Ben explains in-depth why he believes that fee-only planning is the best business model for receiving financial advice. Here is the link to the NAPFA brochure that Ben mentions too.
P.S. Folks, the fees you pay at Bona Fide are worth every penny!
This a rather full question and will take some time to answer. To really appreciate the value that a fee-only approach offers, you have to be aware of the other service models available and know a little bit in how advisors are compensated in those. In addition to fee-only planning (also sometimes referred as fee-for-service), there is a commission-based model and a fee-based model. (There is then also hybrid models which take a little of all three, but for our purposes, it would best to talk about each model as a stand-alone, though you may not necessarily see this as such in practice.
Let’s begin with the commission-based model. In this manner of advising, the advisor functions as an agent (or possibly broker) to some other larger entity that ultimately has some financial product that it would like sold and delivered to the public. The agent/ advisor then works as the company’s representative who mingles with the public and seeks to find ways to place the product among those who “need” it. As product is sold, the advisor receives compensation (commission) from the company (also called the “principal.”). Sometimes, this commission is quite large, as in tens of thousands of dollars. In many circumstances, the company also offers incentives and bonuses to its agents to encourage them to continue the good work that they do. Depending on how successful the advisor is, these incentives can range from little pay bumps to largesse, extravagant cruises and vacations.
Though I imagine many “advisors” involved in this business model would disdain this description, it’s pretty clear that the professional is a salesperson first and an advisor second. As distressing as the third-party compensation is, it is even worse to recognize that most of the education the “advisor” has received has come only from the company that pays him. There may be no outside influences informing the advisor on how best to direct the client.
Truth be told, I think this is a horrible model for advising, for many obvious self-evident reasons but I will limit it to two. First, the advisor is limited in how he can service clients, meaning that it’s not worth the advisor’s time to meet with you if you have no need for his or her product (best-case scenario). Worst-case scenario, he or she tries to convince you that you need to buy what he is selling because it will, it is argued, better your finances. Second, the interests of the advisor lie much more with the mother entity of which he or she is a part more than they do with the client. Your interests, though touted otherwise, tend to come last.
In a spirit of hospitableness, I want to say that I do believe it is possible to receive good service from advisors who operate within this structure. Most financial advice is still delivered in this manner and I know for certain that there are many good advisors who are aware of the conflicts of interest and try to look beyond the incentives and instead just focus on the advice. I admire them for their efforts. I also think they are swimming upstream and should seek better business models. As a consumer, you should be aware that the deck is stacked against you and that you are more likely to receive crummy service and poor, limited advice from someone who operates in this structure. The incentives between the client and advisor are just not very well aligned.
The next model is fee-based planning. This model is a considerable improvement upon the commission-based model, but it does have its shortcomings, in my opinion, too. Before launching into that, the manner of compensation for the advisor is no longer tied to a larger entity or organization. There are no commissions. Rather, the advisor is paid a percentage of the client’s assets each year in what’s called an Asset Under Management (AUM) fee. Depending on the amount of assets, this fee normally hovers around 1%. The fee is often paid quarterly and is simply deducted from the stated value of the client’s investable assets. The client does not pay the fee directly. The fee is rather automatic and somewhat hidden (or at least removed) from the client.
This business model does align the interests of the client with advisor considerably more than the commission model. The advisor often times has to demonstrate enough technical savvy to persuade the client into bringing the money over to manage. Since most people who have large sums of money are well-educated, the advisor has to be well-educated too in order to close the deal. Since the compensation comes from the client, the advice from the planner tends to be more objective and more aligned with the client’s interests. To keep the client’s business, the advisor has to continually demonstrate his or her abilities, since the client can walk away and take their money elsewhere to be managed by someone else.
There is much to like about this model, and it is a definite improvement upon the commission-based model, but it does have its shortcomings.
- The advice can easily be investment centric. Many people bring their money over to an advisor based on the idea of performance in the capital markets. The advisor can get me better returns than other advisors and so I should happily pay the fee because I will make more money. There’s little evidence to support this belief however. Moreover, technology has started to replicate the value advisors would offer here at much lower costs, so if you are looking for “performance” alone, there’s not as much need to work for a financial advisor.
- Advisors in this model tend to only be interested in people who have amassed a sizable nest egg. If you have no money to manage, there’s not much you have to offer to the advisor. This model often then turns advisors into “asset gatherers,” a situation closely resembling salespeople in my opinion.
- This also means that only a small segment of the population has any chance of getting good financial advice. If you don’t have a lot of money specifically invested in the capital markets, then the better advisors will turn you away, even if you make a handsome income or have assets held in other resources, such as real estate or small business. In fee-based planning, the advisor is heavily partial to the capital markets as the best and only way to invest. There are many good reasons to invest in the markets, but I don’t think the pay structure of the advisor should dictate that choice.
- With larger sums of money to be managed, the AUM fee can get quite expensive, as high as $20,000-$25,000 per year for just one client. Though I think advisors do provide a lot of value, that also is a high fee, especially when clients are only meeting with their advisor a few times a year. If the manner of payment were changed, where the client were to pay this fee directly, I don’t think many consumers would be willing to pay this much. This can suggest that AUM fees are an easy way to “milk” clients of high net worth.
Having then considered the downsides to fee-based planning, we are now ready to discuss fee-only planning and why I think it is best.
- All revenue that a fee-only planner makes comes directly from the client and is paid monthly, quarterly or annually. The client knows exactly how much they are paying and they know exactly how the advisor is compensated. It’s very transparent and direct.
- A fee-only planner interests are aligned with the client as much as one could ever hope to find. Since the client is so aware of the fee that is paid, the planner has to deliver value on that fee regularly or the client will take their business elsewhere. This encourages a high degree of efficiency in the relationship between the client and advisor, where the advisor is always looking at ways to improve the client’s finances and keep the client’s overall financial condition “lean and mean.”
- The fee-only planner is also not limited in who he or she wants to service. If the client is willing to pay the fee, then the advisor (should) be willing to work with you. Income is not a factor. Net-worth is not a factor. How your money is invested is not a factor. Choose the service and pay the fee. Matter settled.
- There are no outside influences directing or determining how the advisor ought to advise. The advice given is based on what makes the most sense for the client in their situation. Provided that the planner is well-studied and competent, the advice you receive should be the best that money can buy.
Though these are some very compelling reasons for working with a fee-only planner, it’s worth noting that there are a few handicaps to this business-model.
- Because the fees are so direct, it’s hard to convince the public to pay the price. On its face, the fee can seem expensive. (In reality, if the advisor fails to get your money back and more, he or she wouldn’t stay in business, so it is presumed that value is delivered, but there can still be hesitancy.)
- Since revenue can become haphazard in a fee-only model, it can be difficult to stay in business.
- Lastly, since all insurance products are still “sold,” a client is doubling up on their cost because the client still has to pay the commission and then pay the advisor the fee for the advice. I think the objectivity offered here is worth the extra cost, but it is worth noting that this approach is more expensive (in this specific way) than if the advisor received the commission directly and was compensated by the sale rather than by the fee.
This has been a hefty subject but I believe it sheds light on why Bona Fide Finance is so different from other alternatives. I hope that you will take some time to set up an appointment to learn more.