Using a skilled financial advisor can be a great way to increase your investment returns and help sustain a successful portfolio for the long term. Yet some of these advantages can be offset, or even eliminated, if your advisor is more concerned about building his or her wealth than your own.
There are myriad scenarios where conflicts of interest can occur. For example, if an advisor is anxious to sell you an annuity that will hold every dime you own -- and happens to be earning a large commission on the sale -- this is questionable on several levels.
More frequent are cases where generally ethical advisors might tilt toward making recommendations that aren't necessarily unsuitable for the client but would result in greater compensation for them than other options on the table.
Let's say you're considering two similar investments. One of these is expected to generate returns of 7 percent per year and generates compensation for the advisor of 3.5 percent. A second investment involves likely annual returns of 6.5 percent and pays the advisors 4 percent. If the advisor recommends the second product, would this be because this investment is clearly more suitable for your portfolio and your investment goals? If not, you should assess the advisor's motives.
Read more: Your 401(k): Why You Shouldn't Go It Alone
Keep in mind that brokers usually collect commissions on the front end. In a continuing relationship, where advisors work with clients year-in and year-out, they tend to be more oriented toward giving service after the sale. Thus, they're in a position where they should be more accountable for the long-term consequences of their advice.
It's impossible to eliminate all conflicts of interest. But it's important to know what they are and how deep they run so you can evaluate all advisor recommendations with this information in mind. Here are some questions to ask advisors:
What are your potential areas for conflicts of interest?
Advisors who say they don't have any aren't being candid. A good answer would acknowledge factors that lead to conflicts and should make you feel comfortable with the advisor's process. This process should include full disclosure of potential conflicts involved in each recommendation and addressing all of your concerns as you go along.
Are you a fiduciary?
This is a legal/regulatory term meaning that the advisor carries the highest level of responsibility, accountability and legal liability for his or her advice. Advisors registered with the federal Securities and Exchange Commission or comparable state regulatory agencies are typically fiduciaries. Most brokers aren't. Advisors who are SEC- or state-registered are far more highly regulated than brokers regarding the types of advice they can give clients.
Brokers, who don't tend to be fiduciaries and chafe at the word, are typically regulated solely by the Financial Industry Regulatory Authority (FINRA). Yet some advisors are registered with both the SEC as fiduciaries and FINRA as far as commissions on the sale of products are concerned. Consumers should determine which hat a dually registered advisor is wearing when giving advice and when recommending products.
How are you compensated, directly and indirectly?
Fee-only advisors are generally paid only for their advice to clients — typically as a percentage of total assets under their management. Fee-based advisors are paid on the same basis, but may also earn fees from commissions for the sale of products, including insurance.
If I buy this investment, what's your commission, if any?
By asking this question consistently, you'll start to get an idea of what you're worth to an advisor annually -- from the fees you pay or the commissions he or she earns from investment companies, such as those that offer mutual funds. You might be able to use this as a basis for a reduction in advisory fees if they're higher than those of the general market.
What level of study and evaluation do you do on recommendations?
The more effort advisors put into this their recommendations, such as gathering multiple data points supporting their recommendations, the more likely it is that they have good reasons – in your interest – to make these recommendations.