Financial Geekery

What does "financial advisor" even mean?

June 18, 2018

John Oliver's bit on financial advisors is an excellent (and hysterical) segment, and he hits the nail on the head: the term "financial advisor" is so ill-defined as to be meaningless. If someone calls themself a "financial advisor", that actually could hold a wide variety of meanings, both in terms of the work they do and in terms of how they get paid (and, therefore, potential conflicts of interest). 

 

Here's a breakdown of the four major types of "hats" a financial advisor might wear. Note that these are by no means exclusive -- any given advisor may be virtually any combination of the four, which can muddy the waters even further!

 

IAR(RIA)/Stockbroker

 

In my experience, when most people think of a "financial advisor", they think of an investment manager or stockbroker: someone who handles their investment and retirement accounts. I include these together because while the work they do is quite similar on the surface, the details of how they are compensated are radically different!

 

IAR's (Investment Advisor Representatives) are financial advisors who work for Registered Investment Advisors (RIA's) -- companies that have strict rules enforced by the states' securities boards and the SEC. Their compensation is generally very straightforward: they charge a percentage of AUM (assets under management), with an average tightly centered around 1%. On the surface, this provides a nice incentive: they are paid more if investments do better, so they're theoretically incentivized to do well! However, there are a few conflicts you should be aware of:

 

  • As I've written, asset allocation is a very personal decision. However, a purely AUM-based investment manager is incentivized to make an allocation that fits their firm's risk tolerance, not yours! While your main concern is your portfolio's long-term performance, their livelihood depends on your portfolio's performance year-to-year, so they're incentivized to make your portfolio more conservative than otherwise in order to avoid dips in their revenue due to volatility. (This is likely part of the reason why "60/40 shops" are so common, despite the fact that many high net worth clients have a higher risk tolerance and capacity!)

  • Because they are only paid for assets under management -- which does not include accounts such as 401(k)'s -- they are highly incentivized to have you roll over your 401(k) into an IRA. Now, this is often a good choice, but there are exceptions, such as when you want to make Roth IRA contributions as a high earner. (Clients have asked me why they haven't heard of the Roth IRA strategy mentioned in the link. The answer is simple: it's because AUM-based financial advisors don't want them to know!)

  • Finally, AUM fees will also influence their behavior when they put on the "financial planner" hat (see below). AUM-based advisors are incentivized to recommend any strategy that increases your assets: save more! Refinance your house (and invest the difference)! Lower your spending in retirement! Etc., etc.

 

Having said all this, every RIA is held to the fiduciary standard, widely considered to be the highest standard of care: they are legally required to place their clients' interest first and foremost. 

 

Meanwhile, stockbrokers have their own set of conflicts. Even though on the surface their job is the same (manage your portfolio), they are salespeople -- they're paid to sell products! Some are mutual fund sales reps, who are paid a hefty percentage if you purchase the fund (see FINRA's article on mutual fund share class commissions). Some are simply paid on a per-trade basis: they are incentivized to buy and sell frequently, whether or not it's the best thing for your portfolio. Moreover, because they are first and foremost agents of their employer, brokers are held to the suitability standard, which means that they are legally allowed a lower standard of care. 

 

Luckily, there's an easy question to ask in order to determine whether or not someone is paid on commission: "are you fee-based, or fee-only?" A "fee-based" financial advisor is paid partly by you, and partly on commission; a "fee-only" advisor does not take on commissions, ever.

 

Financial Planner

 

"Financial planner" is the standard title in the industry for an advisor who provides comprehensive advice on your financial situation -- sort of a "general practitioner for your financial health". Like medical GP's, they carry around a large body of knowledge on a variety of topics, and also like medical GP's, they will refer clients to specialists as necessary (CPA's for filing taxes, lawyers for estate planning, agents for insurance, etc.). 

 

Of course, the knowledge level of any given financial planner may vary widely. Certified Financial Planner® professionals are required to have a fundamental understanding of insurance, investments, estate plannng, income tax, and retirement planning, but there's a big difference between taking a class and being an expert. (That said, the six-hour CFP® exam only has a ~65% pass rate, and is the most grueling test I've ever taken -- and as an electrical engineer, that's saying something!)

 

It's quite rare to find a financial advisor who only wears the "financial planner" hat. Not only are planners also insurance salespeople, investment managers, or both, but it's not uncommon to find financial planners who are also CPA's, lawyers, or other professionals. 

 

By far the most prevalent combination is "investment manager + financial planner". Generally these advisors are investment managers first and financial planners second, and their compensation reflects that: they require clients to invest their assets with them, charge the aforementioned average of 1%, and provide financial planning services as an added benefit "for no additional charge". Having said this, there is a growing contingent of advisors who offer standalone financial planning for either a flat fee or an hourly rate. 

 

Side note: "flat fee" does not mean "no conflict of interest"! If you charge a flat fee, you're incentivized to minimize time spent on a client, which can mean improving efficiency but also potentially cutting corners. Of course, if you charge an hourly fee, the reverse is true: efficiency is disincentivized, though thoroughness is encouraged. There's no way to avoid conflict of interest; all you can do is minimize it and fully disclose it (which CFP® professionals are required to do).

 

Another side note: some firms (including Seaborn!) offer a combination of flat-fee financial planning and AUM-based investment management, which has a side benefit of reducing the investment manager conflict of interest I mentioned: because a significant portion of their revenue comes from flat fees that aren't affected by the market, there is less of a temptation to design portfolios that fit their risk tolerance and capacity, rather than yours.

 

Insurance Salesperson

 

"Boooooo!" The idea of an insurance salesperson has such a negative connotation that they were even used as a humorous doomsday device in the old Space Quest series. It should come as no surprise, then, that financial advisors whose primary income comes from insurance don't rush to put that on their business card.

 

Insurance commissions can be quite lucrative, though, so many firms make that an integral part of their business. Financial services companies like Ameriprise and Northwestern Mutual make a lot of money selling insurance-based investment products such as Variable Universal Life policies.This naturally leads to a conflict of interest: if you're paid to sell the client a hammer, every financial problem will strongly resemble a nail!

 

Luckily, if you want to find out if someone's going to try and sell you insurance, you can ask the same question as you would if you wanted to figure out whether they're an IAR or a broker: "are you fee-only or fee-based"? "Fee-only" rules out commissions from either investments or insurance!


Now, there is an argument for fee-based financial services: some financial advisors claim to remain fee-based in order to provide their clients with a full-service experience, ensuring that clients get exactly the right insurance for their financial situation by directly providing the insurance products themselves. That's not without merit, but in my personal judgment, the conflict of interest is simply not worth it. A good financial planner can work just as easily with an insurance agent (once the planner has determined the right product) as they can with a CPA or estate lawyer, handling their clients overall financial picture from an unbiased and comprehensive view, while letting the various specialists handle the details.

 

What next?

 

Chances are high that after reading this article, you have (rightfully, in my estimation) decided that you want to work with a fee-only financial planner. How do you find one? What do you ask? Good questions, but this article has run long already -- I'll save them for another day. In the meantime, as always, feel free to comment or ask questions. Have you had an experience with an advisor who wore a unique combination of hats not outlined above? Did you have an unexpectedly good (or bad) experience? Let me know!

 

 

Britton is an engineer-turned-financial-planner in Austin, Texas. As such, he shies away from suits and commissions, and instead tends towards blue jeans, data-driven analysis, and a fee-only approach to financial planning.

Please reload

Subscribe

RSS Feed

Recent Posts

October 20, 2019

Please reload

Archive

Please reload

Tags

Please reload