Unless you work in finance or have an advisor yourself, it may be unclear what they get paid to do. Financial advisors have received a bad rap in the past. The industry’s history of foul play has not helped their reputation. Movies like Wolf of Wall Street certainly don’t help the image. However, the industry has cleaned up its act considerably over the past couple of decades.
This article will describe the role of a good financial advisor and how they should suit your needs. Furthermore, we will cover the different ways financial advisors receive compensation for their services.
What Does a Financial Advisor Do?
Financial advisors are the professionals in charge of managing clients’ financial lives. This includes, but is not limited to:
- Investment management
- Financial planning
- Coordinating with other professionals (Lawyers, CPAs, etc.)
Most advisors are known for taking over the management of their clients’ investment portfolios. While there are several ways to accomplish this, the majority of financial advisors delegate investment selections to a third party. These actions may be internal, within the firm to which the advisor belongs. Alternatively, a financial advisor may have a contract with an unrelated service (i.e., Dimensional Fund Advisors).
In order for this to be beneficial for all parties, it’s essential that the advisor understands the process and underlying investments the service utilizes. It’s also crucial that both the process and investments are suitable for the clients the advisor places in the portfolios.
Contrarily, some advisors do take on some – or all – of the responsibility for investment selection within their client’s portfolios. This is most common for advisors working with higher net worth clients, as wealthier clients demand an optimum level of service compared to, say, a broad-based ETF portfolio. Typically, these advisors hold specialized designations, like the CIMA or CFA. Once more, it’s essential that the process and investments selected are suitable for their respective clients.
As it relates to investment management, however, the role of a financial advisor tends to add the most value when it comes to behavioral coaching and risk tolerance. Human beings tend to be emotional creatures, and emotions and investing can be a terrible mix. A good financial advisor can walk their clients back from the ledge when the markets get rocky.
Let’s Talk About Financial Planning
Back in the day, what people considered “financial advisors” were really just stockbrokers. Those days are long behind us.
Today, the role of a full-service financial advisor includes providing clients with some personalized level of financial planning. The term is intentionally broad, as it encompasses all area’s of a person’s monetary life, from cash flow management to life insurance and beyond. However, the bulk of this planning concerns retirement. This makes sense, as it’s one of the most significant life events an adult can have. Once more, the higher the client’s net worth, the more specialized care they demand.
The highest standard in the financial industry is the CFP (Certified Financial Planner). To earn this designation, professionals must pass a rigorous curriculum that prepares professionals for every concern their clients may encounter in their financial journeys.
It’s important to note here that some areas, such as taxes and estate planning, should be left to professionals in those respective fields. Some niches require specialized training and years of experience to experience the best outcomes.
To that end, a good financial advisor will coordinate with these professionals to ensure everyone is on the same page for the client’s sake. The primary role of a financial advisor is to guide their clients through their lives in a way that is efficient and maximizes the potential on their financial goals.
How Are Financial Advisors Paid?
The payment structure of financial advisors has been a topic of discussion for several decades, but in the past few years, this scrutiny has intensified. The Department of Labor’s Fiduciary Standard put a great deal of pressure on the industry to examine advisor compensation. Specifically, the government focused on payment and commission as they relate to transactions within retirement accounts. Over time, some of the distrust has faded away, but the topic is still incredibly important.
Let’s look at the different compensation structures available to financial advisors.
In today’s environment, many professionals argue that the fee-only compensation structure is best for clients. Whether that is true is up for debate, but it’s still wise to know the difference when advisor shopping.
Fee-only compensation is exactly what it sounds like: advisors charge a flat rate for their services, regardless of the client’s investable net worth. This means that the advisor does not receive commission or compensation for trading within their client’s portfolios.
Many industry hawks and regulators believe that this removes potential conflicts of interest that occur between a financial advisor and investment provider. One of the more famous examples client exploitation and conflicts of interest took place in the mutual funds market with Mutual Fund Wholesaler. Mutual funds have been heavily scrutinized in the past for their internal expenses and commissions kicked back to the seller – financial advisors.
This brings up the next type of payment structure: commission-based.
In the glory days of stockbroking, you could rake in some serious cash by placing trades for clients. With the rise of Robo-advisors and stricter industry compliance, those glory days are almost entirely behind us. However, there are still instances where advisors can receive compensation for placing trades on behalf of their clients.
These types of payments are typical in less liquid areas of the market, such as in private equity. In any case, advisors must disclose any compensation they to their clients if they receive commission.
Wrap Fee Compensation
The other type of commission-based compensation is a wrap fee. This is a fee based on a percentage of assets under management (AUM). This payment model is more widely accepted compared to flat-out commission-based trading.
Clients tend to like the AUM because it puts everyone on the same side of the table, so to speak. That means that if the market goes up, the advisor makes more money. If the market performs poorly, the advisor makes less. This encourages investors to always trade within their clients’ best interests.
The main criticism against the wrap fee is that it incentivizes advisors to pay more care to the clients with higher levels of investable assets. If you are not über wealthy and value better service, this may be something to consider.
The Final Role of a Financial Advisor: To Suit Your Needs
Financial advisors have quite a bit of responsibility on their plate. But, to whom much is given, much is required.
If you’re looking for a financial advisor, it’s essential to understand exactly what you’re looking for. Do you want someone to help you with your investments? Would you prefer an advisor who examines your entire financial picture? What kind of fee structure are you most comfortable with?
There is no right or wrong answer to any of these questions. It’s important to select an advisor who has your best interests in mind – and the one who determines your best interests is you.
Also consider that you don’t have to stay married to the same advisor forever. You should look for someone you can trust and are comfortable with. If you feel that your current advisor is not serving your needs, then you have every right to transfer your services to a better professional or firm.
The right financial advisor can make a massive difference in your life. Make sure you do your due diligence and know the role of your financial advisor going in: to serve your financial desires and goals.