Why Incentives Matter: Brokers vs. Fee-Only Advisors

When making a major decision in our lives, whether purchasing a new car, buying our first home, saving for retirement, or investing in our children’s education, we are all looking for the same thing; knowledgeable and unbiased advice.  However, it can sometimes be difficult to know whether the advice we are getting is truly in our best interest.

Anybody who has been to a car dealership is familiar with the inherently skeptical feeling you get when listening to a sales pitch. It may not be because you think the salesman is trying to intentionally dupe or mislead you, it’s just that you know it’s in his or her best interest to sell you a car whether or not that car is best suited to your practical and financial needs.  This is because a car salesman’s compensation is tied directly to how many vehicles he or she sells, and not necessarily dependent on the long-term satisfaction of their customers.  Salesmen surely benefit from repeat business, so they are better served by putting you in a car you are happy with, but their immediate interest is the commission they earn from selling you a car right now.

Just as it is important to consider the incentives motivating a salesman when buying a car, it is critical to understand the incentives driving your financial advisor when choosing how and where to invest your money.  There are essentially two types of financial advisors, brokers and fee-only advisors.  Fee-only advisors are compensated on a fee-based system (i.e. an hourly fee, a retainer fee or a fee based on a percentage of the assets under investment management), while brokers are compensated by the investment firm they represent and through commission on investment products they sell.  The addition of a commission structure for brokers creates the possibility for conflicts of interest with their clients.  For example, a broker may recommend a particular mutual fund over another based on a larger commission he or she receives on that fund, regardless of whether or not that is the most appropriate investment for their client’s goals.  A fee-only advisor, on the other hand, receives no compensation beyond the fee he or she is paid by the client, so there is no incentive to recommend anything but the best investment for their clients.

Beyond the compensation structure, fee-only advisors have a fiduciary obligation to their clients, which means they are legally obligated to put their client’s interests first.  Brokers abide by what is called a “suitability standard” meaning they are only legally required to provide financial advice that is ‘suitable” for their client’s needs.  As with a car salesman, a broker obviously wants to make their clients happy to encourage repeat business, but because they are not required to put their client’s interests first, they will likely recommend whatever investments carry the largest commissions, rather than those that will offer the best returns for their client.

Whether you are buying a car or searching for investment advice, it is critical to understand the incentives behind the recommendations you are getting. Visit the National Association of Personal Financial Advisors (www.napfa.org) to find a fee-only advisor in your area.

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