by Jason Black
How do you get paid? It's the most important question you can ask a would-be financial adviser during an appointment. Why is this question so important? Because aligning compensation with your goals, increasing your account, is the most robust way to ensure your goals are experienced. But so many people fail to ask this one simple question. Why? Because most people are intimidated by all the fancy letters after the adviser's name: so title beware!
"The titles they (financial advisers) use mean absolutely nothing," says Ms. Roper, director of investor protection for the Consumer Federation of America. "We have a marketplace for financial advice in which professionals use virtually identical titles. ...You have to dig deeper." If titles don't mean anything what does count?
The truth is that most people are intimidated because they know quite little about investing. They also assume that the professional will put their best interests first. But the problem may not be the adviser; it may be the company they work for.
Over the last several years, financial investment companies of all sizes have been fined millions of dollars for not placing the client's interests first. Nine times out of 10 the problem boils down to how the companies pay themselves and their advisers. In '05 Edward Jones was fined over $75 million because "the company created a conflict of interest by failing to disclose a revenue-sharing deal with seven 'preferred' mutual fund groups. Edward Jones acknowledged it sometimes encouraged brokers to push certain mutual funds to customers. The company failed to adequately alert customers to its agreement with the mutual fund companies," the SEC and the Justice Department said. Edward Jones is not alone. Merrill Lynch, Wells Fargo, Piper Jaffray, and Morgan Stanley have all been fined in recent years.
How they get paid is key. Did you know the vast majority of investment firms and their advisers are paid via commissions and up-front sales loads on mutual funds? This is where the trouble starts. Mrs. Chu from USA Today writes, "Advice that you get might be based around the product, rather than your long-term financial goals. Firms have an incentive to pitch high-commission products."
Informed business people know that the best way to ensure results is to align their employees' compensation with their job performance. For example, if you own a car dealership you want to sell cars, so you only pay your sales force when they sell a car. But is a transactional form of compensation the best method for the financial services industry? And more importantly for their clients?
Imagine if you paid your realtor up front to sell your house. What incentive would the realtor have to ensure your house actually sells? I'll give you a hint...the answer looks like a donut! So if you don't pay your realtor up-front, before you see results, why should you pay a financial adviser up-front? Shouldn't his or her compensation be tied to how well your investments perform?
Commissions, on occasion, can be the best option. They usually work best if investors know exactly what they want, and they don't plan to make very many transactions over time. Recognizing the dichotomy of "unbiased" advice and "up-front" compensation, many small and midsized financial firms are switching to a fee-only platform. With this model, compensation is not linked to the "sale" of any product, thus a greater degree of objectivity can be expected. Fee-only advisers typically use either a flat or asset-based fee. Flat or hourly fees are similar to how an lawyer or accountant bills his or her clients. With hourly fees it is important to define up-front which solutions will be performed, and to receive an approximation of the total cost.
The second type of fee is based on AUM (assets under management). This fee is usually between one and three percent of the account balance per year. This compensation method works best when you hire an adviser to manage your investment portfolio, because the adviser's pay is linked to your account balance. If your account grows, the adviser is compensated. If it doesn't, his or her pay is cut. If Wall Street is to gain investors' trust again they are going to have to change the way they compensate their advisers.
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