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Trust, but verify. The Russians (and famously, Ronald Reagan) were onto something with that adage, particularly when it comes to looking for a financial advisor.
The Department of Labor’s new fiduciary rule, which requires all financial advisers to put their clients’ interests first when working with retirement savings, means that new protections are coming soon for investors. But holding the financial services industry to a higher standard, a fiduciary standard, doesn’t automatically ensure every adviser is competent or trustworthy.
Consider the case of perhaps the most well known financial criminal in recent history: Bernie Madoff. While Madoff was a broker for much of his career, he registered as an investment adviser two years before his massive fraud became public. During that time, he was legally obligated to work in his clients’ best interests. But as we know all too well, that didn’t occur. At the end of the day, no amount of regulation or legislation will stop a criminal.
That’s why it’s still essential for investors to do their homework and investigate every professional they hire to help with their financial wellbeing. Think of it this way: You wouldn’t leave your child with a stranger without first gaining at least a basic knowledge of their background, right? So why risk your financial future with a complete stranger?
Red Flag #1: They're Not Actually Licensed
The first step is to look up your adviser on BrokerCheck, which houses public records for brokers and and links to those of registered investment advisers. The report shows investors an advisers’ employment history, years in the industry and any misconduct that might have occurred.
“The best and most important advice that we can give to investors is to take that first step of checking out their broker,” says Gerri Walsh, head of investor education at the Financial Industry Regulatory Authority. “No matter what role the adviser or investment professional plays, you’ll find them in BrokerCheck if they’re licensed.”
The keyword is licensed. A quick Google search will show you at least a dozen cases in the last year where unlicensed financial advisers swindled millions from unsuspecting victims. Every year, the Department of Justice nabs scores of individuals for working as unlicensed financial advisers. Financial regulators, including FINRA and the Securities and Exchange Commission, have also stepped up their enforcement in the area of unregistered advisers.
Red Flag #2: They've Been Cited For Misconduct
Once you’ve confirmed an adviser is legit, check whether there are any so-called “disclosure events” on his or her record. Like a student’s permanent record, these are instances where an adviser’s conduct may have fallen short. This can include investigations by state or federal regulators, sanctions, past customer complaints, judgments against the adviser, bankruptcies and personal liens.
While the vast majority of advisers have clean records, a recent academic study found that about 7% of brokers registered with FINRA have some misconduct on their record. More alarming, the research showed that those with at least one instance of misconduct are five times more likely to engage in it in the future compared to the average financial adviser.
“If you see any evidence that FINRA or securities regulators conducted some sort of disciplinary action and imposed some sort of penalty that is a big old red flag,” says at Hugh Berkson, a principle attorney with McCarthy, Lebit, Crystal & Liffman and the current president of the Public Investors Arbitration Bar Association.
Pay particular attention to any complaints around specific products, Berkson says. If the write-ups describe sales conduct involving products that the adviser is now trying to pitch you, that’s a red flag. “You are going to be victim number whatever in all likelihood,” he adds.
Any and all disclosure events should be investigated thoroughly, but it’s important to keep in mind that having a disclosure event listed doesn’t necessarily mean the adviser is a bad bet. Walsh says sometimes an adviser’s record will list a complaint that is resolved in favor of the broker, or include a personal bankruptcy that took place because of unexpected medical costs.
“It’s important to look beyond the surface of disclosure,” Walsh says. “Disclosure encompasses a lot of concepts.” This can even include mishaps like failing to file a form within a certain number of days. Although it's not common, it does happen and shows up the same way as a disclosure for being sanctioned.
The timeframe of the event is also key. Beware of unexpected market occurrences. The auction rate securities market froze up in 2008, for instance, leading to a wide swath of consumer complaints that are still making their way through arbitration.
“It’s really a question of the investors’ coming to know the disclosure, understanding it, and determining if it’s relevant to their decision,” says FINRA spokesman Ray Pellecchia.
Red Flag #3: They Jump From Job To Job
A BrokerCheck report also lists an adviser’s employment history; another way investors get a better understanding of a potential adviser. In recent years, FINRA has taken a hard look at advisers who move through a series of employers with shady histories.
“If you see someone jumping from firm to firm in a short period of time, like five firms in five years, that should be a red flag that you at least investigate further,” Walsh says.
The firm’s history is important too. It’s a good idea to take a look at how long the firm has been in business and what its history looks like. “If a firm has been around for a relatively short period of time, only for a couple of years or less than a decade, and has a substantial number of complaints or sanctions against it as a firm, that might be something you want to take into consideration.”
Red Flag #4: They're In Trouble with Outside Agencies
While BrokerCheck is a good first step, checking out an adviser on the site is often not enough to get a good understanding of their entire history. If they've been investigated by a state security regulator or involved in an ongoing criminal case, their BrokerCheck report may not show these incidents until the case is wrapped up.
“Imagine the central records database being a really deep well. BrokerCheck is like only throwing the bucket down two feet and showing you what’s at the top of this 40-foot well,” Berkson says. “It’s not complete, you’re not getting the full picture.”
To get a more in-depth look at an adviser, it may mean getting in contact with your state securities regulator. But Berkson notes that these agencies only carry information on the advisers registered in that particular state and some even charge as much as $100 for these reports.
In those cases, a thorough Internet search may work better, Walsh says. Many state and federal agencies will issue a press release when they bring charges against an adviser. Additionally, there may also be local newspaper reports on these types of events that can provide additional context. Some advisors even appear on review sites like Yelp. Keep in mind that like restaurants, reviews of financial advisers can be very subjective.
And if you do find issues, don’t be afraid to ask the adviser to explain them. “If you see the flop sweat start, probably not a good sign,” Berkson says.
Red Flag #5: They're Pitching Suspicious Products
Investing strategies could indicate red flag. Pay attention to how the adviser is looking to invest your money. It’s not impolite to ask what the strategy offered is costing you, especially when it comes to fees and the cost of certain products.
Some advisers could have a real incentive to maximize their income. Look carefully at any strategy that involves a lot trading, as that could be a sign an adviser is looking to produce income, rather than long-term results. Or if they’re pushing a lot of alternative products, private placements, non-traded real estate investment trust, or variable annuities—that could be a red flag.
“These are products that produce a lot more income than a mutual fund portfolio would,” Berkson says. “Typically, the higher the return they’re promising you, the higher the risk. Ask yourself how easy that money is going to be replace if you lose it.”
Even mutual fund strategies can have pitfalls. “Going in at $42,000 across six different mutual fund companies—essentially getting the same funds offered by each family, that could be a way of maximizing the compensation for the adviser.”
“It’s cliché, but if your broker or investment adviser is offering you something that sounds too good to be true, your antennae should be up and wiggling as hard as you can wiggle it,” Berkson says.