Financial Adviser Spectrum
As an independent financial planner, I often find myself describing my business model and trying to articulate how it is different than many of the other financial advisers in the market. More than most industries, the business model of a financial adviser really matters to his or her customers, whether they know it or not. When a consumer goes to the grocery store, or even goes to buy a car, that individual rarely stops to think about how the person selling the groceries or cars is going to get paid. This is true even in real estate, although there are innovators in that industry that are trying to change the nature of real estate professionals’ compensation. To a consumer of financial advice, however, the way the supplier of that advice gets compensated is a critical criterion for consideration.
The spectrum of business models for financial advisers is very wide, but the models can be aggregated into three broad classes that are typical of how financial professionals view themselves.
There was a time when people rarely used the term “financial adviser”. It was much more typical to hear the term “stockbroker” or “insurance salesman”. A more legalistic term for a stockbroker is a registered representative.
This is a traditional means of dispensing advice. In reality, the role of the broker is to sell products, such as stocks, mutual funds and insurance policies. They receive commission for doing so, and are thus incentivized to sell products that pay the highest commissions or fees. Some of the compensation is obvious, such as the commission on a specific stock trade. Other compensation is less transparent, such as the percentage of mutual fund loads that are paid to the financial advisor. By law, such loads, which are really just sales charges, can amount to up to 8.5% of a mutual fund transaction, and can be charged when buying, selling, or both. Although it is rare to see a load as high as the law allows, they can still add up, and it is not always clear how much the investor is paying and to whom. Interestingly, even no-load funds can charge up to .25% per year for ongoing “service fees” that could go to a financial adviser.
Different products pay very different commissions, and a broker’s loyalty is therefore potentially torn between selling a product that is in the best interest of the client, and selling a product that provides the best compensation to the broker. Often, the client doesn’t know the difference.
Fee-only financial planners
Consumer advocates will almost invariably recommend using a fee-only financial planner/adviser. That’s not to say that all fee-only planners are competent and ethical, and all advisers that operate under different models act solely in their own best interest. However, by definition fee-only planners are paid only by their clients, and that means that they are free to provide objective advice.
Whereas stockbrokers are product salespersons who are registered representatives, financial planners are typically registered as investment advisors and offer advice on a broad range of topics that are critical to meeting the financial objectives of their customers.
Some planners charge based on the amount of Assets Under Management (AUM). A common compensation plan would be for customers to pay 1% of their total AUM annually. This approach has the advantage of aligning the interests of the client with those of the adviser, in the sense that when the portfolio increases in value, both parties benefit. However, this doesn’t work as well for investors who are in the retirement phase and withdrawing funds. It also doesn’t necessarily incentive the adviser to support a diversified portfolio of assets that could include such things as rental real estate. One of the other complaints about this business model is simply that it can be expensive relative to the value received. That, of course, is dependent on the level and breadth of services provided as well as on the actual percentage of assets that is charged.
Another model that is gaining traction in the marketplace is the hourly or flat fee paradigm. Under this method, an advisor charges either by the hour or by the project to deliver anything from a comprehensive financial plan to a couple of hours of consultation on a specific topic. Proponents consider this to be the model that most effectively minimizes the potential conflicts of interest between financial planners and their clients.
Fee-based financial planners
Fee-based planners are kind of a hybrid of brokers and fee-only advisers. They can be compensated through fees for providing advice as well as commissions for selling products. In some cases, such a planner might be paid for a financial plan that includes a range of recommendations and products, but he or she may only be paid commissions on, say, the insurance products.
Often, fee-based advisers offer a financial plan for a nominal fee – or even free – with recommendations that will lead to substantial commissions. Of course, the concern with that approach is that the plan will include actions that may or may not be good for the consumer, but will prove to be lucrative for the adviser.