In theory, planners are expected to act as fiduciaries for their clients, meaning that a planner must put a client's best interests ahead of his or her own. In practice, no human being is truly capable of doing this because in the real world our ethics aren't pure.

Anyone's ethics can be shaped by financial gain. Keep in mind that Webster's dictionary defines ethics as "the discipline dealing with what is good and bad, and with moral duty and obligation."

THE ULTIMATUM GAME

Step outside financial planning for a moment and consider a game that involves ethics. In the Ultimatum Game, there are two players and an experimenter. Here's how it's played: The experimenter gives $10 to the first player, who decides how much of it to give to the second player. (The game is played only once, so reciprocation is not an issue.) The second player then decides whether to accept the amount given by the first player. If the second player accepts, the players keep the money and divide it as the first player proposed; if he rejects the offer, all $10 goes back to the experimenter.

In cases in which Player 1 offered only $2 to the second player, there were many instances in which Player 2 rejected the offer and all $10 went back to the experimenter. In that case, Player 2 decided that the amount shared by Player 1 was unfair and righted the wrong - by giving up $2.

Traditional economics predicts that since Player 2 would be enriched financially and therefore better off by accepting the proposal, he would always keep the $2. Yet this game demonstrates that if Player 2 feels Player 1 has acted in an unfair manner, he is willing to right the wrong by giving up the $2.

What if we raised the stakes a bit? Would behavior change? Say the game was played with $10 million and Player 1 shared the same 20%, amounting to $2 million. Though I wanted to try playing this game with 100 pairs of participants, I unfortunately found myself $1 billion short on funding. So I posted this question on the Bogleheads forum, a group of very smart investors. A full 91% said they would be more likely to accept the $2 million than they would be to accept $2 in the $10 game. Player 1 was just as unfair, keeping 80% of the money but, not surprisingly, Player 2 was not as willing to forgo $2 million to right this wrong.

In reviewing the results, Dan Ariely, a professor of behavioral economics at Duke University and the author of Predictably Irrational and The Upside of Irrationality, noted this is a trade-off between enforcing ethics and the degree to which one would benefit by letting morally offensive behavior go unchecked.

ULTIMATUM GAME LESSONS

I can attest that, as a planner, I would have accepted the $2 million if I were Player 2. This demonstrates that, like every other human being on the planet, my ethics aren't absolute.

Financial planners have many conflicts of interests with their clients, such as:

* Telling a client to pay off a mortgage will usually decrease our income even though it's often a risk-free attractive return for them.

* We may keep cash earning 0.05% for a client when there are alternatives earning 10 to 20 times this amount elsewhere.

* We review a client's decision to take a defined benefit payment vs. an annuity over time even though we nearly always benefit more by telling a client to take the money now.

Before you start sending me hate mail, keep in mind that planners are no different than any other profession. There is an inherent conflict of interest any time money changes hands.

Take dentists, for example. In an interview on NPR, Ariely discussed a study comparing dentists' examination of X-rays for cavities. The study showed that dentists examining the same X-rays were likely to find cavities, but in different teeth from one another. Naturally, dentists benefit financially by filling cavities.

Not surprisingly, this did not endear Ariely to the dental community. Soon after, Ariely says, dentists were calling him and saying he was an idiot and didn't deserve to have a position as a professor.

Ariely notes: "I don't think that dentists are particularly evil, selfish or greedy, just that [much like the rest of us] when they face conflicts of interest they are likely to see the world in a distorted way. They are likely to look, and find, problems for which the treatments are more lucrative."

The only thing that surprised me about this study was how surprised people seemed to be with the results. Steven Levitt, a co-author of Freakonomics, found that real estate agents were likely to sell their own homes for a higher price than their clients' homes because they received a larger benefit. If you see a surgeon, her economic incentive is to operate. A lawyer benefits by telling you your case is good and you should sue.

Meir Statman, a finance professor at Santa Clara University and author of What Investors Really Want, says that conflicts of interests are inevitable. Statman noted that people in many countries are cynical, assuming a negative correlation between wealth and virtue. Americans, however, believe that they can be both superwealthy and A+ virtuous. In truth, few of us earn an A+ in virtue. Many more of us are guilty of grade inflation.

DEALING WITH CONFLICTS

Ariely and Statman both state that the first step in dealing with conflicts of interest is to recognize their existence. Statman explains the dilemma in what he called the "annuiscide" example. Say you manage a $1 million portfolio for a client, charging him 1%, and that it makes sense for your client to buy an immediate annuity with a quarter of this portfolio. You may make an upfront commission when she purchases that $250,000 annuity, but you then earn $2,500 a year less from that client.

Financial Planning Association Chairman Martin Kurtz says when it comes to the issue of conflicts between planners and clients, it's critical to disclose any potential conflicts to clients.

Yet Ariely says several studies have shown that, when professionals disclose their conflicts of interest, this only makes the problem worse. This is because two things happen after disclosure: Those hearing the disclosure don't entirely know what to make of it and the discloser feels morally liberated to act even more in his self-interest and to disregard what's in the public good.

Kurtz notes the inherent conflicts in the assets under management model. He observes that "AUM is a huge step forward from where we came from, but it's not where we need to be as a profession." His firm switched to a fee model based on net worth and income from an AUM model in order to reduce the inherent conflicts.

Ariely suggested planners think about the advice they would give if only a small amount of money were involved. Applying this to the issue of the mortgage would go something like this: If it would cost you $2 to tell the client to pay off that $200,000 mortgage, would you tell her to do it? In actuality, with a fee of 1% of AUM, you'd be giving up $2,000 a year.

Rules of practice for planners could also be useful, according to Statman. In the practice of medicine, physician protocols standardize the tests and treatments of patients with certain symptoms and previous test results, alleviating some conflicts between physicians and patients. Statman noted the same could be done for financial planners.

Harvard economics professor David Laibson suggested that all planners imagine they were the subject of a New York Times story on ethics in financial planning. As planners make decisions for clients, they can keep this imaginary story in mind and ask themselves if they would be proud of the piece.

Ariely, Laibson, Statman and Kurtz all note that an independent third-party review of planners could help clients receive more objective advice. Kurtz says he hopes that someday planners would have peer reviews as a routine part of their practice. Laibson suggests those reviews could be conducted on a random basis. For example, every third year an audit takes place where 10 clients are selected randomly for third-party review. Michael Shaw, managing director of professional standards and legal at the CFP Board, says it is "certainly an idea worth having continuing discussions about."

The word fiduciary is used often to describe our relationship with our clients. But planners cannot hope to reach this lofty standard without addressing the many conflicts all planners have with clients. Every fee model, including mine, which is hourly based, has conflicts of interests with clients. I try to keep them in the forefront of my mind every day.

Kurtz recommends that planners create a list of conflicts they have with clients. If you can't think of any, Kurtz notes, you should be concerned that you may be putting your interests ahead of your clients'.

Statman suggests a good exercise is for planners to grade themselves on their own ethics. If you give yourself a B+ or lower, it means you are aware of your client's best interests and thinking of them far more than those that gave themselves an A+. And that's good for clients. FP

Allan S. Roth, founder of the planning firm Wealth Logic in Colorado Springs, Colo., writes the Irrational Investor column for CBS MoneyWatch.com and is an adjunct faculty member at Colorado College and the University of Denver.