By: Abby Bennett, CFP®
When you decide to work with a financial advisor, you are hiring them to help you prudently manage your financial life. It’s reasonable to expect her to put your interests first, ahead of her own. It seems simple – your doctor takes care of you, your attorney takes care of you, so it’s fair to assume the person advising you on your finances would do the same. Why wouldn’t she? That is what she’s paid to do, right?
In theory – yes. In practice – maybe.
If the world of financial advice wasn’t already confusing enough, it is important to point out that all advisors are not the same. Lack of transparency, complex incentive structures that create conflicts of interest, and vague terminology can make it hard for consumers to know what they’re getting. So, as an advocate for transparency, I’ve put together a short list of things to consider when searching for the team that’s right for you.
Keep in mind, these are not the only three things to consider when choosing a financial advisor. I do believe these three are important to understand at a minimum, and I encourage you to interview multiple firms so you can compare service models, culture, and compensation structures. Information is power.
There are two standards of care that apply to most of the financial services industry: fiduciary and suitability. A fiduciary has a fundamental obligation to act in the best interest of the client. The suitability requirement means just that: a transaction must be suitable, but not necessarily the best option for the client.
Let’s say you need to buy a dress to wear to an event. You find two you like – both fit, so you won’t be uncomfortable with either choice. However, one dress is the same shade of blue as your eyes and would allow for some fun on the dance floor. The other is a bit more restrictive, has a less-flattering shape, and is a bit more expensive. The Suitability Store may encourage you to by the second dress, instead of the first – you would go home with a nice dress, fulfilling your need, and the store would be better off, having sold something more expensive.
However, if you’re shopping at the Fiduciary Store, they’d encourage you to buy the first dress – the one that not only fits, but also looks the best on you.
While this is a simplified example, it is meant to highlight one thing: whether or not your advisor will align their recommendations with your best interests. Everyone is conflicted somehow – both dress shops want you to buy from them – but transparency and disclosure of those conflicts can help you make an informed decision.
I clearly have a strong opinion on whose interests should come first in a client-advisor relationship, but there is a gray area in the financial world. The debate over the DOL Fiduciary Rule is an example of that gray area. Another surrounds the use of the term “Financial Advisor” – as it stands, anyone with the right licenses can put themselves out there as an advisor, even if their primary job function is to sell specific products. Unless regulators crack down on the use of specific terms, it’s up to the consumer to clarify in what capacity the advisor will operate in their entire professional relationship: a fiduciary, or not.
If an advisor is putting you in a proprietary product such as their own company’s stock-picking strategy or annuity, it begs the question, “Will they fire themselves if it turns out they aren’t as good as another strategy?”
Independence allows a firm to access the immense universe of investment options for their clients, with typically fewer limits than large Wall Street institutions. This can mean lower embedded fees, low or no investment minimums, and flexibility to change an investment, should the fund fail to meet expectations.
Advisors at large institutions are often limited to a subset of investments for all of their clients. They have to wait for a change in lineup from folks higher up in the company before they can make changes at the client level. While that isn’t always a bad thing, independence allows firms to be nimble and proactive, instead of reactive.
One of the quickest ways to identify a professional’s main focus may be to identify how they are compensated for their work. In fact, it is often more important to ask “how are you paid and why?” than “how much are you paid?” All-in costs may be similar across advisors, but the effect on your financial situation could be drastically different.
There are different ways in which your financial advisor may be compensated and many of them are appropriate for various circumstances. That being said, having clarity around where the bulk of her compensation is sourced may be helpful in identifying what role that professional may play in your financial life. A few common methods are listed below:
Regardless of how the advisor is compensated, it’s important to be aware of it. It isn’t unreasonable to ask an advisor how much you are paying them, how much they earn off of a transaction, and how that stacks up to industry averages. If an advisor talks about the importance of comprehensive financial planning but seems to offer that service for a cost that is close to “free”, I would recommend investigating how else the advisor is compensated. After all, there’s no such thing as a free lunch. Companies must make money to stay in business, but costs are important, and a lack of transparency should be a red flag.
In order for you to make the right choice for your circumstances, you must understand what you are choosing between. Asking good questions, and making sure you get thorough and understandable answers, is a step in the right direction. While you can’t have a perfectly conflict-free business relationship, understanding the niceties of the arrangement can set the groundwork for a long-term, mutually beneficial relationship with a trusted advisor.
Abby Bennett, CFP® is a financial planner in Charlotte, NC. She provides financial advice to families and business owners, and specializes in financial planning for engineers and tech professionals. Click here to learn more about Abby.
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