Imagine that you were traveling somewhere in Asia, and you went shopping in a flea market. There, you come across a pair of Beats headphones on sale for only $70. The same model goes for $190 in Canada.
"Sweet!", you say to yourself. "I love Asia". You purchase the headphones and head back to your hotel room.
Once you're back, you try your new headphones on. But you notice that something's not quite right. The sound isn't as crisp as you would have expected from a Beats headphone. The material seems to irritate your skin as well.
So you take the headphones off and take a closer look, and then you notice something curious - the 'b' on the side of the headphone is actually a 'd'. Then you double check the box. To your dismay, you discover that it's spelled 'Deats'. Congratulations; you've been had.
Perhaps you feel tempted to wag your finger at the Asian government. Don't they know how poorly this reflects on them? Shouldn't they protect the consumers?
But before you take the moral high ground, there's something you should know. According to a former financial advisor named Larry Elford, the same practice goes on in Canada, in the financial planning industry.
In this article, I will explain what Elford and other like minded reformers are advocating in simple terms. Understanding the issue will also help you understand the motivations and the responsibilities of financial advisors.
Fiduciary Duty vs. Suitability
Elford's aforementioned article centers around two concepts, called 'fiduciary duty' and 'suitability'. Let me explain what they are.
Fiduciary duty is basically a commitment put the clients' best interest first. For example, lawyers have fiduciary duties to their clients, as do corporate directors for the companies they serve on.
Similarly, if a financial advisor owes a fiduciary duty to you, it means the advisor has to put your interest above his/her's. There's some vagueness of exactly what that means, but some suggest that advisors would have to disclose and seek your approval for any compensation they derive from advising you, including the various forms of commissions. It also means that if there's a mutual fund with high expense ratios that's expected to generate subpar returns but high commissions, an advisor under a fiduciary duty can't sell the fund to his/her clients.
Suitability, on the other hand, is a less stringent commitment. Under the suitability obligation, the advisor only has to make sure that whatever he/she sells to the client is consistent with the client's interests. The big distinction here is that the suitability obligation doesn't require the advisor to put the client's interests first. That means an advisor can sell the crappy mutual fund to his/her clients without breaking any rules.
To draw an analogy, Elford says that suitability is like edibility. A food isn't healthy just because it's edible. A financial advisor who only has to meet suitability requirements can serve the mutual fund equivalent of krispy kreme donuts.
The Law In Canada
Obviously, it would be better for the consumer if advisors owed a fiduciary duty to their clients. So is this the case in Canada?
Sort of. That's where the wordplay comes in.
According to the laws in Canada, anyone licensed as a financial adviser (note the 'e') owes a fiduciary duty to their clients. However, most financial advisors in Canada go by the designation advisor, which doesn't bind them to the fiduciary duty.
Instead, most financial advisors are categorized as "dealing representatives", which according to one of our national regulators is a salesperson. Dealing representatives only have to fulfill the suitability obligation that we talked about.
This fact allows a financial advisor to say, with a straight face, that financial advisers are obligated by law to have their clients' best interest at heart, and at the same time sell products that line their own pockets at the expense of the client. They will extol the virtues of Beats headphones while selling Deats.
You might wonder why the regulators let this happen. Officially, it's because some regulators have judged that the term "advisor" is distinct from the term "adviser". If don't see the logic in that, you're not alone.
Unfortunately, the reality is that the regulators maintain strong ties with banks and other financial services firms who derive much of their profits from selling high cost mutual funds. While I believe that regulators often do try to act on the consumer's best interest, they sometimes lose political battles with these firms. This is especially true when there's a lot at stake for these financial companies.
And when it comes to enforcing fiduciary duties on advisors, there's a lot at stake indeed.
Imagine a world where all financial advisors are bound by fiduciary duties. The financial planning industry will look very differently.
When an advisor recommends a fund and wants to sell it to you, the advisor will disclose exactly how much he/she would benefit from the sale, and only do so when you approve.
In this world, the advisor will never recommend mutual funds that charge high fees and expect to underperform the market. Instead, I suspect they'll sell a lot more index funds and ETFs.
However, in this world, advisors make a lot less for their firms, because A) some clients would feel uncomfortable paying high commissions, and B) because good funds will tend to have low expense ratios, which means less money for advisors as well.
Sounds like a better world, doesn't it? Unfortunately, I just don't see things turning around anytime soon. There's just too much vested interest to let that happen.
But that's not to say things will never change. I believe it can, if we decide to stand up for ourselves. One way we can do that is to join the likes of Larry Elford and actively demand change. But you can also help in a less public, but equally important way by educating yourself, and by educating your friends about the realities of the financial planning industry in Canada.
When we stop succumbing to the current advisors' practices, we will reduce profits made by these financial firms. With less at stake, this will reduce the firms' incentives for blocking change, and maybe, just maybe, it'll allow the regulators to push through meaningful change.