The Evolution of the Financial Fiduciary

There is a lot of discussion about who is a fiduciary and who should be a fiduciary. At the core of the discussion is protecting investors from deceptive sales practices that damage their ability to accumulate and preserve assets for their future use.

I think a little perspective is in order about how the financial fiduciary industry got started. I was there.

The Soft Dollar Era

Back in the 1970’s and early 80’s I worked in the institutional consulting group for AG Becker that became Warburg Paribas Becker. We provided services to trustees for pension assets that included performance measurement, manager selection, and portfolio analytics. Back then we were paid with soft dollars from transactions that were produced by the firms that managed the institutions’ assets. Trustees considered us a free service.

In the late 1970’s Becker made the decision to convert from soft dollars to hard dollars. The deregulation of commissions and the advent of the discount broker made it increasingly difficult to produce profits from soft dollars. Profits were even tougher to produce in down markets when money managers moved large amounts of their clients’ assets to cash.

Transition to Hard Dollars

By the early 1980s I worked for a money management firm that wholesaled its services through wirehouses and regional broker/dealers. We were paid a fee for our services. The B/Ds and their reps were still paid with soft dollars.

EF Hutton asked the money managers on its platform to attend a meeting that introduced asset-based fees and wrap fees. Hutton announced it was no longer going to be compensated with commissions from trading securities. Hutton was going to apply an institutional compensation model to retail assets.

Hutton also introduced the first bundled (wrap) fee. Neither announcement caused any serious angst from the money managers. How Hutton was compensated did not impact them. There was some consternation when Hutton announced it would collect the wrap fee from investor accounts and pay the money managers. The managers did not like loss of control over billing and collections. Future revelations about Hutton business practices gave credence to their concerns.

Assets Under Management

This was the genesis of a slow transition to an AUM/RIA/IAR business model for firms and professionals who were willing to make the transition from soft dollar salesmen to hard dollar advisors. There were four compelling reasons why this model motivated thousands of advisors to change their business practices.

  1. The value of continuous, asset-based revenue was substantially higher than transaction based revenue. A fee-based business might sell for two or three times revenue. A transaction-based business might sell for .25 times revenue. AUM facilitated comfortable retirements.
  2. In the commission world, on January 1st brokers started the year with zero revenue on the books. They had client relationships, but they had to generate sales to create new revenue. A successful asset-based fee advisor might have $1 million of revenue (1% of $100 million dollars) on the books at the beginning of the year.
  3. Reinvested income, contributions, and appreciation grew assets without any sales effort. Advisors could focus on helping clients achieve their financial goals. Their incomes went up with the market.
  4. Advisors liked the stability. Money managers were accountable for performance. Advisors could retain relationships with clients by recommending the termination of under-performing managers. They were no longer part of the problem. They were part of the solution.

The Rise of the Fiduciary

Anyone who provides financial advice and services for a fee must be registered as an RIA or IAR. And, by law, RIAs and IARs are fiduciaries who are held to the highest ethical standard in the financial service industry.

The regulations made it pretty clear that if a rep sold products for commissions he would be held to lower ethical standards. After all, he was just a salesman and investors should not expect much from him. The relationship between sales and lower ethical standards was compromised when reps determined they could make more money calling themselves planners or advisors. Unfortunately, Wall Street benefitted from this misleading business practice.

On the other hand, real advisors provided financial advice and ongoing services. There is supposed to be a big difference between sales recommendations and financial advice. Recommendations are a riskier form of financial advice. On the other hand, fee-for-service advice from RIAs and IARs was supposed to protect investors.

Protecting Investors

At the core of the fiduciary code is doing what is best for investors. Their interests are supposed to come first. But, as you may have noticed, doing what was best for investors was not what motivated firms and advisors to transition to hard dollar compensation models that were based on AUM. It was about doing what was best for them.

This type of thinking still dominates the way financial advice and services are sold. Advisors have to make a living. They want to maximize the future value of their business. And, perhaps most onerous, some advisors use their fiduciary status as a differentiating characteristic. They have turned it into a marketing tool.

Doing what is best for investors is still missing in action. New regulations and standards may be coming, but they may be so watered down that they provide minimal protection for investors. And, keeping it real, any new regulations will not protect investors anyway because there is no effective way to enforce the regulations. Or, said differently, there is no effective enforcement that Wall Street will accept.

After 35 years, the treatment of investors will still be based on the personal code of ethics of individual  financial advisors.

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