Conflict of interest in finance can arise when a financial advisor’s personal incentives are not aligned with the best interests of their clients. Financial advisors may face pressure to recommend products that provide them with higher commissions or that benefit their employer, even if those products are not ideal for their clients’ financial goals. Such conflicts can subtly affect the advice clients receive, often resulting in higher costs or less optimal financial outcomes. Understanding the various types of conflicts of interest, as well as how they might manifest, can help individuals make more informed decisions when working with financial professionals.
If you’re looking for help managing your investments or creating a financial plan, SmartAsset’s free tool can connect you with fiduciary financial advisors who serve your area.
Conflicts of Interest for Financial Advisors
Conflicts of interest generally arise when the financial goals or interests between advisors and clients don’t align. In many advisory relationships, financial professionals sit down with clients to identify investment objectives, risk tolerances and time horizons. Clients can also specify any investment limitations or restrictions, but advisors generally hold the discretionary authority to make financial decisions on behalf of each client.
But how do you find an advisor’s conflicts of interest? A more DIY-based approach is to review the financial advisor firm’s Form ADV. A Form ADV is paperwork that all advisory firms registered with the U.S. Securities and Exchange Commission (SEC) must complete. The paperwork has two parts. Part I outlines each firm’s client base, assets under management (AUM), office locations, fees and disclosures.
Part II contains a firm brochure that the firm itself writes. The brochure essentially outlines the advisor’s investment strategies, advisory services, industry affiliations, fee schedules and conflicts of interest. Fortunately, both parts are publicly available. You’ll be able to use this to your advantage if you’re working with an affiliated advisor of an SEC-registered firm.
What Are Some Common Conflicts of Interest?
Advisory firms with fee-based fee structures often have affiliations with registered broker-dealers and/or insurance agencies. This allows firm representatives to earn commission-based compensation from selling insurance or investment products, creating a conflict of interest because advisors have a financial incentive to recommend certain securities or products over others. It’s important to note that this form of compensation is in addition to asset-based fees.
Performance-based fees can also create a conflict of interest if the advisor participates in side-by-side management of performance fee accounts and asset-based fee accounts. When it comes to investment opportunities, advisors may become incentivized to favor accounts with higher fees over other asset-based accounts with lower fees. Fiduciaries often disclose such conflicts of interest, regardless of their fee structure.
Fee-Only vs. Fee-Based: What’s the Difference?
Fee structure is often a reliable indicator of whether your advisor will have any conflicting advisory practices. The two most common fee structures are fee-only and fee-based. If your advisor has a fee-only fee structure, they’re compensated solely for the advisory services they provide and not for the investment products or money managers they sell or recommend. This also means that they don’t earn commissions.
In providing financial services, fee-only advisors earn compensation through a percentage of client assets. These advisors also charge flat fees and/or hourly fees. Fee-based advisors typically earn commissions in addition to the asset-based fees collected from clients. As mentioned earlier, these commissions generally come from insurance or investment products.
Fiduciary vs. Non-Fiduciary Advisors
A fiduciary standard is a legal obligation that requires financial advisors or advisory firms to work in each client’s best interest. All SEC-registered investment advisors and advisory firms have a fiduciary obligation, regardless of fee structure. In honoring the legal standard, advisorsfdf must disclose any conflicts of interest. Non-fiduciaries usually operate under a different standard.
Examples of non-fiduciaries include, but aren’t limited to, broker-dealers and broker-dealer firms and insurance agents. These advisors are typically registered with the Financial Regulatory Insurance Authority (FINRA) or state insurance regulators.
Whereas fiduciaries must honor a fiduciary standard, non-fiduciary broker-dealers historically have been required to abide by a “suitability” standard. Unlike the fiduciary standard, the suitability standard only requires financial professionals to provide advice that is most suitable to a client’s needs.
However, these finance professionals are now required to adhere to Regulation Best Interest (Reg BI), which was designed to increase accountability and protect consumer interests. Under this regulation, broker-dealers must make recommendations in their clients’ best interests, although it’s not quite as stringent as fiduciary duty.
Getting a Second Opinion
If you suspect a conflict of interest with your financial advisor, getting a second opinion can be a practical next step. Seeking advice from a fee-only advisor can help you determine whether the recommendations you’re receiving are in your best interest. Some advisors offer standalone services, including one-time checkups or free consultations. .
Comparing different viewpoints not only provides clarity but also ensures that the financial strategies align more closely with your objectives rather than an advisor’s potential personal incentives. Ultimately, having multiple perspectives empowers you to make a more informed decision about your financial plan.
Bottom Line
With the assistance of a financial professional, you can significantly grow your wealth over time. But you’ll want to take note of factors such as the firm or advisor’s compensation structure and/or any potential conflicts of interest. Financial firms and advisors with fee-only fee structures generally have a lower potential for conflicts of interest than fee-based advisors do. This is mainly because fee-only advisors don’t earn additional compensation from other products.
In narrowing down your search, remember to determine whether your advisor honors fiduciary duty or Regulation Best Interest. Keep in mind that fiduciaries typically must adhere to a higher standard. When it comes to investing, retirement planning or financial planning, a fiduciary may be the better choice. Even if your advisor has conflicts of interest, their fiduciary obligation will protect your assets over the long term.
Tips for Finding a Financial Advisor
- Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- Do you need help managing your investments or have more specific needs, like estate planning and tax strategy assistance? Before choosing an advisor, assess your personal needs and focus your search for an advisor on those who specifically offer the services that align with these needs. As you examine your own financial situation, think about your risk tolerance, short- and long-term goals, as well as your time horizon – how long you have before reaching these goals.
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