Why It Matters How Your Advisor Is Paid

Who gives you financial advice? Why does it matter how he or she is paid? Because it’s probably the most important thing determining the quality of advice you receive.
The SEC and other agencies continue to debate the hotly contended “fiduciary responsibility” issue because billions of dollars are at stake, while the public is confused and underserved.

Can you answer these questions?

• What are the differences amongst brokers, insurance agents selling investment products and “financial advisors” (some regulated, some not)?
• What’s the difference between “fee-only” and “fee-based”? (hint: they sound alike but they’re quite different)..

Here’s a brief guide to help untangle these concepts:

1. Brokers and insurance agents:

Brokers and insurance agents can and do sell financial products (A, B and C mutual funds, annuities, variable life insurance, annuities). Their standard of fiduciary care is a “suitability” standard. This lower standard of care means they can benefit more from product sales than the client -  as long as their products are very broadly considered to be “suitable,” they’re OK to sell.

2. Advisors and financial planners:

This term is confusingly broad – some advisors have no designation, while others can be a CFA, CFP®, ChFC® and/or CPA/PFS. These designations are the ones most acknowledged in the financials industry – they all require study, passage of exams and adherence to standards of oversight. For the purposes of this discussion about compensation, I’ll focus on financial advisors who interact with the general public and who either:
a) Sell products or
b) Don’t sell products

Advisors who sell products can hold any of the above- mentioned designations. They can include fee-based advisors; although they sound like fee-only advisors, “fee-based” advisors DO sell products. Fee-based compensation is popular because advisors can earn compensation from fees paid directly by clients PLUS fees theyr receive in the form of commissions or discounts from products they’re licensed to sell. They are not required to inform their clients in detail how their compensation is accrued. The Fee-Based model creates many potential conflicts of interest, because the advisor’s income is affected by the financial products that the client selects.

Fee-Only advisors, by contrast, do NOT sell any financial products. If their clients need products (e.g. insurance), they work with professionals they trust but there is no fee-splitting or other inducement involved in the sale of products. Fee-Only advisors typically charge a % of investments they manage and/or charge in some other way for their time (hourly, retainer, etc). Conflicts of interest are kept to a minimum with this kind of fee structure.

Conclusion: the Critical Issue of Fiduciary Standards

An advisor held to a Fiduciary Standard occupies a position of special trust and confidence when working with clients because he/she is required to act with undivided loyalty to the client.  This includes disclosure of how the financial advisor is to be compensated and any corresponding conflicts of interest.

If your advisor DOES sell products, it’s hard to know if your needs are deemed more important than his/her needs to earn commission. Is it really better for you to buy a mutual fund with a 5.75% front-end load (commission) from your broker, than a mutual fund with no up-front commission?  Are you getting sufficient services from this broker to compensate for fees you may not even be aware you’re paying because they’re automatically deducted at the point of sale? Is it really better for you to tie up your money in an annuity that charges 3-4% per year vs. putting your money into mutual funds that cost 1/10 that amount? Time and again studies show that clients can be poorly served when product sales commingle with investment management and/or financial planning.

Here’s a common example I see in my practice – I’ll meet a prospective client who has multiple variable annuities. I’m told the advisor wants this client to terminate his 401(k) plan and convert his account to yet another annuity. Or I’m told an advisor wants to convert one annuity to another annuity so he/she can earn a fresh commission. 99% of the time I can see these annuities were NOT helpful to the client, who typically is unclear about the carrying costs and isn’t even sure why he has all of these annuities. What IS clear is that each agent earned a generous commission selling them.  Suze Orman has railed against them (google her on YouTube and listen to her advice to folks to stay away from variable annuities).

A better way to receive investment advice, management and financial planning is to work with professionals who are required to put YOUR needs before THEIR needs. These individuals adhere to the highest standard of Fiduciary can and do NOT combine product sales with advice-giving. The best examples are Fee-Only financial advisors and CPA/PFS individuals who clearly indicate they are Fee-Only.

Yes, Virginia – it really does matter how your advisor is paid.

Here’s an example of the kind of Fiduciary Oath your advisor should adhere to (see www.napfa.org):
The advisor shall exercise his/her best efforts to act in good faith and in the best interests of the client. The advisor shall provide written disclosure to the client prior to the engagement of the advisor, and thereafter throughout the term of the engagement, of any conflicts of interest, which will or reasonably may compromise the impartiality or independence of the advisor.
The advisor, or any party in which the advisor has a financial interest, does not receive any compensation or other remuneration that is contingent on any client’s purchase or sale of a financial product. The advisor does not receive a fee or other compensation from another party based on the referral of a client or the client’s business.


Type of Professional                                  Are They A Fiduciary?

Lawyers                                                                   Yes

Physicians                                                               Yes

CPAs                                                                         Yes

Stock Broker                                                           No

Insurance Agent                                                     No

Registered Representative                                    No

CFP Practitioner                                                    Maybe*

Financial Planner                                                  Maybe*

NAFPA-Registered Financial Advisor              Yes

*Advisors who are affiliated with a broker dealer firm are most likely not fiduciaries. If the client signs an NASD binding arbitration agreement – required by almost every broker dealer firm – then their advisor would not be held to a Fiduciary Standard by the NASD. CFP Practitioners and Financial Planners will be held to a Fiduciary Standard only if they are also registered investment advisors or associated with a registered investment advisor.

“Can a registered rep and investment advisor rep wear two hats at one time? Can they remove the fiduciary hat once it’s assumed?” asked Thomas Orecchio, NAPFA’s chairman and a longtime advisor based in New Jersey. “Under the current situation, the answer is yes. But the consumer doesn’t know when you’re behaving as an advisor or rep. We believe the advisor can’t take off the advisor hat once it is put on. We think that your fiduciary responsibilities refer to the relationship you create with a client, not any one account or transaction.”

But the Securities and Exchange Commission (SEC) doesn’t agree, saying that reps are investment advisors “solely with respect to certain accounts.” In fact, the NAPFA press conference was held as the SEC advances a controversial proposal pundits say is an end-run around the agency’s loss on the same issue in federal court earlier this year. The SEC lost its push to carve broad exemptions for brokers who were offering “advisory” accounts without registering as advisors.
Now the SEC is attempting to create “special rules” that would once again give brokers exemptions, provided they do not exert discretion over accounts or charge separately for advice. The SEC makes clear, brokers won’t have to register as advisors just because their firm offers full-priced and discount brokerage accounts and fee schedules. At the same time the agency is attempting to clarify limited responsibility for those brokers who do register as investment advisor reps, saying, “A registered broker-dealer is an investment advisor solely with respect to certain accounts.” Both NAPFA and the Financial Planning Association (FPA) filed letters in November criticizing the SEC’s attempted carve outs for brokers.

To illustrate the harm NAPFA believes dually registered advisors can do, the group handed out a narrative story about “Bud,” the dual registrant, and “Mrs. Grant,” who hires him for a financial plan. In the NAPFA story, Bud prepares Mrs. Grant’s plan, but then takes off his advisor hat to sell her a variable annuity and some of his firm’s proprietary funds. “How does this fit in with my plan? Are you still my financial advisor?” Mrs. Grant asks. To which Bud replies: “This fits in just fine. Just trust me. I’ll take care of you.”

“The bottom line is that we’re looking for the fiduciary rule to be applied throughout a relationship with a customer, not be taken on and off like a hat,” said Diahann W. Lassus, chair of NAPFA’s Industry Issues Committee and a veteran advisor in New Jersey. Without fiduciary standards, brokers don’t have to put clients’ interests first, disclose conflicts of interest or charge reasonable fees, NAPFA officials say. “It’s fair to assume as much as 40% of total returns offered by the capital market are being consumed by brokers and other financial intermediaries,” Lassus says.
–Tracey Longo


About the author

Eve L. Kaplan, CFP®

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