Subject: Financial Planning - Compensation and Conflicts of Interest
Last-Revised: 19 Apr 2000
Contributed-By: Ed Zollars (ezollar at mindspring.com)
This article discusses the primary ways that financial planners are paid for their services, and illustrates the biases and conflicts of interest that invariably are present in each compensation scheme.
- Hourly rate
- When a financial planner is paid an hourly rate, he or she may have a bias towards selling the client more advice than is needed, and/or selling additional hourly services to the client. However, the actual financial product sold to the client, or even if any is sold at all, is a matter of indifference. A practical problem is that this advice, if done properly (thorough investigation by adviser into the entire background of the client) is going to be very expensive because it needs to be customized to the client. Thus, we see very little of this type of advice except for specialized areas (like taxation, business law, etc.).
- Flat rate
If a financial planner is paid a flat rate, he or she may have a bias
towards giving the client canned advice in order to gain efficiencies.
- Percent of assets under management paid annually
- If a financial planner receives each year a percentage of assets under management, he or she may have a bias towards keeping as much under management as possible, thus leading to some bias against using funds for other purposes (including paying down debt). This structure may also encourage the advising of riskier ventures, since they present the adviser with the potential for higher compensation. Obviously, the client does have to put some assets under management (so there is a bias to do something), but the particular investments are a matter of indifference.
- Commissions on sales
- When a planner receives a commission on any product sold to the client, this can lead to a bias towards closing the sale on a product that will pay the adviser a commission and discouraging the acquisition of products that won't pay this adviser a commission. Since advice is offered as a method to encourage the client to get moving towards a buy, these advisers tend to be rather thorough in raising issues that relate to their products (finding needs). Will tend to have a bias to be less thorough in raising issues for which the solution doesn't involve their product (so in estate planning there will be lots of talk about ILITs or CRUTs, but little talk about FLPs, AB trusts, etc.). A practical advantage is that because the client can simply walk away, this can be the least expensive way to get a good quick general education on the subject at hand. Also, many investments sold by commissioned salespeople spread the fee over a number of years, so it becomes a payment on the installment plan that may allow some people to receive advice they need.
Note that any competent professional will actively control for any bias introduced by the compensation mechanism. Therefore, none of the issues raised here represent an insurmountable flaw of a particular method of compensation. Too often this sort of analysis can degnerate into a mudslinging contest that suggests there is only one right way to handle every situation, which is simply not the case.
In the end, a client of a financial planner should ask/recognize the ways by which the planner gets paid, and use that information to note any bias that might be present in the advice given.
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