Over the last few years, there has been a lot of talk about what it means to be a fee-only financial advisor and a fiduciary. Much of this is a result of the Fiduciary Rule proposed by Department of Labor a few years ago. Many financial writers and news outlets have been advocating for this approach for years. Here are a few examples:
- The Perfect Financial Advisor by James M Dahle MD, on The White Coat Investor
- The 19 Questions to Ask Your Financial Advisor by Jason Zweig
- Retirement Plans: Last Week Tonight with John Oliver
So, what’s all the hullabaloo about? What does it mean to be “fee-only” or a “fiduciary”? In this post, I’ll try to help you understand what makes a fee-only financial advisor different and how to sort out the true fee-only advisors from the impostors.
Sales vs Advice
Think back to the last time you bought a car. How did it go? Odds are, it was uncomfortable. Many people hate dealing with car salesmen.
Why is that?
The simple answer is, they are paid on commission. They want to sell you something on their lot. They work for the dealership, not for you.
What makes it even more uncomfortable, is something called asymmetric information. This just means that the salesman knows more than you do about the car, what its worth, and how much they are going to make on the sale. Are you getting ripped off? Should you try to talk him down? Why does he seem so eager to make the sale?
Contrast this with your last visit to your primary care doctor. Now, going to the doctor is sometimes uncomfortable, and often comes with some anxiety depending on the reason for your visit. But it’s probably safe to say that your doctor listened to you, tried to understand what was going on, and then recommended what they believed to be the best course of action.
No pressure. No feeling like you’re being taken advantage of.
Because the doctor works for you. He doesn’t get paid by the pharmaceutical company that makes the drug he prescribed you. He gets paid by you and has a duty to act in your best interest.
The same can be said for your attorney or your accountant. They work for you for a fee and are obligated to act in your best interest.
This dynamic is at play with financial advisors. Unfortunately, not all financial “advisors” are required to act in your best interest. Some sell products on commission. They are incentivized to sell certain products that make them the most money. And they aren’t required to divulge how much they make for selling those products.
A more accurate term for these types of advisors would be agent or sales representative. But that doesn’t sound as good on a business card.
Advisors who sell products are held to what is known as the suitability standard. This standard essentially prohibits reps from selling products that are inappropriate for their clients (think selling a lifted pickup truck to an 80-year-old in a wheelchair). However, it says little about selling products that generate higher commissions for the rep or revenue for the firm – even if those products are inferior or more expensive for the client.
Fee-Only Financial Advisor
In contrast, fee-only financial advisors do not earn commissions from product sales. Like other professional services, they charge fees directly to their clients. They have what is known as a fiduciary duty to their clients. This means they are required by law to act in their clients’ best interest and they are required to disclose all conflicts of interest.
There are several ways that fee-only advisors can be compensated, including charging a percentage of the investments they manage, a flat annual fee, or hourly fees. But the fee must come from the client, and from no other source.
Because fee-only financial advisors don’t have an incentive to sell specific products, you are more likely to receive holistic and unbiased advice. In addition, the relationship is often longer-term and collaborative, instead of transactional and high-pressure.
Fee-Only vs Fiduciary
Fee-only financial advisors are all fiduciaries. However, fee-only and fiduciary are not synonymous, and here’s where people get confused.
There are some advisors who hold themselves out as fiduciaries, but who also sell products (like life insurance) on commission.
How can this be?
Enter the “hybrid” advisor – sometimes referred to as “fee-based”. This type of advisor works both for fees and for commissions. When they have on their fee “hat”, they are required to act in your best interest and consider themselves fiduciaries.
However, when they have on their commission “hat” they are held to the less strict suitability standard.
The problem is, when are they wearing each hat? How can you know when your advisor is advising and when he is selling?
The reality is you can’t.
Finding a Fee-Only Financial Advisor
Okay, hopefully you have a better idea of what it means to be fee-only and why you might want to work with one. (Of course, you may want to work with a sales rep in certain situations. But now you understand that their duty is to their company, and not to you. So buyer beware.)
But since there are few, if any, financial advisors who call themselves agents or sales reps, how do you find the ones that are truly fee-only?
The first place to look is napfa.org. NAPFA (short for the National Association of Personal Financial Advisors) is an organization of fee-only financial advisors. They have a strict definition of fee-only:
NAPFA defines a Fee-Only financial advisor as one who is compensated solely by the client with neither the advisor nor any related party receiving compensation that is contingent on the purchase or sale of a financial product. Neither Members nor Affiliates may receive commissions, rebates, awards, finder’s fees, bonuses or other forms of compensation from others as a result of a client’s implementation of the individual’s planning recommendations. “Fee-offset” arrangements, 12b-1 fees, insurance rebates or renewals and wrap fee arrangements that are transaction based are examples of compensation arrangements that do not meet the NAPFA definition of Fee-Only practice.
They also have a lengthy application process and do a review of applicants’ business processes. You can be quite certain that if an advisor is fee-only, she is a member of NAPFA.
Questions to Ask Your Advisor
If your advisor is not a member of NAPFA, you should ask several pointed questions to better understand how they are compensated, such as:
- Do you receive commissions, bonuses or any other compensation for specific products you recommend me?
- Are you registered with a broker dealer or affiliated with an insurance agency?
- Will you itemize all of your fees in writing?
- Do you act in a fiduciary capacity 100% of the time?
Bottom line, whatever type of advisor you decide to hire, you deserve to know how they are compensated and how that might influence their recommendations.
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