This is the first in a series of posts designed to help you feel confident in hiring and working with a financial advisor. If these posts raise any questions or concerns, or you would like me to address a specific topic, don’t hesitate to reach out. A later post will review options for people who want help investing but aren’t interested in hiring an advisor.
Narrowing the Field
The first step to hiring a financial advisor is to understand what kind of advisor you should hire.
Part of the problem is that “financial advisor” is a catchall term that can apply to a dozen different professions, all of which are compensated differently and offer different services and products. The financial advice industry doesn’t have quite the same standards, regulations, or educational requirements that doctors or lawyers do. This makes it hard for individuals to know what they’re getting when they hire an advisor.
For example, there are brokers who work at big banks like Morgan Stanley or firms like Charles Schwab (or E.F. Hutton, back in the day). Brokers offer investment advice and execute trades to buy or sell stocks or mutual funds. However, brokers are usually compensated through commissions that are paid per trade executed, or through kickbacks paid from the mutual funds they invest your money in.
These kickbacks are called “sales loads” and generally range from one to five percent. If a broker invests $10,000 of your money into a fund that charges a five percent load, the broker takes $500 from your $10,000 and keeps it. These brokers might mean well, and might offer excellent advice, but the way they are paid means their interests will never align with your own.
Other financial advisors work for insurance companies, and are usually compensated through selling annuities. Insurance and annuities are an important part of any financial plan, but most annuities are grossly overpriced. These advisors are often compensated based on how many products they sell, not the quality of their advice. Because of the way these advisors are compensated, they will often try to sell annuities too early in your investing life. Annuities can be a powerful tool when you are in or near retirement, but they are only one part of an investor’s toolbox, and the high fees can take a huge bite out of your potential returns.
The Pacific Ocean from the California coast. Taken from the Coast Starlight Amtrak train.
The Best Choice
My recommendation is to only hire a “registered investment advisor,” or RIA. To carry the RIA designation, these advisors must be registered with the Securities and Exchange Commission (SEC), and are subject to periodic compliance reviews and investigations by the SEC. This is significant. By registering with the SEC, the advisor is legally declaring that they will operate according the fiduciary standard: They will act in your best interests, not in their own.
RIAs can vary greatly in size, from one-person shops to large firms that manage billions of dollars and offer a variety of services. This is another reason to only hire an RIA: Chances are you will be able to find one that fits your needs, without sacrificing the fiduciary standard.
Some RIAs are set up under the umbrella of large banks like Morgan Stanley or J.P. Morgan Chase. These are called “captive” RIAs. While these are a good choice compared to the kinds of advisors listed above, there are also fully independent RIAs if you want one.
The SEC offers a handy tool that lets you search for RIAs in a radius around a specific zip code. The tool can be used both to search for firms and to check the credentials of someone who claims to be an RIA. By registering with the SEC, the advisor must fill out a Form ADV. This document (which is publicly available through the search tool above) contains a wealth of information, such as how many employees the firm has, how much money it manages, and how it is compensated.
Pay Me My Money
Compensation influences most things people do in the investment world. If a sell-side analyst is paid based on how many meetings they have with CEOs, they are more likely to put “buy” ratings on those companies so that they keep getting meetings. If your broker is compensated through sales commissions, they may find reasons to keep buying and selling stuff with your money.
In contrast, most RIAs are compensated through either an annual fee based on percentage of assets, or a flat fee for services rendered.
Annual fee. Imagine if the advisor charges a one percent management fee on the assets they manage. If you give them $100,000, their cut will be $1,000. Their paycheck is tied to how well they manage your money, not how much they “do” with it — which means they are more likely to be good stewards of that money. The one percent fee isn’t an industry standard, sometimes it is higher or lower.
Flat fee. The advisor will charge you a predetermined amount based on an hourly rate, on a per meeting basis, for special services rendered, or some combination of those. For example, the advisor might charge you for their efforts in setting up an estate plan. Since estate planning is complicated and time-consuming, this will usually carry a large one-time fee.
These two compensation schemes are generally the easiest to understand and are tangibly related to services that the financial advisor is providing you. Of course, there are still bad actors among RIAs, so you shouldn’t surrender your own judgment. But the combination of compliance oversight and aligned compensation make it far less likely.
Stay Tuned
The next post will cover what kind of questions to ask yourself before hiring an advisor.