“There’s plenty of opportunity out there for someone who’s unethical,” warns Harold Evensky, chairman of wealth manager Evensky & Katz. That’s especially true when that someone is a financial adviser, he says, so investors need to carefully select whom to trust. What some advisers do may not be criminal, but it’s still unethical because it’s not in clients’ best interests.
Here are three ways financial advisers might act unethically while staying within what the law allows — and how to avoid them.
1. Not disclosing what their obligations are
Before you hire an adviser, determine what his obligations to you are. Your adviser needs to clearly spell out not just what he’ll do for you, but how he’ll act. You should know whether he’s legally supposed to make decisions that are “suitable” for you or choices that are in your best interest, known as acting as a fiduciary. “Most individual investors don’t know the difference,” says Teresa Verges, director of the Investor Rights Clinic at the University of Miami School of Law.
There’s a key difference between the suitability standard and the fiduciary standard: Brokers, who may call themselves financial advisers and are often paid by asset management companies, have only a duty to put clients into a suitable investment, not necessarily the cheapest or best investment. Advisers bound by the more rigorous fiduciary standard, however, must put the client’s interest first.
What you can do: Find a fiduciary who operates on a fee-only basis. In this case, you — and you only — pay an adviser to work in your best interest.
2. Engaging in ‘reverse churning’
Some brokers might engage in what’s called reverse churning. In this practice, a broker puts clients into a fee-based account and then charges a continuing fee for little actual advice.
Fee-based accounts aren’t necessarily bad, but they can be a poor fit for many clients. For example, buy-and-hold investors generate few fees for the broker, because they purchase investments infrequently and never sell. So the broker moves them into a fee-based account to charge more.
“We’re probably going to see an uptick in this,” Verges says. Increasing pressure on brokers due to recent legal changes, notably the Department of Labor Fiduciary Rule, has leveled the industry’s commissions structure, making it more difficult for brokers to profit. So some brokers have been pushing fee-based accounts.
What you can do: Reverse churning can be hard to detect. Fee-based accounts are perfectly appropriate for some clients, but not for those who don’t need advice or who don’t trade a lot. So know your own goals and what you’re paying for before hiring the adviser or broker. If you can’t get a straight answer, walk away.
3. Pushing complex contracts that are not fully explained
The confusing legalese of financial products is perfect for hiding traps and huge commissions.
While some products, such as mutual funds, are straightforward, others, such as annuities and various types of insurance, can be unnecessarily complicated. Key questions — when and how you as the client get paid, and when you don’t — need to be answered clearly.
However, one important question often isn’t asked: How much is the product issuer paying the adviser? The adviser may be taking as much as 10% of the investment as a commission, an egregious level. For stock funds, the best advisers can point you to products that have no commissions.
What you can do: Keep asking questions. If a complex financial product is right for you, an ethical adviser will explain it completely so that you understand the contract.
If you’re buying any financial product, ask how the adviser is being paid. But remember, just because a fee is disclosed doesn’t make it acceptable.
Final things you can do
A human adviser might not be the right move for every investor. Robo advisers can be a good alternative for managing your portfolio, but that choice depends on your needs. If you opt for a human adviser, remember:
There are plenty of great advisers who are committed to doing right by their clients. Find them.
Get tangible evidence of the adviser’s duty to you. Verges says: “Ask, ‘Are you a fiduciary?’ If clients can get it in writing, even better.”
Consumers should investigate advisers through the Investment Adviser Public Disclosure website’s database of advisers, sponsored by the U.S. Securities and Exchange Commission. Advisers should be licensed and registered, and have few complaints against them.