Before working with any investment advisor, broker, or dually registered financial professional, ask these essential questions surrounding fees and compensation. The answers you may receive could sound off warning bells.
There are three types of financial advisors: investment advisors, brokers, and dually registered professionals (advisors who operate as both a broker and an investment advisor).
Financial professionals who practice solely as investment advisors are considered true fiduciaries, just like doctors or lawyers, and have fewer conflicts of interest.
Fun Fact: Our research found that 99.2% of all financial professionals barred from the industry have been either a broker or dually registered advisor.
Tip: The investor.com Trust Algorithm identifies the type of financial professional right on their profile page. To learn more about this topic, read our help article, Investment Advisors Versus Brokers.
Common answers here may include "fee-only" and "fee-based". Fee-only means the advisor only charges a fee as a percentage of assets under management (AUM). For example, a 1% AUM fee would equate to $1,000 per year on a $100,000 portfolio (1% x $100,000). These advisors only earn money from fees paid by the client.
Contrarily, fee-based means the advisor earns money from their fees as well as commissions on products sold, or other forms of compensation. If working with a fee-based advisor, it is crucial to investigate further to understand the full landscape of potential conflicts (see #3 below).
Beyond paying a percentage of assets under management or commissions, two other ways a financial advisor may charge for their investment advisory services include hourly charges or fixed fees. While uncommon today, charging a flat rate per hour, like an attorney, is slowly growing as an available option.
If the advisor does accept commissions, the answer you will receive to this question will vary drastically. Remember, commissions are often reported only in regulatory disclosures. When working with a fee-based financial advisor, it is crucial to understand all the potential conflicts you may face.
As an example, 12B-1 fees are hidden “marketing or distribution” fees added to the cost of some mutual funds. If your financial advisor sells mutual funds with 12b-1 fees (fund “loads” are another fee to steer clear of), then you are paying more money than needed. SEC research has shown there are no performance improvements associated with purchasing higher-cost funds over their lower-cost equivalents.
Tip: investor.com's Trust Algorithm reads the SEC regulatory filings of each firm and flags a list of notable cost considerations. This summary can be found by searching investor.com's advisor database for the advisor's firm, then scrolling down to the "Cost Considerations" table. For rows with a red, bolded "Yes," we recommend asking the advisor to explain further.
Statistically speaking, annuity sales and other insurance-based products such as variable and universal life insurance, offer the most lucrative commissions for brokers and dually registered advisors.
In the vast majority of cases, annuities are unnecessary products. The adage goes, "Annuities are sold, not bought," meaning annuities are a product created by the industry to generate commissions for the industry. If your advisor is licensed to sell insurance, then make a mental note of this fact.
Fun Fact: If you ever receive an invitation for a "free steak dinner" at a nice local restaurant, promising guaranteed returns, or some other financial claim, then it is a sales pitch from an insurance salesperson. At investor.com, we collect these invitations as reminders of why we do the research we do to help Americans. Remember, there is no free lunch!
If the financial advisor pays a referral fee for new clients, that means they are inevitably charging you more money to offset the marketing fee.
If your advisor, or the firm they work for, cannot service a particular need, they will refer you somewhere. Just like your general doctor will refer you to a medical specialist, the same applies to financial advisors. Just make sure they aren't being compensated for doing so, which is a clear conflict of interest.
It is essential to understand what balance you will need to maintain with your advisor. What happens if you fall below this minimum due to market volatility? Are you subject to additional fees?
Similarly, many advisors offer discounts for managing a more substantial portion of your assets, so you might as well ask. The U.S. average annual fee is about 1% per year.