by Jack Waymire
A 2011 survey of 7,800 investors by Cerulli Associates revealed that 33 percent did not know how they paid for the investment advice they receive, and 31 percent said they thought their financial advisor provided investment advice for free. That means that nearly two-thirds of investors did not really understand how their financial advisors were compensated.
Why do most financial advisors hide their compensation from investors? The answers may surprise you.
How is Your Financial Advisor Compensated?
In general, there are two ways financial advisors get paid:
- Commissions – The source is a broker-dealer or a third-party product company.
- Fees – An asset-based fee (present of assets), fixed fee or hourly fee.
Most advisors charge asset-based fees for investment services and fixed or hourly fees for financial planning services. Some advisors provide investment advice and services for fixed fees.
Let’s examine commission-based advisors first.
Commission-based advisors have a great sales pitch. They will “consult” with you “free of charge,” create a financial plan at “no cost” and recommend a product “solution” for which you “won’t pay anything” unless you decide to buy. Even then, you “won’t have to pay anything out-of-pocket when you purchase the product.” What’s not to like?
But you’re smart enough to know that there are no free lunches, so you ask the advisor, “How do you get paid?” to which he or she might answer, “My firm pays me or a third party pays me.” A third party might be a mutual fund or insurance company that produces the products that were sold to you by the advisor.
Free advice sound attractive, but the devil is in the details.
What You Don’t Know Will Probably Hurt You
Because the commission-based advisor is not paid directly by you, but rather by their firm or a third party, you will never know how much the advisor was paid for the sale and you won’t know how much the firm or third-party provider earned. While you may not feel worse off for not knowing – after all, “it didn’t cost you anything” – your lack of knowledge will cost you a lot more than you know. And the less you know, the more vulnerable you are to slick sales tactics and “free” offers that aren’t really free. In fact, the product companies mark up their fees to cover the expense of paying commissions to your advisor. You may unknowingly pay higher fees for several years or for as long as you keep the product.
The problem is not necessarily the commission, or sales charges, because some of that front-end compensation to the advisor must be disclosed to the client at some point. The real problem is transparency and the way commission-based advisors, and the firm they work for, get compensated on the back end, which is where the bigger conflicts occur.
The crux of the problem in commission-based sales is that, ultimately, advisors work for the companies that pay them. They are your advisor, but they are paid by a third party. At the end of the day, it is naïve to believe your interests are being served by a financial advisor who is paid undisclosed amounts of money by third parties.
Advisors who charge annual fees are paid directly by their clients, which makes them accountable only to their clients. The fee compensates the advisor for working with his or her clients to develop an investment plan, implement the plan and then manage the investments under the plan according to the clients’ objectives.
Advisors who charge fees are regulated by the Securities and Exchange Commission (SEC). They work for Registered Investment Advisors (RIAs) who must adhere to strict fiduciary standards that require them to put their clients’ interests first. In addition, RIAs are required to fully disclose up front all forms of compensation they receive in their interactions with their clients.
Contrast that with commission-based advisors, who are not required to put their clients’ interests first and are not required to fully disclose how they and their firms are compensated. It marks a clear distinction between a true advisor, who is paid specifically to dispense unbiased, conflict-free advice, and a salesperson, who is paid to sell investment and insurance products.
A Note About ‘Hybrid’ Advisors
There is a third class of professionals known as “hybrid” advisors because they wear two hats. Some RIAs charge fees for advice, so they must adhere to the fiduciary standard. They then turn around and offer investment products for which they are paid commissions, which presents a potential conflict of interest.
You should be aware that these types of advisors exist. They work for fees and commissions based on the needs of the investor.
It’s All About Transparency
From the clients’ perspective, it all comes down to transparency. The essence of the client-advisor relationship is full disclosure by advisors so investors can make informed decisions. In reality, the more information the advisor has to hide, the less transparent that advisor will be. The advisor is concerned that full transparency could interfere with the sale.
At issue is the level of trust you can expect to have in your advisor. It’s very telling that, of the investors surveyed in the study referenced above, of those who did not understand how their advisors were compensated, nearly half were unhappy with their current advisors.
Having a clear understanding of precisely how your advisor is compensated is critical in knowing whose interests are being served. When looking for a financial advisor or reviewing your relationship with your current advisor, always ask the advisor to disclose in writing how he or she is compensated and by whom. RIAs must provide their clients with a Form ADV, which is their registration with the SEC disclosing exactly how they are compensated.
One way to know if you are working with a fee-only advisor or a commission-based advisor is to ask for their Form ADV. If he or she is unable or unwilling to provide one, you know you are working with a commissioned-based advisor.
All of this information has been verified and listed on an advisor’s profile that is in the Paladin Registry. To research an advisor by name, click here. To search an advisor by area, click here. To find the best, vetted financial advisor for you, click here.
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