These days the clear lines of demarcation between different financial advisory are a blur. The compensation structures of the various financial advisors – hidden and disclosed – has changed a lot. The sad reality is that investment brokers, financial planners, financial advisers, financial consultants are all different words for a salesperson.
Why should this matter to you?
The quality of the advice you receive greatly hinges on the how you pay for the financial advice you get and the conflict of interest that’s attached to it. Thus, the amount of money the these sales people get, is the undercurrent that drives the advice they choose to give you or not.
How Compensation Biases Your Financial Advice
Compensation greatly biases financial advice and here is how the various compensation structures bias the financial advice you receive:
1. Commission Based Financial Advice
Products with a commission based compensation structure include insurance products, stocks and mutual funds. The more business they bring, the more they get paid – transactions dominate and motivate the sales person. The goal is to create more transaction activity, with a great focus on high commission products.
Such advisors have little to no regard for the suitability of the products to the clients. This makes, commission based financial advice have the greatest conflict of interest of any compensation structure in the industry.
“Fortunately for serious minds, a bias recognized is bias sterilized,” – Benjamin Haydon.
2. Percentage of Assets Under Management
Products with asset under management compensation basis include bank deposits, bank loans, mutual funds, unit trusts and more. Under this compensation structure, the motivation is to maximize consistency of returns rather than profits. This is because, consistent returns increases customer retention rates, which ultimately maximize the investment advisors profits in managing more assets.
A typical situation where asset based compensation posses conflict for advisors is in mortgages under asset management. Advisors will typically advice clients not pay off a mortgage, even though it carries a high interest rate because it will diminish the assets under management.
Another situation is in managing funds and unit trusts under this model. Assuming they charge 2% on assets managed. When you do the math, you’ll realize that at 2%, for a Ksh. 1M investment, they’ll make Ksh 20,000 a year. This is a fee you would typically resist if you were told transparently rather than as a percentage.
Remember, the ultimate goal here is to protect and enhance compensation.
3. Profit Incentive Fee
Under this compensation structure, the advisor is paid a percentage of profits. Sounds great, right? I mean they make money only when you do. This is a misleading sales pitch because you’ll assume that your interests align.
However, you only share profits, not loses. In reality, this model will only motivate the to take greater risks in the hopes of creating greater returns so they can get paid handsomely. At the end of the day, the capital isn’t his/hers and all loses realized are yours to bare – not his/hers. Thus, you bare the full brunt of the risk taken, and for the advisor its just another risk free return.
This compensation structure will likely get you more risk – as for profit? You may or may not end up with more profit.
4. Fee-Only Advice
Fee-only advice is commonly adopted by financial planning and coaching services that get paid they the hour. These services don’t receive a reward for any financial transactions that may arise as a result of your interactions with them – no commissions, residual trailer fees or kickback revenue. Therefore, this makes this type of compensation structure the closest you will ever get to getting financial advice that isn’t marred by compensation.
At Wealth Architects, we’ve used this model. The sole motivation of a true fee-only adviser is to provide you with as much valuable financial advice as possible for the money pay, so that you may continue to purchase more services.
However, there are some limitations:
- Beware of the limitations of your advisor’s experience, education, skill and intelligence.
- Beware of your advisor’s personal morals. Some advisors may opt to partake in kickbacks but claim they are fee-only advisors.
Note that this compensation structure isn’t the most profitable when operated in its truest form. This is one of the challenges I have faced as a financial planner. I would make more money selling financial products and managing money directly, but I have always believed that the best way I can serve is by separating advising from product selling.
Learn more: Financial Coaching: What Is It and How Does It Help
How to Increase the Value of the Advice
There is no perfect compensation structure that will make your advisor care more about your money more than their own money. However, there are ways to increase the value of the advice you get and reduce or eliminating conflict of interest.
Here is how:
Understand the Incentive
Understand what drives the financial advice i.e. the incentives that the advisor stands to get. Always ask your advisor to disclose how they stand to gain the transaction.
However, even with is It isn’t wise to completely ignore all the information get just because its unreliable – back it up with some research.
Separate Fact from Opinion
Separate the facts from opinions in the advice you receive. Know that facts, do the math.
Facts matter, not the sweet blend of words in the sales pitch. Make it a habit to fall back on hard data and numbers to drive your investment decisions.
Realize All Advice Isn’t Equal
Not all advice is made equal. Take note of the educational background, experience, and skills of the advisor before you attach merit.
The sad reality is that a lot of financial advisors don’t even fully comprehend what they are selling. They are taught what to say and how to say it – truth or not.
Use Sales People As A Resource
Use financial product sales people as a source of information only. They’ll introduce you to great investment products that can be used to build your portfolio. When they make a sales pitch, take it with a gain of salt and deem it as the first step to educating yourself – in simple terms, building awareness that x product exists.
Never invest based solely on recommendation. Always remember that there no truly free financial advice – you’ll pay for it one way or another. A poor investment decision based on poor quality advice will cost you a lot more down that road.
Take note, true advice is…
- Paid for directly – not through incentives from the products you buy.
- Results from paying disclosed fees for services rather than hidden fees.
Learn More: Reasons To Be Your Own Financial Expert
Bottomline
In an ideal world, financial advisors of any kind ought to act in the best interests of their clients, and therefore must set aside their personal interests and fully disclose all their fees and any conflict of interest.
This, isn’t the case almost 99% of the time.
You’re responsible for your money and the investment decisions you make.
Nobody cares. Nobody cares about your financial future more than you. That! – you can bank on.
And that’s the best financial advice you can depend on – from me with love.
Happy Building!
Image credits: Top by by Anna Tarazevich from Pexels