The Importance of a Fiduciary Standard of Care vs. Suitability

Financial Planning | Wealth Management

 Peter Lazaroff By: Peter Lazaroff

Today the Department of Labor released new rules regarding retirement savings advice.  We will post a more detailed analysis in the future, but today I want to explore the different standards in place and provide an initial reaction to the new rules.

Fiduciary vs. Suitability – What’s the Difference?

Most people don’t realize that there are two standards of care in the financial industry.

What is the Fiduciary Standard?

The fiduciary standard requires that an adviser put a client’s interest first.  The Securities and Exchange Commission (SEC) enforces this standard for Registered Investment Advisors such as Plancorp.

Fiduciary Standard of Care vs. Suitability

The suitability standard was created by brokers (also known as registered representatives) and is enforced through self-regulatory organizations called the National Association of Securities Dealers (NASD) and the Financial Industry Regulatory Authority (FINRA). Suitability requires that recommendations are “suitable” based on the client’s personal situation, but the standard does not require the advice be in the client’s best interest.

Imagine you need a new car, but you don’t know much about different options.  You head to the closest car dealer, which happens to be a Ford dealership.  The dealer asks you to describe what kind of car you need, and you begin to listing features and attributes that are best described as a Toyota Highlander.

Under the suitability standard, the dealer could say, “A Ford Explorer would meet all of your needs and we have some of those right over here.”  The dealer makes the sale and gets the commission.  You have a car that is suitable for your needs, but it isn’t necessarily what’s best for you.  Since you don’t have a great deal of knowledge about the auto market, you are in the dark.

Under the fiduciary standard of care, the dealer would be obligated to say, “It sounds like you are describing a Toyota Highlander.  We don’t sell those.  In order to get exactly what you described, you would have to go down the street to Toyota and ask for a Highlander.  I can sell you a similar model called a Ford Explorer, it’s more expensive and it isn’t exactly what you described.”  In this scenario, you have more information about your options and the conflicts driving the dealer.

The Ford dealer has a clear conflict of interest in this situation.  He can only sell Fords and will lose the opportunity to earn a commission if the client buys a Toyota Highlander.  Under the suitability standard, the client ends up with a product (Ford Explorer) that isn’t the best fit given their situation and it costs more than the better-fitting product (Toyota Highlander).  Worst of all, the client probably has no idea that they weren’t given advice that put their own interests first.

New Rules from the Department of Labor

Rules governing retirement investment advice haven’t changed since 1975, despite the dramatic shift away from defined benefit pension plans to consumer-controlled options such as an IRA or defined contribution plans such as a 401(k).  The new rules from the Department of Labor help address some conflicts of interest by requiring fiduciary standard of care when advising on retirement accounts.

There has been a negative response from Wall Street and the insurance industry, but this is a huge win for individual investors.  There will still be room for improvement within the broader finance industry, but these new rules will eliminate some bad practices and make it easier for investors to make a successful legal claim against adviser malfeasance.

The biggest downside is that brokers still won’t be required to exercise fiduciary standard of care on all types of accounts and there is a long implementation timeline that could allow for some pushback – firms will be required to acknowledge their fiduciary status by April 2017 and they have until January 2018 to comply with the rules.

For Plancorp clients, we don’t anticipate much change because we already act in a fiduciary capacity.  In fact, we were one of the first Registered Investment Advisors in the nation (and only firm in Missouri at that time) to earn the Investment Advisor Certification for Fiduciary Practices from the Center for Fiduciary Excellence (CEFEX).  You can view our CEFEX certificate here.

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Peter Lazaroff, Chief Investment Officer, first took an interest in investing when his grandmother gave him a single share of Nike stock for his 13th birthday. Today, nearly 20 years later, his investment insights are highly sought after by local and national media. More »