Ethical Issues For Financial Advisors

Honest financial planners can face real dilemmas when trying to do the right thing for their clients. There are some common dilemmas investment professionals may face as well as guidance on how you can overcome them.

Ethical Issues Today

A generation ago, both the tax code and the financial products and services available were simpler than they are today. For example, if someone wanted to buy stock, a stockbroker would place the trade. If someone needed permanent life coverage, a whole life policy was issued.

Today, planners must decide if this traditional approach is better or whether the client would be better off buying any number of the diverse other products available. Likewise, a client who is put into a universal variable life policy may have actually been better off in whole life. The complexity of the financial sector has given individuals greater opportunities to make better decisions. It has also severely increased the risk for misguidance.

The problem extends to investments. Putting clients in suitable portfolios means evaluating and sticking with a client’s risk tolerance and investment time horizon. A 70-year-old client starting out their retirement journey should be advised to invest differently than a 21-year-old trying to build a career and family.

Advisors have the difficult task of balancing their incentives with the needs of their clients. Perhaps there is an S&P 500 index fund that pays a load to brokers to sell it to clients. At the same time, there are several no-load S&P 500 funds as well as low-cost ETFs that will provide the same market exposure for less cost to the client – even if that means the advisor gets paid far less. The client’s needs must be put first.

The modern product maze means that every financial planner faces an ethical dilemma when trying to do the right thing for a client.

Ethical Standards for Professional Advisors

In light of these quandaries, the Certified Financial Planner Board of Standards has issued a substantial revision and upgrade of the ethical requirements for its designation holders. This includes the fiduciary requirement of 2007:

• All financial planning services must be accorded the care of a true fiduciary, as opposed to merely acting in the client’s best interest. This also constitutes a major step up in terms of responsibility, as fiduciaries have a strict set of rules and guidelines that must be followed at all times. For clients, this means that their planners are held to a higher legal standard of care than before.
• The CFP Board breaks down the fiduciary standard of care, highlighting how investment advisors and broker-dealers were held to different standards before: “It is important to recognize that a financial recommendation that is ‘suitable’ for a client (as legally required for broker-dealers) may or may not be a financial recommendation that is in the client’s best interest (as legally required for investment advisers).”

The CFP designation is not the only one to define ethical standards for their members to follow. Licenses CFAs also must learn and uphold a set of ethical standards, and the Financial Industry Regulation Authority (FINRA) also outlines prohibited practices.

Fees vs. Commissions

Regardless of what legal or moral standard they are held to, one of the biggest ethical dilemmas planners face is choosing a method of compensation. The methods of compensation for both sales-driven practitioners and planners are often interchangeable since each can charge either fees or commissions for their services. However, this flexibility can often present a moral dilemma for planners who must choose one method of compensation over another.

A fee-based planner—one who charges clients based on a percentage of their assets—will increase his or her compensation simply by making the client’s assets grow. If the planner charges the client a fee of 1% of assets under management, then the annual fee collected from a $100,000 portfolio will be $1,000. Therefore, if the planner is able to make the portfolio grow to $150,000, his or her compensation will increase accordingly. This type of compensation could motivate the planner to employ more aggressive investment strategies than would a traditional commission-based broker.

Another risk with fee-based planners is the incentive to not help those who may need it the most. Financial advisors have a fiduciary responsibility to uphold their industry. If incentivized to only accept the clients with the highest portfolios, advisors face the dilemma of turning away clients with low portfolio balances – potentially individuals needing the most financial guidance.

A commission-based planner, on the other hand, is compensated for each transaction, regardless of portfolio gains or losses. These brokers face the temptation to use transactions as a means of revenue even if they manage to avoid the technical definition of “churning.” It may be in the best interest of an advisor to execute a trade but not the investor.

The ethical dilemma of collecting commissions on portfolios that lost value can be argued either way. Some advisors can state that potential losses could have been larger had they not provided financial guidance. Others point to the ebb and flow of financial markets over time. There is inherent risk in advisors collecting fees on portfolios that lose money as the ultimate goal of is help the client achieve financial independence by increasing their net worth.

In this sense, each type of compensation presents its own set of ethical issues. Ultimately, planners must be willing to subordinate their own benefit to that of their clients, regardless of what business model is used. Take for example a planner that can work on either an hourly fee or a commission basis.

If the planner meets with a client that has $2 million earmarked for retirement, then charging by the hour would result in a total fee of perhaps $5,000—on the very high end. On the other hand, choosing to charge the client a commission-based fee for investing the $2 million in a variable annuity could pay as much as a 7% commission, which would earn the planner $140,000. This extreme variance in compensation could easily sway even the most stalwart planner. The key thing to remember is that you must act in the best interests of your client, not your wallet.

Sales vs. Advice

The boundaries between sales and advice in the financial industry are becoming increasingly blurred, as new platforms and methods of doing business continue to emerge. What this usually boils down to is getting clients to do the right thing for the right reason.

Many clients will base their financial decisions on emotions rather than what their planner advises. Suppose a 60-year-old woman has her entire savings of $100,000 in certificates of deposit (CD), and is terrified of risking her principal. If she lives for another 25 years, her savings will likely be depleted long before she dies, since these low-risk investments pay a tiny rate of return that will be offset by inflation over time.

The challenge is there is no defined set of rules that complies with every single need of all investors. The demand for growth, liquidity, and risk avoidance vary across individuals and investment products. As a plethora of options may fit a client’s needs, an advisor must begin by assessing what will help their client achieve their investment goals.

As a planner, you obviously need to get your client to diversify her holdings with a sensible asset allocation or at least to consider some sort of immediate annuity option. But how far should you go in encouraging the woman above to do this? Is it okay for you to use aggressive, fear-based sales tactics, or even bend the truth a little, in order to help this client? After all, it clearly is in her best interest to do this. Besides, if no action is taken, you could be held legally liable for failure to provide adequate advice.

In this case, the definition of “fear-based” sales tactics is also somewhat subjective. If the planner shows the client a graphic illustration revealing how she will be bankrupt in less than 10 years, is that using fear as a tactic, or is it merely a revelation of reality? The argument can be made that it is both at once.

Luckily, planners do have help in these types of situations. If a client refuses to take your advice, you can present them with a written disclaimer stating that the client or prospect has refused to follow the recommendations presented by the planner. If your 60-year-old client wants to stick to her CDs and she’s signed this disclaimer, then you are in the clear.

In addition, there is substantial historical and transparent data to support financial advisor recommendations. Though past performance does not guarantee future success, enough number-crunching will arrive at a logical plan of action that can be presented to clients. The truth may hurt – especially if it is found that your client is well behind their financial goals. However, suggestions supported by valid information support your position.

Problems With the System

The fact is that there is no central ethical resource that is available for all types of financial planners. Commission-based brokers can consult their supervisors or compliance departments on certain matters, but they are likely to get “corporate” answers to many of their questions—answers that may allow the planner to create a profitable transaction without incurring liability but may not address what is truly best for the client.

CFP practitioners may consult the CFP Board with ethical questions, and other accredited planners may have ethical codes of conduct to refer to as well. Yet non-credentialed planners are essentially on their own for all practical purposes, as the rules imposed by the regulatory agencies are not designed to address many day-to-day issues that planners face as part of their jobs.

The Bottom Line

Despite the onslaught of legislation and regulations aimed at curbing unethical practices (such as the Sarbanes-Oxley Act of 2002), financial planning in today’s world depends more than ever on understanding a client’s individual situation and objectives and being willing to do the right thing for them. The correct application of ethics in modern financial planning essentially boils down to having the client understand exactly what they are doing, and why, with full knowledge of the costs and risks involved.

An ethical transaction occurs when a client truly understands the ramifications of the advisor’s recommendations and is willing to go forward, assuming that all pertinent laws and regulations are being obeyed. After all is said and done, ethics can still be viewed as simply knowing what the right thing to do is and then doing it.