Following recent Wall Street scandals, many investors are scrutinising who is really investing their capital and what investment strategy they are employing. Investors are spending more time doing their homework and learning how to choose the right financial advisor. E.A. Buck Financial Services – Kailua-Kona Financial Planning is one of the authority sites on this topic. The same questions keep coming up in my travels and meetings with clients. What criteria can I use to choose the best wealth manager? How do I choose the right asset management firm? Are there any frequently asked questions about how to choose the right financial advisor that I can read? Fiduciaries are “Authorized Representatives”? What is the concept of a Registered Investment Advisor (RIA)? What makes a Registered Representative different from a Registered Investment Advisor? With so many excellent questions, I decided to take the time to respond to them and discuss the important topic of assisting investors in choosing the right financial advisor or wealth manager.
Question #1: How do I know if my financial advisor is obligated to act in my best interests?
Registered Investment Advisors make up a small proportion of financial advisors (RIA). RIAs must be kept to a fiduciary standard under federal and state law. Most so-called “financial advisers” are really broker-dealers, which means they are kept to a lower standard of care on behalf of their clients. Finding out how the financial advisor is paid is one of the easiest ways to determine whether he or she is holding to a Fiduciary standard.
The three most common compensation mechanisms in the financial sector are as follows:
Compensation based solely on fees
Conflicts of interest are minimised in this model. For his or her consulting and/or ongoing supervision, a Fee-Only financial advisor charges clients directly. No other financial incentive is offered by some other institution, either directly or indirectly. Only one thing is sold by fee-only financial advisors: their expertise. Some advisors bill by the hour, while others bill by the flat fee or annual retainer. Some charge a portion of the funds they control for you on an annual basis.
This common form of compensation is often confused with Fee-Only compensation, but the two are not the same. Fee-based consultants are compensated in part by the fees charged by their clients. However, they may be compensated in the form of commissions or discounts from financial products that they are authorised to sell. Furthermore, they are not expected to provide detailed information to their clients on how their compensation is earned. Since the advisor’s compensation is influenced by the financial products that the client chooses, the fee-based model introduces several possible conflicts of interest.
Fees and commissions
An advisor who is paid exclusively on fees has a lot of potential conflicts of interest. If a client buys (or sells) a financial product, this form of advisor is not compensated. A commission-based advisor is compensated for each transaction, so he or she has a strong incentive to promote transactions that are not in the client’s best interests. Many commission-based advisors are well-intentioned and well-trained. However, there is a lot of room for confrontation.