Best Interest Standard – Part 2

In a previous post it was argued that a best interest standard is necessary to protect financial consumers from the pervasive conflicts of interest in the wealth advisory industry. The arguments against adopting the standard fail on two accounts: uncertainty is a burden that is better carried by financial advisors than by financial consumers and, more importantly, financial advisors should not be regarded as salespersons but rather, as stewards of their clients’ financial well-being.

However, a fiduciary standard is not a panacea for ensuring the financial well-being of individual investors (retail investors). At worst, the standard could actually undermine clients’ interests by unintentionally cutting off access to investment opportunities that align with their social and environmental values. Millennials, in particular, show a strong interest in investment opportunities that allow them to contribute to positive social and environmental benefits for communities, while also generating a financial return on their investments.

As Canadian securities regulators deliberate over adopting the fiduciary standard for financial advisors this fall, it is essential that their analysis includes consideration for how the standard could impact individual investors’ access to socially responsible investment (SRI) products and investment products that generate positive social and environmental benefits (impact investments). In other words, the concept of investor protection must be extended beyond traditional concerns for conflicts of interests and transparency to include consideration for social and environmental risks and opportunities.

At issue is whether a fiduciary standard would have similar unintended consequences on the average individual (a.k.a ‘retail’) investor, as it has on institutional investors.

For many pension funds, fiduciary standard is widely regarded as a constraint for innovative investment strategies, including socially responsible investment (SRI) strategies and impact investment. For example, a 2004 study of Canadian investors finds that pension fund trustees’ interpretation of fiduciary duty constrains their ability to address full range of relevant corporate responsibility considerations’.

But interpretations of the legal concept have evolved in recent years to reflect a more progressive understanding. For example, one frequently cited legal interpretation argues that trustees’ fiduciary duty actually requires trustees to take into consideration ESG issues when  (i) they are financially material; (ii) the financial risk/return of two investments are equivalent  (iii) they have a mandate from the trust to do so, and (iv) when beneficiaries request non-financial criteria. More recently, regulators in the US and the UK have clarified that fiduciary duty does not preclude the inclusion of material environmental, social and governance (ESG) issues.

However, fiduciary duty continues to be seen as an obstacle to sustainable and responsible investment. The 2015 UN-backed PRI Report ‘Fiduciary duty in the 21st century’ finds that “many asset owners cite their fiduciary duties as the reason why they are yet to integrate ESG issues into their investment processes.”

In applying fiduciary duty to retail investors and their financial advisors, some scholars suggest that the retail sector provides a more generous space than the institutional investor context.  “The debate about the role of social responsibility criteria in the fiduciary obligations of trustees of pension funds is important but it is seldom relevant in the usual settings of financial advisors.”

In particular, Statman (2007) notes that clients of financial advisors are most often also the sole beneficiaries of their portfolios. If the client/beneficiary requests the inclusion of social or environmental criteria in investment portfolio, the advisor’s fiduciary duty of loyalty (impartiality) is not a constraint to doing so. In contrast, pension fund fiduciaries and other institutional investors – by definition – have often thousands of beneficiaries, and incorporating ESG criteria that are not unanimously agreed upon by all beneficiaries would violate fiduciaries’ duty of loyalty (impartiality). To summarize, fiduciaries with individual clients have much lower hurdles in recommending SRI and impact investment products to clients than do fiduciaries that are responsible to multiple beneficiaries at the same time (e.g., pension fund trustees).

But there are other constraints on retail financial advisors to SRI and impact investing that a fiduciary standard would likely impose. In particular, the duty of prudence, which requires that fiduciaries use care, skill and prudence exercised by similar fiduciaries, continues to be seen as a major barrier to SRI by many scholars. This is because measuring prudence with reference to the performance of other investors leads to herding effects, since fiduciaries are afraid to stand out among the herd, even if standing out means better managing portfolio risks and enhanced returns. Financial advisors fearing litigation under a new fiduciary standard may be even more sticking to conventional practices and avoiding customized advice and strategies for their clients.

Initiatives to overcome the challenges to SRI that the duty of prudence presents are underway in the institutional investor context. Many scholars, and even some regulators, are beginning to argue that the duty of prudence actually requires that fiduciaries take into consideration ESG factors when making investment decisions on behalf of beneficiaries, since these sustainability issues present material financial risks to their portfolios.

As Canada’s securities regulators contemplate adopting a fiduciary standard for financial advisors, it is essential that this decision includes consideration for the risks of unintended consequences of cutting off clients’ access to the emerging SRI and impact investment opportunities that are now available to retail investors in Canada, and strategies for mitigating these risks.

Some reccomendations for regulators that are contemplating the adoption of the best interest standard for financial advisors include: 

  • Know your client (KYC) form should include questions that consider the client’s values and social impact investment goals. This information should be given equal weight as the client’s financial risk preferences and return objectives.
  • Advisors should be knowledgable about material environmental, social and governance risks of the products that they are offering to their clients. 
  • Financial stewardship must replace financial salesmanship as the ultimate guiding principle for actions of financial advisors. Stewardship invokes a more holistic approach to advising clients on their wealth management.

Finally, it is important that regulators recognize that fiduciary duty is not the only obstacle to SRI and impact investment opportunities. As one scholar points out, “this obsessive focus on the supposed fiduciary law barrier to SRI can overlook other institutional [and organizational] obstacles to its practice.” Advisor education, misaligned incentives and lack of standard approaches to measurement of impact and social returns remain significant constraints to extending SRI and impact investment opportunities available to institutional investors to retail investors. These barriers, among others, are  highlighted in the Retail Impact Investing Guidebook for Canadian Credit Unions, authored by Purpose Capital and the Canadian Credit Union Association.

 

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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?