Friday, March 20, 2015

Types of Financial Advisors

Remember when I spent a short stint working as a financial advisor getting paid 100% commission? This experience helped me learn how important it is to know the different types of financial advisors. Even if you don't want to BE a financial advisor, you will likely interact with a financial advisor at some point, so it's a good idea to know which type of advisor is best for you. The easiest way to differentiate between advisors is the way that they are paid. How an advisor is paid will determine what they are able to offer you, and can also be a sign of potential conflicts of interest. For simplicity, I'll combine these into three groups, commission based, fee-only, and salary based advisors.

  1. Commission based – This is perhaps the most common way that an advisor is paid. This is also known as a broker. Whenever you make an investment through a broker, you are charged a commission (whether or not you realize it), which goes to pay the broker. Seems pretty straightforward, right? Unfortunately, it's a lot more complicated than it sounds. You may or may not be aware of how much you are paying in commissions, and even if you think you do know, there are likely other behind the scenes payments that occur that you aren't aware of. Another problem is that different investment products pay different rates of commission, with those that pay the highest commission often being the investments that are the worst things an investor could buy. When I worked under this pay structure, I saw this conflict of interest daily and usually saw co-workers leading with the highest commission paying products first. For example, if a broker sells a variable annuity or a private placement, they could earn as much as a 10% commission, quite a bit higher than if they were to sell you loaded mutual funds that pay a 5% commission up front. I don't care who you are, earn twice the money for recommending one thing over another and you're going to see the higher commission investment recommended more often.


    Unlike other critics of the commission model, I'm not 100% opposed to working with an advisor that earns a commission, where I do have a problem is when commission represents the vast majority of pay.


  2. Fee Only – A fee only advisor is just like it sounds, they only are paid in fees, and those fees can only come from you and there are no behind the scenes financial arrangements. A fee based advisor works for you, and when you enter into a relationship with one, you should have a clear picture of what to expect from them and how they are paid. Currently, a fee-only advisor is held to the fiduciary standard, meaning their recommendations must be in your best interest. This type of advisor could charge you in the $150-300 per hour range for things like financial planning, but the most common way a fee-based advisor is paid is on a percentage of assets. This means that they are actively managing your investments and charging you a set percentage based on how much they are managing. As your account balance goes up or down, so does the amount they can collect in fees. This is typically as high as 1%, but generally decreases the more you have invested.

    The challenge with this model is that most of these advisors will have high minimum account balances, usually requiring at least $500,000 to $1,000,000, making it nearly impossible for the average investor to work with a fee-only advisor until they are well on their way towards wealth accumulation. Lately there have been 'robo-advisors' popping up that attempt to offer the same service in a web-based, automated solution with minimal contact with an actual person, but I believe that these are still untested. The true test of the robo-advisors will be how they perform in a market downturn. I spent a lot of time in down markets trying to convince clients not to sell everything, and a lot of time in up markets trying to convince (in some cases the same) clients to not invest too aggressively. I'm not sure how well an automated system can reason with a human.

  3. Salary based –A salary based advisor generally can act as a broker or as a fee based advisor. Because they are licensed as both types of advisors, they can earn commissions when acting as a broker, but if they are acting as a fee-based advisor, cannot earn commissions. This can be confusing, so keep in mind that if you aren't clear how you are being charged, the advisor is acting as a broker. To my knowledge, it is mainly large discount brokers (E*Trade, Fidelity, Schwab, TD Ameritrade, etc.) who will have this structure, and my belief is that it is done this way not to be schizophrenic in their business model, but rather to be able to offer as many different services as possible. These companies are generally in the business of having as many assets under administration (AUA) as possible, whether managed on a fee-only basis or on a commission model. An advantage of this is also that you can typically meet with a representative from this type of company when you are just getting started and don't have to wait until you have accumulated the large minimums most fee based advisors require. They will also often have much lower minimums for fee-based relationships (between $50,000 and $200,000).


    When I worked under this model, my pay was roughly 25% salary, 25% commission and 50% bonuses that were based on customer retention, referrals, and customer satisfaction survey results. Yes, I was earning commissions, and yes, the commission rates were different depending on the product sold, but the difference in commission between products was very small. If a client invested $1,000,000, the difference between the highest and lowest commission I could earn was only $400. My real incentive was not to sell the highest commission generating product, but rather to develop strong relationships with my clients and to retain their business, whether that be fee based business or commission based business.

Should you find yourself needing a financial advisor, my recommendation would be to steer clear of the 100% commission based broker. Not only will you be paying fees and commissions, but they will likely be much higher than you are aware, and much higher than if you were to work with one of the other types of advisors.

If you're curious how a financial advisor is paid, it should be as simple as asking the person you are meeting with. If you'd rather research on your own or before going in for a meeting, dig around on the company website and you'll likely find what you're looking for. Fidelity and Schwab have actually published their compensation details on their websites.

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