One central factor to consider for choosing an investment professional is to know what type of compensation they receive: fee based or commission based. Those two types of compensation are today at the very center of a long heated debate in the financial industry regarding transparency, disclosures and professional duties. This is the debate between Fiduciary Duty and Suitability.
Fiduciary Duty vs Suitability
Investment professionals have different compensation schemes that dictate their professional duty and loyalty.
Suitability: Commission based compensation
Commission based professionals are compensated by a firm or a third party and will receive a commission when they make a sale, that is they will ONLY receive a commission when we buy them financial products and the selling price of their financial products will include their commissions.
Brokers-Dealers, Life Insurance agents and Independent Retirement Advisors (IRAs) are typically compensated by commissions. Their professional duty and loyalty lies entirely with their employers, not the clients buying their financial products, which brings certain ethical issues. To resolve this, commission based agents are legally bound to only offer financial products that are suitable to their clients in terms of risks, nothing else. Even if their financial products have below average performance and will not give a value advantage to their clients, they can still legally sell them as long as the underlying risks fit with their clients risk expectations.
You should know that the Suitability principle operates under a rigid self-regulated environment (FINRA).
Fiduciary Duty: Fee based compensation
Fee based professionals are compensated directly by their clients. This is a huge difference with commission based agents because their loyalty and duty is directly with their clients. Their clients interests go first, even before their own, no matter how little compensation they receive for their investment advice. Choosing the right financial assets to achieve their clients (us) objectives is their priority. What this also means is that you will need to pay a fee up-front for their investment expertise, even if you don’t buy any of the financial products they would recommend. It’s a lot like going to your physician for a consultation, and taking (or not taking) the medication he would prescribe. Unfortunately, most fee based investment professionals will only take clients with a lot of capital to invest (often with a minimum of $200,000), neglecting clients with only small savings (less than $50,000). Therefore small clients will often fall into the net of commission based agents with their questionable sales practice.
The Fiduciary Duty principle operates under a Federal and State regulated environment (State Regulators, SEC).
By definition, broker-dealers are intermediaries that can buy and sell listed securities on your behalf. They can also be distributors of non-listed third party investment products. Broker-dealers fall under the self-regulated Suitability principle.
Broker-Dealers perform a dual role in carrying out their responsibilities. As dealers, they act on behalf of the firm, initiating transactions for their own account. As brokers, they handle transactions, buying and selling securities on behalf of their clients. In their dual roles, they perform two vital functions: they facilitate the free flow of securities on the open market, and they buy or sell securities in their own accounts to ensure there is a market in those securities for their clients. In this regard, broker-dealers are essential, and they are also well-compensated, earning a commission on either or both sides of a securities transaction.
Financial Advisors / Financial Planners / Registered Investment Advisors (RIAs)
These investment professionals might have overlapping roles making their label definition somewhat challenging to identify. Again the type of compensation they receive will eventually define their true role.
By definition, a financial advisor provides financial advice or guidance to clients for compensation. Financial advisors, or advisers, can provide many different services, such as investment management, income tax preparation and estate planning.
Financial advisor is often used as a generic term with no precise industry definition, and many different types of financial professionals fall into this general category: brokers, insurance agents, tax preparers, investment managers and financial planners are all members of this group. Estate planners and bankers may also fall under this umbrella.
What may pass as a financial advisor in some instances may be a product salesperson, such as a stockbroker or a life insurance agent. A true financial advisor should be a well-educated, credentialed, experienced, financial professional who works on behalf of his clients as opposed to serving the interests of a financial institution. Generally, a true financial advisor is an independent practitioner who operates in a fiduciary capacity in which his clients interests come before his own. Only Registered Investment Advisors (RIA), who are governed by the Investment Advisers Act of 1940, are held to a true fiduciary standard. There are some agents and brokers who try to practice in this capacity, but their commission-based compensation structure does not make them truly loyal to their clients.
An investment advisor is defined by the Investment Advisers Act of 1940, as any person or group that makes investment recommendations or conducts securities analysis in return for a fee, whether through direct management of client assets or via written publications. An investment advisor who has sufficient assets to be registered with state securities authorities or the Securities and Exchange Commission (SEC) is known as a Registered Investment Advisor, or RIA.
RIAs have a fiduciary duty to their clients, which means they have a fundamental obligation to provide suitable investment advice and always act in their clients best interests.
A financial planner is a qualified investment professional who helps individuals and corporations meet their long-term financial objectives by analyzing their clients financial situation and setting programs to achieve their clients goals. Financial planners specialize in tax planning, asset allocation, risk management, retirement and/or estate planning. Also referred to as a Registered Financial Planner, when the financial planner is registered with the Registered Financial Planner Institute (RFPI).
All these labels above can be misleading, but what we need to remember is that the Fidiciary Duty principle should be central in our selection process, and that the only true financial advisor is a Registered Investment Advisor.
Asset Management Firms – AMC
An asset management company (AMC) is a company that invests its clients pooled funds into securities to match certain financial objectives or investing mandates. Asset management companies provide investors with more diversification and investing options than they would have by themselves. AMCs manage mutual funds, hedge funds and pension plans, and these companies earn income by charging service fees or commissions to their clients.
AMCs charge their clients set fees. In other cases, these companies charge a percentage of the total asset under management (AUM). Some AMCs combine flat service fees and percentage-based fees.
Typically, AMCs are considered buy-side firms. This simply refers to the fact that they help their clients invest money or buy securities. They decide what to buy based on in-house research and data analytics, but they also take public recommendations from sell-side firms (Broker-Dealers).