Conflicted Advice - Why Fee-Only Is Not Conflict Free

During my time working for financial planning firms, I have been employed predominantly by fee-only advisors. A fee-only advisor provides financial advice without receiving any commissions for products recommended, as opposed to a commissioned advisor or fee-based advisor. (For a good, simple explanation of the three predominant compensation models in the financial planning world, I recommend this post by Roger Wohlner, CFP®.) I am a believer in the fee-only model as the best current compensation model to deliver financial advice. However, I want to make you aware that even this model has conflicts of interest and then compare this conflict to the conflicts of the the other two models. 

The Fee-Only Conflict

The fee-only model does remove the conflict of interest created by wanting to sell products which pay commission. My belief is that this can increase the quality of advice delivered to a client. There are still very important conflicts which remain, however. The predominant potential conflict of interest arises if you pay your fee-only advisor a fee based on assets under management. A conflict exists when you ask questions about removing investment assets to make purchases or pay off debts. As an example, if you have investment assets to pay off your mortgage and ask your advisor whether you should do so, the advisor has financial incentive to find a case for you not to pay your mortgage. By paying your mortgage off and reducing assets under management, your advisor could receive less revenue from you. Furthermore, under this scenario it is very easy, and often correct, to make a case to maintain a mortgage. Your advisor is performing this analysis, however, from a conflicted viewpoint. You must consider whether you believe the advice to have been put together with an understanding of your beliefs and values around debt and your appetite for risk. This conflict exists with any question pertaining to consuming or saving investment funds which could create income for the advisor.

The Conflict Impact

Fortunately, a state or SEC registered investment advisor is required to put your interests ahead of their own when a conflict exists. This means that even in the mortgage scenario above, the advisor should provide you advice which is correct for you. And, from my experience, I believe advisors generally try to do this. Nevertheless, two questions exist on which you must pass judgment. First, the financial incentive to advise against removing assets could be working on a subconscious level with your advisor. They may have preconceived ideas about paying off mortgages which can be justified with financial projections, but are partly based in the need to maintain income sources. Second, there can be an argument made about what is in your best interest. One advisor can point to a financial projection showing that you come out ahead maintaining your mortgage and keeping your money invested even if you would feel more comfortable with the debt eliminated. They can rightly argue that they are acting in your best interest to maximize your financial wealth. A second advisor can argue that you should pay off your mortgage despite the risk that you may lose some financial wealth because you do not have the risk tolerance to maintain the mortgage and you value highly being debt-free. Neither opinion is incorrect. You should have a clear understanding about what assumptions your advisor makes when providing advice. Are they trying to maximize your financial wealth or taking into account your beliefs and values? My goal is not to take a position on that question, but to make you aware of the thinking behind the advice and that this conflict does exist.

Other Models

How does this conflict of interest compare to those conflicts which commissioned or fee-based advisors are presented with? I believe the fee-only conflict is a far more transparent and manageable as long as your advisor makes clear to you what assumptions they use when providing their advice. A commissioned advisor must sell products which pay a commission for them to earn a living. They can discuss this conflict of interest with you, but they have no way of minimizing the conflict. If they hope to get paid, they are limited in the advice they can provide. A fee-based advisor is in a seemingly better position. They can provide you advice based on the fee without having to push commissioned products. Commissions are only a portion of their income source.  Their conflict is minimized. However, they do still derive some of their income from commissions and are therefore given incentive to offer commissioned products and make a case that these are equal to non-commissioned products. Secondarily, the fee-based advisor has the same conflict of interest as described above for a fee-only advisor. This fee-based advisor works under two sets of potential conflicts.

Conflicted Advice

What this means to you as the client of financial advisors is that there really is no conflict-free advice under any of these three compensation models. My belief is that the fee-only model provides the most manageable conflict of interests and that the legal requirement to put a client's interest first provides a layer of legal protection to clients. What is important is that you understand these conflicts and how they may be impacting the advice you receive. It is also important that your advisor be clear about the conflicts of interest they operate under with you. If they have not been, ask them. Be direct... and if your advisor is not forward or is unclear about their conflicts of interest, be very wary, regardless of compensation model.


Evacuee said...

Nate, I'm not sure that you've made your point here. Fee only via AUM is just one way of doing it. I know of many fee-only advisors who charge an annual retainer based on different factors, mostly income & net worth.

I agree that nobody is conflict-free, but your example above doesn't really prove the point you're trying to make.

Nathaniel G. Gehring, CFP® said...

I agree that my example is not relevant to all fee-only advisors. I use the above example as only one, glaring example of an existing conflict for many fee-only advisors. I do believe AUM remains the predominant fee-only model. My primary points are that clients should remain aware that conflicts exist regardless of compensation model, that these conflicts can impact advice given, and that advisors should be frank and open about their conflicts of interest. I would love to see a discussion about other conflicts for other models and, more importantly, how to work toward minimizing these conflicts.

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