There are a lot of people you’ll interact with when you make purchasing decisions who will try to influence your decision. Mostly it’s easy to understand where they are coming from. Your friends and family want what’s best for you, but that may be influenced by their own preferences or desire to have you be more like them, particularly if it means you could share a hobby. The cashier or floor person at the store gets paid by the store. They make money only if the store does, but probably their pay won’t be affected by this one decision, so they can probably be helpful. The restaurant person wants you to like what you ordered so that you’ll come back, but will also tend to recommend more expensive things as long as they’re good.
So far so good. But this becomes more important and a little murkier when we get to big transactions and financial planning. We rely on the advice of people in these positions much more because the decisions are big and we don’t understand them as much. But that makes it important that we also understand the influences on their decision-making.
There are a couple of things you need to know when working with these people. One, how do they make their money? Do they make it as a sales commission, a salary, or a set fee? This can strongly impact the kind of advice they give. Two, what are their fiduciary duties? There are actually legal principles around this kind of position determining whether their ultimate responsibility is to give you the best advice, or do what’s best for their company. Many people aren’t clear on when it’s one or the other.
So let’s discuss how both of these things work in some common examples, so that you know what to look for.
Financial Advisors and Insurance Agents
The people giving you financial advice – meaning, should you buy this or that investment? How should you plan for retirement? What insurance do you need? – make their money in several ways. It breaks down to variations of a fee, or a percentage. A commision arrangement with the fund management company is one common method. Here, the advisor gets paid a percentage of what you choose to invest. So if they are getting a 5% commission from Fidelity and you invest $1,000, they get $50 and you actually invested $950.
The fees come in a few flavors. It could be an hourly rate that they charge to speak with you. It could be a flat fee charged to come up with a plan that you will then follow after you’re done talking to them. Or it could even be a retainer fee, which is basily a yearly fee you pay to have the advisor available for all of your financial decisions.
Sometimes it’s a combination of these – you may be paying a fee, and then some of the recommendations come with a commission that will be paid on top of this.
You can see that knowing how this works is an important question in evaluating the advisor’s advice. Commissions give an incentive for the advisor to recommend those funds over other funds with lower commissions, or to recommend that you put in as much money as possible.
This pull can be tempered or not depending on whether the person you are talking to actually has a fiduciary duty to you. A fiduciary duty is a legal obligation to provide advice that is in your best interests. They must also clearly disclose any conflict of interest, i.e., a commision, on a particular fund or the fact that the fund is managed by their own company. Financial advisors registered with the SEC are required to fulfill this duty.
By contrast, brokers, broker-agents, or any other person you might be talking to about financial decisions only has to meet the ‘suitability’ standard, which means that the thing they recommend has to be more or less the same type of thing that people in your situation might want. Think of it like the implied warranty when purchasing real goods. Stores have a responsibility to sell you something that is actually a safe, working version of what they said it was, but not to make sure you get the exact best kitchen equipment for your needs.
What you should do
Ask. You should always ask whether the person you’re talking to has a fiduciary duty since it’s not always clear. This is especially true if you are talking to someone associated with the plans you get through your employer. If they say they do have a fiduciary duty, your next step is to ask for the declaration in writing. If they don’t have this duty, keep that in mind when evaluating their advice.
You should also ask them to be very clear about fees and commissions for any advice they are giving. It will help you to understand their advice and to ask follow-up questions. An example follow-up question might be to clarify the difference between a high-commision fund they are recommending and a similar-sounding fund with a lower commision.
These are your decisions, not the advisor’s. Don’t fall into the trap of doing what the ‘expert’ says without understanding where they are coming from. You’re the one that will have to live with the consequences of your choices, not them.