With the value provided by good financial decision making and the impediments people face to achieve good financial outcomes for themselves, it is worthwhile discussing more about the advisory profession and understanding how advisors are paid, if for no other reason than in the interest of increased transparency.
Though the financial services profession is highly regulated at both the state and national levels, use of the terms “financial advisor” or “financial planner” as job titles is hardly regulated. Regulation generally focuses on the nature of business activities rather than job titles. Pretty much anyone can use these terms without any further oversight about training, competency, education, or qualifications.
Generally, those calling themselves financial planners or advisors represent one of three types: registered investment advisors, stock brokers, or insurance agents.
Of the three types, investment advisors are the only ones required to serve as fiduciaries for their clients, at least when they are wearing their “investment advisor” hat. The fiduciary standard of care requires investment advisors to act in the best interests of clients and disclose any material conflicts of interest to clients for the advice they provide.
Fiduciary advisors who serve only as fiduciary advisors are generally part of Registered Investment Advisor (RIA) firms, and they often use the term “fee only” to differentiate themselves from competitors. The National Association for Personal Financial Advisors (NAPFA) is the membership organization for fee-only advisors.
A fee-only advisor is paid directly and only by their clients, generally as a percentage of assets the advisor manages. That percentage generally decreases as the account size increases. Fees usually cover financial planning advice and investment management.
Some fee-only advisors may have different fee structures. Other possibilities include an hourly charge or fixed retainer fees for services. With other fee arrangements, the advisor is less likely to make trades on their client’s behalf. With such fee arrangements, the advisor makes investment recommendations but the client implements them.
The important point of this fee structure, and the meaning of “only” within the term “fee only,” is that these advisors are paid only by their clients. They do not receive any commissions or other financial incentives for getting their clients into any particular investments or financial products, which eliminates an obvious source of potential conflicts. A comprehensive financial planner should assist their clients with eight core planning areas: investments, taxes, debt management, education planning, retirement planning, estate planning, insurance, and household budgeting.
As you can see, there is much to do beyond just investment management.
Presently, the fiduciary standard of care is not applied to brokers or insurance agents, though proposals on Capitol Hill could change this policy. For instance, in April 2016 the Department of Labor enacted rules to strengthen requirements for those advising on retirement plans to serve as fiduciaries. These landmark rule changes could have big impacts over the coming years, since retirement plan assets represent a significant portion of the investment assets help by American households.
Brokers and insurance agents are currently treated generally as salespeople, and they are required to use a suitability standard of care with their customers. Any recommended financial products must be “suitable” for the purchaser’s situation, though the recommendations do not necessarily need to serve the best interests of the purchaser.
For those acting as brokers and insurance agents, their primary professional obligation is to their employer rather than their client. For instance, a suitable investment or insurance product that pays a higher commission to the broker or agent—presumably because it is a more profitable product for the employer—could be recommended under the suitability standard, even if another approach would better serve the customer’s interests.
Surveys of the public generally reveal that most people do not understand the distinctions between the fiduciary and suitability standards, nor do they understand the differences between investment advisors and brokers. Perhaps a simple example is the analogy of selling cars. When you go to a Honda dealership, you reasonably expect the salesperson to sell you a Honda. The salesperson will probably not suggest that you would be better served by heading over to an unaffiliated Ford dealership.
Consumers understand this about people who sell cars, but they often do not recognize that this same issue exists for brokers and agents. People naturally tend to believe financial advisors are independent and seek to work in their clients’ best interests, as they should.
A fiduciary investment advisor faces little to no conflict in directing client investments because his or her compensation is not tied to a specific product. They can essentially recommend you buy the most fitting car from any available car dealership, which is the treatment consumers generally expect from all advisors.
But brokers do not have this freedom; they are obligated to sell their sponsoring company’s financial products. If another dealership would fit your needs better, they would still encourage you to buy from them instead.
To make matters worse, low-cost products that can better serve consumers carry a lower commission, making them less desirable for brokers to sell. Products that are harder to sell because of their complexity may have reduced effectiveness for clients, but they tend to carry higher commissions in order to incentivize their sale. It’s like doctors providing prescriptions based on pharmaceutical company kickbacks rather than the patient’s health.
Many advisor websites make it difficult to understand how they are registered and what sort of standard of care they provide. It would be simple if we could just separate the advisors from the brokers, but a number of advisors are registered as investment advisors and brokers or agents.
Dual registration muddles the situation for clients further, as it may not always be clear when the advisor is wearing the hat of a fiduciary, and when they are making recommendations under suitability requirements. Because they can also receive commissions, such dually registered advisors should use the term “fee-based” to describe their firms, rather than “fee-only.” Clients could then have a clear understanding of when they are being served under the fiduciary or suitability standard.
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