We talked a bit in our last post about the importance of understanding how the firm that is managing your money is regulated and how it makes money. For those of you that zoned out a bit with the technical jargon, let me try to simplify this a bit since this is of critical importance when looking for someone to help you manage your money. Let me illustrate the difference in the Suitability Standard and the Fiduciary Standard using a much simpler product: men’s suits.
Imagine that I need to buy a new suit and there are two men’s clothing stores at my local mall – Goldman Suits and Fiduciary Suits. Goldman Suits operates under the suitability standard and Fiduciary Suits operates under the fiduciary standard. I have $500 to spend, and my measurements indicate the best fitting suit for me is a 42 Long.
The danger of the suitability standard becomes evident when Goldman Suits has a surplus of 56 Long suits. They got a great deal on them and, as a result, will make a $200 profit on each one sold. They will make only $20 if they sell me the best fitting suit for me – a 42 Long. Would they legally be allowed to sell me a 56 Long under the suitability standard? Sure. Under the suitability standard they are not required to find the best-fitting suit for me, only one that is, well, “suitable.”
Goldman Suits could definitely make the case that the 56 Long suited me. It covers my body. It protects me from the elements. It keeps me warm. Unfortunately, it looks terrible on me and, by any reasonable standard, is certainly not the best fitting suit for me. The good news for Goldman Suits is that the suitability standard allows them to legally sell me the 56 Long that makes them $200 versus the best-fitting suit that would only make them $20. Good news for Goldman Suits, bad news for me.
Across the mall is Fiduciary Suits, a men’s clothing store that works under a fiduciary standard. They are required to put my interest first and do what is best for me. Because they understand that incentives drive behavior, Fiduciary Suits wants to create an environment that is most conducive to people abiding by the fiduciary standard and doing what is best for me, the client.
To create this fiduciary friendly environment, Fiduciary Suits gets paid the same no matter what suit I buy. No hidden markup. They charge a simple fee for helping me find the right suit. They tell me ahead of time exactly how much it will cost me to have them help me find the right suit. If I have $500 to spend on a suit, they make the same amount of money no matter which $500 suit I buy. They are not incented to sell me a suit from any particular manufacturer or a suit of a particular size or color or fabric type. Unlike Goldman Suits, Fiduciary Suits is not only legally required to help me find the best fitting suit for me, they have no incentive to do anything other than that. So you don’t have to wonder, why are they selling me this suit?
Sadly, the overwhelming majority of the financial industry works under the suitability standard and has incentive plans that are not designed to encourage advisors and brokers to do what is best for you. The good news is that there are financial services firms out there that operate like Fiduciary Suits. A great place to get more information on this unique breed of financial advisors is www.NAPFA.org.
If you don’t know what standard the firm you are working with is operating under, or fully understand all the ways the firm makes money, you may be buying your suits at Goldman Suits.