Aug 31 2010
photo by TheBusyBrain
When evaluating the differences between financial advisors be sure you are comparing apples to apples. One way of doing this is evaluating how the advisor is paid. The following excerpt discusses some of the responsibilities an advisor has to their client and looks more in depth at fee-based advisors.
To read the complete article visit Wikipedia
Financial advisers may help their clients invest for both long and short term goals. It is the financial adviser’s duty to determine the clients’ goals and risk tolerance and then to recommend appropriate investments. Generally, a long time horizon allows for the advisor to recommend more volatile investments with potentially greater risks and rewards. Such investments include direct investment in stocks or through collective investment products such as mutual funds and unit investment trusts/unit trusts.
If the client has shorter term goals, the adviser should recommend less volatile investments with shorter time spans. Such investments could include cash deposits, certificates of deposit, and short term bonds. While these types of investment generally have lower returns there is less volatility and there is less likelihood of losing principal capital. Although short-term investments can guard against loss of capital, their value can be eroded by inflation over longer periods of time.
Fee-Only financial advisors
As defined by the review materials for the Certified Financial Planner exam and the National Association of Personal Financial Advisors, fee-only financial advisors are compensated solely by the client, typically achieved through a combination of hourly fees (including retainers), financial planning fees, and asset management fees. Neither advisors nor affiliates may receive commissions, rebates, awards, finder’s fees, bonuses or other forms of compensation from others as a result of a client’s implementation of the individual’s planning recommendations. The fee-only model of compensation reduces the potential for conflicts of interest between the advisor and the client in that the advisor is not beholden to insurance companies, particular investments, and other financial companies.
A clear distinction should be made between brokers, who often refer to themselves as “Fee-Based” (receiving both fees and commissions) and Fee-Only (someone who never receives compensation or incentives from a third party.)
A fee-only advisor may reduce conflicts of interest such as:
- advising a client to buy products and make investments when holding cash and other liquid assets may have been a more suitable recommendation at that time.
- an incentive to generate commissions through the unnecessary buying and/or selling of securities (also known as churning).
- an incentive to convert non-cash assets such as real estate and collectibles to cash and securities so that the advisor can generate a commission.
- an incentive to make recommendations that pay higher sales commissions to the advisor when a less expensive alternative may have been available.
Working on a fee-only basis allows the advisor to:
- Customize an investment portfolio that is designed to help the client realize short-term and long-term investment goals.
- Provide simplified performance reporting, making it easy for clients to monitor their accounts.
- Support the client with ongoing professional advice, timely information about accounts and updates on the world’s financial markets.
- Manage a client’s portfolio and make investment changes–without commissions–as a client’s objectives or the economic climate changes.
It is worth noting that:
- Operating on a fee-paying basis may make the advice too expensive to obtain for the broader market otherwise catered for by commission-based advisers. If a client must pay a flat fee of $1000 to their adviser as a lump sum, this is less manageable for all but the wealthy, rather than the more manageable option of paying through regular charging and commissions. However this is not to say that fee-only is more expensive than paying by commission; commissions earned by brokers can add up over the course of a year, especially if many changes are made. It is worth noting that many fee-only advisors charge an annual fee that is deducted on a quarterly basis.
- On the other hand, if an advisor charges a flat percentage (e.g. 1% of total assets under management) for all clients, the advisor may not be able to afford to service clients below a minimum net worth.
- Asset based advisors may have the prerogative of managing all of a client’s manageable monies. Although this is a particular bias for asset-based advisors, this can also lead to a more streamlined and efficient working relationship and service. However this may create a conflict of interest with regard to questions of the use of client funds. If a client inherits funds and is choosing to pay off debt or invest with the advisor, they should weigh the fact that the advisor is paid if the money is invested and not if the debt is paid off.
- While fee-only advisers cannot accept commissions, they may still have personal favorites amongst product providers and investment houses that lead to one provider being specifically favored over another when competing advice is given.
- If certain restrictions are not in place, there can be an incentive to take too much risk in a portfolio to generate additional gains that translate into “raises” for an asset-based advisor.
To be continued…
Paragon Wealth Management is a provider of managed portfolios for individuals and institutions. Although the information included in this report has been obtained from sources Paragon believes to be reliable, we do not guarantee its accuracy. All opinions and estimates included in this report constitute the judgment as of the dates indicated and are subject to change without notice. This report is for informational purposes only and is not intended as an offer or solicitation with respect to the purchase or sale of any security. Past performance is not a guarantee of future results.