Are Independent Financial Advisors Unbiased?
How to find a great independent financial advisor that will work for you
I practice as an independent financial advisor, and specifically as a fee-only advisor, which means I cannot receive commissions from the sale of insurance or investment products. Some independent financial advisors can collect fees and commissions, and will refer to themselves as "fee-based". Does either compensation model truly deliver unbiased advice? I'll be the first to tell you the answer is no.
Every compensation model in the financial services industry has some inherent flaw. Let’s look at how you pay an independent financial advisor, either fee-only or fee-based, and see if that may affect the advice they give.
The Illusion of Unbiased Advice with a Fee-only Advisor
First of all, what does fee-only mean? It means your independent financial advisor can only receive compensation directly from you for services delivered. They represent you. They can charge this fee as a flat fee for a project such as preparing a financial plan, an hourly rate, a percentage of assets they manage on your behalf, or as an annual or quarterly retainer fee.
The most common fee-only model is that of an advisor who charges a percentage of assets they manage. Let’s look at two examples where this could cause a potential conflict of interest.
1. Should you pay off your mortgage?
If you withdraw funds from an account your advisor manages to pay off your mortgage, they will make less.
Despite this, a good independent financial advisor will do a thorough analysis, and if it is in your best interest based on your income, assets, tax-rates and goals, they will recommend you liquidate investments to pay off your mortgage, regardless of how they are compensated.
In the heyday of strong market returns, I saw many advisors recommend their clients not only not pay off their mortgage, but take out an additional home equity loan specifically to invest the proceeds.
This is scary. Every advisor I saw recommending this strategy received some personal economic benefit when the client invested their funds. Most of these advisors, however, did not practice as independent fee-only advisors; they were more likely to be ones who received a commission from the product they were recommending.
Why would it be unlikely to see a fee-only advisor recommend this strategy despite the fact that it would make them more money? Because the stakes are higher if they recommend something that is not good for you. Legally they are liable for the advice they give and the advice must be deemed to be in your best interest. The same rules, unfortunately, do not as of yet apply to a commissioned advisor.
2. Should you buy an annuity?
Annuities offer some unique guarantees as you head into retirement. For those who have no sources of guaranteed income other than Social Security, allocating a portion of your investments to an annuity can make sense.
Unfortunately, most annuities are still commissioned products, so as a fee-only advisor I have had to do extra research to seek out no-load products (no load means they pay no commission and so the fees inside the product are lower) that offer guaranteed features for my clients.
Fee-only advisors as a group have been known to be biased against annuities, in some cases for good reasons, but in other cases, in my opinion, 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 be overcome. In the last few years, many new no-load annuity products have become available, and new research has validated the use of annuities in an appropriate amount, as part of an income distribution portfolio.
As a whole, I think independent fee-only advisors need to go through some re-education and take an objective look at how the right annuity products can add value in the retirement income phase of a client’s life.
An independent financial advisor that practices as fee-based, meaning they can charge fees and collect commissions, would have additional annuity products available to them and would receive a commission if you buy those products.
Once again, regardless of how they are compensated, a good independent financial advisor is going to present you with solutions that meet your goals and objectives. To be a good consumer, you need to be aware of how they are compensated and how that may affect their recommendations.
You also need to ask tough questions and look for straightforward answers. If someone discloses a potential conflict of interest in an upfront, straightforward way, that is a good sign.
What About Conflicts with the Hourly Model of Compensation?
Paying your financial advisor hourly can work well - if you will actually follow through on the advice they provide. Hourly advisors I have spoken with have expressed 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 recommendations.
In the past, I have offered hourly services, and have experienced this myself. I've watched people make expensive mistakes with their money that could be prevented if they had a more comprehensive relationship with a qualified independent financial advisor, but instead they only sought advice once in awhile, and much was missed.
Nevertheless, I think paying your advisor hourly in some circumstances makes sense. Hourly financial planning services can be great if you need help with a specific question or analysis, or even better if you define a more comprehensive relationship and are willing to pay for the hours necessary for the advisor to deliver holistic advice.
What about Conflicts with the Commission Model?
Paying your advisor commissions or through a broker-dealer or wirehouse still seems to me to be the model that inherently presents the most conflicts of interest. I worked as a financial advisor for one of the largest brokerage firms in the country, and from my experience, there was little in that culture that inspired you to do independent analysis and the right thing for your client. It was all about sales.
When I travel to conferences, the lack of knowledge by some of these advisors/brokers, some who even practice as independent fee-based advisors, astounds me. Like me, they got a securities license and were sent out to sell. Unlike me, some of them never furthered their education much beyond that point.
That being said, I think there are GREAT advisors under all compensation models, and I have met many. Finding them is the challenge.
Finding a Great Independent Financial Advisor
Starting with an independent financial advisor that practices as an RIA, or registered investment advisor, can help eliminate 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 unnecessary risks.
How can you find such an advisor? Here are some of the things I look for:
- Do they do planning or just sell product?
- Do they incorporate tax-planning into their advice?
- Do they have a thoughtful approach to investing or just drop their clients into automated programs provided by their firm?
- Do they understand the nuances of Social Security claiming strategies?
- Do they understand investing in the retirement distribution phase of one’s life is a completely different ball game than investing for accumulation?
What you must do is take your time when hiring a financial advisor. If you are working with an excellent and knowledgeable independent advisor, 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. Do you need a financial advisor?
I’d also recommend you read Who’s Watching Your Money: The 17 Paladin Principles for Selecting a Financial Advisor by Jack Waymire.