Lesson 2: Adviser Compensation
I’m not expressing a political opinion here, but I need to quote a certain party’s icon. Ronald Reagan use to say “Trust but Verify”. I humbly suggest you modify this saying to “Verify then Trust” when it comes to your money. There is no better way to cut through the avalanche of advertising and smooth sales talk, than to identify how someone is compensated. Understanding how your adviser is paid is paramount. Even the best intentions are influenced by the need to buy groceries and provide for one’s family. In other words, we aren’t judging the person, just the system (or box) that confines them. We’ve learned how company structure can be wrought with conflicting interests. Compensation adds another level of potential conflicts.
A few words about titles. Please don’t be confused by someone’s title. There is no formal definition for who can use titles including the word “adviser”. Brokers use a multitude of titles – financial adviser, portfolio adviser, client adviser, wealth manager, etc. Thus, titles have absolutely no value in assessing how that individual is compensated or what you can expect from them.
2. Fee Based
3. Fee Only
This one is simple. A commission based adviser is a sales person. They don’t get paid unless you buy (or sell) something. The problem with this arrangement is that it rewards the adviser for recommending their clients take part in commission based investments even if it isn’t appropriate for them.
2. Fee Based
This method is the most complex. These advisers are compensated in two ways – a flat fee for their advice plus a commission from selling products. An example of this type of arrangement is paying a fee for financial planning and then commissions on products they recommend. A financial planner who has a financial stake in the course of action that he or she recommends to a client faces an inherent conflict of interest and cannot be considered objective and unbiased. This is true even if the planner truly believes that they have the best interests of the client at heart. Unfortunately, the vast majority of financial advisers in the United States are sellers of financial products. Some or all of their income may be dependent upon their ability to steer their clients to a limited number of the thousands of financial products available today. Putting aside the conflict-of-interest factor, this limiting of choices, in and of itself, often is enough to impact the quality of the investment advice.
3. Fee Only
This form of compensation means that in all circumstances, the adviser is compensated solely by the client, with neither the adviser nor any related party receiving compensation that is contingent on the purchase or sale of a financial product. This type of fee is usually based upon a percentage of the assets they manage for you. If you’re investments shrink, so does the advisers income. It aligns goals nicely. Plus, with all the potential conflicts removed, the adviser is free to recommend what is right for you.