’d tried to sell you a semi-tractor? Some might argue that a semi is suitable. A difficulty with suitability is it leaves the door open for interpretation. As evidenced by Pam’s probing questions, the fiduciary standard implies greater discernment on the part of the provider. The needs of the client are presumed to be clearly identified before making recommendations.
Another problem with the suitability standard is that it can imply indifference on the part of investment professionals as to which product the consumer purchases. But, when the investment professional’s income is tied to the sale of a product, common sense tells us this couldn’t be farther from the truth. When each product pays a different level of commission, it ensures that often the suitability standard is insufficient to guarantee that the consumer will be provided the most appropriate product for his needs. The fiduciary standard indicates that bias has been removed and that the consumer receives transparent advice and is shown the most appropriate investment products. In summary, we can conclude that as the financial industry transitions from the suitability standard to the fiduciary standard the shift will prove better for consumers by promoting an atmosphere of openness and fairness among financial institutions.
Dennis Gravitt, AFC®, CFP®, is the president and owner of Long Run Financial, Ltd., a boutique fee-only Registered Investment Advisory firm. Since opening his business in the fall of 2007, he has remained a strong proponent of the fiduciary standard and committed to helping middle class people manage their finances, empowering them to make good financial decisions, and assisting them in retiring with dignity.