Normally in the shopping process, a customer will need to know how much a particular item or service costs. When shopping for a financial advisor, it is important to find out how they are paid along with how much. Leaving the dollars aside for a moment, you must also consider whether the compensation model keeps your best interests in mind. It sounds strange, but in the financial world, that is not always the case!
The term “financial advisor” is very broad. It can refer to a wide range of financial professionals, ranging from fee-only investment advisors to full-commission stockbrokers. To understand what type of advisor you will be working with, there are three important questions to ask before making a decision:
- Who Compensates The Advisor? – Do you pay it as a direct fee, is it paid by you indirectly through a portion of your investment funds, or is it paid by other parties such as investment companies, insurance firms, brokerages, and the like in the form of commissions? Are they independent or an employee of a company?
- What Services Are They Performing? – Does your advisor handle investment and financial planning, or just investment management? Does the total fee they are charging seem in line with the overall services they provide? Is the advisor a Certified Financial Planner (CFP), who can demand a higher fee?
- What Standard Are They Following? – You may think that all financial advisors are held to the same standards, but they are not. If they are held to a fiduciary standard, they are required to act in your best interests as an investor and disclose potential conflicts of interest.
However, if they are held to the lesser suitability standard, they are obligated to make recommendations deemed suitable to your circumstances as an investor. They are not required to put your best interests first, nor are they required to disclose potential conflicts of interest. Basically, they are selling financial products to you. That doesn't mean the product isn't right for you — but they aren't required to find the best fit for your circumstances.
With this background information, let's look at the three primary methods of compensation.
- Commission Sales – Financial Advisors on commission sales are generally compensated by sales of specific financial products or services. A cut of what you are paying for that product is directed back to the financial advisor, either a fixed amount or percentage. Virtually all commission sales follow the suitability standard, so the advice you receive is not necessarily unbiased.
Examples of commission sales fees are front-end load charges for mutual funds, deferred surrender charges on annuities, and flat fees or percentages of the sales price paid by the provider of a financial product.
- Fee-Only Sales – The advisor is paid only through client fees; there are no commissions. Fee-only advisers are more likely to adhere to the fiduciary standard. Because of this, and the fact that they are paid directly by you, you are more likely to receive unbiased advice in a fee-only situation.
The most common fee type is as a percentage of the value of your account, typically an annual fee from around 0.5-2.5% of your total account depending on the size of your account. Other potential fee-only methods are independent of your account size – hourly rates, monthly or quarterly retainers, or flat fees for specific projects such as designing a retirement plan for you to follow.
- Fee-Based Sales – Don't confuse fee-based with fee-only compensation. In fee-based compensation, the financial planner may be compensated through both fees and commissions. In this case, it is wise for you to fully understand how they receive their compensation, especially how much of their compensation is commission-based, to determine your comfort level that you are receiving unbiased advice.
Starting in 2017, new regulations will require financial advisors to act as "fiduciaries" and put their clients' interests first. Certain types of compensation that could cause a conflict of interest, such as higher commission on a more expensive fund, will no longer be allowed, unless the advisor qualifies for an exemption that keeps the customer protected.
Financial firms will be able to charge only "reasonable compensation". Their website must explain how their money is made and they will have to disclose any potential conflicts. Disclosures will, however, be simplifed by the regulations. Firms won't have to give performance projections for one, five- and ten-year time periods anymore. It is important to note that these rules do not apply to all investments – only tax-advantaged retirement accounts such as IRAs and 401(k) plans will be regulated.
While commission sales and the suitability standard increase the odds of receiving biased advice, there are many responsible commission-based financial advisors. Also, potential bias in advice does not correlate to the competence of the advisor. Just be aware of potential conflicts and incentives of your financial planner as you evaluate their value to you, and make sure you understand the details of their compensation to avoid surprises. As with any important financial decision, get everything in writing in a formal financial plan prepared by the advisor. If you are going to trust someone with your money, it is important to know how they make their money.