When Merely Being ‘Suitable’ is Not Enough

In past articles, I’ve addressed the importance of knowing whether your adviser really is a fiduciary, and why not all fiduciaries are created equal. Now, let’s explore another ERISA-based mystery: the so-called “Suitability Standard.”

Let me start by asking if merely meeting the standard of suitability — that is, providing financial products and services that are merely suitable for the customer — also meets the criteria for being a fiduciary, which holds that those same products and services put the customer’s best interests first.

Put another way: Is acting suitably a necessary, but perhaps not sufficient, condition for being a fiduciary?

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One Standard Bearer to Rule Them All

The difficulty in defining a “fiduciary” is in part due to regulatory requirements and in part legal judgments. That is, many of the rules that have come to define what being a fiduciary means have been written by or decided by lawyers, judges, regulators and politicians — and not always in consult with financial advice practitioners. This can often leave the clients of financial advisers in the unenviable position of trying to unpack a warren of argot and dusty legal precedent to determine if their adviser is, in fact, a true fiduciary and to which standard they will be held.

So, back to the “Suitability Standard.” First, we must realize that financial advisers, especially those regulated by ERISA and the Investment Advisors Act of 1940, in their dealings with retirement plans, are held to several additional standards. Not only the broad, summary “Fiduciary Standard” itself, but also the “Prudent Man” standard, the “Best Execution” standard, the “Best Interest” standard and the “Sole Interest” standard.

At their core, each of these standards is designed to protect consumers and ensure that all advisers ultimately act in some level of fiduciary capacity, with an elevated duty of loyalty and care. Put another way, each separate standard, when adhered to in combination, is meant to ensure that the result of any investment interaction with a financial adviser is in the client’s interest.

However, over time, these standards have become a nuanced way to interpret and manage the actions of different kinds of advisers. While some of these standards now apply to all advisers (e.g., any “Prudent Man”), certain types of firms (e.g., broker-dealers) are required to adhere only to a standard of suitability and not the more elevated “Best Interest” and fiduciary standards of true fiduciaries.

Hypothetical A: High Returns, Low Fees = Suitable? = Fiduciary?

Let’s look at a hypothetical sponsor retirement plan. The plan’s investment adviser is a broker-dealer, or affiliated with a broker-dealer, one who also has relationships with several mutual fund companies. It is likely that a) the adviser will put clients on that broker dealer’s platform for trading and custody purposes and b) the adviser will take advantage of their broker-dealer’s relationship with the mutual fund shops and provide those funds with priority (or even exclusivity) to their plan sponsor client’s investment lineups.

The end result of this action could mean that the plan sponsor client (and by extension plan participants) receives the cheapest market-available brokerage and custody alongside outsized returns for the lowest possible fee. In this scenario, although the adviser was clearly conflicted and incentivized to provide product and services in a certain way through their broker-dealer relationship, all worked out well.

In this scenario, the client would likely agree, as would most any jurist or regulator, that the adviser acted prudently, suitably and in the best interest of the client. In short, they were likely acting in a fiduciary capacity at some level — likely as a 3(21) fiduciary — so, it’s unlikely they would face any scrutiny about their conflicts or other potential concerns.

Hypothetical B: Average Returns, Higher Fees = Suitable? = Fiduciary?

Let’s now imagine another scenario in which the same broker-dealer affiliated adviser put the same client into the same mutual funds. The adviser also put a client on the same broker-dealer and custody platform. However, in this instance, a subsequent evaluation of these actions by a plan participant’s attorney noticed that the funds’ fees were higher than others of similar investment orientation, and that the funds’ returns were average against their peer group and benchmark. At the same time, the fees paid for custody and brokerage to the broker-dealer could have possibly been lower had the adviser engaged in a vendor request for proposal and selected the most competitive rate.

In this scenario, the adviser may have still acted prudently and suitably (i.e., they did not advise putting their client into complex derivatives or other obscure instruments that are ill-suited for retirement savings, nor did they violate anything set forth in the client’s investment policy statement), but it is highly questionable as to whether they acted in the client’s best interest.

Hypothetically, even if the funds did have a positive return (i.e., no one lost money and in fact gained some) better returns and/or lower fees were possible, and because the adviser was conflicted due to their broker-dealer affiliation, they may not have engaged in the broad due diligence a more independent adviser would likely have undertaken. That is, they did not act with the elevated duty of loyalty and care as required of a true fiduciary.

As such, it now may become a matter of law as to whether the adviser breached the fiduciary duty to the client.

Or does it?

Since the broker-dealer affiliated adviser is likely a 3(21) fiduciary, their obligation is to merely be “suitable,” and despite their conflicts, lesser returns and higher fees, they have met their burden to their client. In the event of a lawsuit alleging breach of fiduciary duty, the full burden would fall on the shoulders of the plan’s truest fiduciaries — the plan sponsor and its board.

So, Which Is It?

In Hypothetical B, a subsequent legal case (likely brought by a plan participant against the plan sponsor) and any damages awarded may hinge on the idea of the “Suitability Standard.” The Suitability Standard is part of the ERISA-governed fiduciary litmus test, and in any litigation or finding of fact, it is likely to be debated whether the adviser’s actions were “suitable” for their clients. This is often an ex-post-facto finding, as no one would claim unsuitability for 10% above benchmark and peer group returns with low fees. They would likely claim unsuitability if the result was the same as in our Hypothetical B scenario—average or below average relative returns, higher-than-usual fees, clear conflicts, etc. But again, a 3(21) broker-dealer affiliated adviser must only meet this suitability standard.

The question now becomes, did the adviser have a “reasonable basis” for believing that the recommendation of these mutual funds and this particular brokerage and custody platform met their client’s financial goals and other investment criteria? It may be that the adviser was simply following a playbook that says plan sponsor clients with X number of participants and $X of plan assets will get these certain securities in their investment lineup. No case against the adviser is likely possible, and again, the full burden falls to the plan sponsor and its board.

Now we come to the crux of the matter. In Hypothetical B, we have just found that our adviser is likely to have acted suitably and therefore carries little to no legal burden in any litigation from plan participants.

However, let’s extend our analysis to see if the same broker-dealer affiliated adviser did, in fact, breach the fiduciary standard to which a true 3(38) fiduciary would have been held.

If the adviser put the client into, say, high-yield bonds (i.e., junk bonds) or engaged in excessive trading, knowing full-well that this was prohibited by their client’s investment policy statement, this would add to a growing body of evidence that the adviser clearly breached their fiduciary duty.

However, in our more shades-of-gray scenario, it seems the adviser may have had a reasonable basis (i.e., a tried-and-test playbook formula that any other reasonable adviser would have also utilized) for putting their client into a set of mutual funds and brokerage platforms that matched their investment criteria — the funds simply didn’t perform relatively well, and the fees couldn’t be justified by outsized performance.

Yet, as we look deeper, we may find that the adviser was simply “lazy” and failed to perform proper diligence on other cheaper options that would have yielded similar results. It is rare that someone will be blamed for simple underperformance if the suitability standard is met, but couple underperformance with higher-than-usual fees and a lack of documented diligence relative to those fees and that is another kettle of fish altogether.

A further look may find something more insidious — that the adviser was not simply lazy, but rather incentivized to their own financial gain to place their client on their broker-dealers’ trading and custody platform while also providing mutual funds that paid them commissions or soft-dollar kickbacks. Not illegal, and perhaps not even imprudent or unsuitable, but certainly not in the “best interest” of their client, and certainly not adherent to the elevated duties set out to act as a fiduciary. But again, as a broker-dealer affiliated 3(21) fiduciary these additional burdens do not apply — the suitability standard was met.

What you are seeing here is the jigsaw puzzle and if/then set-piece logic that comes into play when determining a potential breach of fiduciary duty. And depending on whether your adviser is a 3(21) or true 3(38) fiduciary, there may be a series of additional complexities and contract clauses to consider. In our scenario, had a 3(38) fiduciary acted as our Hypothetical B adviser did, they would most certainly have been found in breach of their fiduciary duty.

The Bottom Line: How You Can Best Protect Yourself

There is only one true path to ensure that your adviser is acting in a way that is prudent, suitable and in your best interest. And that way is to work with a fee-only, independent and unconflicted true 3(38) fiduciary — especially those who obtain the Centre for Fiduciary Excellence, LLC (CEFEX) certification and thus adhere to its high-level of ongoing scrutiny. CEFEX is an independent certification organization that works closely with industry experts to provide comprehensive assessment programs to improve the fiduciary practices of investment stewards, advisers, recordkeepers, administrators and managers. For more information, please go to www.CEFEX.org.

Joseph F. Bert, CFP®, AIF®, the Founder of Certified Financial Group, Inc., has been in the financial planning profession since 1976. He is also President of Certified Advisory Corp. Joe is a CERTIFIED FINANCIAL PLANNERTM professional and a member of the Financial Planning Association where he served as its President and Chairman of the Central Florida Chapter.