How Do Financial Advisors Get Paid?
(What is a “Fiduciary” Anyways?)
Broker vs. Registered Representation vs. Investment Advisor Representative vs Fiduciary.
Whew! Why does this have to be so complicated?
Whenever you choose to work with a financial advisor they fall into one of two camps: brokers and fiduciaries. What’s the difference?
Let’s start with broker relationships. Brokers are paid transactionally. If you are working with a broker and they put you into some sort of financial product, they are paid via a commission. If they move your money to another spot later down the road- they get paid again. It’s transactional.
In my personal experience, when working with a broker, people like you can’t help but say to themselves, “Sure, Dave seems like a nice guy and he certainly knows what he is doing, BUT…. is he using this particular product because he’s getting paid more? Is there some sort of financial kickback, lurking in the background, which helped him make his decision?”
In addition, whenever a broker suggests a change to an investment strategy you might say to yourself, “Is he doing this so that he can get paid again? Or is this actually in my best interest?”
Brokers are held to a “suitability standard” which means they are “required to implement an investment strategy that meets the objectives of the investor.” Notice that it doesn’t say, “Brokers have to put you in the absolute best investments for your situation.” It only says that it must at least loosely satisfy what you are looking for.
Am I splitting hairs? Let’s take a look at how fiduciaries must operate under the legal standard: “…the fiduciary standard simply means that the advisor puts their clients’ interests above their own. For example, the advisor is prohibited from making trades that may result in higher commissions for the advisor or his or her investment firm.”
The other big difference is how a fiduciary is paid. An advisor entering into a fiduciary arrangement with a client is not allowed to receive commissions. Their compensation is not transactional. Generally, fiduciaries are paid an advisory fee (usually around a 1% annual fee) which fosters a professional, long-term relationship vs. a limited, transaction-oriented one.
How does the 1% fee work? Let’s say at the end of the year, you look at your portfolio’s performance and you see an 8% gain. In reality, the portfolio returned 9%. Most advisors would bill (directly from the account) .25% each quarter to total the 1%. The fees are completely transparent and listed on your statement.
With a broker, it is difficult to determine their compensation, which usually consists of hidden fees that are difficult to translate.
Why is this important? Because, while working with a fiduciary, you never have to ask yourself, “Why is my advisor choosing this investment vs. that investment? Why is my advisor making trades in my account? Why is my advisor moving my money from one place to another?”
Within a fiduciary relationship, you are inherently on the same team. When you do better, they do better. The more your money grows, the more they make (the 1% fee is on a larger account value).
I’m not saying everyone needs to be working with a fiduciary. Broker relationships can still be beneficial to some people. But in my own personal experience, client relationships, where I am operating as a fiduciary, seem to be the most productive and meaningful.
So how do you find out if your advisor is acting in a fiduciary capacity? Just ask them!