How financial advisors are compensated doesn't determine their character, but it does influence their behavior.
As the debate over regulatory standards of conduct for financial advisors plays out in Washington, the issue for investors boils down to how their advisors are paid and how well the arrangement aligns the interests of the advisor with their own.
No compensation model is perfect, and all have conflicts of interest that investors need to be aware of and that advisors need to manage.
"We see more and more compensation models in the marketplace," said Gabriel Garcia, head of relationship management for Pershing Advisor Solutions. Pershing serves as custodian for 550 advisory firms.
"As the needs and complexities of client situations increase, we see a wider variety of compensation arrangements between advisors and their clients."
Those arrangements include commissions on transactions executed by advisors, fees charged on assets under management, project-based work, hourly engagements and retainer fees.
The charging of commissions remains a controversial practice. Most brokers who earn commissions on transactions are regulated by the Financial Industry Regulatory Authority under a "suitability" standard of conduct.
It does not require that they act in the best interests of their clients as registered investment advisors, as fiduciaries must. It only requires that they sell investments that are suitable—not necessarily optimal—for their clients.
The Securities and Exchange Commission and Finra have been moving toward applying a fiduciary standard to all financial advisors. It remains to be seen whether commission-based advisors can live up to it, and whether regulators can effectively ensure that they do. Most fee-only advisors don't think so.
"Commissions don't put financial advisors in the best position to act as a fiduciary," said Tim Maurer, a certified financial planner with Buckingham Asset Management. Maurer, who now works on a fee-only basis with clients, began his career as a commissioned broker at Legg Mason. "I feel that I was always a fiduciary to my clients, but I also feel a lot less conflicted now," he said.
The conflict for brokers is that they make their money on transactions. The more transactions they execute, particularly involving investment products with high commission rates, the more they earn.
Jude Boudreaux, a CFP and founder of Upperline Financial Planning, doesn't think it's impossible for advisors receiving commissions to act in the best interests of their clients—but it is tough.
"There are massive conflicts of interest all around [with] people earning commissions," said Boudreaux, who also had a brief experience selling whole-life insurance policies for Mass Mutual earlier in his career. "It takes a special person to not have it affect their decisions.
"Fee-only advisors get high and mighty because we see people taken advantage of all the time."
Securities brokers, however, aren't the only ones who have conflicts of interest with their clients. All compensation models create incentives for potentially undesirable behavior.
Advisors charging flat fees have an incentive to add more clients and potentially do less work for each one. Anyone who has experienced a lawyer stretching work to increase billings can appreciate the downside of an hourly compensation model. It also creates a disincentive for consumers to seek advice when they have issues.
"We're not attorneys," said Shannon Eusey, a founding partner of Beacon Pointe Advisors, a fee-only advisory firm. "We don't want to set a clock on what we do."
The asset-based fee is increasingly the compensation model of choice for financial advisors. It's simple and consistent, and advisors do well if their clients do well.
"The assets-under-management (AUM) fee directly aligns us with the interests of our clients as far as the growth of their assets," Eusey said.
The major conflict that AUM fee advisors have is that they want as big a share of their clients' wallets as they can get. A client who might want to pay off a mortgage to save money or keep assets in an annuity, a college savings plan or some other investment vehicle not managed by the advisor could get compromised advice from a fee-based advisor.
"It's a meaningful conflict," said Maurer. "The benefit of an AUM fee is that it's simple, but there is no conflict free compensation model."
The other significant issue with fee-only advisors is that they typically need minimum asset thresholds for clients to make the relationship profitable.
Boudreaux decided an asset-based fee would prevent him from serving too many clients.
"A $200,000 asset minimum excluded most of the people I knew," he said. "I wanted my own firm and I didn't want it to be AUM-based."
Boudreaux's compensation structure is instead based on a flat fee equal to 1 percent of a client's annual income and 0.5 percent of his or her net worth, excluding home equity and business assets the client may own.
"I now take on a lot of clients that the typical RIA can't, " he said. "There is no perfect model, but we think this is better than an AUM fee."
Complicating matters is the increasing number of advisors who wear two hats. Dually registered advisors are registered as Series 7 brokers with Finra but also operate as investment advisors under a corporate RIA registration of their broker-dealer.
Hybrid advisors operate their own RIA registered with either the SEC or a state securities regulator and maintain an affiliation with a broker-dealer. They receive both fees and commissions and are regulated under the suitability and fiduciary standards.
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"It's tough to swivel your chair and be a fiduciary in one instance and then act under suitability rules in another," said Garcia, whose firm serves a growing number of hybrid advisors. "Time will tell how stable [the dually registered] model is from a regulatory and business model perspective."
The key for any financial advisor under any compensation model is understanding the conflicts of interest that exist for them and communicating them to their clients.
"As long as advisors understand their biases and so do their clients, they'll be all right," said Eusey.