Should you be working with a fee-only financial advisor? There are many benefits to working with someone who is compensated solely by what they charge directly to clients, and not from the commissions earned from the sale of financial products or financial transactions. But there are drawbacks too. Let's review and discuss the options.
- Many financial advisors are shifting to a fee-only compensation structure, where they receive the same flat fee for their planning services in lieu of traditional commissions or fees based on AUM.
- The benefits of fee-only include transparency, no hidden fees, and no bias due to conflicts of interest to sell a certain product line or company offering.
- The downsides can include paying more than you would in a traditional structure, they may be less skilled than traditional advisors, or a limited scope of products and services offered.
The basic compensation models for financial advisors are:
- Advisors who only charge an hourly or a flat fee for the planning services they provide. Depending on the engagement, they may provide limited or comprehensive advice. Engagements may be one-time or ongoing.
- Advisors who charge based on assets under management (AUM), for example, 1% of the investment account value. The engagement may or may not include planning and/or other advice, which is usually secondary to money management.
- Advisors who only receive commissions based on the sale of a product or a financial transaction, such as a stock trade. Advice or planning might be ancillary to the product sale (as with a stockbroker), or they might be a key part of services (as with a financial planner).
- Advisors who are compensated through a combination of fees, assets under management, and/or commissions. The exact mix varies by advisor. Also known as "fee-based," this model allows advisors to offer clients a wider range of services as well as work with them to implement recommendations and monitor progress.
There has been some debate as to how "fee-only" compensation should be defined––mainly, whether it should include the second group, those who charge based on AUM. Generally, though, most agree, fee-only refers to payment from fixed, flat, hourly, or percentage-based fees.
Pros of Using a Fee-only Advisor
One of the major benefits of selecting a fee-only advisor is the freedom from the inherent conflict of interest that can arise when a significant portion of the advisor’s income comes from selling you financial products. The concern you should have as a potential client is whether or not the advisor is recommending a certain financial product because it enhances their bottom line and if the products recommended are truly in your best interest. In fact, in there are some registered reps and others who earn all or part of their compensation via commission that may be required to favor products offered by their employer – which may or may not be the best vehicles for your situation. Since fee-only advisors do not sell commission-based products, receive referral fees, or other forms of compensation, the potential for conflicts of interest is limited.
For this reason, many recommend that you only work with an advisor who charges a fee. The rationale is they're acting as a fiduciary and are legally required to act in your best interest, as you're their client. Generally, an advisor is a fiduciary when they charge a fee for planning services and/or they are investing money in an advisory account. Also, Registered Investment Advisors and Certified Financial Planners act as fiduciaries. In contrast, an advisor who only earns commissions is held to a lower standard and does not have to make the ‘best-interest' recommendation, but rather one that is "suitable" for your needs.
Another benefit of using fee-only financial advisors is the opportunity for them to offer an objective second opinion of your situation. This is especially true if the advisor works with clients on an hourly, as-needed basis or perhaps will do a financial plan or financial review for a fixed project fee. Services here can range from addressing a specific financial question to a review of your investment portfolio or a full-blown financial plan.
Cons of Using a Fee-only Advisor
All this may be true, but there are still some potential downsides to the fee-only model.
First of all, fee-only advisors might be costly. For example, let's say through the planning process, a fee-only advisor discovers a need and recommends that a client buys a commission-based product, such as disability income insurance. If the fee-only advisor doesn’t sell the product, then the client would need to find and work with an insurance broker, adding additional steps to an already complex process. Also, the insurance broker receives a commission from the sale of the product – so the client ends up paying both a fee and a commission (albeit to different people). Also, some states limit an advisor's ability to charge a fee for the analysis of just insurance products or needs.
Consequently, the fee-only advisor has to either limit the services they offer and/or charge clients a higher fee. For wealthy individuals who are willing and able to pay a substantial retainer, a fee-only advisor could be the right choice. But, for many individuals with limited resources or whose assets are tied up in qualified plans, the out-of-pocket costs for a fee-only advisor could get prohibitive.
No form of advisor compensation is conflict-free. If you're working with an advisor who is compensated via a percentage of the investment assets under management, can you always be sure that their advice is not tilted towards keeping as much of your money under advisement as possible? For example, if you were to ask about withdrawing say $200,000 from your investment accounts to pay off your mortgage, can you be sure their potential lost revenue didn't somehow motivate the advisor's advice against doing this?
Another issue to consider is that a desirable compensation structure like fee-only does not ensure that the advisor is competent. Just like any other professional, such as a lawyer or an accountant, the knowledge and experience of fee-only financial advisors will vary. Some advisors have more expertise than others. Additionally, some advisors may be better suited to working with clients with your unique needs than others. For example, a fee-only advisor who specializes in working with teachers and government employees nearing retirement probably would not be the best advisor for a high-earning thirtysomething professional in the private sector.
Some fee-only advisors may only deal with clients with a minimum level of assets to invest, or charge a minimum fee that equates to that asset level. This may exclude several investors with smaller portfolios who need advice. You will want to understand issues like this when doing your search for a fee-only advisor.
How to Find a Fee-Only Advisor
The National Association of Personal Financial Advisors (NAPFA) is one of the largest professional organizations of fee-only financial advisors in the country. It has a find an advisor link on its website. You can search by zip code and then further by area of specialization. Note that NAPFA members run the gamut from solo practitioners to large multi-advisor firms. Additionally, NAPFA members offer a wide range of service options, including hourly as-needed services, ongoing investment and portfolio advice, and almost everything in between.
The Garrett Planning Network is another organization of fee-only financial planners who mostly focus on providing hourly advice. There is a degree of overlap in the membership of the Garrett Planning Network and NAPFA. It also has a find an advisor function.
The accounting profession also has a financial planning designation for Certified Public Accountants (CPAs) called Personal Financial Specialists (PFS). Please note that while many holders of the PFS designation are fee-only, they are not required to be. You will need to ask these folks how they are compensated; here is a link to find a local PFS holder.
The Certified Financial Planner Board also has a directory of financial advisors who hold the CFP designation. Again, being a CFP does not mean the advisor is fee-only. The CFP Board recently has revised its compensation classifications to include fee-only, fee-and-commission, and commission. There has been some controversy surrounding its definition of fee-only, so again investors using this database need to ask and be diligent in investigating advisors found here to ensure they are fee-only. Here is a link to the CFP Board’s find a financial planner section of their site.
The Bottom Line
It is important to understand that the quality of the advice you receive is not solely tied to an advisor’s compensation model. However, the kind of advice you receive may be affected by the advisor’s compensation model. Compensation arising from sales commissions on financial products could cause advisors to recommend products mandated by their employer and/or products generating the highest commissions for the advisor. These products might not always be the best fit for your situation even if they meet the standard of suitability.
Critics of fee-only argue that this sort of arrangement tends to be more expensive. Of course, fees are an up-front expense – but make no mistake, the commissions paid to a financial advisor also come out of your pocket in the form of lower returns on your investment. Fee-only is not a perfect arrangement, but it is generally a bit more transparent; fees charged for advice are more visible; commissions may be harder to ascertain.
Also, no advisor (or advisor group) can excel at everything. There are times when you may be better off working with an advisor who specializes in certain commission-based products, such as a disability or health insurance, and understands the various options. However, if you want advice on retirement planning, and do not necessarily need to buy a specific product, an advisor who charges planning fees may be the right choice.