Financial Term-a-palooza

As I’ve written in previous blog posts, the financial industry is full of confusing concepts, terms and acronyms. This week’s post is about a number of those terms that many people don’t fully understand. As with any terms or conditions focused around your hard earned money, understanding them is of critical importance.

Custody / Custodian – A “custodian” has “custody” of your investments. This one isn’t too difficult to grasp. A Custodian has “physical” possession of your assets, and is tasked with the duty of caring for them. This does not include selecting the stocks, bonds or mutual funds that make up your portfolio but does include making sure you get a statement, and ensuring your account balance on paper matches what you have in your account. Think of the custodian as the keeper of a vault that contains your assets. They are on the hook for protecting what’s in the vault.

The most common custodians have names most people recognize and include Vanguard, Fidelity, Schwab and Ameritrade to name a few. They also include some lesser advertised names including Shareholder Services of America, Trust Company of America and Trade PMR.

A certain Mr. Madoff was a “custodian” and had “custody” of his client’s funds … see why this is an important concept to fully grasp?

Discretionary Authority – Discretion / Non-Discretion – This one is a bit trickier to follow, but it is one of the most important concepts for you to comprehend.

Using the vault analogy from our custodian example:

  • Anyone who has discretionary authority has the power (authority) to add or remove items from the vault (your portfolio) without consulting you (discretion) beforehand. Typically used by financial planners (who must act in your best interest) within the mutually agreed on parameters of your Investment Policy Statement.
  • Anyone with non-discretionary authority has the same power (authority) to add or remove items from the vault but must sell you the item by obtaining your permission (non-discretion) first. Typically used by an “Advisor/Broker” (financial product sales people) and are required by law to use non-discretionary authority. You wouldn’t want a salesperson to have full run of your vault would you? It might be a pretty slick way to make a ton of commissions, wouldn’t you agree?

So to summarize the differences:

  • Discretionary already has your permission to add or remove from the vault (based on the limitations in the Investment Policy Statement)
  • Non-discretionary requires your permission (as they are making a sale) prior to adding or removing from the vault

Authority (access) is granted by adding the person to your account by filling out a form generally provided by your custodian. The options selected on that form determine the amount of access a person has and what they can or can’t do within your account. Generally the forms are called a Power of Attorney, Limited Power of Attorney, Trading Authorization, or Limited Trading Authorization. Some of the custodians use one form and others use multiple forms.

The key thing to understand is the difference between “full powers” and “limited powers”.

  • Full power of attorney gives the person the authorization to buy or sell securities, add or remove funds, issue checks from the account (including to themselves). In other words they can do everything in the account that you can.
  • A limited power of attorney limits what specific items a person can perform on your behalf. Generally, you will be able to grant permission to buy or sell securities (and then further define as discretionary or non-discretionary), move funds from one account to another (but not withdraw funds), issue checks (but only in your name and not their own), and receive a copy of your statements issued by the custodian. In some cases you can also just limit the access to the account to view only and not give the power to perform any transactions.

Investment Policy Statement – (IPS) – Typically used by a financial planner in combination with discretionary limited power of attorney to access your portfolio accounts. The purpose of an IPS is to define and constrain the types of transactions the planner is allowed to make on your behalf. The IPS is written specific to your situation, and must be suitable to your circumstances. It also defines your investment time horizon, risk tolerance, investment objectives, tax situation, liquidity needs, asset allocations, performance measurements, legal considerations and any special circumstances. This is mutually created and agreed upon long before any transactions take place in your account, and should be reviewed periodically.

As always, be sure to consult with your financial planning and legal professionals to determine which options are best for your specific needs.