I recently sat down with a financial planning client for our first meeting. Their first question was about fees specifically what was the difference between fee-only and fee-based. This then led to questions about suitability and the fiduciary standard of care. But ultimately, the client wanted to know how to discern what was what when listening to any kind of financial service professional.
Good questions. There is a cost to everything including investment advice. The origin of the phrase “There is no such thing as a free lunch” is not known. It is sometimes attributed to Milton Friedman who used the phrase as the title of a 1975 book but the phrase may date back to the 19th century when American bars offered a “free lunch” in order to entice drinking customers--at least according to Wikipedia. Unfortunately, for many people (other than my clients, of course), their concept of financial management focuses on the liquid part.
So the answer to my client’s quandary about fees and service standards is… it’s complicated.
Fee-only is the most straight-forward of all fee arrangements: the client pays so the client can be sure the advisor has no conflicts of interest. In a fee-only relationship, the financial advisor only receives compensation from the client and not from any other source. Most importantly, the compensation is fully disclosed. The client can clearly understand what financial influences are at work in the relationship otherwise a conflict of interest could arise. Lawyers and CPA’s are extremely fastidious about this. Their respective professional cannons of ethics are quite clear on this point, and people can lose their license for violations. An hourly rate, a fixed price per project, a retainer, or a percentage of assets under management are all typical examples of fee-only relationships.
Fee-based is being a little bit pregnant. There is a basic fee (e.g. hourly rate or a percentage of assets under management) but the financial service provider also gets rebates or kickbacks from third parties (generally the broker/dealer) for pushing certain products or meeting certain sales targets. The conflicts in these types of arrangements are never visible. The British derisively call this type of side arrangement a “fiddle”.
Commissioned-based compensation is also straight forward but, unfortunately, is rarely visible. Insurance is a good example here, but at least the cost of insurance policies can be compared roughly. Annuities typically pay among the highest commission rates which is why annuities are one of the most heavily advertised financial products in the financial marketplace.
Suitability refers to a standard of service which the financial services professional offers. Registered Representatives (aka stock brokers or “stock jocks”) are licensed under the Securities and Exchange Act of 1934. The basis in the law for their client relations is that the investment be suitable (aka appropriate). Not good, better or best but just appropriate.
Conflicts of interest are allowed, so sales and production incentives are common. For years before I became a Registered Investment Advisor, I had an account with a major broker/dealer. I was never sure when the stockbroker called me with a suggestion if the suggestion was a good one or if I was just the last person on the list to try to peddle the investment idea to earn his commission. While there are many diligent stock brokers (aka Registered Representatives) out there, it is hard to know to whom their allegiance is to.
Look for the words “Registered Representative” or an SEC exam series particularly Series 6 or 7 to identify individuals operating under the suitability standard. Anyone working for JP Morgan/Chase, Merrill Lynch, would be under the suitability standard. Likewise, people working for TD Waterhouse, Fidelity or Schwab. Note—I custody my client accounts at Schwab but I do not work for them—I am completely paid by my clients.
A fiduciary is someone who is required to act solely in the best interests of the client “period, full stop”.
[For my younger readers, telegrams were transmitted by telegraph and were the fastest means of written communication at the time. There was no punctuation in telegraph communications. The word “stop” was used to indicate the end of a sentence since it was shorter than the word “period”. “Full stop” indicated the end of the telegraph itself. So “period, full stop” was about as emphatic as one could get. Think of the telegraph as the Twitter of the late 19th and all the 20th century and “period, full stop” as an early version of an emoticon].
Lawyers and CPA’s are required to act as fiduciaries—they may not have any conflicts of interest in serving the client. Registered Investment Advisors were created under the Investment Advisers Act of 1940 must by law act under the fiduciary standard as well.
How to tell?
The only sure fire way to find out a) how a financial professional is compensated and b) the financial professional’s standard of service is to ask them. Because the whole financial services profession is changing dramatically, an individual seeking the services of a financial professional can be easily misled if the individual does not ask upfront.
The Board of the Certified Financial Planners went through a rather embarrassing public expose several years back when it was revealed that many fee-based advisors holding the CFP® designation were advertising themselves as fee-only. Moreover, one prominent member of the CFP® organization owned both a broker/dealer which employed registered representatives and a financial advisory firm which employed Registered Investment Advisors. Talk about “Want a blue suit? Turn on the blue light!”
The two most advertised financial planning attributes are the CFP® and membership in the Financial Planning Association (FPA). Neither attribute conclusively describes the method of compensation nor guarantees the fiduciary standard of service. Any other financial designation would be even less dependable.
The one organization that is dedicated to fee-only planning and investment management in a fiduciary relationship with the client is NAPFA
– the National Association of Personal Financial Advisors. Every year in order to renew my membership in the organization I have to go through an extensive checklist of items to certify that I am really a) fee-only and b) following a fiduciary standard of service. As a CPA, I am usually most of the way there.
The following table summarizes the above detail.
I reviewed this mix of compensation and service arrangements with Riley, our golden retriever. It would appear that Riley is commission-based—she wants a piece of everything she sees me eating… and a piece of anything she sees anyone else eating. At the same time, Riley is close to the fiduciary standard as she is extremely loyal and will follow me everywhere, including, from time to time, into the bathroom. Only “close” to the fiduciary standard because she will dump me in a heartbeat to chase a squirrel.