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While having a good advisor is one of the best decisions you can make, choosing the wrong advisor can do more harm than good.
If you are going to hire a professional, the biggest investment you can make is in the time you put into selecting the right person.
This starts by understanding some of the major differences between professionals in the industry.
Listen now and learn about:
- Scenarios in which financial advisors may not be acting in your best interest
- The best designations to look for in a financial advisor
- Differences in advisor compensation that impact the advice you receive
Show Notes
This is the second installment of a three-part series on hiring an advisor. Listen to the first installment, “Do It Yourself Or Hire An Advisor?” here.
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While I am biased in thinking that choosing a good advisor is one of the best decisions you can make, I’m not naïve to the fact that choosing the wrong advisor can do more harm than good.
Choosing a financial advisor can be a confusing process, especially because different professionals adhere to different standards of client care. Making matters worse are the litany of fancy titles and the alphabet soup of designations that professionals stick on their business cards.
If you are going to hire a professional, the biggest investment you can make is in the time you put into selecting the right person. This starts by understanding some of the major differences between professionals in the industry.
Even when two professionals go by the title “advisor,” it does not mean they provide the same service or adhere to the same ethical standards.
Differences in Standards of Care
Most people don’t realize that different financial professionals are held to different standards of care.
The fiduciary standard requires that an advisor put a client’s interest first. Registered Investment Advisors (RIAs) adhere to the fiduciary standard, and they are regulated by the Securities and Exchange Commission (SEC), which enforces the rules around what it means to be a fiduciary.
The suitability standard does not require advice to be in the client’s best interest. The suitability standard only requires a broker to make recommendations that are “suitable” based on a client’s personal situation.
This standard is enforced through self-regulatory organizations called the National Association of Securities Dealers (NASD) and the Financial Industry Regulatory Authority (FINRA).
Brokers or registered representatives are held only to this suitability standard and not the fiduciary standard. While they may call themselves “advisors,” they’re salespeople with a vested interest in getting you to buy specific financial products.
Imagine you need a new car, but you don’t know much about the different options available.
You head to the closest car dealer, which happens to be a Ford dealership, and the dealer asks you to describe what kind of car you need.
You begin to list features and attributes that are best described as a Toyota Highlander, but you can find some of what you mention in a Ford Explorer, too.
Under a suitability standard, the Ford dealer could say, “A Ford Explorer sounds like a good fit and we have some of those right over here,” and never mention that a Toyota Highlander more closely aligns with your needs.
The dealer makes the sale and earns a commission. You have a car that is suitable for your needs, but it isn’t necessarily what’s best for you.
The Ford dealer has a clear conflict of interest in this situation. The dealer can sell only Fords and will lose the opportunity to earn a commission if the client buys a Toyota Highlander.
Under the suitability standard, the dealer can recommend the Ford Explorer, even if that is not necessarily what is best for you. Without a great deal of knowledge about the auto market, you wouldn’t know you settled for what was only suitable.
Now, let’s compare that to what happens under a fiduciary standard.
If the car dealer acted as a fiduciary, the salesperson would be obligated to say, “It sounds like you are describing a Toyota Highlander. We don’t sell those. In order to get the car that best fits your needs, go down the street to Toyota and ask for a Highlander.”
The dealer might mention a similar Ford model, but they’d also disclose that the Ford was more expensive and not exactly what you need. In this scenario, you have more information about your options as well as the dealer’s financial incentives before choosing a car.
This same thing happens in the financial world. Financial professionals working under the suitability standard can sell you certain investments or insurance products that compensate them over competing options that might be a better fit for you.
It is also surprisingly common for financial professionals to have multiple industry affiliations that let them act as a fiduciary in some cases and not others. This allows the advisor to be a fiduciary in developing a financial plan or investment allocation, but then act under the suitability standard when implementing the recommendations.
This is enough confusing that I think this is perhaps worse than someone only adhering to the Suitability Standard.
It’s unfair to expect the average person to know when an advisor is or isn’t acting as a fiduciary.
Most people using a financial professional have a hard time conceiving that the recommendations being made aren’t in their best interests.
Attorneys and accountants are required to put the interest of their clients first. Medical professionals do not put their own interests before the patient’s. Why should financial advice be any different?
Many financial advisors always act as a fiduciary; you just need to know how to find them.
One way is to use a Registered Investment Advisor (RIA), which is required by law to act as a fiduciary at all times. For additional assurance, some RIAs go the extra mile to be certified by the Centre for Fiduciary Excellence (CEFEX), which independently verifies that firms are fulfilling their fiduciary duty to the highest standard.
You can check to see if an advisory firm is CEFEX certified by visiting www.cefex.org/CertifiedAdvisors.
Finally, you should require your advisor to put their fiduciary commitment in writing, otherwise they cannot be held accountable. Most fiduciaries put their fiduciary commitment in the client agreement you sign at the beginning of a relationship. If not, then ask your advisor to sign a fiduciary pledge.
The Meaning of Various Advisor Titles and Credentials
Another area of confusion for consumers is the wide range of job titles and professional designations that people use to convey their expertise. While a job title might have some relevance to a firm’s internal hierarchy, you can start with the assumption that all job titles are a form of marketing.
I wouldn’t get hung up on whether your advisor’s title is Wealth Manager, Planning Associate, Financial Planner, Portfolio Manager, Financial Consultant, Financial Specialist, Director, Senior Vice President, President, Principal, Partner, and so on. The title doesn’t matter in the context of trying to find the best financial advisor for you.
While it’s a challenge to understand the services someone will provide based on a title, the hundreds of professional designations are perhaps even worse.
It is very rare these days to meet a financial professional without some combination of letters after his or her name on a business card. The problem is that not all letter combinations require the same degree of expertise, knowledge, or training.
There are three designations that are more meaningful credentials in the financial advice industry. All three require extensive knowledge, continuing education, and adherence to a strict code of ethics. They are listed in alphabetical order here.
Certified Financial Planner (CFP®)
This designation is the most comprehensive designation with regard to financial planning. Certification requires a lengthy education requirement and requires you sit to pass a two-day board exam.
The curriculum covers general principles of financial planning, education planning, insurance planning, investment planning, tax planning, retirement planning, and estate planning.
The CFP® board requires you have three years of professional experience related to the financial planning process or two years of Apprenticeship experience that meets additional requirements.
When I see someone with a CFP® designation, I know that they’ve gone through training to recognize issues that may affect your financial plan in all stages of your life.
Certified Public Accountant (CPA)
The CPA designation is focused on taxes and accounting. Before sitting for the CPA exam, candidates are required to have 150 semester hours of relevant courses.
The CPA exam covers auditing and attestation, financial accounting and reporting, regulation, and business environment concepts.
In my experience working with the financial advisors that are CPAs, I find that the prerequisite coursework and exam prepares a CPA to assist in strategic decision making for individuals, businesses, and other organizations.
Chartered Financial Analyst (CFA)
Financial professionals often consider the CFA designation to be the most difficult to earn. CFA Candidates must pass three exams, which each require roughly 300 hours of study and most recently had pass rates for Levels I, II, and III of 26%, 29% and 39%.
The graduate level curriculum focuses on topics including portfolio management, economics, financial analysis, quantitative methods, and corporate finance. Before using the designation, CFA candidates need four years of professional work experience in investment decision making.
Having earned the CFA designation myself, I feel like this is the gold standard for investment certifications, but I would caution against expecting superior investment performance or anything like that just because someone has a CFA. There is really no evidence of that.
But when I see an advisor with a CFA designation, I feel safe assuming they have a very deep understanding of investing issues.
Now that we’ve addressed the titles and designations you might find in an advisor’s email signature or business card, let’s address something you generally can’t figure out without asking.
Differences in Compensation
The way financial professionals are compensated can impact objectivity. Fee-only advisors are paid only by their clients, which creates an incentive structure with the fewest conflicts of interest.
The most common fee-only advisor is paid a percentage fee based on the amount of assets being managed, with that percentage fee decreasing as the account size increases.
Other fee-only advisors charge by the hour or set fixed retainer fees for financial planning services. Because a fee-only advisor’s compensation is not tied to a specific product or strategy, they can objectively provide advice without being swayed by personal benefits. This makes it easier for fee-only advisors to adhere to a fiduciary standard.
At the complete opposite end of the spectrum, a commission-only advisor earns income on products sold to the customer such as insurance products and mutual funds. They also earn income from transactions made and accounts opened for customers.
The more activity a customer has, the more a commission-only advisor earns. Remember, a commission-only advisor works for his or her company, not you. The recommendations they make are filled with conflicts.
One final subtle distinction to note is between fee-only and fee-based advisors. Fee-only advisors are desirable because they always act as fiduciaries and their compensation closely aligns their interests with a client’s interests.
Fee-based advisors earn some their revenue from fees paid by their clients, but also earn commissions from selling certain mutual funds, insurance policies, or brokerage products. Fee-based advisors often adhere to the suitability rules, which means their financial recommendations may not be in your best interest and those conflicts of interest are harder to uncover.
Beyond how the firm is compensated, you’ll also want to know how the individual advisor is being compensated. Are they salaried or paid a percentage of the revenue their clients generate?
I’d argue that working with a salaried advisor further reduces conflict of interest. Someone that is paid a percentage of the revenue their clients create might have an incentive to push you away from options that would prevent you from investing more money with them. For example, they might encourage you to roll your 401(k) over, even if the 401(k) would be cheaper — I actually know an incredibly large number of advisors that do this, so that’s something to ask an advisor upfront.
Next Steps
Now that you understand some of the basic differences among financial professionals, the next episode in this series will focus on the process of hiring the right person for you.
Until next time, to long term investing.
Resources
- Episode 24: Do It Yourself or Hire An Advisor?
- Sample Fiduciary Pledge
- Submit your question for the show through my “Ask Me Anything” form
Get Your Finance Questions Answered
Do you have a financial or investing question you want answered? Submit your question through the “Ask Me Anything” form at the bottom of my podcast page.
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Until next time, to long-term investing!
About the Podcast
Long term investing made simple. Most people enter the markets without understanding how to grow their wealth over the long term or clearly hit their financial goals. The Long Term Investor shows you how to proactively minimize taxes, hedge against rising inflation, and ride the waves of volatility with confidence.
Hosted by the advisor, Chief Investment Officer of Plancorp, and author of “Making Money Simple,” Peter Lazaroff shares practical advice on how to make smart investment decisions your future self with thank you for. A go-to source for top media outlets like CNBC, the Wall Street Journal, and CNN Money, Peter unpacks the clear, strategic, and calculated approach he uses to decisively manage over 5.5 billion in investments for clients at Plancorp.
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