When I was 11 years old, I played Little League baseball in Canton, Ohio. Any player in the league who hit a home run received a 6-pack of Coca-Cola, in classic 16-ounce bottles. Surprising everyone, I somehow managed to hit two home runs in the first three games. Of course, after relishing 12 bottles of soda, I spent the next five games or so “swinging for the fences”. The strike outs mounted and my batting average plummeted. About midseason, my older brother, who was my idol, attended a game. Afterwards, he talked to me about shortening my swing, choking up on the bat, putting the ball in play, and forgetting about the Coca-Cola. My season turned around!
Two main lessons from that experience are applicable to what I’ve witnessed in my career in financial counseling, “advisors do what they are paid to do”, and “trustworthy, independent advice is priceless”.
Although many different labels are used, there are really three types of financial advisors in the investment industry:
2. Fee-based and
3. Independent and fee-only.
While there are excellent advisors in all three categories, and there is a place for each in the industry, it is important for any informed consumer to understand how each is compensated, and how that can impact the advice the advisor delivers.
Commission-based advisors sell products such as annuities, insurance, stocks and actively managed mutual funds. They earn their living on the products that they sell, and while they may refer to themselves as financial planners and offer elements of financial planning, it is rarely the cornerstone of the relationship. Purchasing a commission-based product is not inherently bad; after all, most young couples with children need life insurance, but the right product, not the fee earned on it, should be paramount.
Fee-based advisors also sell products that pay commissions or are proprietary, but these sales supplement a fee that is typically based on a percentage of assets under management. For example, some fee-based firms may charge their clients a fee on the account market value, and earn additional fees when certain private equity and hedge funds are used in the portfolios. These arrangements are not necessarily inferior, as long as the products sold are appropriate, best-in-class and the conflict is fully disclosed.
Independent, fee-only advisors (usually Registered Investment Advisors) receive compensation based on either a percentage of the assets managed, or a fixed or hourly fee. They do not earn commissions on products or mutual funds that they recommend and do not have proprietary products. The focal point of the relationship is a goal-based, comprehensive, customized financial plan that drives investment allocations and provides the frame of reference for decisions and meeting agendas. If a commission-based product is needed, they make referrals to people they trust who sell these products.
Finding a great financial advisor can be perplexing. You’ve hit a home run when you find one who is knowledgeable and attentive, makes decisions based on comprehensive information, cares about you and your family, and always recommends what is best for you, regardless of how the advisor is compensated.