Why Should You Choose a Fee-Only Financial Advisor?

There’s a lot of confusion and misinformation out there about how financial advisors are paid for the services that they provide. In fact, the term “advisor” creates a great deal of this confusion as it implies that you are receiving unbiased advice, rather than a sales pitch. However, the term “financial advisor” is not a regulated term and just about anyone in the financial services industry can assume that title. Because of this, understanding how an advisor is paid is vital. Compensation models can have a big impact on the incentives, legal obligation, and expertise of the advisor. This in turn can affect the objectivity and quality of the financial advice given to clients.

How do financial advisors get paid?

There are three basic models for how financial advisors are compensated:

Commission

Commissioned financial advisors are paid when they make a sale - just like sales reps in other industries. Some examples of financial products often sold for commissions are annuities, life insurance, and mutual funds. While they may use the title “financial advisor”, this group is made up of stockbrokers and insurance agents.

The financial advice these agents give is deemed to be “solely incidental” to the sale of the product, and the salesperson is held to a fairly low legal standard called “suitability”. The suitability standard of care is designed to protect consumers from products that are egregiously inappropriate for the client’s specific financial situation, but says nothing about conflicts of interest or excessive, hidden fees.

This means that they can sell financial products that are best for them, and not for you.

Commissioned advisors are also not usually required to disclose the amounts of the commissions they receive or any conflicts of interest.

Finally, as commissioned advisors essentially act as sales reps for the companies they represent, their training is predominately geared toward learning how to sell the products that make their company the most money. Sort of the way a salesman at the Honda dealership will know everything about Honda’s and how to sell them, but will be less equipped to offer holistic car-buying advice to find the best car to suit your needs.

Fee-only

Fee-only financial advisor’s compensation comes directly from their clients. They do not receive compensation from any other third-party agreements. This ensures their objectivity and duty to their clients. They are incentivized to act in the best interest of their clients rather than selling a product that earns them the highest commission.

In addition, fee-only financial advisors are subject to a strict fiduciary standard, which imposes both ethical and legal obligations to put their clients interests ahead of their own.

Because fee-only advisors don’t have a financial incentive to recommend one product over another, they are also more likely to understand and utilize a wide range of products that fit varying client needs.

Fee-based

Fee-based financial advisors are a hybrid of commission and fee-only. They often charge clients fees to manage investment portfolios, but also receive commissions for selling products such as life insurance or annuities. Similar to commissioned financial advisors, they are not usually required to disclose the amounts of commissions they receive or other conflicts of interest. This can cause a lot of confusion for unknowing investors who wonder whether they are being given advice or a sales pitch. When your advisor can switch between both roles, it can be hard to tell.

Why hire a fee-only financial planner?

Hiring an advisor who earns commissions for product sales is like going to a doctor who is employed by the pharmaceutical company. Though it is possible for commissioned advisors to act in their clients’ best interests, the financial incentives and the lack of legal obligation to act in clients’ best interests create an environment that is ripe for abuse.

In short, there are three primary reasons to consider working with a fee-only financial advisor:

1. Reduced conflicts of interest - because their compensation doesn’t vary based on the product they recommend, you are more likely to receive objective advice.

2. Legal obligation to act in your best interest - anyone can claim to offer unbiased advice, but working with someone who is committed to the fiduciary standard 100% of the time can give you peace of mind that the advice is in your best interest.

3. Holistic approach - because fee-only advisors are not incentivized to sell a specific product, they are more likely to have a broad understanding of options that work best for your unique situation - rather than offering one-size-fits-all solutions.