The industry for financial advice is confusing. Professionals in the business of helping the public with their personal finances work for different types of companies, are compensated in different ways, and have varying standard by which they’re required to treat their clients.
This is my 13th year in the industry. Though my experience probably gives me more knowledge than the average consumer, there are quite a few I’m confused by all the layers at play. (Yeah yeah, there’s a joke to be made there). Whether it’s my cognitive abilities or whether the industry is in fact confusing, this post will attempt to break down & describe the industry for financial advice. I’ll split this up into a few statistics, how advisors are compensated, one of the major problems this structure creates, and how you might interview an advisor you’re considering.
There are a lot of financial professionals in the United States. FINRA (Financial Industry Regulatory Authority), is the national organization that keeps track of advisor licensing and currently lists about 630,000 representatives registered to deliver financial advice. Now, many of those are not in the direct business of financial advice. They may be investment bankers, they may be operational staff, and they may be running narrow products and services like managed futures or commodities strategies. None of these are what I’d consider to be in the business of providing financial advice or planning services.
Cerulli Associates is a research company that does a much better job putting a finger on the actual number of people delivering some type of financial advice across the country. Their most recent study estimated about 311,000, which includes professionals across all industry channels. Of those 311,000, only about 50% deliver financial planning services. Meaning, there are more or less 155,000 financial professionals in the US directly delivering advice and planning services. This seems surprisingly low to me, given that there are about 125 million households across the country. That means that if only half of the households in the US worked with a financial planner or advisor, each advisor would need to serve over 400 households!
There are predominantly three ways that advisors and their firms are compensated for providing services:
- Commissions on products they sell;
- Fees charged directly to their clients; or
- Some blend of the first two
Generating income from sales commissions is pretty straight forward. A financial professional works for an insurance company or mutual fund company, and their job is to sell the company’s products. This type of arrangement is well understood, reasonably transparent, and perfectly fine in my book. We expect our real estate agents to collect a commission when they help us buy & sell homes. We should also expect an insurance agent to collect a commission when we buy life insurance.
On the other end of the spectrum lies fee-only financial advisors. Fee-only advisors & their firms are compensated only by their clients directly. A client needs some help with their financial situation, and pays an advisor directly for their professional help. This arrangement is also transparent, in that clients know exactly what they’re paying their advisor, and are able to compare that to the value they get from the engagement.
Of the 155,000 or so financial planners around the country, it’s actually quite difficult to get a feel for how many of them are fee-only. The National Association of Personal Financial Advisors (or NAPFA) is a professional organization that requires its advisors to be fee-only, and currently has around 3,000 members. But there are certainly thousands of advisors around the country operating in a fee-only fashion who are not members of NAPFA.
What’s even more confusing is that there actually several different definitions of “fee-only”. The strictest definition entails that no one in an advisor’s entire household may receive a commission for working with clients – even if an advisor’s spouse is an insurance agent or real estate broker. On the other hand, the loose interpretation of fee-only relates only to investment products. Advisors working under this interpretation could sell insurance products for a commission freely, and still label themselves fee-only. Michael Kitces called out CNBC’s list of the top 100 fee-only advisory firms a while back, as 90% of them fit this definition. How’s that for misleading?!
Fee-Based Does Not Imply Fee-Only
Commission based and fee-only are at opposite ends of the compensation spectrum. Anything in between is what many professionals are now calling “fee-based”. Basically, it means that they’re licensed to both deliver advice for a fee and sell products for a commission. They may charge you for advice, but also collect a commission if you take the advice and purchase the product they’re recommending.
I’ve heard fee-based described in several different ways. Some professionals will say “90% of my business is fee-only”, or “I’m almost totally fee-only”. Descriptions like this aren’t necessarily disingenuous, but are certainly misleading. Being fee-only is like being pregnant. You can’t be 90% pregnant. Either you are or you aren’t. In the financial world, either your only source of compensation comes directly from your clients, or it doesn’t. Being 90% fee-only means a professional is fee-based.
Just as it’s difficult to put a finger on what portion of the advisors in the US are fee-only, it’s just as difficult to determine what portion are fee-based. From my experience I can tell you that it’s the majority of the 155,000 or so out there delivering advice and planning services today. And again, this isn’t bad in and of itself. I know tons of wonderful advisors who are fee-based. Many of whom deliberately do not want to be fee-only, as they prefer to help their clients obtain & implement insurance coverage just as they do investment portfolios.
Despite the ambiguity surrounding the exact definition of fee-only, the real problem lies with professionals misrepresenting how they’re compensated and how their firms are structured. A financial professional isn’t “bad” just because they work on a commission basis, sell insurance, or some blend of the two. What is bad is when someone uses the guise of objective advice to sell products.
There are hundreds of examples out there, but take this Reddit user’s post about their experience with a “financial advisor” referred by a friend. This couple needed some help with their financial situation. They have a baby on the way and want to make sure they’re saving enough for retirement – very common issues. The “advisor” they speak with asks a bunch of questions about their preferences, goals, and situation, which is a prudent first step. A week later during their next meeting, the professional slaps a fat, confusing financial plan on the desk and begins explaining how they need more life & disability insurance.
Might this couple have had a need for more insurance coverage? Absolutely, and especially with a baby on the way. But what was not disclosed clearly (it could have been buried in a tiny disclosure in the middle of the financial plan) was that this “advisor” is a representative of the insurance company they work for. If the professional wants to keep their job, they’ll need to meet sales quotas. Or work with this couple in other ways that may not be in their best interest. Yet the professional claims to be in the business of delivering advice.
This type of situation is where the problem lies. Again, I’m not saying that selling financial products for a commission is bad. It’s that too many financial professionals out there use planning as a vehicle to sell products in a disingenuous way. Can a financial professional work honestly and provide a valuable & fair service if they’re commission or fee-based? Absolutely! I know tons of great advisors that work this way. But it’s so confusing to people who don’t work in the industry that some firms and professionals take advantage of the opportunity.
What Does All This Mean?
As you can see, and have probably already observed, the financial advice & planning industry is confusing. There are a lot of professionals out there, and a lot of different ways they may be set up to deliver services. How an advisor is organized and compensated for their work should not be an indictment of their professionalism. But it does mean the public should scrutinize who they work with more judiciously. Because just like the example I mentioned above, regardless of the integrity or caliber of the professional, advisors are often compelled by the firm that employs them to behave in ways that are profitable for the firm but not very good for the client. (Hello, Wells Fargo.) And even that’s assuming that every professional has genuine, sincere intentions.
A few years back I wrote about what factors you should consider when hiring a financial advisor. In light of this post, here’s a list of questions I’d be certain to ask:
- Do you act in a fiduciary capacity to your clients, 100% of the time you work together? May I see the portion of your service engagement where this is stated? Fiduciaries are obligated to act in your best interests, and not all advisors are required to be fiduciaries. On top of that, most fee-based advisors are only required to be fiduciaries *some* of the time.
- What are your credentials & designations? Gauging advisor competency can be difficult. Having professional designations isn’t a perfect way of evaluating an advisor, but is a good place to start. The three I’d look for are CFP®, CFA, or CPA. These three are the generally the most rigorous to obtain and applicable to financial advising. Also note that many others can be obtained in a few days or a weekend.
- Have you ever had any disciplinary action from regulators? Regulatory actions are in the public domain, and can be reviewed on the Investment Adviser Public Disclosure site, and/or Brokercheck.
- Have you ever had any client disputes to go arbitration? What was the result? There’s not much mandatory disclosure required in this area, but it’s worth asking about.
- Have you ever had to make a claim on an errors & omissions policy? What was the result? Again, not much required disclosure, but it’s worth asking about.
- Are you compensated by anyone other than your clients directly? This question will tell you whether an advisor is fee-only, fee-based, or commission based. Again, it’s not necessarily bad if an advisor sells insurance or investment products. But you should definitely know about it and have enough information to gauge whether it might influence their objectivity.
- Do you have targets or quotas for selling certain financial products? Follow up question to the above. If an advisor is compelled to sell certain products, that’s probably something you’d want to know about.
All in all, the industry has a long way to go to rebuild its reputation and earn the public’s trust. The SEC and Department of Labor are both working on regulations aimed at cleaning up some of the problems I addressed above. This will be a step in the right direction, and with any luck eliminate situations where insurance salesmen claim to be financial advisors. Until then, be sure to scrutinize who you work with. There could be layers in your advisor’s business model that you don’t know about.
What questions did you ask when evaluating advisors?
What questions did I miss in my list above?