Selecting An Advisor 101

 

Fee Only Advisor

People who may need a financial plan and investors selecting a financial professional will encounter the following terms:

  1. Fee-only advisors
  2. Fee-based advisors
  3. Commission-based advisors

What’s the difference between all of these arrangements and how does it impact me are most likely questions going through your mind. The terms sound similar, but there are important differences between each type of financial professional. Unfortunately, the system doesn't make it easy to identify unless you go out of your way to find out. In fact, many investors aren’t even aware a difference exists. After all, they all openly refer to themselves as "Financial Advisors". For simplicity we will focus on the fundamental difference between Fee and Commission. "Fee based" simply refers to a practitioner that dips their toes in both pools.

So what is the difference and why does it matter? The type of relationship you have with your Financial Professional is largely determined by how they are compensated. In order to understand why this is such a critical element, one must first learn the difference. Keep in mind, there is no good guy or bad guy. We recommend when an investor is interviewing a candidate to just be aware which “guy” they are talking to. Click here for a free interview questionnaire.

Typically, fee-only advisors conduct their business under a “fiduciary duty,” which means by law, they must have their clients’ best interest at heart. Registered Investment Advisors are typically regulated by the states and must operate under this duty. Certain professional designations also carry this requirement, such as a CERTIFIED FINANCIAL PLANNER™.

Fee-only advisors have no inherent conflicts of interest, they don’t accept fees or compensation based on product sales, and they generally provide more comprehensive advice. Many also carry professional designations which hold them to strict codes of professional and ethical conduct. Fee-only advisors can charge a one-time or ongoing fee, depending on the types of services they provide, which comes directly from the client. The fees may be hourly, flat or based upon a percentage of assets under management. A “Fee Only” advisor is also legally obligated to disclose any conflicts of interests to the client prior to making a transaction or recommendation. These “fiduciary” relationships typically will charge an ongoing fee between 1% - 2% to manage a portfolio of investments and maintain a consultative relationship.

Commission-based advisors aka "brokers" receive commissions on the products they sell. Commission-based advisors hold licenses that allow them to sell investments or insurance products and receive compensation with each transaction. These transactions include, buys and sells as well as the addition of new money. Because commission-based advisors generally don’t have a “duty to disclose” their method of compensation, it can be confusing for clients who want to understand exactly how much of a fee their advisors are charging. The potential for confusion underscores the importance of understanding how advisors are compensated. A financial advisor’s compensation arrangement has the "potential" to create conflict of interest between what is best for you, the client, and what is best for the advisor’s wallet. Commissions can range from 3-8% and can come in the front or back end of the investment, depending on which share class the broker and client mutually agree on. This fee is typically one time or spread out over a short period of time. Brokers can also receive additional compensation called a “trail” that ranges from 0.25% - 0.5% for as long as the investor holds the investment. Brokers and agents are obligated to provide suitable investment advice.

There is also an inherent “moral hazard” with commission-based advisors. When someone is paid on a transactional basis, an immediate incentive comes into play, thereby a motivation to sell unsuspecting customers the products that will pay the highest commissions. A moral hazard is a situation where conflict of interest potentially exists.

Before you decide to work with a financial advisor, whether at a small firm, a big brand-name financial institution, or a broker-dealer, you really need to do your research and ask some tough questions. If you walk into a major bank seeking help with managing your money and investments, it’s virtually guaranteed that the “financial advisor” is working for the bank. Ask questions, such as: What are the professional qualifications and educational background of the advisor? Where does his or her experience and expertise lie? How are they compensated? Are they held to a fiduciary standard? Have they ever been disciplined by the SEC or FINRA? Why are they recommending a certain product to you? Ask them to explain the suitability of any financial strategy considering your unique situation. Don’t be afraid. Put them on the spot. It’s your money, after all!

Lou The Butcher Vs. The Dietitian

Here is a little real world application that may help our readers relate to the concept. A commission-based advisor is not much different than our friend “Lou the Butcher”. If you visit Lou at his butcher shop, you are there to purchase meat. Lou is the ultimate “meat guy”. If you want a T-bone, he will provide the best T-bone available in his store. His responsibility to you, as a meat salesman, does not extend beyond that transaction. If your diet is low in vitamin C and high in cholesterol, it is not in his job description to warn you against eating more meat or encourage you to visit the salad isle of your local grocer. His job is to sell you meat and his business depends on it. Many of us have visited a butcher in one form or another. We rarely come away with no meat in hand. A Dietitian however, is vastly different even though they both provide advice on food. When you see your Dietitian, it is of no interest to him/her if you eat meat or a salad. Their examining your overall health and seeing what you are deficient in for nutrients. It also makes no difference to your Dietitians compensation if you decide to leave the consultation and buy a steak or a salad. Their interest is your health and educating you on the importance of a balanced diet. The Butcher and Dietitian have extremely different roles and obligations. We go to the Butcher to buy meat (product). We see a Dietitian to monitor and manage our overall health (advice). This difference is similar to a Broker (commission based) and Fee Only Advisor.

Client Centered Fiduciary Advice

HFG Advisors

Our Firm has set internal requirements that we believe exceed the industry standards of becoming a financial advisor. In order to be considered as a candidate, an individual must first satisfy our first requirement and show the highest degree of honesty and integrity. We value our clients' welfare and protect it dearly. So we are very careful whom we invite to join our team. There is unfortunately no perfect test to confirm this required trait, however, we go through great lengths to learn about the candidate’s past. As a provider of Client Centered Fiduciary Advice, we feel the characteristics of honesty and integrity are essential to meeting this obligation.

Secondly, the candidate must meet an educational requirement. Most of us would require our physician or doctor to have gone through medical school, right? To be a competent advisor, we believe individuals should have either a finance, accounting or economic degree as a foundation. We believe there is no substitute for going through the rigor and grind of school, and having to learn and test over 4 years. We also believe that not everything is learned in a classroom. Our advisors will go through HFG training for at least 2 years before being designated as a financial advisor. In other words, we don’t allow them to use others as guinea pigs. After their two years, they will work with a seasoned Certified Financial Planner™ (CFP®) that will evaluate their work.

The third requirement is that all of our advisors must pursue and successfully obtain their Certified Financial Planning Designation. Once the CFP designation has been obtained, they must commit to a life of perpetual learning. As a Firm, we chose to submit to the CFP designation and standards as we believe they have set the bar higher than the traditional financial services industry in regard to ethics and professional responsibility, as humorously portrayed in this 30 second video:

They can make light of these differences because of the standards they maintain as stated below:

"When it comes to ethics and professional responsibility, CFP® professionals are held to the highest of standards. They are obliged to uphold the principles of integrity, objectivity, competence, fairness, confidentiality, professionalism and diligence as outlined in CFP Board’s Code of Ethics. The Rules of Conduct require CFP® professionals to put your interests ahead of their own at all times and to provide their financial planning services as a “fiduciary”—acting in the best interest of their financial planning clients. CFP® professionals are subject to CFP Board sanctions if they violate these standards.

CFP Board’s rigorous enforcement of its Standards of Professional Conduct — including releasing disciplinary information to the public — distinguishes the CFP® certification from the many other designations in the financial services industry. Everyone who seeks CFP® certification is subject to a background check, and those whose past conduct falls short of CFP Board’s ethical and practice standards can be barred from becoming certified. After attaining certification, a CFP® professional who violates CFP Board’s ethical and practice standards becomes subject to disciplinary action up to the permanent revocation of certification. Through diligent enforcement of its ethical and practice standards, CFP Board provides you with the confidence that your CFP® professional is both competent and ethical."

We believe the most important question any investor interviewing and searching for a financial professional should ask themselves will this financial advisor act in my best interest at all times? Once you have answered that question, you are well on your way to making better informed decisions for your financial future.