What Is a Conflict of Interest?
Conflicts of interest are a common issue in the financial advisor industry. Learn what they are and how you can spot them in this article.
When you work with a financial advisor, you’re placing an immense amount of trust in them to help you make the best decisions. But what if they don’t have your best interest in mind, even if they’re supposed to? As a client, it’s important to know how to spot potential conflicts of interest so you can avoid poor suggestions or unethical professionals.
In this article, you’ll learn what a conflict of interest means in the world of finance, as well as how to protect yourself from them. This includes breaking down common examples, fee-only vs. fee-based advisors, and how you can spot bad professionals.
Understanding Conflicts of Interest
A conflict of interest can occur in many different relationships, such as those with a boss, attorney, coworker, or financial advisor. No matter the scenario, this concept means that one person’s interests aren’t in line with the other’s. For example, imagine a situation where your boss hires a close friend, even if they’re not qualified to do the job. This is a prime instance because they have a biased reason to employ their friend beyond what would apply to other applicants.
In the financial advice industry, conflicts of interest arise when a professional has priorities other than your success and prosperity in mind, such as earning a commission. Tyler Meyer, a CFP and the founder of Retire to Abundance, explains that, from his perspective, the concept comes about “when the client’s interests are not perfectly aligned, a reality that persists across various business models in the financial industry.” Essentially, when a professional and a client don’t have the same goals or values in mind, there’s likely a conflict of interest.
Rules and Regulations for Conflict of Interest
Typically, financial advisors must adhere to strict regulations regarding conflicts of interest if they’re part of a registered investment advisor (RIA) firm with the SEC. RIAs are bound by a fiduciary duty, meaning they must always act with the client’s best interest in mind. This disqualifies these types of firms or their representatives from recommending investments for their own benefit.
Broker-dealers are another type of firm you may encounter. These are firms or professionals that register with the SEC and FINRA. They specialize in trading securities on your behalf in exchange for a commission.
Unlike RIAs, broker-dealers follow the less-strict suitability standard and the regulatory best interest rule (RBI). The former requires a broker to only suggest investments that are “suitable” for the client based on their risk tolerance, time horizon, and goals. With the latter, a firm must prioritize investments that are in a client’s best interest over those that may generate more revenue.
Regulatory bodies like the SEC and FINRA are essential to protect clients, but they may not always stop conflicts of interest from happening. Meyer explains that “those bodies play a crucial role in setting training standards and information requirements”; however, “the sheer volume of information can be overwhelming for clients.” In this way, it’s also important that the advisor industry’s “clientele” be as informed as possible.
Common Examples of Conflict of Interest
As mentioned earlier, a conflict of interest occurs when a financial advisor’s priorities stray to those that benefit themselves, rather than the client. This can take on many forms, such as when a professional collects a commission from a trade. Below are the most common examples you should watch out for:
- Commission-based portfolio management. When an advisor can earn a commission for products they recommend, this may be a conflict of interest.
- Excessive trading. Advisors can generate fees by constantly executing trades with your account. This may be a conflict because they benefit from such costs.
- In-house products/investments. At times, large firms will have in-house products/investments, such as mutual funds. An advisor may be more inclined to steer you toward such products to generate revenue for the company, creating a conflict of interest.
- Solicitation arrangements. This refers to a situation where an advisor can earn higher commissions from a company in exchange for pushing its products on clients. Naturally, this would give a professional an unethical incentive to recommend these to their clients, resulting in a conflict of interest.
Keep in mind that this isn’t an exhaustive list of the possible conflicts of interest an advisor may have. It does, however, list several ones that may commonly occur. As a client, you should be on the lookout for unethical behavior from your advisor at all times and never be afraid to ask questions.
Why Fee Structure Matters
Your advisor’s fee structure can either create or eliminate a potential conflict of interest. The two core types are fee-only and fee-based. The former charges you a flat rate for an expert’s time or services, whereas the latter may require you to pay a combination of fixed fees and commissions.
Fee-only structures minimize conflict of interest because the advisor only benefits from flat rates for their services. Dominic Murray, CEO and financial advisor at Cameron James, says his firm uses “fixed fee structures, as they are transparent and not linked to the sale of specific financial products.”
While fee-only structures are often ideal for removing conflicts, Meyer says he tends to “advocate for a fee-based model” because it allows a professional to charge “fees for investment products while retaining the capability to offer insurance products.” However, he says that he believes “any commissions on investment products should be avoided.”
When you have your initial consultation with your advisor, be sure to pay close attention to the fee structure they use. If they employ a fee-based model, be sure you know why that is and how they expect you to pay for each service. Otherwise, you may miss what could be a conflict of interest.
How to Avoid Bad Financial Advisors
When you hire a financial advisor, you’re likely going to be working with them for several years or even decades to come. For this reason, you’ll want to do your best to avoid professionals with potential conflicts of interest or ethical concerns. Here are some ways you can do so:
- Ask questions. It’s always a good idea to ask a prospective financial advisor about how they do business. This includes details regarding their fee structure, services, and any disclosures you should be aware of.
- Know what services they provide. What your advisor offers can help you identify any red flags. For instance, if they’re keen on selling specific products or investments, they may not have your best interest in mind.
- Check their disclosure history. RIAs and broker-dealers must report legal actions as disclosures. You can access these for firms and individuals via FINRA’s BrokerCheck or the SEC’s Investment Adviser Public Disclosure (IAPD) search tool.
- Read reviews/check references. What others say is a powerful indicator of a firm’s quality. Before working with an advisor, it’s worth going online to see how people rate them. You may also request references from them, which you can speak with to verify their expertise and trustworthiness.
- Don’t rush into working with them. The first consultation with an advisor can go a long way toward you deciding to hire them, but it shouldn’t be the only factor. Be sure you do your research on the above factors before making your decision. Rushing into hiring an advisor could cause you to miss red flags.
During your search for an advisor, we recommend you prioritize a fiduciary. These professionals must always act in your best interest and adhere to strict regulatory standards. To find one, you can a free matching tool, such as this one. After filling out a brief quiz about your current financial situation and goals, it’ll connect you with up to three vetted experts near you.
Frequently Asked Questions
Can a fiduciary have a conflict of interest?
A fiduciary must always prioritize your best interest, but even they are susceptible to potential conflict of interest. For example, if an advisor works for a large corporation, they may be more likely to recommend products or investments that their firm offers, such as an index fund.
What are common red flags in a financial advisor?
Financial advisors should be as transparent as possible at all times. If they attempt to rush you into making decisions, hide information, or fail to communicate potential conflicts of interest, you should avoid them. Moreover, if they try to aggressively sell you products or investments, this is a red flag that they’re more in it for their benefit than your own.
When should a financial advisor disclose a conflict of interest?
Advisors should always disclose any potential conflicts of interest to new and existing clients. They need to make you aware of issues that may arise. Additionally, the SEC requires RIAs to do so in adherence to the fiduciary standard.
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