In light of recent Wall Street scandals, many investors are taking a closer look at who is actually managing their money and what investment methodology they are following. Investors are taking the time to do their due-diligence and are becoming more educated on selecting the best financial advisor.
In my travels and meetings with clients, I continue to hear the same vein of questions. How do I select the best wealth manager? How do I select the best investment management company? Are there FAQ’s on selecting the best financial advisor that I can read? Are “Registered Representatives” fiduciaries? What is a Registered Investment Advisor? What is the difference between a Registered Representative and a Registered Investment Advisor? With such great questions, I wanted to take the time to answer these questions and address this fundamental topic of helping investors select the best financial advisor or wealth manager.
Question #1. How do I know if my Financial Advisor has a Fiduciary Responsibility? Only a small percentage of financial advisors are Registered Investment Advisors (RIA). Federal and state law requires that RIAs are held to a fiduciary standard. Most so called “financial advisors” are considered broker-dealers and are held to a lower standard of diligence on behalf of their clients. One of the best ways to judge if your financial advisor is held to a Fiduciary standard is to find out how he or she is compensated.
Here are the 3 most common compensation structures in the financial industry: Fee-Only Compensation This model minimizes conflicts of interest. A Fee-Only financial advisor charges clients directly for his or her advice and/or ongoing management. No other financial reward is provided, directly or indirectly, by any other institution. Fee-Only financial advisors are selling only one thing: their knowledge. Some advisors charge an hourly rate, and others charge a flat fee or an annual retainer. Some charge an annual percentage, based on the assets they manage for you.
Fee-Based Compensation This popular form of compensation is often confused with Fee-Only, but it is very different. Fee-Based advisors earn some of their compensation from fees paid by their client. But they may also receive compensation in the form of commissions or discounts from financial products they are licensed to sell. Furthermore, they are not required to inform their clients in detail how their compensation is accrued. The Fee-Based model creates many potential conflicts of interest, because the advisor’s income is affected by the financial products that the client selects. Commissions An advisor who is compensated solely through commissions faces immense conflicts of interest. This type of advisor is not paid unless a client buys (or sells) a financial product. A commission-based advisor earns money on each transaction-and thus has a great incentive to encourage transactions that might not be in the interest of the client. Indeed, many commission-based advisors are well-trained and well-intentioned. But the inherent potential conflict is great.
Bottom Line. Ask your Financial Advisor how they are compensated.
Question #2: What does Fiduciary mean in relation to a Financial Advisor or Wealth Manager? fi•du•ci•ar•y – A Financial Advisor held to a Fiduciary Standard occupies a position of special trust and confidence when working with a client. As a fiduciary, the Financial Advisor is required by law to act in the best interest of their client. This includes disclosure of how they are to be compensated and any corresponding conflicts of interest.
Question# 3: Who is a Fiduciary? Fiduciary responsibility does not arise only in the financial services industry. Professionals in other fields also are also legally required to work in your best interest. Who is a Fiduciary? Physician – Yes, follows the Hippocratic Oath Lawyer – Yes Stock Broker – No Insurance Agent – No Registered Representative – No Registered Investment Advisor – Yes CFP Practitioner – Maybe** Financial Planner – Maybe**
**Advisors who are affiliated with a broker-dealer firm are most likely not fiduciaries. If the client signs an NASD binding arbitration agreement (which is required by almost every broker-dealer firm), then the firm’s advisors would not be held to a Fiduciary Standard by the North American Securities Dealers. CFP Practitioners and Financial Planners will be held to a Fiduciary Standard if they are also Registered Investment Advisors (RIA) or associated with an RIA firm. Be sure and ask!
Because broker-dealers are not necessarily acting in your best interest, the SEC requires them to add the following disclosure to your client agreement. Read this disclosure, and decide if this is the type of relationship you want to dictate your financial security: “Your account is a brokerage account and not an advisory account. Our interests may not always be the same as yours. Please ask us questions to make sure you understand your rights and our obligations to you, including the extent of our obligations to disclose conflicts of interest and to act in your best interest. We are paid both by you and, sometimes, by people who compensate us based on what you buy. Therefore, our profits, and our salespersons’ compensation, may vary by product and over time.”
Bottom Line. If this disclaimer appears in the agreements you are signing, you need to question your advisor. Obtain complete disclosure about how he or she is compensated, and where his or her loyalties lie. Then decide if the relationship is in your best interest.