Who pays your advisor?

A Very good Poker joke is “Look around the table. If you are not able to find who is to be had that evening, it is you”. Similarly when you are with a professional and you do not bother to find out how he is compensated, frankly, I do not think it is the advisor’s fault. Learn to ask the correct questions. The title of this post is one such question.

The greatest dividing line that separates financial professionals is fiduciary obligation. By law, a fiduciary must act solely in the best interest of the client. As such, a fiduciary is obligated to reveal any potential conflict, as well as to fully disclose how they are compensated for their services.

Doctors, lawyers, chartered accountants, trustees are fiduciaries. In April 2005, the SEC set forth recent regulations that require brokers and other financial professionals to include the following to indicate an absence of fiduciary obligation:

“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 interests. 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.”

If you see this disclaimer, you should ask questions, request complete disclosures, and really question if this is the establishment that seeks to advance your best interests.

After all, that’s why you hire a financial advisor in the first place, isn’t it?

However, most investors do not spend enough time and effort on training themselves about the questions that they should ask. That is gross neglect. See what even SEC is saying is “advisers will answer questions that are asked”. So if you do not know what to ask, God save you!

How Does Your Advisor Get Paid?

The manner in which your advisor gets compensated speaks directly to the question of whose best interest is being served—yours or theirs. Essentially, there are three distinct compensation models for financial advisors:

Fee-Only Compensation: This model can minimize conflict of interest. A Fee-Only Advisor is paid for advice rendered and for ongoing management. No other compensation can be rendered by any other financial institution, thus advancing the fiduciary standard. Fee-only advisors are paid solely for their knowledge and their asset management services.

Fee-Based Compensation: Frequently confused with Fee-Only Advisors, but not at all the same, fee-based advisors may earn only part of their overall compensation from advisory fees paid by clients. They may also receive compensation for commission-based products they are licensed to sell, advancing an inherent conflict of interest. As such, fee-based advisors do not hold to a fiduciary obligation.

Commissioned Compensation: Commission-compensated advisors can face enormous conflict of interest. A financial benefit can only be derived through transactions, creating a bias toward account activity. Unbiased advice is an improbable outcome for investors who use the services of commissioned advisory services. Further complicating the conflict of interest issue, commissioned representatives can receive incentives for selling one investment over another.

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