The financial services industry suffers from significant ethical challenges, but most people do not realize the extent to which their interests directly conflict with the interests of their financial advisor or how those conflicts impact their wealth. For example, only 9% of financial advisors are both obligated to provide investment advice that is in their client’s best interest and are not permitted to be compensated through commissions or sales charges.
Why should you care if your financial advisor is obligated to act in your best interest or how your advisor gets paid? The U.S. Department of Labor estimated in 2016 that conflicted investment advice may cost Americans as much at $17 Billion a year! One way to avoid paying the potentially high costs of receiving conflicted investment advice from a trusted financial advisor is to only work with an advisor bound by a fiduciary duty to you and works on a fee-only basis.
What is a Fiduciary?
A fiduciary financial advisor is bound by an ethical obligation to act only in their client’s best interest. A fiduciary must avoid conflicts of interest and clearly disclose any possible conflicts to their clients.
Common Conflicts of Interest
Financial advisors can have many conflicts of interest that are likely to harm your financial success and cost you a fortune in fees. Here are two examples of common conflicts you should be aware of when working with a financial advisor:
- Fee-Sharing Agreements – Many financial advisors enter into fee-sharing agreements with mutual fund providers. A mutual fund provider can charge investors in their mutual funds an annual sales fee that may then be given to a financial advisor as a kickback for investing their clients in the providers funds. Fee-sharing is a huge conflict of interest because financial advisors are incentivized to only invest their clients in mutual funds that kickback fees to them, instead of investing in funds with the best management and lowest fees or better yet, not buy mutual funds at all for their clients.
- Commissions on the Sale or Trading of Financial Products – Many advisors receive large commissions for investing their clients in mutual funds, insurance policies and annuity products. It is common for advisors to recommend expensive annuities and other insurance products because they earn very large commissions by selling them to their clients.
Also, earning commissions on the trading of mutual funds through up-front fees can incentivize an advisor to “churn” investment accounts. Churning occurs when an advisor trades excessively in order to extract additional commissions from their clients. Upfront fees on a mutual fund (called front-end loads) can be as high as 5% of the value of the trade. If you have a half a million-dollar account and an advisor invests the entire account in several 5% front-end load mutual funds, you just paid $25,000 dollars in fees out of your retirement savings and your financial advisor receives a portion of those fees as sales commissions. When the advisor decides to switch funds in the future you are likely to pay front-end load fees again!
Avoiding Conflicted Financial Advisors Can Be Difficult
Hiring a financial advisor who is a fiduciary and free from conflicts is harder than you may think. At the end of 2018, only 9% of the 691,041 securities industry registered representatives were both fiduciaries and charged on a fee-only basis[i]. Fee-only means the advisor is not registered to sell insurance, annuity products or receive kickbacks or commissions for investing in mutual funds. A fiduciary, fee-only advisor only earns a fee for managing a client’s investments and receives no commission or sales-based compensation of any kind. Most fiduciary, fee-only advisors charge 1% of the value of the assets they manage for their clients per year and this is the only compensation they receive.
Advisors who do not charge on a fee-only basis, charge a fee of around 1% of the value of the assets they manage for their clients a year, plus the commissions they collect for selling financial products and the kick-backs and sales charges they receive from mutual fund companies. Annual fees earned by advisors that do not charge on a fee-only basis can easily total more than 2.5% of the value of a client’s assets per year! It is not hard to figure out why only 9% of advisors are fiduciaries who charge on a fee-only basis.
How To Hire A Fiduciary, Fee-Only Financial Advisor
As public awareness of the benefits of hiring fiduciary, fee-only financial advisors has increased over the years, the broader industry of non-fiduciary advisors have learned to use misleading language to imply they operate as fiduciaries. Only a fiduciary can claim to be a fiduciary but claiming to put client’s interests first and making other statements of trust are permitted by regulators. Tricky language can make it difficult for even industry professionals to easily tell if an advisor is a fiduciary and charges on a fee-only basis.
Most people do not know if their financial advisor is a fiduciary and fee-only. To ensure your financial advisor is a fiduciary and free from conflicts of interest they should meet the criteria listed below.
Your financial advisor should:
- Have a fiduciary duty to you and be free from conflicts of interest.
- Be registered as an Investment Advisor Representative (not a Broker-Dealer Representative or Dual Registered).
- Work for an Independent, Registered Investment Advisor.
- Charge you on a fee-only basis.
- Not sell any financial products, particularly insurance and annuity products.
Making sure you receive unbiased, independent financial and investment advice can reduce your fee load by more than half. So, make sure you ask any financial advisor you work with or plan to work with the right questions and potentially save yourself a fortune over the long-term.
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[i] Source: Financial Industry Regulatory Authority.
