How the person providing your investment advice is compensated could have a bigger impact on your financial plan’s success than any other factor. Compensation drives the quality of advice and the amount of time an advisor spends working for you. In the investment business, there are three popular model firms utilize to deliver investments or investment advice to their clients.
The first and most common compensation model is the commission model. In this model, the advisor, known as Registered Representatives, are compensated by the investments they recommend. A commission compensated advisor might sell products like life insurance, mutual funds, and annuities.
A second model is called fee-based. These advisors usually have licenses or the CFP(tm) which allow them to give advice for a fee in addition to their Registered Representative licenses. They may call themselves Financial Advisors, Financial Planners, or a number of other titles. These dual licenses advisors are called fee-based because they primarily provide investment advice for a fee, but also utilize annuities, life insurance, and other securities in their practices that pay a commission to the advisor for making a sale.
The third business model is the fee-only business model. Practitioners of this model are licensed as Investment Advisor Representatives of a Registered Investment Advisor (RIA). The term fee-only acknowledges the fact that they are only compensated by the fees their clients pay them. (related: Wall Street Journal: Sometimes Fee-only Isn’t What You Think)
Surprisingly, most advisors aren’t fee-only and many don’t provide advice for a fee at all. For now I will avoid the discussion of why that is and instead focus on why fee-only makes sense:
- Avoiding the possibility of a conflict of interest. There may not be any conflict of interest when a advisor sells you a security, but how can an investor know? By not receiving commissions for the investments recommended, a fee-only advisor eliminates the possibility of any pressures from the issuers of investments to recommend a certain security or strategy.
- Commissions are paid up front. I’m sure the purchaser of a mutual fund from an advisor believes they will be receiving service and advice after the sale, but what is the advisor’s incentive to do so? Fee-only advisors typically charge an hourly rate for a pre-defined amount of work or they charge a fee based on the assets they are managing. The fee-only advisor is then required to continue working for the client to earn their fee as the client can end the relationship at any point.
- Incentive for performance. If the fee-only advisor is being compensated as a percentage of assets he or she is managing, then they can earn a larger fee as the account grows. This creates an incentive (in addition to other requirements to do so) for the advisor to provide regular service and advice to the client in an effort to grow the account.
If you haven’t picked up on it, I am a believer in fee-only investment advice. So much so, that it is the model I’ve chosen for my own business. I value the transparency of the RIA model and I think it allows for strong client/advisor relationships. When presented with their financial plan and investment recommendation, clients of a fee-only advisor know that there is no question as to why a recommendation was made. I think that’s critically important when dealing with something as important as your financial future