Separating ‘Fiduciary’ From ‘Compensation’

It may be useful to also compare how the term has changed, if at all over time. Webster’s 1828 dictionary provides the following definitions:

1. Confident; steady; undoubting; unwavering; firm
2. Not to be doubted; as fiduciary obedience
3. Held in trust

Compensation isn’t as relevant as many suppose

It is interesting to note that all of the definitions deal with trust, or whether someone is acting in a trustworthy manner. Fiduciary has to do with one’s character. Importantly, methods of compensation or other conflicts of interest, although potentially relevant to identify, are not necessary to the core concept of “fiduciary.” Even more important to understand is that “fiduciary” is subjective. Multiple people can be trustworthy and still give differing advice regarding the same topic.

Proponents of a new regulatory “fiduciary standard” argue strongly that an advisor’s manner of compensation is extremely important to consider in determining whether or not that advisor is or can be a fiduciary. I would counter that this is a fallacy. Compensation in and of itself cannot make or break a fiduciary advisor. If this were the case, the only trustworthy advisors would have to be completely pro bono. I’ll expand on this concept below.

Given my background as an attorney, I am very familiar with a different industry in which being a fiduciary is at the core of the profession, and yet the debates about compensation rarely play into that concept. Attorneys are required by the standards of care in every jurisdiction to always act in their clients’ best interest; to always be trustworthy as a fiduciary. Are there bad apples? Certainly. But those exist, and will always exist, no matter how the attorney is compensated.

Attorneys can get paid in several ways very similarly to how financial advisors and insurance agents are paid. They often charge an hourly rate, but many work on a flat fee as well for certain services. When hired for litigation work, attorneys commonly charge a large commission plus expenses, which could be more than a third of the judgment. There are also attorneys who provide trustee services, and these lawyers will often take a percentage of assets as their fee, often 1% per year, similar to an AUM wrap fee.

None of these fee structures is seen by the ABA or the industry at large as inherently better or worse than the other — they just exist for different purposes. Nobody is making the accusation that trial lawyers are by their nature more immoral or greedy than others simply because they earn a commission rather than an hourly or trustee fee. Why should financial advisors be treated differently based on their compensation structure?

Any method of compensation can lead to conflicts

The accusation is often made that if an advisor or insurance broker earns a commission (often for an annuity sale), he is naturally incentivized to sell more annuities to earn more and larger commissions, and this means they will be looking out for their own interests rather than those of the client. Therefore, the argument goes, this advisor could never properly be a “fiduciary.” But this same argument would apply to every other form of compensation as well.

If an investment advisor in an RIA earns a 1% management fee for assets under management, there is also a natural incentive to gather more AUM. This pushes the advisor to recommend larger and larger portions of assets to be in the market managed for that fee, and disincentivizes the advisor from recommending the client hold cash in the bank or other places in reserve.

There are some advisors who advertise to be “fee only,” and they charge a flat financial planning fee, and then outsource the investment management to other firms. These advisors would argue that all conflicts are now eliminated, because there is no incentive to recommend one product over another, and all their clients pay exactly the same price. Yet these financial planners also hold a natural economic incentive to work quickly and churn out plans faster and faster regardless of quality, so they can get to the next client and earn more income.

What about switching to an hourly rate? As such, you just get paid per hour for the work you do. In this case, the advisor would be “incentivized” to work slowly and rack up more and more hours to squeeze as much juice out of each client as possible.

Educating the consumer is crucial

Does this mean any of these compensation systems are better or worse, or that they should all be thrown out the window as inadequate for fiduciary advice? No. The point is that as long as money exists and we live in an economic system, everyone has a natural incentive to maximize their own compensation to provide for their families. This fact should have nothing to do with whether or not an advisor is a “fiduciary.”

Is the advisor trustworthy? Honorable? Knowledgeable in the areas they are being hired for? Does the advisor give good advice tailored to each client, and does that advisor put the client’s needs ahead of his own regardless of the manner in which he is compensated? Is the advisor willing to put all of the above in writing? If the answer to those questions is “yes,” then the advisor is definitely a fiduciary, regardless of whatever regulatory or compensation framework is being used.

Let’s stop beating each other up as an industry and stop focusing on compensation. It has no impact in and of itself on the creation of “bad apple” advisors. Instead, we should prioritize training and messaging to educate clients and advisors on how to choose an advisor that is experienced, honorable, and trustworthy to meet clients’ needs and create better outcomes for everyone.

Daniel Razvi is an attorney who owns Higher Ground Legal, a nationwide law firm, specifically focused on trusts, wills and taxes. Also, a partner in Higher Ground Financial Group with his father Imran Razvi, Daniel is passionate about assisting clients with planning for retirement, minimizing risk, fees and taxes.

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