Despite all the recent hoopla over financial markets reform, there are still questionable business practices in place—especially in the field of financial planning. If you ever plan on using a financial planner, whether through a broker or an independent planner, it would be in your best interest to make sure you know what you are getting. In the retail industry as in the financial planning industry: buyer beware. The burden falls on you to ask your financial adviser the right questions. To help you find an honest financial adviser, here are the top three questions to ask:
1. Do you accept commissions of any form?
The best answer is “no.”
Many financial advisers are actually paid “commissions” by third parties to promote their goods. The most commonly affected products include investments, insurance, annuities, mortgages, and loans. Commissions are often the biggest revenue source for the nation's largest advisory firms. Even many independent advisers who are not directly associated with the product provider will take commissions.
Not all commission-based advisers are necessarily bad people. But you should understand that commissions can bias your adviser's recommendations. Why should you care? Because these commissions are ultimately paid by you in the form of larger fees that are often difficult to detect. They can take the form of sales loads, management charges, surrender penalties as well as back-end charges when you take your money back.
Fees can have a tremendous impact on your bottom line over time. Consider, for example, Sally who is age 30 and has a $50,000 IRA. She makes annual contributions equal to 4% of her salary. At age 65, her projected balances are $252,258 with a typical commission-based financial adviser. But, if her adviser suggested similar investments without embedded commissions, she is projected to have $344,317 or more, even if we subtract the fees that Sally might be paying the adviser directly for no-commission advice.
After adjusting for taxes and inflation, fees can easily eat up a majority of an investment's return on a risk-adjusted basis. Even Morningstar, which famously ranks mutual funds, acknowledges that low fees are more predictive of good future performance than its own coveted ratings. They wrote: "In every single time period and data point tested, low-cost funds beat high-cost funds."
The best financial advisers are “fee only,” since their only compensation is fees paid directly by you, not the mutual funds or insurance companies. But you have to ask specifically for “fee only.”
2. Are you “fee based” or “fee only?”
The best answer is “fee only.”
So-called “fee-based” advisers are actually dual registered advisers who can hat switch between “planning-fee mode” and “commission mode.” By doing so, they end up collecting both planning fees and commissions! Even the Financial Planning Association, the largest trade organization for financial advisers, has acknowledged, to its credit, that few clients are aware of this type of switcheroo. The U.S. Government Accountancy Agency has recently argued for providing clients with clarity. The UK has recently outlawed the practice altogether.
There is one clear legal way to understand your adviser's true method of compensation. In particular, ask for his or her form “ADV Part 2.” A commission-based adviser should check the box “Commissions.” Commission-based advisers are also regulated by a non-governmental group called FINRA. In contrast, a true “fee-only” adviser will not check the commissions box and reports directly to governmental state regulators or the SEC. Many fee-only advisers, such as Veritat Advisors, are also members of NAPFA, a trade organization that bars its members from accepting commissions.
3. At all points in time, will you serve me as a fiduciary?
The best answer is “yes.”
By law, a fiduciary, such as Veritat Advisors, must act in your best interests. Fee-only advisers are required to be fiduciaries at all times and cannot collect commissions. In contrast, dually registered “fee-based” advisers can jump in and out of their fiduciary status in order to collect commissions. When they exit their fiduciary status, they must only follow a “suitability” standard that does not require them to serve your best interests. Again, this “hat switching” is almost never apparent.
The SEC has recently recommended new rules that would bar advisers from switching off their fiduciary obligations. But the rule naturally faces stiff industry resistance. Hence, you must proceed carefully. Some financial planning firms advertise on their websites that they act in your best interests. But they omit the word “always” and then require you to sign a lengthy Client Service Agreement where you acknowledge that you understand these sorts of conflicts of interest. Of course, very few people probably read or really understand this fine print—after all, they've come to a financial adviser for help in the first place.
A good financial adviser can help you to live a rewarding life, while a bad one can be devastating to your life planning and financial savings. Asking the right questions ahead of time can put you on the right path. Even if you decide to work with a commission-based adviser, you should at least understand the conflicts of interest ahead of time.
About the Author: Kent Smetters is a professor at Wharton and founder of Veritat Advisors, a fee-only firm that makes personalized financial planning affordable for all households.
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