Can You Trust Your Financial Advisor?
Any service provider requires a certain level of trust. You want to know that your car mechanic is honest, your doctor is interested in your best welfare, and your teachers are knowledgeable. This is especially true for financial advisors. These professionals are instructing you as to the best way to invest and grow your retirement funds. Not only is it a significant amount of money, but you may be depending on it to eventually pay basic living expenses. This is true for both classic retirement accounts, as well as a Self Directed IRA.
The Challenge of Financial Industry Incentives
Choosing a solid financial advisor can be tricky. Like most professions, the majority of those working in the field will be honest and try to deliver a reputable service. However, there is one major factor that can impact the effectiveness of an advisor: commissions. Whenever there is money to be invested, there are companies who would like to access it. To achieve this access, they can incentivize financial advisors with commissions on specific products. In these cases, if the advisor is able to get their clients to invest in specific funds (or other applicable products), the fund sponsor will send them a nice commission. As such, the advisor might be tempted to advise his clients on assets that are not in their best interest.
In the language of the financial industry, this advisor would not be acting as a proper fiduciary. A fiduciary is anybody who offer financial advice and directs an investment for some kind of financial gain. As the Department of Labor defines it: “... a person is an investment advice fiduciary to the extent he or she renders investment advice for a fee or other compensation, direct or indirect, with respect to any moneys or other property of such plan, or has any authority or responsibility to do so.” Once a person has the legal status of a fiduciary, they are mandated to give advice that is in the best interest of the client. Advising the client to invest in a marked-up or unreliable investment can be a violation of fiduciary responsibility.
The Government Wants To Fix The Problem
The DOL is well aware of fiduciary lapses, and it’s getting ready to enforce legislation that will provide for more consumer transparency. PTE 2020-02, “Improving Investment Advice for Workers & Retirees” was adopted in December 2020. These rules seek to improve the financial advisor experience by introducing or reinforcing a number of fiduciary responsibilities. These include:
- A statement in writing that they are acting as a fiduciary
- Disclosure of conflicts-of-interest
- Limiting charges to “reasonable compensation”
- Avoiding misleading statements about any given investment or transaction
- Documenting specific reasons why a rollover was advised
- Advising in a way that is fully in the investor’s best interest
Enforcement has been scheduled for December 2021 in order to give financial advisors time to set up for proper compliance.
Implications For Self Directed IRAs
Financial advice is often associated with standard IRAs and 401(k)s. Consumers are usually less educated about the pros and cons of various financial products, and tend to rely on their advisor's recommendations to place their funds. This is different in a Self Directed IRA where investors trend towards assets that they understand. Many open a Self Directed IRA specifically to access these types of assets. However, that doesn’t mean that they’re impervious to bad financial advice.
When an investor uses a Self Directed IRA to purchase an alternative asset (e.g. property), they usually have a good sense of the real value of the asset and any risks involved. This is not the case when investing in a private placement. Many times the investor will not personally know the principals involved, nor the asset that is being acquired. This leaves investors open to heavy handed sales tactics or misrepresented assets. Whatever minimal oversight would be present from the SEC will be lacking due to the private nature of the transaction. In cases where the investment is being offered or promoted via a professional who has a fiduciary requirement, then the new government regulations can give the consumer a little more peace of mind.
In both cases, account holders should always research the proposed investments to the best of their abilities. This is especially true when a deal is markedly better than what is commonly available.
FAQ From the Department of Labor
The DOL published an extensive FAQ that includes many of the “common sense” questions an investor may have about the new rules. Here are some of the highlights:
- Commissions are still legal - Financial advisors can still receive payments or commissions for their advice. As long as the advice is deemed to be in the best interest of the client, advisors can render it even if they will be compensated for doing so. Advisors will only run afoul of the new regulations if it appears that their advice was influenced by a prospective payment.
- Full conflict disclosure - Disclosure of conflicts of interest have to be comprehensive and legitimately informative. This means that all conflicts of interest have to be reported, as well as any payment and compensation arrangements. This disclosure must be written in such a way so that the client will get a legitimate understanding of all the factors involved. Standard boilerplate in technical language will not satisfy the requirement.
- Analysis of investment worthiness – Financial advisors will no longer be able to just promote the benefits of the new asset. Rather, they have to give a detailed accounting of why it’s a more optimal choice. The factors to be considered include:
- Investment alternatives where status quo may be considered as the better choice.
- Comparison of fees between the current plan and the proposed IRA.
- Analysis of fee payments, i.e. those that an employer has been paying but will now be paid by the account holder.
- Different services or choice of assets between the two accounts.
Investing in Alternative Assets
As mentioned above, alternative assets lend themselves to a clientele who is more knowledgeable in that asset’s niche. If you already have an asset in mind, schedule a call with a Madison specialist today. You can find out more about the Self Directed IRA process and whether or not your proposed asset will work.
