Today, I want to talk about how to choose a competent financial advisor.
Let me start by saying I'm in favor of everyone taking charge of their finances.
The more knowledgeable we are, the better we will be at our finances.
If you're comfortable doing your own investing and know how much you need to fund your goals, how to make your money last, protect it, and pass it on the way you want, by all means, you should do it yourself.
There are lots of great free tools out there to help. Many in the FIRE community and personal finance bloggers take advantage of those tools and teach others how to do the same.
And again, I'm in favor of anyone who's so inclined to do so.
And I recommend Personal Capital to anyone who's a DIYer or thinking about becoming one.
But what about those people who aren't comfortable with any of those things?
Or those who feel they don't have the time to do that?
What are they to do?
Keep reading, and I'll offer my thoughts.
My journeyLet me preface this post with the following declaration. The financial advice industry as a whole has a well deserved bad reputation.
In large part, they are salespeople pushing products for their employers.
For me, this is not an outside view. I worked for some version of these companies for most of my career.
I started with a regional brokerage firm in Indianapolis, IN, where I grew up. Back then our job title was a stockbroker.
My job was to call anyone with a pulse cold and try to sell them some product.
My product of choice at the time was municipal bonds. It was brutal. You must have pretty thick skin and much perseverance to stay with it.
From there I moved to bank brokerage, where I spent the next couple of decades.
What I've learned
It is challenging to operate in an environment when the pressure to meet sales goals and other company requirements get imposed on you. The client is put at the bottom of the list of priorities by the firm.
I worked for a brokerage firm inside a bank. In bank brokerage, there is another layer of expectation added in addition to the brokerage sales expectations.
The bankers I partnered with in my branches also carried limited licenses to sell mutual funds and annuities (no conflict of interest there, no sir).
Notice I said sell.
If we advisors didn't put clients into funds where they got paid, our referrals would slow down or stop altogether.
It was all about sales, not clients.
Evolution of fee-based investing
When I started in bank brokerage, fee-based compensation was coming into vogue.
Registered investment advisory firms (RIAs) were a growing, competitive force. Most brokerage firms operated on a commission basis. They needed transactions, a lot of them, to generate revenue.
RIAs charged fees based on the size of the portfolio clients invested. Typically, these fees averaged around 1%.
Even today, when talking about advisory fees, a good average is 1%.
Clients began to transfer dollars into these fee-based accounts.
Brokerage firms adapted by forming RIAs inside their firm's holding companies.
That structure is what currently exists in the brokerage world today.
Here's the problem for investors.
When you sit down with someone who is both a broker, (who can sell products and earn commission) and is also an investment advisor representative, (who can charge a fee) how do you know which hat they're wearing?
In my experience, this is typical brokerage firm behavior.
A dirty little secretDo you know how brokerage firms choose many of the funds their advisors offer?
Mutual fund companies pay brokerage firms a fee to gain “shelf space.” Shelf space is where a particular fund gets recommended in the preferred funds' menu.
Often (not always) the funds at the top of the list pay the highest fee.
Yup. That's how it works.
I bet you thought it was about performance, didn't you?
Of course, the firms aren't stupid. A fund must have a decent record of performance to move toward the top of the list.
However, the overriding criteria are how much the fund offers to the firm in a revenue sharing agreements.
No conflict of interest there. No sir.
How do they get away with it? In their brokerage disclosure documents and the fund prospectuses.
Granted, you'd have to be a Harvard trained lawyer to read and understand these legal documents.
But because these conflicts are in writing and given to the clients, they get away with it.
I'm curious. How many of you have read a brokerage agreement and its disclosure documents?
How about a fund prospectus?
In this world, it's caveat emptor!
Firms can no longer provide financial incentives to sell their proprietary funds. But trust me, there are other ways to move them to the top of the priority list.
I'm not trying to bash brokers. I'm sharing my personal experience and what I know to be true while I was at these firms.
As far as I can tell, nothing much has changed.
Oh, and by the way, don't think the discount brokerage shops don't do some of this.
If you deal with their in-house advisors, be sure to ask whether the funds they're recommending pay a fee to the firm for shelf space.
Let me also be clear about one more thing when it comes to brokers and their firms.
There are some excellent advisors at these firms who take seriously the responsibility to act in their clients' best interests.
I was one of those advisors, and there are many more. Here's something to consider.
When you're looking for an advisor, do you want to try and figure out whether they are acting as a product salesperson or an advisory role?
There are alternatives you can choose where you don't have to make that choice.
Read on, and I'll tell you what to look for in a financial advisor and how to find a competent one.
Advisor titles and descriptionsThere is a lot of confusion about financial advisors. It starts with what they call themselves.
Are they brokers or advisors? Fee-only or fee-based? Commission only or hybrid? Financial advisors or financial planners?
You see what I mean?
There's a way to narrow down these choices.
Stick with a fee-only registered investment advisor firm that has no relationship with a brokerage or insurance company.
Fee-only is a description of a method of compensation.
A fee-only advisor is someone whose only form of compensation comes from a fee their clients pay them for the advice they offer.
Fee-only advisors do not accept commissions.
These advisors commit to acting in your best interest. They operate as fiduciaries.
Fiduciaries are legally bound to act in your best interest. They chose this business model intentionally.
According to the Center for Fiduciary Studies,
“An Investment Fiduciary is someone who manages the assets of another person and stands in a special relationship of trust, confidence, and legal responsibility.”
The Cornell Law School (and many others) say the fiduciary standard is the highest standard of care (learn more here).
Generally, fee-only advisors only relationship with a brokerage firm as the custodian who holds clients investment in safe-keeping (TD Ameritrade, Charles Schwab & Co, etc.).
There are several ways fee-only advisors get paid.
- A percentage of assets – as mentioned, the average fee is typically 1%. There is a lot of discussion and debate over whether this model is still valid. I'll talk more about it shortly.
- A flat fee – in a flat-fee arrangement, the advisor has set a price for specific services. Fees often vary depending on what kind of plan you need. The cost may be one-time, up front with an annual maintenance fee. Subscription fees are more and more common. In this arrangement, you pay on a monthly or quarterly basis.
- Hourly – Here you pay the advisor for the time they spend working on your plan. An hourly arrangement is similar to how your attorney or CPA charge for their services.
Ideally, I'd look for a firm that offers all or some combination of these compensation choices.
If you're in the accumulation phase and don't have enough assets or if you're not interested in having an advisor manage your assets, you can still get planning services, investment advice, and advice on many other areas (estate planning, insurance, etc.) for the fee.
Fee-only vs. fee-based
Stay with me on this one. The discussion of fee-based vs. fee-only can be confusing.
The brokerage firms love it when their prospective clients get confused. (Sorry, I guess that was a broker bashing comment).
I've talked about fee-only already. So what about fee-based?
Fee-based is a hybrid method of compensation. Fee-based advisors can charge an asset-based or flat fee (they rarely do flat fee) plus take commissions on products they sell.
Let me be clear. Advisors can't charge you a fee and then sell commission-based products to you in that fee-based account.
However, they can charge you a fee for one account and commissions in a different account.
Why would they do that?
It's simple. Advisors want to earn more money.
Many firms (including mine) offer a tiered fee schedule. That means as you move into higher asset levels, your fee gets reduced.
If you have multiple accounts in your household, those should be aggregated to reduce your overall fee (if on a tiered schedule).
Having both commission and fee-based accounts may allow the advisor to charge a higher fee on the managed (fee-based) accounts and earn commissions on the other.
Often, combining these accounts would be better for the client and lower their fee.
Firms deny this happens, but it does.
And again. I'm not broker bashing. I've seen it done.
How to reduce conflicts
The solution to this is pretty simple.
If you don't want to put yourself in a position to try and figure out what hat your advisor is wearing (broker or advisor) stick with a fee-only RIA.
Does that guarantee you'll get a great advisor?
Of course not.
Does it eliminate some of the confusion over compensation and whether or not they're bound to act in your best interest?
Yes, it does.
Your chances are much better if you can eliminate as many conflicts of interest as possible.
A lot of fiduciary advisors will tell you they operate in a conflict-free environment. I'm going to have to call bull*&%# on that one.
The fact that you're paying advisors a fee has an inherent conflict built into it, doesn't it?
Here's an example often used to illustrate.
A client has a mortgage and the funds available to pay off said mortgage. Their advisor manages their assets with an asset-based fee.
The client comes to the advisor asking them what they should do? Pay off the mortgage? Keep the money invested?
You see the conflict here?
Telling the client to pay off the mortgage comes with a pay cut for the advisor. Selling the funds reduces the assets under management where the advisor gets their income.
That's a tough one. It's also a common one.
A personal example
I'll give you a real-life example I recently had with one of my asset management clients.
Jonathan (not his real name) was a very successful attorney who retired ten years ago from his prestigious law firm. I met Jonathan while working at one of the bank brokerage firms I mentioned earlier.
When I started my firm, Jonathan came with me. He also kept accounts with the former firm, along with three or four other firms.
He was a guy who loved to do the comparison game – looking at how one account performed vs. another. It was an odd, pretty inefficient way to do things, but that's the way he rolled.
His wife had no involvement with their finances or investing. I tried to include her in the meetings. When she did sit in, she seemed uninterested in the financial conversation.
She was a terrific person, and we had a great relationship. But it was clear she had no interest in the finances.
A risky conversation
A couple of years ago, I asked Jonathan if he'd thought about whether his wife would want to deal with four or five advisors after he died.
He said he'd never really thought about it. I recommended he do that. Of course, selfishly, I wanted him to consolidate his accounts at my firm.
He had a significant account with me. But I also understood he had a much higher amount with my former firm.
He turned 75 a few months ago.
I got a wonderful email (I'd rather it was a phone call, but I digress) thanking me for the great job I'd done for him over the years managing this part of his portfolio.
He was happy with the returns and the growth of the money but informed me he had decided to consolidate his accounts with the other firm.
He said when he turned 75, he decided it was best for him and his wife to have everything in one place.
I'm confident the prior conversation planted the seed for him a couple of years ago. It was a risky thing to do financially. I also knew it was the right thing to do.
I'm not going to lie to you. It was a big hit financially.
But I can lay my head on the pillow at night knowing I did what was right for the client.
The Investment Advisor Public Disclosure site (IAPD) – The IAPD is a place specially designed to learn about registered investment advisor firms and investment advisor representatives. Firms file an ADV form, either with the SEC or their State Securities Department annually to give the regulators and the public the details of the firm.
You can search by an advisor or firm. Once you've entered the name, click the view ADV by section tab. On the left-hand menu, you will find a section by section breakdown of the information available. Look section by section on the left-hand column. You'll find everything you need to evaluate whether this is a firm or advisor you'd like to consider, including any complaints against them.
Another place to look is on the Broker Check site of Finance Industry Regulatory Authority (FINRA). FINRA is not a government agency. Here's how they describe themselves on their About page – “FINRA is not part of the government. We’re a not-for-profit organization authorized by Congress to protect America’s investors by making sure the broker-dealer industry operates fairly and honestly.”
Now there's a big Pandora's box in that description that I'll leave for another day.
However, the Broker Check site is a useful resource to find out how long a broker has been in business, where they've worked, and whether they've had any complaints against them. Many (not all) RIAs transitioned from the brokerage industry. You can find their records while in the brokerage industry on the Broker Check pages.
Use these two resources as a starting point to decide who makes your short list.
I hope I shed some light on the differences in the types of advisors out there.
There are good advisors at the brokerage firms. There are bad advisors in registered investment advisory firms.
My advice on finding a competent financial advisor is to only talk to fiduciary advisors. There are several resources to check them out. I've offered a couple above.
A couple more include NAPFA (National Association of Personal Financial Advisors. NAPFA is a membership organization that only accepts fee-only advisory firms. A new requirement is that they also be CFP's (Certified Financial Planners).
The CFP Let's Make a Plan site is another good site to look for an advisor.
There are great advisors out there who are not members of these organizations. And some bad advisors are CFPs.
The critical component IMO is to choose a firm and advisor committed to the fiduciary standard who does not sell products or take commissions.
OK… That's it for now.
In my next post, I'll give you my thoughts on what a good financial advisor can do for you. It may surprise you.
Now it's your turn. What experience have you had with brokers? Do you currently use one or handle things on your own? Was this information helpful to you? Let me know in the comments below. To get notified when new posts go live, complete the form on the right sidebar of the page.
Until next time…
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