At Financial Freedom, we see this scenario often: You have a bit of money saved up that you’d like to put to good use. Perhaps you’re thinking about investing some of it so you can earn more than the measly interest rate that your bank gives you. Add to it a portion of your monthly income, and you’re off to a great start. And if you’re disciplined with your spending and smart about your income, you’ll be able to accumulate a decent nest egg when the time comes to draw down on it. After all, the power of compound interest is real, especially if you have time on your side.
But all this can change if you work with the wrong financial advisor.
Once you decide on what to do with your money, the next question becomes how you go about doing it. If you aren’t familiar with how investing works or aren’t comfortable doing it on your own, you might be tempted to call your bank and talk to one of their “financial advisors.” The advisor will probably offer to invest your money for a very low fee, or even no fee. However, here is where things get tricky.
Banks are in the business of making money. If they ever offer you a service that sounds too good to be true, chances are very high that there is a catch. So, before you go about taking that “free” advice, let’s look at what the fiduciary duty is and why the fiduciary rule matters to you.
What is a Fiduciary?
The dictionary definition of a fiduciary is a person who can be trusted to work for the benefit of another. The first fiduciary relationship that often comes to mind is that of a lawyer whose clients trust him or her with legal matters. Lawyers must do everything in their power to work in their clients’ best interests. The rule is clear-cut: All lawyers have a fiduciary responsibility to their clients. For the sake of simplicity, lawyers cannot represent both the plaintiff and the defendant on the same case, for example.
Similarly, in financial planning, a fiduciary is an advisor whose clients trust him or her with financial matters. Fiduciary financial advisors must put their clients’ interests above their own. This may sound simple enough, but in the financial services industry, the line isn’t always so clear.
Think of fiduciaries as independent third parties whose only job is to give you sound investment advice. For instance, given the option of making two similar investments on behalf of their clients, fiduciary financial advisors must choose the investment that charges lower fees.
Why does this matter to you? When a financial advisor is following the fiduciary rule, only then can you truly avoid conflict of interest. You can trust that the advisor is not recommending a product simply because he or she will make a hefty commission.
At Financial Freedom, we are fiduciaries and take this fiduciary duty very seriously.
What is NOT a Fiduciary?
Unfortunately, the finance world’s definition of a fiduciary is not as straightforward as that in the legal realm. Although common sense should prevail in defining the responsibilities of financial advisors to their clients, not all advisors are required to adhere to the standards of a fiduciary.
Let’s go back to the advisor from your bank that we mentioned earlier who is all-too-happy to offer you “free” financial advice. At closer look, you may see that the investments he or she recommends tend to be their employer’s own products. The investments themselves may not be too bad, but the fees they charge are more than likely higher. The bank makes money from your transaction, and the advisor takes a percentage of the profit as commission.
Given the chance to pick one of two similar products, the non-fiduciary advisor isn’t necessarily going to pick the one that charges the lowest fee, but rather the one that pays the highest commission. They simply have to abide by the suitability standard – as long as their investment recommendations are suitable for their clients, they’ve done their job. You technically get financial advice for free, but it’s similar to working with a car salesman, who will give you free advice to buy a car on the dealership’s lot. The car may be great, but the salesman isn’t incentivized to tell you that a similar car next door sells at a lower price point.
The Cost of Non-Fiduciary Responsibility
The problem with non-fiduciary advisors is that all the fees add up, little by little. The difference between paying 0.75 percent and 0.25 percent, for example, on a particular investment may not seem like a big deal right now, but compound the difference every single year, and you stand to end up with a much smaller nest egg.
Here’s an example:
Let’s say you put aside $10,000 every year for the next 30 years. If you earn 8 percent per year, you’ll have a nest egg of $1,132,832 at the end of 30 years. However, if your advisor recommends an investment that takes a fee of half a percent, and your annual return goes down to 7.5 percent, you will end up with $1,033,994 at the end of 30 years. The difference comes out to almost $100,000. The power of compounding works in reverse, as well.
To further drive this point home, a report published by the office of the U.S. President in 2015 states, “An estimated $1.7 trillion of IRA assets are invested in products that generally provide payments that generate conflicts of interest. Thus, we estimate the aggregate annual cost of conflicted advice is about $17 billion each year.”
The Fiduciary Rule
In response to this eye-opening report, the Department of Labor proposed a fiduciary rule that would have placed more stringent requirements on financial advisors to avoid conflicts of interest. It expanded on the original ERISA Act of 1974 to broaden the scope of fiduciary duty. However, it was not received well and was ultimately scrapped.
In other words, many financial advisors do not want to be legally bound as fiduciaries.
Fortunately, there are financial advisors who do abide by fiduciary duty. You should always ask potential financial advisors how they make money and whether they receive commissions. If they don’t answer your questions clearly, we suggest you turn around and walk away.
Fee-only fiduciary financial advisors are your best bet to maximizing your earnings and minimizing the fees you pay. They are independent third parties who don’t work for a bank. They charge transparent fees for giving you financial advice, and they don’t make money from commissions or kickbacks. Most importantly, fiduciaries are required to put your interests above all else, including their own.
When you seek investment advice, think about the fiduciary rule. Your future nest egg will thank you for it.