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Do Your Financial Advisor's Incentives Align With Yours?

Written by By Matt Wright, CFA® on .

A few weeks ago my son was in need of some Cub Scout gear, so I stopped at a local Scout Shop. Our den leader had told me the few specific items that we needed and that everything else was optional. Nonetheless, the Scout Shop employee made a good effort to sell me items that we didn't need. He even pointed out that the amount I was spending was way less than I would spend on sports equipment later on, implying that justifies spending more money when I don't need to. That might work on some people, but I'm guessing not many financial advisors fall for this!

The experience reminded me that every type of business, even a non-profit, has a conflict of interest with its customers. Ideally, a transaction is beneficial for both the business and the customer, but an adversarial tension exists nonetheless.

As with any industry, financial advisors have conflicts, too, but you may not be aware of how different business structures can impact the alignment of interests with an advisor and you, the client. Summit Wealth Advocates, for example, is a fee-only advisor. This means that all of our compensation comes directly from our clients. We are not paid by outside companies to sell their products or services or provide referrals to them. As a result, when we make financial recommendations to clients, we do so as if we are sitting on the same side of the table as them.

This is not the case for all financial advisors, many of whom still operate on more of a traditional sales model where they are paid commissions from the company selling a product, a cost the client doesn't see directly. This business model has typically provided the salesperson a commission. The conflict with this business model is that the salesperson may have an incentive to replace a client's old products with new ones over time in order to generate new commissions.

Some recent moves in the mutual fund industry highlight one way that these conflicts still exist. Responding to regulatory changes, several major firms have announced that some "C class" mutual fund shares held for a specific period (e.g., 10 years) will be converted going forward to "A class" shares. The C class and A class shares of a particular fund represent the same underlying investments – the only difference is how the commissions are paid to the salesperson. Mutual fund A shares generally pay more up front with less on an ongoing basis (e.g. 5.75% up front and 0.25% each year), while C shares may pay nothing up front but more on an annual basis (e.g. 1.0% each year.

Consider a financial advisor with a large portion of his or her income coming from C share mutual funds sold at varying times in the past. As a hypothetical, he/she may be receiving compensation of 1.0% each year from the fund companies. However, as time goes by, portions of this 1.0% income stream will be converted to a 0.25% income stream. That loss of income to the advisor is a cost savings to the client, which seems great at first glance. But look at the incentive problem this just created for the advisor! Will they sit idly by and watch their income decline? Or might some be tempted to convince clients to swap into new products that will get them back to a higher income stream? Will the new products actually be more suitable for the clients both for investment and tax purposes?

Do you really want to be in a position of having to question the motivation of why your advisor is making a recommendation? At SWA, we don't want our clients or ourselves to be in that position, which is why we believe a transparent method of compensation is in everyone's best interest.

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