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'Fee-only' financial planners aren't perfect

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A frequent refrain in the media, and in the financial planning community at large, is that individual investors should seek professional investment guidance exclusively from “fee-only” planners.

On the surface, this position seems sound enough. As highlighted in the Department of Labor’s proposal to impose a strict fiduciary standard around retirement advice, conflicts of interest abound in commission-based sales. Disclosure about compensation is often limited or not required at all, and representatives or agents selling retirement products may be under no obligation to place the interests of the client above their own.

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Financial advisors operating under this compensation scheme have an obvious economic incentive to steer clients toward products that pay higher commissions, to oversimplify risks and product features to generate sales, and to generate as much commissionable trading activity as possible. The only incentives to act in the interests of the client — aside from the threat of regulatory penalties — appear to be the vague economic notion of the cost of attracting new clients relative to the value of retaining existing ones and the advisor’s own moral compass. So the commission model seems an easy and justified target for criticism.

But for all the vitriol heaped on commission-based financial advice, the idea that fee-only models are beyond reproach has been largely unquestioned. In fact, it is not uncommon to hear suggestions that fee-only planning is entirely free of conflicts of interest. Take these examples:

The stakes are so high in investing that you should consider fee-only planners. They’ll give you a fixed price up front for their services, regardless of the product they recommend. You won’t have to worry about conflict of interest.
— Clark Howard, “How to Find a Financial Planner

With fee-only planners, there is no conflict of interest because the adviser will charge either an hourly fee or a flat annual fee based on a percentage of your assets he or she is managing. In the latter case, when you make money, so does the adviser. Likewise, if you lose money, so does the adviser. In this way, your goals are aligned.
— Lynnette Khalfani-Cox (“The Money Coach”), “How to Get the Most out of Your Financial Advisor

As with all business transactions, evaluating the relative merits and objectivity of fee-only planning models entails ferreting out the economic incentives in play. And this requires an understanding of the compensation structures that qualify as “fee-only.” While the term has no official regulatory or statutory standing, the most common definition is the one applied by the Certified Financial Planner Board of Standards: “a CFP professional may describe his or her practice as ‘fee-only’ if, and only if, all of the certificant’s compensation from all of his or her client work comes exclusively from the clients in the form of fixed, flat, hourly, percentage or performance-based fees.”

Of these forms, asset-based percentage fees are by far the most common compensation model among registered investment advisors and financial planning firms, according to FA Magazine. At first blush, as Khalfani-Cox suggests, advisor and client interests do indeed seem clearly aligned under asset-based fees, since “when you make money, so does the adviser. Likewise, if you lose money, so does the adviser.”

Unfortunately, this assessment represents a naive and incomplete understanding of the economic incentives that may be at work. Intuitively, advisors who operate under this compensation structure have an incentive to control as much of their clients’ assets as possible and to discourage clients from withdrawing assets under management. For instance, a planner who may be asked to advise a client on whether to invest in real estate or securities has an obvious incentive to steer the client toward securities. Similarly, planners who are paid asset-based fees may have an incentive to discourage clients from gifting or making charitable donations, since these may reduce billable assets.

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In defense of the asset-based fee model, one could argue that fee-only advisors are regulated by the SEC and are held to a fiduciary standard that requires them to always place the client’s interests ahead of their own. However, the SEC’s fiduciary standard requires all advisors to clearly disclose all potential conflicts of interest to prospective clients via a form colloquially known as the “customer brochure.” In reality, few advisors who charge asset-based fees disclose the potential conflicts inherent in this compensation structure in their customer brochures. Thus, when incentives are fully considered, it seems reasonable to question whether this compensation model is really any less conflicted than the commission model.

Indeed, this point has been raised by an increasingly vocal and zealous group of advisorswho advocate for a shift to flat-fee, hourly and/or retainer-based compensation, rather than asset-based fees.

Again, the implication is that these alternative compensation models are free from the conflicts that plague other models — and again, the moralistic hyperbole reflects a naive understanding of basic economic principles. For instance, an advisor working under the hourly model has an incentive to bill as many hours as possible, while the consumer has no way to verify actual hours worked. Similarly, if an advisor adopts new technology that dramatically reduces the time required to perform his planning tasks, he may be conflicted as to whether he should lower his billable hours. (This concept is known in economics as “value billing.”)

Conversely, under the hourly billing model, the client has an inherent financial incentive to avoid sharing information with the advisor, since frequent and prolonged communications incur direct costs. This obviously runs directly counter to the information-gathering portion of the financial planning process.

Incentives under the flat-fee and retainer compensation structures are enitrely different but no less conflicted. Under these models, the advisor has the incentive to do as little work as possible to maintain the relationship. The suggestion by some that hourly and flat-fee/retainer models are a cure-all for conflicts of interest in the financial planning profession seems ironic given that these are the exact same compensation models employed in the legal profession — and which are routinely and roundly pilloried for their inherent conflicts of interest.

None of this is intended to disparage fee-only planning. Rather, my aim is to dispel the notion that any compensation model is morally and ethically superior and to encourage you to keep in mind the presence of Adam Smith’s “invisible hand” when evaluating various advisor compensation models. To borrow a line from the authors of “Freakonomics”: “Morality, it could be argued, represents the way that people would like the world to work, whereas economics represents how it actually does work.”

Rather than sermonizing over the moral superiority of one compensation structure over another, perhaps the most objective advisor business model is one that offers all of the afore-referenced schemes and provides clear advanced disclosure of the economically discernable potential conflicts inherent in each.

This post first appeared on Nasdaq.

Learn more about J.R. on NerdWallet’s Ask an Advisor.

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