There needs to be a discovery period between advisor and prospective client. It should be conducted almost as an interview. Both advisor and prospective client NEED to find out if the relationship will be a good match. Each situation will be different, but here are a few essential questions every prospective client should ask their potential financial advisor.
How are you compensated?
This is THE MOST IMPORTANT question to ask before beginning a relationship. A financial professional can receive compensation in many different ways and it can often be confusing for clients.
- Fee-Only –The fee paid is usually based on assets under management (AUM). The advisor will charge a percentage fee on the amount of assets under his/her control. These types of professionals do not get compensation from any product sales. The ONLY form of compensation they can receive is from the fee.
- Hourly Financial Planning Fee – Some advisors charge hourly fees based on the amount of time spent working on a particular client’s financial plan. This will be on a case by case basis.
- Fee-Based –Not to be confused with fee-only, they are NOT the same thing even though they sound very similar. A fee-based financial advisor has the ability to charge a fee based on assets under management AND collect sales charges and commissions on the products they sell. Fee based financial advisors are usually what are known as “hybrid advisors”. This type of compensation structure has serious flaws to it. If the advisor is compensated for selling products, wouldn’t he/she pitch the product that pays the most? This type of compensation structure often leads to conflicts of interest between client and advisor.
- Commission-An advisor that gets paid on commission gets a percentage of every transaction they execute for a client. Some of the commission goes directly to the advisor with the rest of it going to the firm. This type of compensation structure is loaded with conflicts of interest. The advisor will want to perform as many transactions as possible so they receive more money. Also in some cases, firms place minimum transaction requirements on their advisors. The firm forces their advisors to execute transactions in client accounts even if it is not in the client’s best interest.
- Wrap-Fee – A wrap fee account is an all-inclusive compensation method. The advisor charges an assets under management fee and a set fee for all of the trading commission. A wrap-fee would make sense for someone that wants to do a lot of trading in his or her account. Therefore, in a sense there is a limit on the amount of commission the advisor can collect. However, the conflict of interest from receiving commission still exists.
Are you a fiduciary?
There are many different titles financial professionals call themselves (wealth managers, wealth consultants, financial advisors, financial planners etc…). None of these matter as much as whether that person is a fiduciary.
A fiduciary is required to put the client’s interests ahead of their own. Investment advisors are legally bound by the fiduciary standard. Under the fiduciary standard advisors must try to avoid conflicts of interest and disclose any conflicts that do arise. Advisors must use best execution practices when transacting client accounts. Best execution involves performing the transaction at the lowest cost and by the most efficient means possible. Fiduciaries’ loyalty reside with the client only.
A financial professional with any other title beside investment advisor or certified financial planner may not be required to act as a fiduciary. All other financial professionals will be acting under the suitability standard of care. The financial professional has to believe that the investments are suitable for the client. They do not have to act in the best of interest of their clients. As long as the recommendations of the financial advisor meet the objectives of the client, the suitability standard has been met. The disclosure of conflicts of interest are also less strict under the suitability standard. The financial professional’s loyalty is split between what is best for his/her firm and what is best for the client.
What is your investment strategy?
An advisor’s investment strategy should be one that can adapt to meet your objectives, time horizon and risk tolerance. An advisor should be as transparent as possible when explaining the strategy to you. If an advisor cannot explain their investment strategy to you in a way that you can comprehend, you should probably not work with him/her. If the advisor seems to have a “black box” or says the strategy has “upside with no downside” run the other direction.
It is important to know what kind of investments the advisor will use as well. Most advisors use a combination of stocks, bonds, mutual funds and ETFs in their strategies. There is no need for a strategy to be more complex than that. Simple is better when it comes to investing, despite what some may say.
Clients of advisors should also be told where the investment accounts will be held. Most financial advisors use a discount broker as the custodian of client accounts. The advisor should let the client know which discount broker they work with. This way the client understands where they will be getting statements from and how to access their funds.
What services does your firm provide?
This might seem like a dumb question to ask, but many financial firms provide different services. Some firms are all inclusive meaning they do financial planning, investment management, tax preparation, estate planning, insurance planning etc. While other firms may just specialize in investment management or another area. It is important to define the scope of the engagement prior to entering into a relationship with a financial professional.
It amazes me how little research and effort some people put into finding the right financial advisor. Just because your friend or relative refers you to their financial advisor does not mean they will also be a good fit for you. There is no right or wrong answer as to what type of advisor to work with. What is most important is to ask and UNDERSTAND at least these questions before agreeing to work with an advisor. When you sign up with a financial advisor you’re trusting that person with YOUR money, YOUR livelihood. Do the research, ask questions and don’t accept anything other than 100% transparency. It’s your future at stake after all.
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