Uncertainty and the ‘Best Interest’ Standard

On a recent episode of Last Week Tonight, comedian John Oliver made the stuffy topic of financial advisors’ fiduciary duty to their clients both entertaining and informative. To be sure, his analysis skims many of the important nuances of the debate over the fiduciary standard in favour of comic effect. Nonetheless, the point is loud and clear: regulatory changes are needed to mitigate the conflicts of interest between incentives for financial advisors and the financial well-being of their clients. 

In the United States, it is estimated that these conflicts of interest cost investors $17 billion each year in the form of fees and other kickbacks paid to financial advisors. Until the new Department of Labour rules come into full force, it is legal for some financial advisors to recommend high-commission products to their clients, even if these products are not in their clients’ best interest. Add to this the lack of financial literacy among the general population, and it is clear that the average financial consumer requires greater protections.  For example, researchers find that financial advisors encourage their clients to take high degree of risk, while failing to provide customized advice despite charging their clients high fees. And fees eat up a significant portion of an investor’s returns. 

Under the new ‘best interest’ standard, most financial advisors in the US will be considered fiduciaries of their clients. This means that advisors have a legal obligation to make investment decisions in their clients’ best interests. Fiduciary duty involves a higher standard of responsibility than what is provided to a client through a contract.

It seems hardly surprising that some are advocating for this same legal concept to be applied to Canadian wealth advisors. According to Morningstar, Canadian mutual funds have some of the highest fees in the world, and pervasive conflicts of interest in the Canadian wealth advisory industry are widely documented.

But the most recent round of Canadian Securities Administration consultations reveals a nation divided, with regulators in Ontario and New Brunswick both in favour of the principle and Alberta, Manitoba, Quebec and Nova Scotia expressing strong reservations. British Columbia is outright opposed to the adoption of a fiduciary standard. 

Among the regulators that support the adoption of a best interest standard, it is argued that requiring advisors to make decisions that are consistent with the best interests of the client is necessary under conditions of uncertainty. A fiduciary standard can “guide registrants in addressing situations not covered by a specific rule.” 

Interestingly, the same appeal to uncertainty is used by those regulators that oppose the adoption of a best interest standard: The British Columbia Securities Commission is concerned that “the introduction of a regulatory best interest standard over and above the proposed targeted reforms is vague and unclear and will create uncertainty for registrants.” Their point is that the relationship between clients and their financial advisors is often complex. Consider the following example:  “Would an advisor have a fiduciary obligation to disclose to his or her client that a competing advisor offers the same services at a lower cost?” 

So which is it? Does fiduciary duty serve to guide financial advisors’ in an uncertain environment, or does the best interest standard contribute to creating uncertainty for these same advisors? It is probably a little of both. But the more relevant question is who is better able to manage uncertainty?

In the absence of a fiduciary standard, financial consumers will continue to make important decisions about their personal wealth in a cloud of uncertainty. To be sure, disclosure and transparency rules are an important step in the right direction. But these rules are not sufficient. This is because many financial consumers do not have the competencies to make use of this information to make better decisions. Moreover, studies suggest that the average consumer is unable to determine the extent to which advisors are offering them biased advice. 

Adopting a fiduciary standard means shifting the uncertainty burden from the (mostly) financially illiterate consumers to the financially savvy advisory industry, which is arguably better equipped to manage uncertainty. And at this point it is important to recall that the goal of regulators is to protect consumers, and not to protect the business model of the wealth advisory industry. 

At the heart of this debate then is the question of whether the fiduciary standard would have adverse impacts for financial advisors that would be passed down to their clients. 

One way that these unintended and negative impacts of fiduciary standard could be passed down is by increasing advisors’ compliance costs. It is frequently argued that a best interest standard would significantly increase monitoring and operational costs to ensure compliance. Compliance costs would create a less efficient market structure, where only the largest advisory firms would be able to stay in the market. The end result, it is argued, is that advisors would no longer find it financially viable to serve less wealthy clients, thereby cutting off their access to financial services.   

There are several reasons to be skeptical of these claims. A study of the US market for financial advice finds that despite the difference in adoption of fiduciary standards across states, there was no significant difference in competitiveness of advisory firms, nor does fiduciary standard prevent access to less wealthy clients to financial advice.  In other words, there is no evidence that the fiduciary standard leads to negative impacts for advisors or their clients.  Some advisory firms are even voluntarily adopting the fiduciary standard. And as financial consumer advocate Elizabeth Warren unabashedly points out, some of the most vocal critics of the standard contradict themselves in statements to their shareholders by claiming that fiduciary duty does not present significant challenges to their business model.

Another concern often raised by its critics is that fiduciary duty would adversely impact clients by contributing to a false set of expectations. In a brief summarizing the CSA consultations, it is noted that “clients may expect that all registrants have an unqualified duty to act in their best interest, not understanding that some conflicts would still be permitted.” The brief goes on to note that “it is not possible to require a salesperson of proprietary products only to act in a manner that is truly in an investor’s best interest.”

But this criticism makes forcibly the case for why a fiduciary standard is necessary in the first place; financial advisors should not be regarded as salespersons. We trust our financial advisors with our plans for retirement, our children’s education and our first house. Buying a mutual fund is not the same as buying a vacuum. We share with advisors our most intimate dreams and hopes for the future and we trust our advisors to guide us through a complex set of decisions in order to make them a reality.  Financial advisors must be strongly encouraged to regard themselves as stewards of their clients wealth and aspirations, and not as salespersons. 

Future posts will consider the ways in which financial advisors acting as stewards can add value for their clients and the implications of adopting a fiduciary standard for the availability of socially responsible and impact investment products. 

 

Notes

For an excellent review of literature on the topic, see Punko, N. (2015). Should Canada’s Financial Advisors be Held to a Fiduciary Standard?