The Problem(s) with Financial Advice
There’s an old saying, “Opinions are like _______, everyone has one, and they all stink.” Financial advice is usually an informed opinion, but it can be fraught with problems. Chief among the potential pitfalls are the definition of advisor, compensation models, and conflicts of interest. If you’re thinking about getting financial advice, you’ll want to know about these three issues so you can make sure your interests come first.
What is a Financial Advisor?
This should be an easy answer—a person that gives financial advice, right? Sure, but what if any person that likes to touch your skin was allowed to be called a dermatologist? To get that discoloration evaluated, you might want to see some credentials so that you don’t get misdiagnosed by a hobbyist posing as a skin doctor. Unfortunately, while there are several entities that regulate the financial services industry, none has thrown down with a definition of “Financial Advisor” that defines licensing, education, ethics, oversight, supervision, etc. for people that call themselves financial advisors.
Instead, we as potential clients have to sift through titles like Financial Coach, Financial Advisor, Financial Adviser, Broker, Broker/Dealer, Investment Advisor (Representative) or IAR, Registered Investment Advisor (RIA), Financial Planner, Certified Financial Planner® (CFP®), Chartered Financial Analyst (CFA), Certified Public Accountant (CPA), Personal Financial Specialist (PFS), Chartered Financial Consultant (ChFC), Chartered Life Underwriter (CLU), Enrolled Agent (EA), and the list goes on.
No single body bestows the myriad titles that allow someone to call themselves a financial advisor. Many entities such as FINRA, the SEC, the CFP® Board, the IRS, and individual state regulators govern who can earn what title, how to keep the title in good standing, and how to sanction bad actors. If this is confusing, or even so boring that you’re wondering why you’re still reading… welcome to the majority!
While advice about whether to use the Roth or Traditional TSP in a given year based a one-off income event and the need to prepare for military retirement while transitioning to the airlines might be fairly specialized advice, general advice like “avoid debt and save” might not need special training to dole out. Depending on your financial advisor’s company policies, she may only be able to give advice on certain topics. That could a blessing if it keeps the advisor in their lane, but might not be helpful if you need more comprehensive, integrated advice. Either way, how do you know if your advisor is qualified to give you the advice you’re getting?
Now that we’re sufficiently confused about who’s sitting across the table, let’s consider how they’re getting paid.
Commissions—If an advisor sells things such as life insurance policies, annuities, stocks, bonds, mutual funds, etc., s/he very likely receives a commission for each sale. Commissions can be fixed, such as $25 for a stock trade, or a percentage like 5% of insurance premiums for the first 5 years or both.
Referral Fees—Many in the industry pay sources for referrals. This can also be a flat fee or a percentage.
Incentives—A firm may offer its sales teams a bonus for selling a certain type of product. This could be in addition to other compensation on the same transaction.
Hourly—While less common, some financial advisors may charge an hourly rate like an attorney or accountant for financial services.
Flat-fee/subscription—Another option is to charge a client a flat-fee for a yearly contract with defined services. This is getting more common and may also be called a retainer model.
Assets Under Management (AUM)—For a long time, charging a percentage of AUM has been the standard for many advisors. Fees of 1% to 2%+ are a common starting point.
Fee-Only—Some governing bodies like the CFP® Board specifically define this model as receiving compensation only from the client (no commissions, etc.). This can include hourly, flat-fee, and AUM, but not commissions.
Fee-Based—This term can be a little more slippery as it usually indicates that much of an advisor’s compensation comes from the client, but some commission and referral revenue is possible too.
Again, you could be forgiven for not wanting to have to get a PhD in how your advisor is compensated just to hire an advisor, but the reality is that there are a lot of ways an advisor can be compensated and if you’re looking to max-perform your wallet… caveat emptor (buyer beware).
Conflicts of Interest
Conflicts of Interest are inherent in all financial relationships. You want a cheeseburger? The restaurant has an incentive to sell it to you with the highest price and cheapest ingredients possible, but you’d like to get the best taste and experience for your dollars. Since the cheeseburger isn’t an ongoing relationship that could be worth five to seven figures over a lifetime, it’s probably okay to limit your angst over this particular conflict, but it’s still there.
When it comes to financial advice, the scale of the conflict is worth paying more attention to. Since all compensation models have conflicts of interest, you need to think about them when choosing a financial relationship.
Commissions—If you choose to buy the product, your advisor puts food on his table. He has an incentive to sell you as much product as he can and as often as possible. How will you know how much product is right for you if your advisor has to sell you a product to earn a pay check?
Referral Fees—If your financial advisor gets a fee from the attorney he just referred you to, how do you know you’ll get the best legal advice instead of the legal advice your financial advisor benefits from?
Incentives—If two products might meet your needs, but your advisor gets a 10% bonus for selling you the more expensive or in-house proprietary product, how does that benefit you beyond putting your wallet on a diet?
Hourly—If your advisor charges by the hour, is the meter always running? Is it possible that she inflates the time required for your work in order to run up the bill?
Flat-fee/subscription—Similar to the cheeseburger conundrum, the advisor has an incentive to do the least amount of work on your case in order to get your fee.
Assets Under Management (AUM)—While a simple compensation model that doesn’t require you to write a check (fees are usually deducted from the managed account—sometimes with a tax advantage), charging based on AUM has several conflicts. First, the advisor has an incentive to make sure she manages all of your dollars. This can be a real problem, for example when you move money out of the TSP to the advisor’s custodian. Second, the advisor has an incentive to take risk in order to boost return and her fees. Finally, much like the flat-fee model, the advisor has an incentive to do as little as possible since the fee tends to feel stealthy to the client.
How to Navigate the Mine Field
This article is a quick snapshot of the problems inherent in financial relationships. Compounding the difficulty of choosing the right level of training and credentials that you want an advisor to possess is the variety of compensation models and the inherent conflicts of interest. So how do you navigate the mine field? Of course, the answer is, “It depends,” but here are some guide posts to help you out:
- What is your requirement? If you need comprehensive financial advice covering multiple domains like cash flow, insurance, taxes, investments, college, and retirement, then an advisor that mainly sells insurance products or stocks might not scratch your itch.
If you feel comfortable with everything but investment management, then a robo advisor (e.g. Betterment or Wealth Front) or other advisory service that focuses only on investments might be the right fit.
If you’re happy managing your own investments, but would like comprehensive help integrating your financial life, a CFP® or financial coach might be a better option.
- What do you value?
Are you looking to minimize expenses? An hourly advisor for a specific set of issues will likely be the least expensive path.
Are you at that point of “more money than time?” It may be worth paying a little more for a firm that offers concierge-type services.
Is it more important to trust your advisor than find the lowest price? You’ll likely prefer a fiduciary that is willing to spend plenty of time getting to know you before asking for a commitment.
Do you want 1-stop shopping rather than separate firms for investments, insurance, taxes, etc.? It may be best to seek a firm that has in-house experts in financial planning, insurance, taxes, investments, and attorneys for estate documents.
- Have “The Talk.” If you’re already working with an advisor, it’s okay to revisit the topic of how the advisor is compensated. Many people assume that an advisor’s services are basically “free” because they don’t realize that fees, commissions, incentives, etc. are being deducted “out of sight, out of mind.” If you’re considering working with a new advisor, make sure you fully understand how they are compensated. There’s no right or wrong answer because your requirements and values will likely shape the best type of relationship. It’s just important to know what you’re getting into.
- Make Sure You’re Receiving Value. With all of these other factors in mind, at the end of the day you probably need to answer one question— “Is the value you’re receiving worth what you’re paying?” If not, perhaps it’s time to shop around. If so, then you probably have a relationship worth nurturing over the years to achieve your goals.
The world of financial advice can be challenging to navigate and our regulatory environment certainly doesn’t give you the best map. Financial complexity frequently creates the need for professional financial help, and a Financial Advisor may assist many of us. Unfortunately, choosing a financial advisor has pitfalls, so keep in mind the landscape of qualifications/titles, compensation, and conflicts of interest—fight’s on!
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