People who may need a financial plan and investors selecting a financial professional will encounter “fee-only” advisers and “fee-based,” or commission-based financial advisers. What’s the difference between the two? The terms sound similar, but there are important differences between these types of financial professionals.
There are four important terms everyone needs to be familiar with when it comes to selecting which financial professional to work with: fiduciary duty, conflict of interest, duty to disclose and moral hazard.
Typically, fee-only advisers conduct their business under a “fiduciary duty,” which means by law, they must have their clients’ best interest at heart. Registered Investment Advisers are typically regulated by the states and must operate under this duty. Certain professional designations also carry this requirement, such as an Accredited Wealth Management Adviser.
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Fee-only advisors have no inherent conflicts of interest, they don’t accept fees or compensation based on product sales, and they generally provide more comprehensive advice. Many also carry professional designations which hold them to strict codes of professional and ethical conduct. Fee-only advisers can charge a one-time or ongoing fee, depending on the types of services they provide. The fees may be hourly, flat or based upon a percentage of assets under management.
However, fee-based advisers may charge both fees and commissions based on the products they sell. Most fee-based advisers hold licenses that allow them to sell investments or insurance products for a commission. Because fee-based or commission-based advisers generally don’t have a “duty to disclose” their method of compensation, it can confuse clients who may not fully understand when their fee-based advisers are working for commissions. The potential for confusion underscores the importance of understanding how advisors are compensated. Any financial adviser’s compensation method can create a conflict of interest between what is best for you, the client, and what is best for the adviser’s wallet.
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There is an inherent “moral hazard” with commission-based advisers. When anyone is paid on a performance basis, an immediate incentive comes into play, thereby a motivation to sell unsuspecting customers the products that will pay the highest commissions. A moral hazard is a situation where a party has a tendency toward being more willing to take a risk, knowing that the potential costs or burdens of taking such risk will be borne, in whole or in part, by others.
Before you decide to work with a financial adviser, whether at a small firm, a big brand-name financial institution, or a broker-dealer, you really need to do your research and ask some tough questions. If you walk into a major bank seeking help with managing your money and investments, it’s virtually guaranteed that the “financial adviser” is working for the bank.
Ask questions, such as: What are the professional qualifications and educational background of the adviser? Where does his or her experience and expertise lie? How are they compensated? Are they held to a fiduciary standard? Have they ever been disciplined by the SEC or FINRA? Why are they recommending a certain product to you? Ask them to explain the suitability of any financial strategy considering your unique situation. Don’t be afraid. Put them on the spot. It’s your money, after all!
Michael Philips is the founder and owner of Financial Mastery Wealth Management and a Registered Investment Advisor in California.
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