We all have to manage our money. Our long-term financial plans depend on it. For those with an interest in personal finance and spare time, developing your own financial plan is a viable strategy. Many of us, however, either don’t have the time or the interest and would prefer the services of a professional. Those in this second camp need a financial planner.
There are several things to consider in choosing the financial planner that’s right for you. One of the most important is finding a planner whose way of making money aligns their interests with your own. Although “fee-based planner” and “fee-only planner” sound confusingly similar, both payment methods aren’t equal. Fee/commission-based planners have interests that are misaligned with their clients’, making them inferior to fee-only planners.
To understand why fee-only planners are superior to planners who rely on commissions, we first need to clarify what exactly a financial planner is.
What is a financial planner?
Financial planners are a subset of financial advisors. “Financial advisor” is a general term for anyone who helps clients manage their money. Examples include investment advisors, brokers, wealth management experts, and financial planners.
Financial planners are financial advisors who specialize in helping clients meet their long-term financial goals. Where a broker may do little more than facilitate the purchase of a security, a financial planner provides holistic financial advice based on your goals.
Not all financial planners are equal. Anyone can call themselves a financial planner. It’s therefore important to make sure: (1) The planner is qualified. Look for well-known certifications such as the CFP (Certified Financial Planner); and (2) the planner makes money in a way that aligns their interests with yours.
Financial planners earn money in one of two ways. One way is from feed paid directly to the planner by clients. You want to pay these fees in exchange for advice. The second way is from commissions for placing the money the planner manages in a firm’s investment products. It’s in your best interest to avoid financial planners who accept a commission, as it creates a conflict of interest between you and your planner.
From planner to planner, the importance of commissions varies. The amount planners are beholden to commissions allows us to divide financial planners into three groups: commission-based, fee-based, or fee-only. Here’s a summary:
- Payment source: Commissions from firms only
- Fiduciary responsibility: No
- Example: Full-service brokers
- Payment source: Commissions from firms and a fee charged to clients
- Fiduciary responsibility: Depends on registration
- Example: Planners employed by a firm that provides investment products
- Payment source: Only fees charged to clients
- Fiduciary responsibility: Yes
- Example: Independent financial planners and financial planning firms
1. Commission-based planners
Commission-based planners are essentially salesmen. Their entire income comes from commissions and the salary their firm pays them. This allows commission-based planners to charge you no fee for their services. Financial advisors at brokerage firms often operate on this payment model.
No fees sound attractive, but it comes at the expense of misaligning the financial planner’s interests with your own. Commission-planners don’t receive any of their income directly from you and therefore don’t have as much of an interest in helping you optimize your financial life. As long as their firm’s financial products comprise your portfolio, they get paid.
To make matters worse, commission-based planners don’t have a fiduciary obligation to their clients. The Financial Industry Regulatory Authority (FINRA) only holds them to the lower “suitability” standard. Instead of having to put the client’s interests before their own, commission-based planners only must provide clients with “suitable” products. Though FINRA removes some of the ambiguity by outlining what exactly “suitable” products are, it is inarguably a lower standard than that of a true fiduciary.
The law obligates a fiduciary to not only act in the client’s interest and provide them with suitable investments, but mandates that the planner put the client’s best interest before her own.
This isn’t a distinction without a difference. Often, a suitable product isn’t the best product for a client. For example, if a client is looking for a mutual fund that tracks the S&P 500, any fund that mirrors the index will be suitable. However, one fund may charge a much lower expense ratio than its competitors.
A financial planner who isn’t a fiduciary could place their client’s money in the more expensive fund if it somehow benefited them (perhaps via a commission). Technically, both funds are suitable for the investor, just not optimal. Fiduciaries, since they’re held to a higher legal standard, are prohibited from engaging in this sort of behavior.
The above factors make commissioned-based advisors undesirable. They’re salesmen first and planners a distant second. This isn’t speculation. The adverse effect of commissions on investment advice is well documented. A 2015 study by the Council of Economic Advisors estimated the cost of conflicted investment advice, such as that from commission-based planners, at about 17 billion dollars annually.
2. Fee-based planners
Fee-based planners are the not-so-happy middle ground between commission-based and fee-based planners. These planners make money from both fees and commissions. Usually planners employed by a company that provides financial products follow the fee-based model.
Fee-based planners may or may not have a fiduciary duty. This depends on whether they are registered with FINRA or the SEC. When registered with FINRA, they only need to follow the suitability standard. However, if they are accredited as Registered Investment Advisor (RIA) by the SEC, fee-based planners are fiduciaries.
Fee-based planners who aren’t registered with the SEC are no more credible than commission-based planners and should be avoided for the same reasons.
Fee-based planners who are in fact registered with the SEC are still suboptimal. The presence of commissions, again, misaligns interests (albeit to a lesser extent due to the legal responsibility that comes with being a fiduciary). This misalignment raises the same issues as previously discussed. The 17 billion dollars investors lose annually due to conflicted advice should always be kept in mind.
Financial planners registered with the SEC will have a publicly available Form ADV. The form contains important information including sources of commission, previous misbehavior, and general investment strategy. This is a powerful tool for identifying possible conflicts of interest when vetting a financial planner.
The fiduciary responsibility as well as the availability of the ADV form makes fee-based planners superior to commission-based planners. This isn’t a high bar. You still need to do due diligence to ensure a fee-based planner is acting in your interests and not instead chasing commissions. Opting for a fee-only planner allows you to avoid entirely the headaches caused by commission-accepting planners.
3. Fee-only planners
Fee-only planners make all of their income from fees charged to clients. They don’t accept commissions, which avoids the misalignment of interest endemic to fee/commission-based planners.
This isn’t the only benefit. Fee-only planners also are almost always fiduciaries. If they’re an RIA registered with the SEC, which any reputable fee-only planner will be, they’re a fiduciary. There’s no need to worry about FINRAs suitability standard. The SEC registration also comes with the added benefit of a Form ADV.
Out of the three compensation structures, fee-only aligns your interests with your planner’s most effectively. You’ll still need to do your due diligence. Not all fee-based planners structure their fees identically. Depending on your financial situation, different fee structures may be more or less appropriate.
Related: Here’s a list of financial planners we’ve vetted. They’re all fee-only.
The choice of a fee-only advisor over a fee/commission-based advisor is a rare case of financial advice that can be nearly universally prescribed. Choosing the proper management fee structure, however, isn’t as simple. Your net worth and the complexity of your financial situation are important factors in determining the proper fee structure for you.
AUM planners want to grow your investment
Many planners charge a fee based on a percentage of assets under management (AUM). AUM rates depend on your net worth as well as the reputation of the financial planner you’re hiring. Robo-advisors offered by many large financial service firms typically cost 0.25% to 0.5% of AUM. Investment management by a human planner is more expensive, with the industry standard rate being 1%. Premium planners that specialize in high net worth clients often charge more, sometimes upward of 3%.
AUM planners often require a minimum investment amount. For many planners, 1% of five-figure investment isn’t worth their time. This often makes AUM planners unavailable to early career lawyers.
Even if you have enough assets to hire a planner who charges an AUM rate, it may not be the best choice. These planners have an interest in keeping your money locked away, as their fee is proportional to the size of your investment. AUM planners are therefore biased towards advising you to delay major purchases (e.g., a home) or servicing debt (e.g., student loans).
However, the corollary to this bias is beneficial to you as the client. An AUM planner has a vested interest in growing your initial investment. The larger your investment, the more fees the planner will collect.
AUM planners also quickly become expensive. A lawyer who invests $50,000 annually for 30 years while paying the standard 1% AUM fee will end up paying 1 million dollars in fees.
Flat fee planners are a good option for early career professionals
For these reasons, planners who charge a flat fee are often the better option, especially for early career lawyers. Flat fees can be hourly, yearly, or a retainer. Hourly rates usually run from $200 – $400 dollars while yearly rates go from $2,000 to $7,500. Retainer rates vary significantly.
While it is possible to find less expensive rates, you need to ask yourself if less expensive is always better. Charging well below market rates often signals inferior services. Flat-fee planners already have less financial interest in growing your investment as they don’t receive any of the profits. A financial planner who lacks significant incentive to grow your investment and who is poorly compensated can potentially be indifferent to the success of your investment.
The way your financial planner makes money may seem like a secondary consideration in finding the perfect advisor. In reality, it serves as a proxy for other important information. Your planner’s compensation structure indicates whether they are a fiduciary or a glorified salesman. It also aligns, or entirely misaligns, you and your financial planner’s interests.
Financial advice is famously equivocal and littered with disclaimers. The correct course of action varies based on the investor’s goals and risk tolerance. The choice between fee/commission-based planners and fee-only planners is a rare exception. As I’ve stressed throughout this article, fee/commission-based planners are inferior to fee-only planners.
Biglaw Investor has taken the time to vet financial planners, all of whom are fee-only. Most are former lawyers, and all are advisors with a track record of providing sound financial advice.
Joseph Parise is a junior at the University of Buffalo. Joseph grew up in New York and is majoring in Philosophy and Economics. He is currently taking a gap year to study for the LSAT exam and to serve in the US Air Force Reserves.