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There Are 2 Crucial Questions to Ask When Interviewing a Financial Advisor:
1. What is your compensation model?
2. Under what type of business structure do you operate?
Why? Let’s start with Business Structures.
Types of Business Structures
Typically there are two business structures that we see in the financial advisor space.
1. Broker Dealers:
Typically larger companies or banks like TIAA, UBS, JP Morgan, Ameriprise, Northwestern Mutual, Goldman Sachs etc.
– In a broker dealer model, you pay the company or bank, who in turn pays an employee to provide you with “financial advice”. Why is this bad?
The company creates incentive structures that impact the advice the financial advisor gives you, the consumer. Typically we see these types of advisors pushing proprietary products that may not be the best fit for their clients, and may incur higher fees for the client. In exchange for pushing these products, the company will pay the advisor commission. This not only results in the client not being invested in securities that don’t make sense for their situation, but also limits the clients exposure to a full range of investment options. Many broker dealer companies may say that there is no upfront fee to manage your investments, but where they make their money is through fund expense fees and front load fees.
We have had several clients make the switch from broker dealers because they didn’t realize they were paying over 2% per quarter on their portfolios, significantly impacting long term returns and costing upwards of $20,000 per year on a $1 million portfolio. In addition to this, some of these investment products may have front load fees upwards of 5%. This means that when you invest, you are automatically charged 5% of the balance of your portfolio. On a million dollar portfolio, this is $50,000!
2. Registered Investment Advisor or RIA Firms:
Usually smaller investment firms that don’t have their own investment products.
RIA firms are typically a better option than the broker dealer model. RIA’s typically do not have their own investment products, so you won’t see many of the conflicts of interest that come with the broker dealer model. HOWEVER: there are still many RIA’s out there that will push products for broker dealers through a partnership. This is where compensation models come into play.
Knowing how your financial advisor is compensated is crucial. The compensation model can significantly affect the advice provided to you.
Types of Compensation Models
Generally, advisors fall into three categories: fee-only, fee-based, and commission-based. Each has its own set of implications for investors. Let’s dive in:
1. Commission-Based Financial Advisors
Commission-based advisors earn their money solely from the products they sell or from transactions they facilitate. This compensation structure can lead to significant conflicts of interest because the advisor’s income is directly tied to the purchase and sale of products. In such cases, the advisor may be incentivized to recommend more transactions or products that are not aligned with the client’s best interests but are rather aimed at generating higher commissions. Many of these advisors will not consider your situation at all, and may just place you in strictly the highest fee products they have, which in turn generates higher commissions for themselves.
Potential conflicts of interest:
- Often prioritize short-term, transactional relationships
- Income tied to purchases and sales
- May recommend unnecessary transactions or unsuitable products because it generates the advisor a higher commission
Consumers instinctively recognize the shortcomings of this model, as it typically benefits the advisor at the expense of the client. More recently, reflecting consumer dissatisfaction with being treated like sales targets, many traditional commission-based financial advisors began transitioning into what is known today as “fee-based” advising.
2. Fee-Based Financial Advisors
Don’t get tricked into thinking Fee-Based is the same as Fee-Only! Fee-based advisors are a hybrid model, receiving both fees paid by the client and commissions from selling products for financial institutions. While they can still offer quality advice, the potential for a conflict of interest is greater because their income may be supplemented by the financial products they sell.
Some RIAs may consider themselves Fee-Based, and even some broker dealers like Ameriprise and LPL do as well. This can lead to situations where the products recommended are not necessarily what’s best for the client, but what will garner the advisor a higher commission. How does this affect you? As a client you would typically be charged and investment management fee, but also be subject to higher fund expenses, which in turn generate higher commissions for the advisor.
Fee based advisors may offer services like investment management, financial planning, or ongoing advice (similar to fee only advisors), but will sell life insurance products, annuities, firm proprietary products, and mutual funds. In our opinion, the sale of these products compromises the other services they are providing and introduces a massive conflict of interest.
A Fee-Based advisor may tell you that they are held to a “suitability” standard. This means that investment products they recommend must be suitable for the client BUT do not need to be the best possible investment for a client. This is much different then the Fee-Only “Fiduciary” standard that we will get to later.
Potential conflicts of interest:
- May recommend products that generate higher commissions rather than what’s best for the client
- Incentivized to sell certain products or services that may not be in the client’s best interest
- Could prioritize fee-generating activities over non-revenue producing advice
- Might be less likely to recommend low-cost investment options
- May have divided loyalties between the client and the financial institutions they represent
In summary, we find Fee-Based to be deceptive to the average person looking for an advisor free of the conflicts of interest that come with making commissions. Thanks to the similar name to “Fee-Only”, many people think it is the same thing. We’re here to warn you that it is not.
3. Fee-Only Financial Advisors
Fee-only financial advisors are compensated exclusively by their clients and never earn commissions from selling products. The payment structure for fee-only financial advisors can vary; some may charge a flat fee, hourly rates, or a percentage of the assets under management.
The important thing to understand is that since the advisor is compensated solely by you, their allegiance lies entirely with you.
Fee-only advisors are held to a different standard than fee-based and commission based advisors. This standard is called the Fiduciary Standard. The fiduciary standard requires that the advisor put their clients’ interests first and foremost.
All recommendations made by a fee-only advisor have to be what’s best for you, the client. Fee-only advisors typically stay away from high-fee investments because there are almost zero scenarios that warrant a high fee annuity, mutual fund, or ETF being the absolute best option for a client.
Benefits:
- Aligned interests between advisor and client
- Recommendations based solely on client’s best interests
- Typically avoid high-fee investments
With a fee-only advisor you can rest assured that all recommendations, from investments to planning, are with your best interests first.
How to Confirm Your Advisor is Fee-Only:
Commission advisors can be easier to spot for most, but fee-based frequently gets confused with fee-only. There are a few easy ways to determine what type of advisor you are dealing with:
CHECK THE FIRMS ADV:
The Form ADV is a compliance document hosted by regulators that will explicitly list whether an advisor is fee-based or fee-only. It also includes the size of the practice, if they receive compensation in other ways, and whether the firm has had prior disciplinary actions brought against them.
CHECK FEE-ONLY PORTALS:
For sites like NAPFA, Garrett Planning Network, and XYPN, it is a requirement for an advisor to be fee-only to be a member.
ASK THE ADVISOR:
Anything other than a direct response should be considered a red flag. Fee-only advisors have no reason to be anything other than completely transparent. The choice between fee-only, fee-based, and commission-based financial advisors can significantly impact your financial planning and investment outcomes. At United Financial Planning Group, we pride ourselves on our Fee-Only structure that fosters trust and aligns our success with yours. By removing any potential conflicts of interest, we provide financial advice that is solely focused on what’s best for you, helping you to achieve your financial goals with confidence. Contact us today to learn more.