How Your Financial Advisor Gets Paid, and
Why You Should Care
by Chuck Yanikoski
As someone who owns his own business (and therefore is always concerned about marketing) and as a former marketing manager in a large financial company, but also as someone who likes to think of himself as an ethical person, I can attest to this:
When your paycheck depends on people buying a certain kind of product or service, it is very easy to come up with persuasive reasons why that product is just the right thing for them, and a competing offering is not quite right.
That's one problem. Here's another:
A friend of mine in the financial industry talks of experienced advisers who have "insurance company DNA" or "investment company DNA." For people trained in the insurance industry, almost every problem has an insurance-related solution (usually life insurance, or annuities). For people trained in the investment industry, almost every problem has an investment solution (usually some form of mutual fund or other managed account).
So while you, as the customer with a problem to solve or an opportunity to exploit, want the best answer to your questions, the recommendation you receive will rarely be based on a fully-informed, totally unbiased evaluation of all the possibilities. Rather, it will depend on what knowledge and biases your adviser has acquired, what solutions s/he is most familiar with, and probably, which solutions generate income for the adviser.
Most advisers, of course, do not see this as a big problem (well, maybe in their competitors, but not in themselves). From their own point of view, the products and services they offer are the best, or at least among the best, which is why they offer them. The fact that this judgment on their part is or was, at some point, influenced by whether their professional background was in the insurance or investment (or banking) industry, or how their compensation is structured, is a reality that they might acknowledge, if pressed, but really don't want to think about.
And frankly, I don't blame them. They could not be effective if they had to re-think every situation from scratch. You go to professional advisers precisely because you believe they have experience with situations like yours, and already know most of the answers. It would be harder for them, and more costly for you, if they had to treat your situation as a totally unique one, and question every assumption that they use in their business.
So they may not think a lot about this. But you should, because the answers you get will depend on who you talk with - and on how that person gets paid.
Many advisers - and often "objective" parties in the financial press or on TV or radio - criticize the way certain other advisers get paid. But there is no "right" way. Every method of payment imposes biases that may or may not impede the best processes from being used, or the best ideas from being recommended.
By understanding the modes of compensation, and what biases they can engender, you can take these biases into account both when selecting advisers and when evaluating their recommendations.
Generally speaking, there are three ways that financial advisers get paid. Depending on what licenses they hold, some of them can offer you more than one option:
- Advisers who manage your money - which typically means mostly determining how it should be invested, and then carrying out those decisions - usually get paid by taking a percentage of your assets. This percentage is typically about 1% a year, so that if your portfolio earns 6%, you end up with only 5% (and if your portfolio loses 6%, you lose 7%). What's good about this method is that everyone's selfish interests are in alignment: your adviser gets paid more if s/he can make your investments grow more. What's bad about this method is (a) that the adviser's incentive toward growth may not be a good match if your own preferences are more conservative; and (b) that the adviser has a strong disincentive to recommend that your funds be used to purchase any other kind of financial product (e.g., insurance, annuities, certificates of deposit), to the extent that they remove money from that adviser's control, even if those products would benefit you.
- Advisers who sell you financial products, especially life insurance and annuities, but also certain kinds of mutual funds and other financial products, may receive a commission on the product. The commission is paid by the financial company that offers the product, so it doesn't come directly out of your pocket, though of course indirectly, it does. What's good about this method is that it is the least painful to you - you don't know how much of whatever you pay for the product is going back to the adviser, so you don't feel the pinch very keenly. What's bad about it is that it can bias the adviser toward solutions that enable him/her to collect a commission, instead of solutions that don't, or toward specific products that pay higher commissions than other products that might be better for you.
- Some advisers charge you for their time, but do not manage money for a fee or sell products for commissions. What is good about this method is that they do not need to be biased in what kinds of solutions they recommend, because they get paid only for their time, not for the content of their recommendations. What is bad about this is that they may be biased toward solutions that require more of their time, or toward analytical processes that are more detailed, or to the production of presentation materials that are fancier than you need. And even though they may not be biased in their product recommendations because of their compensation, they may still be biased by their backgrounds, or by their professional relationships with other product and service vendors to whom they may refer you.
To be human is to be imperfect, and so don't expect any adviser to be perfectly objective, perfectly informed, or perfectly selfless. But do make sure you understand how your advisers get paid, and then take that into account along with other factors when you decide whether they are the right people for you and whether you should be taking any specific piece of advice.
And of course, you can always ask for a second opinion, just as you can with a doctor. But if you do, don't be surprised if second opinions (or even third or fourth opinions) are more out of tune in financial matters than they are in medical ones.