A friend recently asked me to vet several financial advisers he was considering to manage his retirement portfolio. As one who hates to see people getting fleeced, I'm cautious of Madoff-like malefactors, the latest of which cropped up in the case of the PFGBest brokerage in Cedar Falls, Iowa. So I curbed his enthusiasm a bit about money managers who had impressed him with their initial pitch.
Despite two years under the Dodd-Frank financial reform law, millions of investors are still highly vulnerable when it comes to advisers. Buffeted by relentless lobbying by the financial services industry, the strongest pieces of Dodd-Frank have yet to be implemented. Here are key questions you need to ask a prospective financial adviser before you sign up:
1. How are you compensated?
I have no problem with paying advisers what they're worth, but often they are overcompensated at your expense. Most of them can't beat the market after fees and inflation in risk-adjusted terms. Generally, advisers who hold broker-dealer licenses are paid by commission. The more transactions or products they sell, the more money they make.
While there are plenty of honest brokers out there, this has been, for me, the greatest conflict-of-interest for investors. The temptation to churn accounts to generate commissions is always there. How do you remove the temptation? Compensation by flat fees, hourly rates or a combination.
If they manage money directly, they will charge you a sliding percentage scale based on assets under management. Generally, 1 percent annually is a starting point and should drop the more money you have to manage. In any case, ask them all of the ways they will get paid. They may layer on fees within mutual funds and insurance products or receive "revenue sharing" from those funds. All registered investment advisers must provide you a "Form ADV" that spells out their compensation schedules and possible conflicts (see Part II of the filing). If they dodge full disclosure, move on.
2. How are you licensed?
If they sell securities, insurance, mutual funds, futures or options, they must pass several tests and be a registered representative. I prefer advisers who are certified financial planners (CFP), which requires several years of education and experience. Certified public accountants (CPA) and chartered financial analysts (CFA) are also worth considering - if they have specific experience in preparing financial plans. Avoid advisers who place "senior specialist" in front of their title. They have come under scrutiny from regulators for various abuses.
For money management, registered investment advisers (RIAs) and CFAs generally have the most experience, but CFAs have the most rigorous training and have to pass one of the toughest tests in the business before they receive their designation. Check the backgrounds of any registered investment advisers or brokers through your state securities agency.
3. What products do you sell?
If they start pitching you before asking you detailed questions about your life and financial goals, turn around and leave. The best advisers just sell their time and expertise. They can recommend lower-cost products, such as mutual and exchange-traded funds they don't manage. Ideally they don't receive a commission from recommending them. If you do your own investment research, use online deep-discount brokers to fill your orders.
4. Can you prepare a comprehensive financial plan?
You may not need this service, but you should consider it if you have to integrate portfolio, tax, college, estate, insurance and life planning needs. Brokers and insurance agents who are not certified financial planners may not have the training.
If your needs are specialized, find a CFP who has done the kind of plan you need. The Certified Financial Planner Board of Standards provides a free search service. Take your time if this is the route you choose. A workable financial plan may take several months to a year to customize, so don't get snookered by the idea that a few mutual funds or stocks will fit the bill after a brief meeting.
5. Are you a fiduciary?
A fiduciary firm takes full legal responsibility for their services. By law, they must put your interests first and you can sue them if they wrong you. Brokers, in contrast, are regulated by less-stringent "suitability" standards. In the event of a dispute, you usually have to go through their arbitration forum and sign away your ability to sue.
If you're dealing with a broker, keep in mind that their suitability guidelines were tightened last week by FINRA, the industry's self regulator. Brokers "must perform reasonable diligence to understand the nature of a recommended security or investment strategy…as well as the potential risks and rewards" while considering your "age, investment experience, time horizon, liquidity needs and risk tolerance."
While this is a big step forward, it's no substitute for the black-and-white language of fiduciaries. The SEC is considering making all brokers fiduciaries, but has dithered on completing the rule and putting it into force. Nevertheless, every adviser should also be crystal clear on how they plan to manage your money, employ risk management/hedging techniques, disclose conflicts and use of derivatives. Of course, having a fiduciary designation is no guarantee. They still have to account for how your money is being invested and any unusually high returns should be suspect.
More importantly, forget their sales pitch and glossy literature and focus on what you need before you even approach them. Do you need them to preserve principal? Can you afford to take market risk? Based on their management style, what's the worst-case scenario?
And don't hesitate to keep asking hard questions, especially in light of the fraud stories hitting headlines. How will your money be held? Who has access to it? If it's in an independent custodial account with a brand-name brokerage that has protection from the Securities Investor Protection Corportation (SIPC), that's a good sign. If they're earning above-market returns, be skeptical. How are they doing it?
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