The Informed Investor

How Does Your Investment Advisor Get Paid? Why Does It Matter?

Randy A. Garcia, CEO

August 21, 2020

When you talk to your investment advisor or wealth manager, you probably assume that they are always giving you honest advice, right? After all, that’s what you likely hired them for: to help you make better investment and financial planning decisions.

With some professionals, however, you may not be receiving genuine advice at all. You may simply be getting a product recommendation (simply put, a sales pitch) for something on which they will receive a commission.

Wait—how can an “advisor” be selling you a product? That is a very important question…and one that many investors don’t realize even needs to be asked.

This is known as “conflicted advice.”

The Danger of Conflicted Advice

While it sounds alarming, conflicted advice is actually very common. So common that a 2015 White House Task Force estimated it costs unsuspecting American retirement savers over $17 billion every year.[1]

Conflicted financial advice may be offered to you by a professional who is not required to put your interests before their own. That’s what you risk when hiring an advisor who gets paid on commission rather than a fiduciary investment advisor.

Fortunately, a commission-based advisor is not your only choice. There are fiduciary investment advisors whose business models are meant to act in your best interest, not theirs.

Know Your Options

Not all investment advisors are compensated in a similar manner. In fact, there are three ways that an invesment advisor can be compensated:

  • Commission-Based. Commission-based investment advisors are paid when you buy or sell an investment. It probably sounds familiar because that is how most salespeople are paid. The more they sell, the more commission they make. Unfortunately, that is where a conflict of interest exists; these advisors make more if you buy more products. Even worse, some mutual funds or insurance products pay a higher commission than others, which gives advisors a financial incentive to recommend those products to you over less expensive options which may be better suited to meet your financial goals.
  • Fee-Only. A fee-only investment advisor may charge an hourly rate, a flat fee, or a percentage of the assets under management. In this case, you are paying the advisor directly, instead of them receiving commissions from a third party for selling you a product. This structure may sound familiar; most accountants and attorneys are paid on this basis.
  • Fee-Based. To add to the confusion, there is also a third option, which is a hybrid of the two. “Fee-based” advisors will charge you fees for some services (such as charging you a percentage of your assets under management for investment advice and financial planning). In addition, they may charge commission on selected services (often, insurance sales). Other fee-based advisors, such as the Investment Counsel Company, only charge on your assets under management and all their services are included for that fee. The onus is on you to ask questions and learn how an advisor receives their compensation from clients.

How Is This Legal?

People often wonder how a person can legally call themselves an “advisor” without the requirement to give you unbiased, objective advice.

This has been an ongoing industry controversy for the past few years. There is a current SEC regulation that may prevent commissioned advisors from calling themselves “Advisors.” However, it’s not presently clear if this will be implemented and/or enforced.

In the meantime, the message is “buyer beware.” You must do your research before hiring an investment advisor to make sure you know exactly what you are getting.

A Double Whammy

You might believe if the commissioned advisor is recommending more expensive products, it may be because these are superior. With some products, it may be true that you get what you pay for, so it’s reasonable to expect the same principle to apply to investment products.  Research suggests that is not the case, however. Let’s take mutual funds, for example. Every mutual fund charges a fee for management, which of course makes sense. However, some funds charge significantly more than others.

While you would think the premium should be for better performance, Morningstar, a large mutual fund research company, found that those higher-cost funds usually underperform, simply because they have higher costs![2]

So there is no advantage to you, the consumer, for paying more. And there is every reason you should look for an investment advisor who specifically selects low-cost products for use in your portfolio.

Fee-Only Advisors

Many investors choose a fee-only investment advisor for the simple reason that doing so can help them avoid conflicted advice. With no commissions, advisors have fewer conflicts of interest, since they aren’t financially motivated to promote a more expensive investment product for their own gain.  Since their fee is based on your assets under management they want to see your investments perform well.

The Value of a Fiduciary Relationship

Best of all, fee-only investment advisors are licensed by the SEC as Investment Advisor Representatives, and practice with Registered Investment Advisor firms. What does that mean? Well, the important thing to remember is that these particular advisors are obligated by law to act as your fiduciary.[3] Simply put, they are legally required to always put your interests before theirs. If they don’t, you would have legal recourse.

These fiduciary investment advisors are very different from commission-based advisors. Commission-based advisors are not required to put your best interests first, they technically only have to offer you something “suitable” for your needs (even if the product only costs more because it pays them a higher commission).

Hiring a fee-only fiduciary investment advisor isn’t an automatic guarantee that they’ll dispense sound advice. That is where you need to look for decades of experience and the right credentials to ensure they are good at what they do.

Putting It All Together

As you can see, selecting an investment advisor or wealth manager is much more complicated than just asking your friends for recommendations.

So take your time and be sure to ask the right questions. Is your advisor a full-time advisor?  Are they fee-only or commission?  Select someone who will act as your fiduciary at all times. Also, consider working only with fee-only investment advisors to help minimize the conflicts of interest, so you can rest easy that you’ll be receiving honest advice instead of a sales pitch.

 

[1] Furman, Jason, and Betsey Stevenson. “The Effects of Conflicted Investment Advice on Retirement Savings.” National Archives and Records Administration, National Archives and Records Administration, 23 Feb. 2015, obamawhitehouse.archives.gov/blog/2015/02/23/effects-conflicted-investment-advice-retirement-savings.

[2] Kinnel, Russel. “Fund Fees Predict Future Success or Failure.” Morningstar, Inc., Morningstar.com, 5 May 2016, www.morningstar.com/articles/752485/fund-fees-predict-future-success-or-failure.

[3] SEC Fiduciary Standard – Investment Adviser Association. (n.d.). Retrieved June 14, 2020, from https://www.investmentadviser.org/home/side-content/sec-standard

 

 

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