Navigating the Financial Landscape: How Advisors Make Money
Posted Sep 26, 2019
Understanding this can help understand conflicts of interest
The financial services landscape today is extremely complex. With many different financial companies offering services to individuals, it is hard for consumers to know what kind of financial professional they are dealing with. You might not know that is many companies’ intention. At the highest level, there are three types of financial professionals: registered representatives, life insurance agents, and investment adviser representatives. Because there are no regulations around job titles, registered representatives (they used to be called stockbrokers until that term went out of fashion) and life insurance agents now commonly refer to themselves as financial advisors, financial consultants, wealth managers, wealth advisors, and financial planners, muddying the water so that consumers don’t fully understand who they are speaking with.
To make the water even murkier, these advisors can be associated with all three types of companies. Depending on what product or service they are talking with you about, they are going to be “wearing different hats”. Depending on which “hat” they are wearing, these advisors can get paid in various ways and are held to different standards of care with vastly different kinds of protection for consumers.
There are two standards of care when it comes to consumer protection. First is the broker-dealer suitability standard of care. Advisors that work for the broker-dealer are considered registered representatives and are sales reps for the broker-dealer. They are paid through commissions and the products and recommendations that they provide must be considered suitable, which means the financial professional must only have an adequate reason to believe a recommendation fits the client’s financial situation, needs, and other investments. The advisor can recommend products that pay a higher commission as opposed to the best option because it fits the definition of suitable.
A fiduciary duty is the second and highest standard of care. Fiduciaries are legally obligated to work in your best interest at all times and go through a prudent process to determine what’s in their client’s best interest. A common analogy is “Suitability is a salesman who sells you a suit that fits. Fiduciary is selling you a suit that actually looks good on you”.
Advisors that work for a Registered Investment Adviser (RIA) are referred to as Investment Adviser Representatives (IARs) and are individuals that are paid through fees for providing advice about securities to their clients. RIAs and their IARs provide investment management services, and financial planning advice and are legally obligated to work as fiduciaries for their clients.
Advisors that work for life insurance companies work in the best interest of the insurance company as their agents. Agents that sell life insurance and annuities can be paid up to 100% of your first year’s premium in commission for life insurance, and annuities can pay up to 10% of premium in commission (this can amount to tens if not hundreds of thousands of dollars in commissions). Life insurance and annuities can be a critical part of your comprehensive financial plan, but you need to understand that there might be a major conflict of interest in why a product is being recommended.
I might be a little biased, but having been associated with all three of these different business models, the RIA channel (specifically as a fee-only RIA) is the only way to truly work in the best interest of the clients. Being compensated in a “fee-only” capacity is critical to this relationship. A fee-only advisor is not paid differently based on their recommendations, whereas the introduction of commissions by human nature will interject major conflicts of interest into recommendations. Because the fee-only business has received such positive press over the last decade, registered representatives and insurance agents created the “fee-based” description in trying to confuse consumers. In an attempt to fix this problem amongst CFP® professionals, the CFP Board restricts CERTIFIED FINANCIAL PLANNER™ certificants from using the term “fee-based” and requires them instead to describe their compensation method as “fees and commissions”. While this certainly helps, only a small portion of the advisor population are CFP® professionals and even fewer are fee-only, so the rest of the industry is free to keep using this misleading term.
A fee-only financial advisor is defined by the CFP Board as someone that is compensated solely by the client, with neither the advisor nor any related party receiving compensation that is contingent on the purchase or sale of a financial product. This means that anyone associated with a broker-dealer or that is insurance licensed cannot call themselves fee-only and has major conflicts of interest in their recommendations and business model. They can obviously mitigate these conflicts of interest and find ways to work around them, but a fee-only advisor has chosen just to eliminate these inherent conflicts of interest from their business model to better serve their clients.
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