Independent financial advisors are in the business to help you manage your money, or to help you make more, but let's face it: they're also using your money to help them make more money too. There are a few ways advisors can be paid, based on their license and practice. Some, called "fee-based," collect fees and commissions based on the money they handle. Others, called fee-only," are not allowed to receive commissions from the selling products, and must charge in other ways. Does either payment model truly promise unbiased advice? The answer is no.
The truth is, every compensation model in the financial services industry has flaws. Let’s look at how you pay an independent financial advisor, whether fee-only or fee-based, and see if that may affect the advice they give.
- Fee-only financial advisors do not receive commissions from the products they sell or recommend.
- Fee-only financial advisors may charge a flat fee, by the hour, or a percent of the assets they manage on your behalf.
- To find an experienced, knowledgeable financial advisor, ask questions about their approach to planning.
The Illusion of Unbiased Advice
First of all, what does fee-only mean? It means your advisor can only receive payment direct from you for services they provide. They work for you. They can charge this fee as a flat fee for a project, such as helping you prepare a financial plan. Or they can charge an hourly rate, a percent of assets they manage on your behalf, or as a retainer fee for a set time, such as by year or by quarter.
The most common fee-only model is that of an advisor who charges a percent of assets they manage. Let’s look at two cases where this might cause a conflict of interest.
Example No. 1: Should You Pay off Your Mortgage?
Let's say your advisor has set up an account to help you pay off your mortgage. The greater the funds in this account, the greater the cash assets they have to work with. If you withdraw funds from the account, they stand to make less. Despite this fact, a good and honest advisor will conduct a thorough analysis, and will make a recommendation to best suit your bottom line. They should assess the full scope of your current finances and more: your income, assets, tax-rates, and goals. Here, if they decide it would be best to liquidate your investments to pay off your mortgage, they'll say so, even though it means one of their income sources will suffer.
In the heyday of strong market returns, many advisors told their clients not only not pay off their home loans, but to take out an extra home equity loan on top of that, just to invest the proceeds. This is scary. Advisors using this tactic received some personal benefit when the client invested their funds. It's worth noting that most of these advisors did not practice as fee-only; they were more likely to be ones who received a commission from the product they were touting.
It would it be rare to see a fee-only advisor suggest this strategy, despite the fact that it would make them more money. Why? Because the stakes are higher if they suggest something that is not good for you. By law they are liable for the advice they give, and the advice must be deemed to be in your best interest.
The same rules do not as of yet apply to an advisor who works on commission.
Example No. 2: Should You Buy an Annuity?
Annuities can offer some unique perks as you head into retirement. For those who have no sure sources of income other than Social Security, putting aside a portion of your investment budget to buy an annuity can make sense.
Most annuities are still commissioned products. A fee-only advisor has to do extra research to seek out no-load products that offer income features for their clients.
"No-load" products are those that pay no commission, and so the fees inside the product are lower for the buyer.
Fee-only advisors as a group have been known to be biased against annuities. In some cases this is for good reason, but in other cases, the bias comes because if the client pulls their money out of a managed account (on which the advisor charges a fee) and puts it into an annuity, the advisor will make less money. This bias needs to change. In the last few years, many new no-load annuity products have made their way to the market, and new research has backed up the use of annuities, in a prudent amount, as a smart part of an income portfolio.
The right annuity products can add value in the retirement income phase of a client’s life, and as a whole, fee-only advisors could use some fresh insight. Fee-based advisors, for instance, often have annuity products on hand to offer their clients, and fee-only advisors could do the same, with other payment models.
The Hourly Model
Paying your advisor by the hour can work well if you can follow through on the advice they provide. Hourly advisors have been known to express frustration that they give their clients a list of actions to take, and when they meet with them again, the client did not follow through on any of the action items.
As a whole, people can prevent making costly mistakes with their money if they had more frequent meetings with their advisors. Instead, they tend to seek advice only once in a while, or when things are dire, and much is missed.
Still, paying your advisor hourly in some cases makes sense. Hourly financial planning services can be great if you need help with a specific question or analysis. It also makes sense to pay by the hour if you are seeking a more holistic approach and are willing to pay for the time it takes for the advisor to offer well rounded advice.
The Commission Model
Paying your advisor commissions or through a broker-dealer still seems to be the model that presents the most conflicts. Indeed, there is little in the banking culture that inspires advisors to do independent analysis and the right thing for clients—it's all about sales.
The role of a broker is not to give advice, but to sell. In the past, they were bound to loose standards to protect their clients, but this varies by state, and laws are in flux. Still, you cannot assume they have a fiduciary duty to act in your best interest, as advisors do.
There can be a lack of knowledge among some of these advisors and brokers, even those who practice as fee-based. Like all other advisors, they got a securities license and were sent out to sell. Some of them never sought further education much beyond that point. That being said, there are great advisors under all payment models, and finding them is the challenge.
Finding Your Financial Advisor
Starting with an advisor that practices as an RIA, or registered investment advisor, can help protect against some potential conflicts of interest, but of course not all of them. The real focus should be on finding a competent, experienced, knowledgeable advisor that cares about you, and who will not expose you to needless risks.
Questions to Ask a Financial Advisor
How can you find such an advisor? Here are some things to look for:
- Do they offer a full range of planning or do they simply sell a product?
- Do they include tax planning in their advice?
- Do they have a thoughtful approach to investing, or do they just drop their clients into template programs set up by their firm?
- Are they mindful of the nuances of claiming Social Security?
- Do they know how to invest in the retirement phase of one’s life in a distinct manner from how they invest for earnings?
The Bottom Line
Once again, no matter how they are paid, a good independent financial advisor is going to present you with honest advice and options that meet your goals. To be a good consumer, you need to be aware of how they are paid, and how that model may affect their advice. You also need to ask tough questions and look for real answers. If they reveal a potential conflict of interest in an upfront, honest way, that is a good sign. You must also take your time in the hiring process. If you are working with a solid advisor who can be trusted, it doesn’t matter how you pay them. If you are working with an unethical or inexperienced advisor, it won’t matter how you pay them either.