Do you know what financial products you’re invested in? Do you know why you should invest into them? Do you know someone you can trust to tell you how your investments should be?
While you may think you know the answers to these questions, there is a lot developing below the surface of the financial planning world. In an annual industry profile conducted by the Investment Advisor Association, the number of Registered Investment Advisors (RIA) grew at a steady clip of about 400 between 2017 and 2018. Client lists and assets under management (AUM) are also expanding, surging by $32 trillion over the course of five years. At the same time, average investors are more risk averse and flocking to passive investments, with millennials being particularly wary of how their savings are allocated.
Financial advisory firms are attempting to evolve alongside the changing demands and expectations of their clients. In the middle of this, individual advisors are being forced to adapt to new way of mediating your money.
But why should they have to adapt? You’re paying them. Shouldn’t they invest your money like it was their own? That’s a complex question with a lot of different interpretations, but the ultimate answer is no. Below we’ll get into the reasons why you should have a clear understanding of financial advisors’ relationship with your money and how that relationship fits into both of your bottom lines.
Advisors Are Not Your Friend—They’re Your Advisors
First, to the question of how invested your advisor is in your investment. The cynical reason as to why financial advisors don’t handle your money like their own is because they mostly don’t have to.
Those aware of the short, sad saga of the Labor Department’s Obama-era Fiduciary Rule know that there is currently no requirement that advisors work to their clients’ benefit. The rule, which would have gone into effect in April 2017, set out requirements mandating that financial advisors act in the interest of their clients before acting in their own. In essence it would have mandated that all financial advisors be held to fiduciary standards in recommending investment products that help achieve their clients goals rather than aim for outsized performance figures or simply net themselves a higher commission.
However, implementation of the rule was delayed by the Trump administration shortly after inauguration. It was then delayed further, challenged in court over the course of the delays and officially killed by the new DoL head in the summer of 2018.
A new “best interest rule” by the SEC is winding its way around legislators, but many find the wording and lax enforcement of the rule to be toothless. And, while Industry ethics and best interest regulations among RIAs and Certified Financial Planners (CFP) have the weight of their licensing body to enforce best practices, CFPs only account for about 20 percent of profession financial planners and unlicensed broker-dealers often take on the same client roles as RIAs.
Non-certified investment advisors can still be a valuable asset to your investment plans, but there is a greater onus on the part of the client for understanding the products and strategies they suggest.
Your Goal vs their Goals
However, the more clever answer to why financial advisors shouldn’t invest your money like their own is that it’s not in your interest that they do. Your investments should be tailored to your financial goals, and it’s your responsibility to understand whether the investments your advisor suggests will accomplish them.
But you can’t sit back and trust that your advisor’s goals align with your own. Even if your advisor wants you to succeed, it’s important to understand what success means for you and what success means for your advisor. A Critical part of this is understanding how your advisor is paid. Below, we’ll break down the most common ways financial advisors get compensated. Keep in mind that many advisors use some combination of the compensation methods listed below, information on which they should provide before you sign on with them.
Commission, Commission, Commission
We’ll start with commission-based advisors since, according to the IAA’s annual report, it is also the compensation type that is gradually being edged out, at least in part. The number of RIAs that pay commission down by 13 percent since 2016.
Commission-based advising is exactly how it sounds: the advisor makes a percentage of whatever products she sells to a client. In the worst case scenario, the advisor will place a higher emphasis expensive or incentivized products that might not be best for their clients, which is why some investors are more wary of this type of pay schema. The one benefit certain investors might see in a commission-based advisor is that they can often be cheaper than other advisors, which can be a big selling point if you’re certain about how you want to invest.
Flat Fee or Fee-based Advice
Gradually gaining in popularity among investors and advisors is simply providing a flat fee structure. The supposed simplicity of this structure is meant to eliminate any question of conflicts of interest by giving clients a simple audit of products bought and services rendered. It is also the preferred billing type of CFPs, who must comport themselves to the fiduciary standard.
However, underlying the straightforward appearance is a lot of small text about how what charges are for, how much each charge should be, and any number of other calculations. Fee-based advising leaves it to you to understand your bill—and these can be surprisingly complicated. While all the charges are there in black and white, investors should understand what each one means and whether it conforms with industry standards.
Performance-based Fees
Another less common payment structure, performance-based advisors charge clients based off how well their investments perform compared to benchmark like the S&P 500. The reason they are uncommon is that these types of plans are reserved for accounts of $1 million or more. This is for a very good reason, as performance fees incentive advisors to make high-yield, high risk investments.
Again, this type of billing plan is reserved for high net worth clients or investment pools like mutual funds, so your average long-term investor will likely not have to consider whether performance fees should factor into their money management. While the perceived benefit of having your advisor work for his wages might seem appealing, it is likely not the right fit if you have an array of investment goals over short term gains.
The infamous AUM %
More common among advisors is to charge clients a percentage of the total assets they have in their investment accounts. This setup is intended to deliver an equilibrium between prioritizing client needs with advisor acumen, as both benefit from effective, long-term management of the client’s money.
In practice however, AUM fees can be tricky to negotiate depending on the client’s needs. For instance, a common 1-2 percent AUM charge might be suitable for a client with money invested in stocks or funds, but someone invested in treasury notes probably won’t have high enough returns to justify this setup. It can also create tension in how the advisor views certain accounts or transactions, larger accounts might get a higher priority over smaller ones and advising how funds should be added or moved around in the account could be seen as biased given how the advisor’s paycheck is directly correlated to the size of the account.