Who Does Your Financial Adviser Represent?

In a world of uncertainty, where one hundred and fifty year old financial institutions declare bankruptcy or are seized by the government over night, it becomes crucial for investors to understand who the advisers handling their money represent. Does their financial adviser put their clients’ interests above those of their own and their company, or are they simply selling them the recommended investment product du jour.

In 2008, customers of UBS, Merrill Lynch, Wachovia, Bank of America, and other larger financial institutions were shocked to find that their savings were locked up or wiped out when their “safe” option rate securities were no longer liquid. They were “sold” these products by their trusted advisers as an alternative to money markets. Meanwhile, their companies were being paid to create these securities. These companies were sued by their customers and several state attorneys' general and forced to pay for any losses incurred.

Others are now being told by their investment advisers that variable annuities are an excellent alternative for investing. These annuities offer a minimum “guaranty” of principal invested so that when the market goes down, “your money is still safe”. Thus, if you invest $100,000 and wait ten years past the penalty period, you will be “guaranteed” at least your money back. Why were these products not offered before the market collapsed? What are the costs associated with them? How good is the “guaranty” when companies as large as AIG can fail?

The people dispensing financial advice are split primarily into to two camps; those that have a legal fiduciary relationship to their employer, and those that have a fiduciary relationship to their client.

Fiduciary Relationship Lies With Employer or Broker Dealer

Financial Advisors that have a fiduciary relationship to their employer are called “Registered Representatives”. They are registered with their broker dealer, usually their employer, which they represent. They carry cards with such titles as “Financial Advisor”, “Investment Advisor”, “Financial Consultant”, “Financial Planner”, “Registered Representative”, “Insurance Agent”, and many others. In most cases, they work for large brokerage firms like Lehman Brothers, Bear Sterns, Merrill Lynch, Morgan Stanley, just to name a few. Some work for insurance companies such as AIG or banks such as Washington Mutual or Wachovia. These advisers generally carry Series 7 and insurance licenses so that they can legally receive commissions or referral fees on products they sell.

These individuals are tasked with selling products their organizations have created or recommend to their customers. Their regulator is the National Association of Securities Dealers, or the NASD. According to Scott Simon, author of the Prudent Investor Act: A Guide to Understanding, “registered reps follow the “suitability” standard under NASD regulations. This standard doesn’t require a registered rep to place the interests of its clients ahead of its own. Under this non-fiduciary suitability standard, a registered rep need provide only “suitable” advice to its clients-even if it knows that the advice is not the best advice.”

As Liz Pullium West, author of Easy Money: How to Simplify Your Finances and Get What You Want Out of Life, puts it, “At best, they're held to a "suitability" standard, which means they're supposed to reasonably believe that the investment and insurance products they want you to buy are appropriate for your situation. Just "appropriate" -- not "the best choice" or "in your best interests." Let's say you have $10,000 a year to save for retirement. Your financial adviser could recommend you invest the money in a low-cost index fund that might net you a return of 8% a year. After 30 years you'd have over $1.1 million. But let's say the adviser could earn a fat commission for recommending a higher-cost investment being promoted by his financial-services firm. So instead of netting 8% a year, you might net 6%. After 30 years, your nest egg would grow to just under $800,000, a difference of more than $300,000. The high-cost investment might be perfectly "suitable," since it meets your financial objective of saving for retirement, even if it could leave you significantly poorer than had you invested in the index fund.”

Merrill Lynch has gone to court to defend this concept of having a fiduciary duty to the company instead of the client. In an attempt to have its cake and eat it too, Merrill Lynch was able to get a court ruling, now called the “Merrill Lynch Rule”, to allow them to operate like a true advisor to the client while still representing the firm. This rule was overturned in 2007.

Fiduciary Relationship Lies with the Client

The second camp of investment advisors are Registered Investment Advisors (RIAs). Under the law, these advisers have a fiduciary duty to their client. They must register with the Securities Exchange Commission (SEC) once they have over $25 million under management. According to Mr. Simon, “Given its fiduciary status, an RIA must follow the “trust” standard- the highest known in the law-which requires it to place the interest of its clients ahead of its own and fulfill critical fiduciary duties…” Most hold the Certified Financial Planner designation which has its own separate “code of ethics”. Unless they are also a “registered representative”, they do not receive commissions or referral fess for investments they recommend. As a fiduciary, they have clients rather than customers. The have no incentive to select products based on commission paid nor are they required to provide specific investment products by their employer. They are free to select the best investments for their clients based on what is best for the client.

So why do so many wealthy individuals take the advice of those that represent their company rather than their client? The answer is the implied additional security combined with the sales power of a large firm. Here is a quick comparison of the financials of Charles Schwab and Merrill Lynch as of June 30, 2008:


(click to enlarge)

According to Wikipedia, “leverage (or gearing) is using given resources in such a way that the potential positive or negative outcome is magnified and/or enhanced. It generally refers to using borrowed funds, or debt, so as to attempt to increase the returns to equity.” ML is levered up 60 times! This is a primary cause of its forced sale to Bank of America.

With an increasingly complex financial world it becomes more important than ever to seek sound advice. Just make sure that advice comes from a professional who puts your interests first.