investments

 When seeking advice, most investors call a trusted financial advisor or stockbroker at their brokerage firm.  If this happens to be the same person, then investors should pay attention to the SEC’s new rule.

Beginning January 31, 2006, all U.S. brokerage firms that offer fee-based financial services must disclose whether an account is a brokerage or advisory account.   Furthermore, brokers must disclose if they are selling to or advising a client, what their income will be for the service, and the nature of the relationship on every communication to the client. 

This new rule is designed to reduce conflicts of interest between salespeople and advisors.  It’s a start, but stockbrokers and their advice remain fraught with conflicts. The roles and fees of these different professionals must now be clearly identified.  

The Differences in Brokers and Advisors

The problem is that most investors don’t know the difference between a broker and an investment advisor, and believe that both brokers and advisors have a responsibility to serve their best interest.  They expect brokers to offer sound advice and behave as fiduciaries (someone with objectivity who is ethically responsible for serving the client’s best interests).

In fact, with their income directly tied to sales, brokers will advise clients to purchase investments that are more profitable for the broker, and not necessarily in the best interest of the investor.  If enforced, the new rule will reduce, not eliminate, this conflict and help better protect consumers from unethical brokers and advisors.

The Consequences of Misplaced Trust

Prior to the January 31 rule, brokers could provide investment advice that was incidental to their sales role and receive special compensation for the advice.  Brokers could wear both hats because the SEC interpretation of its 1940 provision was confusing, especially after a 1999 SEC proposal that allowed brokerage firms to offer fee-based investment services without registering as investment advisors.

Enforcing the New Rule

Some brokerage firms complied with the new ruling by issuing statements that define the two roles and their firm’s obligation to avoid conflict of interest.  One national brokerage firm separated the two by requiring all financial advisors become independent Registered Investment Advisors (RIAs) who no longer sell investments. To define the problem more clearly, a broker-dealer holds its own inventory of securities. A broker buys and sells these securities as an agent for clients; a dealer trades this same inventory in the market - all “under one roof.” Conflicts abound!

The SEC is expected to do spot checks of the statements issued.  However, it is really in the hands of financial professionals to comply – and consumers to ask the right questions to protect themselves. As investors become more concerned about their families’ financial security and health, as well as focusing on their investments, they will understand that working with an objective fiduciary is very important.

In the future, the SEC could make additional changes.  The Financial Planning Association (FPA) believes the rule doesn’t go far enough to protect consumers from conflicts of interest and should include bankers, attorneys and CPAs who provide investment advice but are currently exempt from the rule. As a truly fee-only firm free from these conflicts, we at Kanaly concur.

How to Qualify Investment Advisors

With many different titles and professional designations in the financial planning world (RIA, CFP® Practitioner, ChFC, etc.), it can be confusing for investors to know who provides what services. Here are some things investors should know:

1. Advisors have a fiduciary duty to act in a client’s best interest.  Brokers are salespeople and are not impartial.

2. Advisors must describe how they conduct business and disclose any potential conflict of interest. 

3. Advisors cannot trade on behalf of their clients from their own brokerage house inventories, because they earn significant profits from these trades.

4. Advisors typically charge fees based on a percentage of managed assets.  They cannot accept referral fees or other compensation for a client’s business.  Brokers earn money from various compensation structures.

The government and the American people desire a stable securities market.  Better standards for all financial professionals are essential to improving client service.