How is Your Advisor Compensated (and Does it Matter)?

How is Your Advisor Compensated (and Does it Matter)?

Let’s say you haven’t been feeling well, so you visit your doctor.  You describe your symptoms; he examines a few things, runs a test or two and determines that you have a case of Feelingterribleness (not an actual disease).  He writes a prescription for a two-week supply of Beachitara (also not real).  You’ve never tried it before, but you recall the TV ads with the aging couple playing on the beach with their grandkids and dog and think how nice it would be to feel that good again.  On the way out, you stop to pay your bill for the services rendered and are told that there is no charge because the doctor is paid a commission from the pharmaceutical company. 

How comfortable would you be with this kind of arrangement?

In the world of financial advice, there are two sets of legal standards that investment advisors can be held to.  Brokers, or Registered Representatives, are held to a suitability standard.  This means that the investments they recommend must be suitable for the client.  As their title suggests, they are representatives of their employer and have a legal duty to act in their employer’s best interest.  Their compensation typically comes as a commission for selling investment products.  Like other salespeople, any advice they give is incidental to their primary job function of selling products. 

If doctors were held to this standard, the above scenario could easily be a suitable recommendation for the patient, given the symptoms.

A higher legal standard applies to Registered Investment Advisors.  They are held to a fiduciary standard requiring them to act in their client’s best interests.  Advice they give must be more than suitable, it must be the best advice the advisor can give.  Any potential conflict of interest must be disclosed to clients.  Fees directly paid by their clients rather than by payments from investment products typically compensate registered Investment Advisors.  This greatly reduces the potential for conflicts of interest.

(There is a third kind of arrangement know as dually registered in which an individual is both a Registered Investment Advisor and a Registered Representative, but not necessarily at the same time.  At times, dually registered advisors may charge a fee for advice and other times may be selling a suitable investment product for a commission.)

Truth be told, there are both great and not-so-great advisors in each of these regulatory environments.  Unfortunately, the investing public knows very little about the differences and when they do know, they overwhelmingly indicate that understanding these differences will influence their decision (TD Ameritrade Investor Perception Study 2006).  There are plenty of other important factors to consider when choosing an investment advisor, but their legal duties and compensation method ought to part of the discussion.

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Alan Campbell, MBA, CFP® is an advisor with Spinnaker Financial Advisor, LLC, a fee-only Registered Investment Advisor.  Alan received his masters’ degree in financial planning from Texas Tech University and is a certified financial planner™ practitioner.  For more information, visit Spinnaker’s website at www.spinnakerfinancial.com or contact him at alan@spinnakerfinancial.com.

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