By Joel Chouinard, CFP®
September 5, 2024
The term financial advisor (or financial planner) seems to be thrown around quite a bit these days. If you asked 100 clients of 100 different financial advisors, I bet they’d each have a different definition. This is no fault to anybody, as the regulatory bodies in charge of the financial services industry have not made it a priority to clarify the job description. The main issue with this lack of clarity is that it affects the perception that most people have of financial advisors.
In a recent study, the CFA Institute found that financial advisors ranked as low as mechanics on the trustworthiness scale.* This isn’t a knock on mechanics, but finances are such an integral part of someone’s life that consumers should be able to trust the person they go to for advice. In contrast, other industries have made this a priority. For example, a medical doctor is not able to call themselves a doctor until they’ve gone through rigorous training and graduated from medical school. This supports the CFA Institute’s finding that doctors are at the top of the list in terms of trustworthiness. So how can you find a financial advisor that you know will have your best interest in mind? One way is to look for a fee-only advisor.
What is a Fee-Only Financial Advisor?
The National Association of Personal Financial Advisors (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.** Such contingent compensation (or commission) is typically seen with the sale of mutual funds, life insurance, and annuities. In addition, contingent compensation could also be in the form of financial incentives received from the insurance or mutual fund company. For example, a life insurance company could offer an all-expenses-paid vacation if their agents hit a certain level of production for one year.
In addition to the fee-only model, there are two other compensation models in the financial services industry:
(1) Commission-based: advisors who receive their compensation only from the sale of financial products; and
(2) Fee-based: advisors who receive compensation both directly from their clients (e.g., financial planning and investment management fees) and from commissions.
So, what are the benefits of working with a fee-only advisor?
1. Unbiased Financial Advice
The number one thing you should be looking for in a financial advisor is whether they have your best interest in mind when they make recommendations. That’s true for all types of compensation models. That said, fee-only advisors receive no extra compensation for recommending financial products. Therefore, if they recommend it, there is a good chance it is in your best interest. For example, a financial advisor may recommend to his or her client, who is a young professional with a young family, a high level of life and disability insurance coverage to protect against unforeseen events. Fee-only advisors do not get compensated for the implementation of those recommendations (i.e., purchasing the products), so the client can rest assured that the advisor is acting in their best interest. The fee-only model isn’t completely free of conflicts of interest, but it is the model where your needs are most aligned with your advisor’s.
2. Transparent Fees
Under the fee-only compensation model, you know exactly what fees you are paying for the services you receive. You may be charged a flat financial planning fee, hourly fee, or asset-based fee (i.e., percentage of investments managed by the advisor). Either way, you get a detailed breakdown of how much you are paying. In comparison, commission-based compensation does not need to be disclosed, so clients don’t know how much commission is being paid to their advisor unless they ask.
3. Fiduciary Responsibility
According to Merriam-Webster, a fiduciary is “[obliged] to act with loyalty and honesty and in a manner consistent with the best interests of the beneficiary of the fiduciary relationship.”*** In a financial advisor-client relationship, the client is the beneficiary of the relationship. Fee-only advisors are required by law to act as fiduciaries for their clients because their sole role is to provide financial or investment advice. In contrast, fee-based advisors are only required to act as fiduciaries when giving advice. When they are acting as the agent in the sale of a financial product, they are no longer required to act as a fiduciary. Therefore, fee-only is the only compensation model where your advisor is acting as a fiduciary for you at all times.
4. Customized Financial Planning
As noted in #1 above, fee-only advisors get compensated for giving financial or investment advice. Their compensation isn’t tied to the sale of specific products. An added benefit of this model is that the advisor can provide customized financial planning unrelated to specific financial products. For example, if a client’s most pressing need or goal is to pay down student loan debt, the advisor can charge a flat or hourly fee and get compensated for doing that work. This isn’t true for the commission-based compensation model because the client-advisor relationship is often contingent on the sale of a financial product (unless the advisor is willing to work for free in hopes that the client will implement their product recommendations).
5. Focused on Long-Term Financial Goals
Regardless of the compensation model, all advisors should have their client’s long-term financial goals in mind when making recommendations. To do this, the advisor needs to address all aspects of your financial situation, including budgeting, debt management, insurance, retirement planning, college funding, investment management, tax planning, and estate planning. If one of the areas of your financial plan is deficient, it is your advisor’s job to point it out and help you address it. If your advisor is only capable of helping in one area due to their compensation model (e.g., insurance or investments), you may not be maximizing your relationship.
Final Note
The bottom line is clients choose advisors because they trust that the advisors have their best interests in mind. There are many fee-based and commission-based advisors who have done wonderful work for their clients. At the end of the day, in most cases, clients are better off working with an advisor than not, regardless of the compensation model. But if you’re looking to start fresh with a new advisor, consider one that is fee-only, so you know their incentives will be aligned with yours.
Sources
*https://www.wealthmanagement.com/industry/advisors-rank-almost-low-mechanics-trustworthiness/
***https://www.merriam-webster.com/dictionary/duty#legalDictionary/
SharpEdge Financial LLC is a registered investment adviser registered with the State of Texas. Registration does not imply a certain level of skill or training. The views and opinions expressed are as of the date of publication and are subject to change. The content of this publication is for informational or educational purposes only. This content is not intended as individualized investment advice, or as tax, accounting, or legal advice. Although we gather information from sources that we deem to be reliable, we cannot guarantee the accuracy, timeliness, or completeness of any information prepared by any unaffiliated third-party. When specific investments or types of investments are mentioned, such mention is not intended to be a recommendation or endorsement to buy or sell the specific investment. The author of this publication may hold positions in investments or types of investments mentioned. This information should not be relied upon as the sole factor in an investment-making decision. Readers are encouraged to consult with professional financial, accounting, tax, or legal advisers to address their specific needs and circumstances.
SharpEdge Financial LLC is a registered investment adviser registered with the State of Texas. Registration does not imply a certain level of skill or training. The views and opinions expressed are as of the date of publication and are subject to change. The content of this publication is for informational or educational purposes only. This content is not intended as individualized investment advice, or as tax, accounting, or legal advice. Although we gather information from sources that we deem to be reliable, we cannot guarantee the accuracy, timeliness, or completeness of any information prepared by any unaffiliated third-party. When specific investments or types of investments are mentioned, such mention is not intended to be a recommendation or endorsement to buy or sell the specific investment. The author of this publication may hold positions in investments or types of investments mentioned. This information should not be relied upon as the sole factor in an investment-making decision. Readers are encouraged to consult with professional financial, accounting, tax, or legal advisers to address their specific needs and circumstances.