Why Fee-only planning?

May 9, 2015

 

 

My completely biased opinion about why fee-only planning                                should be the first stop for everyone. 

 

 

There are three ways that financial advisors get paid, typically.

 

PAID BY COMMISSION

 

The most o̶l̶d̶-̶f̶a̶s̶h̶i̶o̶n̶e̶d̶  traditional business model for financial advisors is "by commission."  If an advisor gets paid "by commission", every time they buy or sell an investment for you, they're authorized to get paid a percentage of that trade. You see this commission listed separately on your trade confirmations. 

 

Insurance agents and insurance brokers are also paid by commission, but in this case the commission is usually invisible to you, the client.

 

Financial advisors paid by commission often also do financial planning for you, and often they'll do it for free, because they want to keep your business; they have an incentive to advise that you keep your investment accounts with them. 

 

What's more, brokers who are not also "Registered Investment Advisors" are not even legally required to put their clients' interest above their own.

 

In addition, many brokers are employees of their firm, and their firm probably encourages them to buy that company's funds.  As a broker-less example, I have noticed that when I am searching for a fund on a custodian's website, that custodian will point me to its own funds by default; it takes a few more mouse clicks on small font to get me to its whole universe of available funds. 

 

 

Why I don't like it: 

 

  • If they don't trade your accounts, they can't make a living. Therefore, they have an incentive to trade even when it's not necessary. 

  • They have an incentive to sell you an asset that has a higher commission over one that has a lower commission, or no commission. For instance, if two equally good mutual funds are available, and one pays your broker 5.75% and one pays him nothing, which will he be inclined to choose?

  • They have an incentive to NOT tell you when it makes sense to use your investment money someplace else (besides in accounts that they manage). What if you have debt you should pay off? What if it makes sense to keep it in a CD right now? What if it makes sense to buy a house with that money? 

 

 

 

ASSETS UNDER MANAGEMENT

 

Getting paid a percent of "assets under management" (AUM)is aligns advisors' interests more with the clients than the commission model does. In the AUM model, an advisor gets, for instance, maybe 1% per year of your portfolio, regardless of whether he or she trades like a crazy person or doesn't trade at all.  

 

The advantage is that when your portfolio increases, their pay increases. They have an incentive to see your portfolio grow. (This is also the disadvantage, as I explain below.)

 

Again, most advisors under this model will also do financial planning for you. Some of them will charge separately for it but most will do it in order to keep your business.

 

 

Why I don't like it: 

 

  • They have an incentive to grow your portfolio and/or keep it big, even if it might make more sense to use that money for other things, like pay down debt. In my experience, their financial planning emphasizes that as well, so their financial plans may not be disinterested. 

  • If you don't have a pretty big portfolio, it's not worth it to the advisor to help you, so it's hard to hire one. 

 

 

HOURLY FEE-ONLY OR FLAT FEE

 

 

An hourly or flat fee financial advisor doesn't care how big your portfolio is and doesn't care if you only have debt. It makes no difference to her income level if you buy expensive things or cheap things. If it makes more sense to pay off debt, there is no incentive to her to tell you to keep it in a managed investment portfolio. 

 

And hourly or flat-fee advisor is 100% on your side of the table. She can help you hire a portfolio advisor or she can spot-check that advisor's work to see if it makes the most sense for your situation. She can advise you on insurance without being swayed by commissions. She can tell you what she thinks makes the most sense for estate planning, and help you find an estate planner. 

 

Recommendations in her financial plans have no financial incentive to direct your money one place or another. 

 

In the spirit of full disclosure, the conflict of interest:

 

The principal conflict of interest in the hourly model is that more hours of work means more money for the planner. It is possible to suggest more hours than is strictly necessary. 

 

I work around this by using a flat-fee model AND disclosing every option to every person that I can see available to them.

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