What You Need to Know Before Seeing a Financial AdvisorJune 3, 2015
In our household, there’s one thing we understand when it comes to financial advice from others – there’s no one who truly cares about our money more than we do. Because of this, we’re always cautious when faced with “hot tips” and financial shortcuts.
Nowhere has this attitude become more important than when I was faced with working with a financial advisor. While meeting with a financial advisor may be considered the “adult” thing to do for some, it can also turn out to be more harmful than helpful towards your long term financial situation if not carefully considered.
If you’re curious about getting your finances in order with the help of an advisor, here’s what you need to know before going in.
Almost anyone can claim to be a financial advisor
A person who is classified as a “financial advisor” should not impress you. Almost anyone can claim to be a financial advisor. Not only that, but there are numerous certifications and degrees which qualify a person to be a financial advisor, and that doesn’t mean they provide the same services. They could provide estate planning, investment advice, long term financial planning, etc.
The merits of what a financial advisor has done and can provide for you should be irrelevant when you’re in the early stages of finding an advisor. The true defining characteristic for an advisor is how they are paid for their service. This can make the difference between retiring wealthy or struggling to make ends meet in your 70s.
The fiduciary difference
Many bankers, doctors, lawyers and accountants operate under a fiduciary responsibility. That is, they are required by law to act in their clients’ best interest. We would expect the same responsibility from financial advisors, right?
Sadly, many financial advisors do not operate under a fiduciary responsibility. They have no legal obligation to provide you with service and advice that is truly in your best interest. This takes us back to the way in which advisors are paid.
A very common way that non-fiduciary advisors are paid is through commissions from selling you products and services. While this may seem reasonable to you at first, consider that many advisors also place your retirement savings into funds that charge very high fees in order to take a cut of the fees for themselves. Studies have shown that retirement funds that charge high fees can wipe out a considerable portion of your long term investments.
Here’s an example. A friend of mine recently shared with me that he rolled over his previous 401K savings into a Traditional IRA set up by his advisor. When we investigated the fees associated with his IRA, we were alarmed to find that by the time he would retire, my friend would lose up to 76% of his investment earnings to this advisor’s fees.
This practice of recommending products and services that are a financial benefit to the advisors (even if it’s not beneficial to the client) is known as a conflict of interest. Unfortunately, many people are unaware of this conflict, and the advisor might not be truly open and honest about the benefit he receives from recommending certain services.
Hence, these commission-based financial advisors could lead to a great deal of wasted money. These advisors are also simply known as Brokers, or better yet, salesmen (Financial Advisor has a better ring to it, don’t you think?), and a chief concern of brokers is the amount of commissions and fees he is able to extract from you.
There is, however, a second form of financial advisor that does operate under a fiduciary responsibility. These are typically fee-only advisors who charge solely on the time they provide for giving you advice. They do not receive a commission from selling you services or encouraging high-fee investments. Because of this, the advice they provide has a better chance of being in your best interest. The downside of this route is that you could be paying over $100 and hour to receive their advice, and to echo my earlier statement, does anyone else truly care about your money as much as you do?
Beware their investment advice
While there are a wide range of services provided by financial advisors, one of their primary goals is to give you advice on how to invest your money. The reality is that the vast majority of people don’t understand the ins and outs of investing. Further, many people don’t care to dedicate the time to learning how to properly invest. Hence, the supposed need for financial advisors.
Financial advisors will tell you that their expertise gives them a greater chance of beating the market, but studies show that most of them suck at this. What they will never tell you is that the market is truly random. There are no tricks that guarantee whether stocks will rise or fall on any given day. However, it has been widely shown that investing in Index Funds – which are passively managed and do not typically involve heavily trading stocks to beat the market – consistently display performance that beat the advisor-approved actively managed funds over the long term.
If that’s the case, why do advisors consistently encourage the actively managed funds? It’s simple – fees. Passive funds typically involve low fees, very little of which goes to the advisor. There’s simply not much money to be made in directing people towards passive funds. So, do you want investment advice to be in your interest, or in the interest of the advisor’s bottom line?
Should I meet with a financial advisor?
If you discover that your advisor is a broker, and at no point mentions a fiduciary responsibility, then no, you should avoid using his service. The chances of him or her actually working in your best interest depends solely on their willingness and ability to turn down higher profits.
Additionally, here are a few red flags that you should be aware of when speaking with an advisor:
- They strive for market-beating investment results
- They tell you that their funds will beat the market by a specific amount (I was actually told this before)
- They strongly discourage passively managed investment funds in favor of actively managed funds
- They cannot tell you and / or put into writing that they will work with you under a fiduciary responsibility.
If any of these situations comes up, turn and run. Brokers are not your friends.