By Bill Gallagher, CFP®, MPAS®
If you are considering working with a financial advisor, or if you have been working with one for many years, it is important to know how your financial planner is compensated. In addition, it is important to know if the financial advisor acts as a fiduciary, as that may have an impact on the services provided, and the way in which you pay for those services. There has been a lot of talk over the past few years regarding the term fiduciary. While many people understand the definition of a fiduciary, they may not fully understand how the term impacts the financial advice they receive. If your financial advisor is a fiduciary, then she is both legally and ethically required to provide financial advice and guidance that is in your best interest. In addition, as a fiduciary, she is required to disclose any, and all, conflicts of interest that may come up over the course of the relationship. If you are in the market for a financial advisor, please be sure to add these questions to your list while you are going through the interview process:
- Are you a fiduciary?
- Do you act as a fiduciary 100% of the time?
- How are you compensated?
- Do you earn a commission on the sale of any financial product?
- What is the total cost to work with you?
While the responses you receive will vary among advisors, financial advisors typically operate within three compensation models:
A fee-only financial planning firm will be registered with the Securities and Exchange Commission (SEC) as a Registered Investment Advisor (RIA). RIAs are held to a higher standard as they must act in a fiduciary manner. In a fee-only setting, 100% of the advisor’s compensation will come directly from the people she works with. A fee-only financial advisor will not earn or accept any commissions or third-party kickbacks from any investment providers. Typically, the fees are calculated as a percentage of assets under management (AUM) and are deducted directly from your account(s), on a quarterly basis. This compensation model ensures that the advisor is acting in a fiduciary manner, where she and the client are on the same side of the table – the advisor will do better when the client does better. In addition, since the advisor is earning a fee, she is not enticed to make any recommendations that would result in her selling an investment product to generate a commission. Therefore, the financial advice in this setting is objective, and not contingent on any specific product(s).
For those that are comfortable managing their own investment accounts but would like to engage a financial advisor for financial planning services, a fee-only advisor may be able to accommodate. For example, a fee-only financial advisor may offer to complete a comprehensive financial plan for a flat fee or provide an hourly service where she can work on a specific financial project for her client.
A commission-based financial advisor, or registered representative, is often affiliated with a broker-dealer. A broker-dealer is a firm that sells its own products or another financial company’s products to its customers. A broker-dealer, and its registered representatives, are not held to the same fiduciary standard as an RIA. Therefore, a financial advisor who earns a commission is not necessarily required to act in your best interest. Yes, she has to make sure the investment product she recommends is suitable for your situation, but she is not required to put your financial interests first. Therefore, the relationship between you and the commission-based advisor tends to be more transactional, as opposed to an ongoing, financial advice-driven relationship. When the advisor sells you a certain product, she will receive a commission directly from the investment provider. The amount of the commission tends to be a certain percentage of the investment amount and can range from high to low. For example, if you invest $250,000 into an annuity that pays the advisor 6% commission, the advisor will receive a payment of $15,000 directly from the insurance company.
A fee-based advisor is registered as an RIA as well as a broker-dealer, and therefore earns both a fee and a commission. Since a fee-based advisor is dually registered, she is not required to act as a fiduciary 100% of the time, or when outside the financial planning arena. Similar to a fee-only advisor, a fee-based advisor will charge an AUM fee. In addition, she may charge a separate fee for financial planning services. However, unlike a fee-only advisor, the fee-based advisor may also receive a commission on certain investment products that she sells to her clients.
As we can see from the financial advisor compensation models above, it is important to understand how you pay for financial advice, the type of financial planning service you receive, and if your advisor is required to act in a fiduciary capacity. If you require a comprehensive financial plan and ongoing advice, perhaps a fee-only or fee-based model would be appropriate for your needs. However, if you are comfortable managing your own investment accounts but need some advice on which products to purchase, a commission-based advisor may be the right fit. By understanding the different compensation models and how the advisor is registered (RIA or broker-dealer) you can make an informed decision on what is the best fit for your needs.