Hiring a financial advisor can be a smart and profitable decision: As we detailed in a recent blog article, advisors using industry best practices can help their clients earn a significant investment premium.
There’s a catch, though. Not all financial advisors do the right thing, consistently, for their clients. Surprisingly, the great majority of financial advisors are under no legal obligation to put their clients’ financial interests ahead of their own.
Behind this strange state of affairs is an old distinction between brokers and true advisors. Remember the term “stockbroker?” These folks are still around, although almost all have changed their titles to the more consumer-friendly-sounding “advisor” or “financial consultant.” Whatever they call themselves, brokers are salespeople. Like car salesmen, they receive sales commissions for selling you investments.
Sales commissions are paid by the manufacturers of mutual funds and other products—and they differ in size from product to product. And legally, brokers are allowed to take their own compensation into consideration when they choose an investment to recommend. So let’s say Fund A has historically performed a little better than Fund B. Fund A, however, only pays your broker a 5% sales commission, while Fund B pays 6%.
If your broker has unimpeachable integrity, he will of course recommend Fund A. But in a commission-based compensation model, he will continually face a conflict that pits his financial interests against yours. You will simply have to trust that he continues to choose your best interests over his own.
On the other hand are true financial advisors. This group, comprising just about 15% of the advisory industry, operates under what’s known as the fiduciary standard. Far more rigorous than brokerage standards, the fiduciary standard legally obligates an advisor to act in their clients’ best interest.
True fiduciary advisors use a compensation model based on a fixed, ongoing fee. In return, clients receive objective, ongoing financial and investment advice. Fee-only fiduciaries such as Janiczek never sell products or receive sales commissions, so they avoid a major conflict of interest.
Now, you may have heard that the federal government recently ruled that by 2018, all advisors dispending advice about retirement investing will have to adopt a “fiduciary” standard. While this is a step in the right direction, it falls far short of fully protecting consumers against conflicts of interest. A few reasons why:
- Sales commissions. Under their weakened version of a “fiduciary standard,” brokers will still be able to sell investments and earn commissions. They’ll simply have to provide a contract stating that their advice is in their client’s best interests.
- Questionable products. Brokers have been criticized for peddling unduly expensive and complex products, even those with poor performance. The new rules permit them to continue this practice.
- A limited scope. The new rules only apply to certain types of retirement accounts. For traditional taxable accounts, brokers will be able to continue acting as non-fiduciaries.
Finally, it’s worth noting that the brokerage industry fought the proposed new fiduciary standard tooth and nail. You can be sure that its acceptance of a more client-friendly approach is grudging. True, longstanding fiduciary advisors like Janiczek don’t do the right thing because we’re forced to. We do it because we believe our clients deserve it. Whose side is your advisor on?
