If you asked them, many people probably couldn't explain exactly how their financial advisors get paid, or even how much they get paid. Which is surprising, since this information could have a direct effect on their long-term financial wellbeing.
Advisors are compensated in a variety of ways, including receiving planning fees, commissions, referral fees and soft money (awards, recognition and reimbursement from investment and insurance companies). Some advisors disclose the sources and kinds of compensation they receive, but usually not the full amount. Also, it’s important to recognize that one type of compensation arrangement isn't necessarily better than another, and that some products, such as insurance, are only sold under a commission arrangement.
Fiduciary Vs. Commissions
How do you find out how an advisor is compensated and if this compensation model could potentially impact the advisor’s recommendations? Official titles, such as financial advisor or consultant, are confusing and really don’t clarify anything. The only way to truly know is by asking the advisor to detail all the ways that they're paid and to see if they're acting as a fiduciary.
The fiduciary question is a simple yes or no. An advisor who's acting in a fiduciary capacity, such as a Certified Financial Planner or the trustee of a 401(k) plan, is required to act in the client’s best interest and disclose all potential conflicts of interest (for more, read: Meeting Your Fiduciary Responsibility). While this doesn't guarantee the outcome of their recommendations, it does mean that all advice they provided wasn't driven by any potential compensation incentives or have conflicts of interest.
When you pay an advisor a financial planning fee, they should be acting as a fiduciary and so only provide general advice; there should be no specific product recommendations involved. The advisor might charge by the hour or just have a flat fee for the planning session. The advisor is being paid for their time and you're free to implement their recommendations yourself, whether using the advisor in question or hiring another financial consultant. However, if you work with a fee-only advisor, you'll have to go to another commission-based advisor to actually purchase any investment and insurance products. So keep in mind that you could wind up paying twice for services that a fee- and commission-based advisor could potentially offer together, at a lower overall cost.
What can be confusing is that if you decide to implement the advisor's financial recommendations by subsequently using the same advisor, they no longer will be acting as a fiduciary when it comes to recommending specific products. And when an advisor isn't acting in a fiduciary capacity (such as serving as a stockbroker or a mutual fund representative), they're held to a lower standard, one that only requires that the products and strategies they recommend are suitable for you, the client. The advisor has no responsibility to act in your best interest or to identify a "superior" product. However, it's important to keep an open mind and recognize that an advisor who's not acting as a fiduciary could still recommend the better product or offer quality advice.
Licenses and Affiliation
An advisor's licensing and affiliation could also affect the advice that they offer and compensation they receive. To sell insurance in a particular state, an advisor must be appointed in that state and have an insurance license. Advisors who only have an insurance license are limited in the advice they can offer and they can only sell fixed insurance products, such as life, health and long-term care insurance or fixed and index annuities.
Advisors that sell investment products must be registered and have to maintain FINRA and state insurance licenses. Advisors that hold a FINRA Series 6 and 63 and state insurance license are limited to offering advice on insurance products, mutual funds and variable annuities. To sell and provide advice on stocks, bonds and Exchange Traded Funds, an advisor must hold a FINRA Series 7 and 63. While requirements for offering fee-based planning services vary, the advisor usually must hold at least a FINRA Series 6 or 7 and 65, as well as having an earned designation, such as being a certified financial planner or chartered financial consultant.
All advisors who hold FINRA licenses must be affiliated with a broker dealer (BD) that custodies assets and supervises their activity, or they need to be listed as a registered investment advisor (RIA). BDs can range from large wirehouses like Morgan Stanley to small independents. Some advisors are agents of an insurance company and thus are affiliated with the insurer’s captive BD. As agents, they're employees of that insurer and so could be obligated to push that company’s products over other available products. To further confuse things, every broker-dealer has some restrictions on the products that their advisors can offer and each has a different compensation model that provides incentives and bonuses for selling certain products and hitting sales targets.
The Big Picture
To put this all together, you first should find out if and when your advisor is acting as a fiduciary. You also need to see if they have any conflicts of interest and what licenses they currently hold, and how those could affect the products they recommend. You should find out whether their broker-dealer restricts the products they can offer, and what the BD's compensation model is (and if the advisor receives incentives or bonuses for selling certain products). And you should see if they receive any ‘soft money’ from investment and insurance companies whose products they sell. While it will take some time, and a probing set of questions, to get all of this information, the potential impact on your investments makes it worth the effort.