The very thought of managing our personal finances makes us nervous. There is a whole array of terms that one reads about or hears constantly – annuities, insurance, retirement plans, mutual funds and stocks. Most of us will need help from competent professionals i.e. financial planners or advisers at some point in our lives. These planners help us identify our financial priorities and goals, de-mystify various financial terms and build us a financial plan.
It is therefore vital to hire the right financial planner. Equally important is to understand how exactly they get paid. There are four ways in which financial planners are compensated. Let us run through them.
1. Commissions
A high percentage of agents in the world of personal finance work on the basis of commissions. These include stockbrokers, insurance agents, analysts, lawyers, accountants and some financial planners. Most of them push products of a particular company and derive commissions from the sale.
Commission-based financial planners differ from the lot in that they advise what’s best for you. They have the license, training and experience to advise you on the best options available to meet your financial goals. They review your life insurance, annuities, the stocks, bonds and mutual funds you hold and give advice.
If you do not agree with their recommendations and choose to ignore their advice, you need not pay. You pay only if the planner’s recommendations are implemented. Financial advice costs money and if you consider their advice unsuitable, you don’t need to pay.
Critics of the commission-based payment system argue that such planners fail to provide objective and unbiased advice. The very fact that they earn commissions suggests they get paid for routing you to company products. Does the mutual fund of company ABC that the planner has recommended suit you or the planner? Is it being thrust forward because the company pays handsome commissions? This conflict of interest severely limits your investment options and impacts the quality of advice. It is possible that the best option was never revealed because the planner derived no benefits from recommending it.
2. Fee-only
The fee-only planners sidestep the conflict-of-interest issue neatly by charging a flat fee for their services. They do not accept any sales or trading commissions or bonuses. They are compensated solely by the client - which is you.
Some planners charge an hourly rate for information and advice as and when the client seeks it. This is just like dealing with a lawyer. Others charge a flat annual fee, which varies depending on the complexity, for the services rendered. They review your budget, cash flows, debts, retirement plans, and insurance and offer advice.
Fee-only financial planners require no license to practice. This is held against them as anyone, without certified training, can be called a fee-only planner. Industry associations like NAPFA address this issue by having rigorous standards to assess competence.
Since fee-only planners charge a flat fee, they claim their advice is in sync with your best interests.
3. Fee-based
This is different from a fee-only compensation in that commissions, if any, are added to the flat fees charged by the planner. The commissions come from the investment products purchased through the planner. The planner receives commission if the client follows recommendations and purchases a particular product.
A variant of fee-based compensation is the “percentage of assets”. Here the planner charges a percentage of the client’s assets on an annual basis. The assets figure could be all of the client’s assets or only the assets under the planner’s management. If the assets appreciate based on the advice, the planner gets a higher compensation. The asset management fee is getting to be increasingly popular with both planners and clients, since the fee is directly related to the asset performance based on the planner’s advice.
4. Fee-offset
Here commissions, if any, are set against the flat fee charged. In essence, commission is added to the fee in a fee-based payment plan, and subtracted from the fee in a fee-offset payment plan.
Fee-offset planners are licensed individuals and claim to have the same objectivity of fee-only planners.
If you have a higher net worth, it is advisable to have a fee-based planner, especially one that charges an asset management fee. While more money does not mean more complex finances, the planner’s advice can help you save a lot. If your assets are modest and you need occasional advice, a fee-based planner with an hourly rate suits you the best.
Some planners may come up with an ingenious mix of the 4 modes of compensation. It is important to carefully check the financial planner’s charges and payment modes before signing one on.
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