The accounts discussed in this section are known as fiduciary accounts. A fiduciary is a third party overseeing another person’s assets. Fiduciaries must put their client’s interests before their own and act in their best interest. All of the accounts in this section share this characteristic in common.
Fiduciary accounts are governed by the Uniform Prudent Investor Act (UPIA), which requires fiduciaries to invest assets with a holistic (big picture) perspective. For example, assume you’re managing an account for a risk-averse investor. A few aggressive investments could exist in the portfolio as long as the overall structure reflected a conservative outlook. A fiduciary’s performance is not based on one or a few investments, but on the comprehensive output of the portfolios they construct.
We’ll discuss these fiduciary registrations in this section:
A discretionary account provides a financial professional with trading authority over an account. If you didn’t have the time or knowledge necessary to manage your own brokerage account, you could give your broker power of attorney (POA), which allows them to make investment decisions on your behalf. When a firm has POA over a customer’s account, they make investment decisions for them without prior customer approval.
In order for the firm and/or broker to make suitable decisions, customers must answer all suitability questions posed by the firm. If you recall, suitability questions (like net worth and annual income) are voluntary for customers to answer. However, if they are unanswered, the customer cannot be provided with recommendations. The same rule applies to discretionary accounts.
Discretionary accounts require added supervision due to the power they give financial professionals. If your broker has POA on your account, they have a lot of control over your financial assets. Therefore, all trades made on behalf of customers must be marked as ‘discretionary’ and must be reviewed more often by principals (supervisors). All discretionary trades must be reviewed promptly after being submitted.
A discretionary order is defined as one where the financial professional is making a decision on behalf of the customer pertaining to any of the following:
Asset: what security is being bought or sold
Action: if the security is being bought or sold
Amount: how many shares or units are being bought or sold
Many people remember this as the “AAA” rule. If the financial professional chooses the asset, action, or amount for a trade, the order is considered discretionary and requires a POA to be submitted.
Sometimes, financial professionals can make certain choices for customers and avoid the trade being considered discretionary. Both of the following can be decided without POA or discretionary status:
Price of the security
Time of the trade
Financial professionals can choose the price and/or time of a transaction without the trade being considered discretionary. Regardless, the trade must be completed within one day in order to maintain its non-discretionary status. If it takes more than one day to complete, the order reverts back to discretionary status and requires a POA.
Discretionary accounts are usually marketed to customers as “wrap” accounts. These accounts come with a list of services, which typically include asset management and general account maintenance. Instead of paying the firm for separate services and trade commissions, wrap accounts have all of their services “wrapped” up into one fee.
Wrap account fees are usually charged as asset under management (AUM) fees. For example, a customer with a $100,000 account would pay an annual fee of $1,000 if their wrap account fee was 1% of AUM.
Wrap accounts are considered investment advisory products and require financial professionals to be properly licensed as investment adviser representatives in order to sell them. This typically involves passing the Series 65 or Series 66 exams.
Custodial accounts are opened for minors under the age of 18. A custodian must open the account and manage the assets on behalf of the minor, but the assets in the account are the property of the minor. Custodians are typically parents, but technically can be anyone. Only one custodian and minor are allowed per custodial account.
If you want to open a custodial account for a child, all you need is their social security number (SSN), as all of the taxes are reported under the minor’s SSN. Reporting taxes under the minor’s SSN is a big benefit. Minors typically pay little or no taxes due to their lack of reportable income.
The two types of custodial accounts are UGMA (Uniform Gifts to Minors Act) and UTMA (Uniform Transfer to Minors Act), named after the laws that created them. The UGMA was the first version of a custodial account, which requires custodians to give control of the assets to the minor at the age of majority (usually 18 or 21 depending on the state). UTMAs were created later and allow custodians to delay the transfer of assets (up to the age of 25 depending on the state).
In addition to acting in their best interest, custodians cannot pursue some aggressive investment strategies in UGMA or UTMA accounts. In particular, short sales, margin, and some option strategies are forbidden in custodial accounts due to the risk involved.
All gifts made to a minor’s custodial account are irrevocable, and cannot be taken back. The custodian may only take withdrawals to spend money on items that will directly benefit the child*, or they may keep the assets in the account until they must be turned over at adulthood. Additionally, the assets in a custodial account can never be transferred to another beneficiary. Bottom line - as soon as the account receives a contribution, it’s the minor’s money!
*Withdrawals from custodial accounts may not be used for essential living expenses, which include food, clothing, and shelter. However, they may be spent on non-essential items that will directly benefit the child, including the cost of summer camp, a computer, a car, education expenses, etc.
When someone cannot manage their own finances, a court-mandated guardian may be appointed to oversee that person’s assets. Typically involving mental incapacitation or an inability to manage money, guardianship accounts are opened by financial firms when they receive proper court appointments. At that point, the account owner’s assets are placed into a guardianship account and can only be managed by the court-appointed guardian.
A trust account is a type of fiduciary account that is created for the benefit of a specific beneficiary. Trusts are legal entities and have many parties with varying responsibilities.
The grantor is the person responsible for creating and funding the trust. To create the trust, the grantor utilizes legal services in order to create a trust agreement. Within this agreement, the grantor specifies the objectives, management, and beneficiary of the trust. Trusts can have various objectives, which could include funding a child’s college education or taking care of an elderly parent.
The grantor names trustees in the trust agreement. Trustees manage the trust as fiduciaries according to the instructions provided by the grantor. When a trust account is opened with a brokerage firm, trustees have the power to trade and transact on the account.
The trust is managed for the sole benefit of its beneficiaries, which could be a person or an organization. Beneficiaries don’t have any legitimate power over the trust, as the trustees are in control. However, the trustees serve the trust and its beneficiaries.
Trust accounts are fiduciary accounts, but are not subject to the same suitability standards as normal fiduciary accounts. If the grantor specifies it in the trust agreement, trustees could pursue more risky investment strategies. Additionally, trust accounts can be opened as margin accounts as long as the trust agreement specifically allows it. When a trust account is opened, the brokerage firm requests the trust agreement to see if the account is eligible for margin.
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