The financial advising industry has changed dramatically over the past 20 years. When I worked for the country’s second largest brokerage firm back in 2005, we acted as our client’s broker. A broker is an investment professional who has passed their Series 7 licensing exam (as well as other state level exams) and charges a commission when transacting stock orders they recommend to their clients. Back in 2005, there was very limited access to the stock market via the internet. Discount brokerage firms like Scottrade® and E*TRADE® were just starting up. From the early 1900s, the only way to access the stock market was through a brokerage firm. This allowed brokers to charge what are now considered to be very high commissions. I remember buying $20,000 worth of Apple stock for a client and charging them $500 for that one transaction. It was the client’s way of paying for my advice. With the internet and technology advances, discount brokerage firms started to pop up everywhere. They would guarantee $25 commission per trade when no advice from a broker was given. Then, more and more online platforms popped up, the beauty of capitalism kicked in and the race to the bottom on commissions commenced. On October 2, 2019 Charles Schwab announced completely free stock trades and within 24 hours, E*TRADE and TD Ameritrade followed suit. Granted, these platforms are not designed for people who are seeking financial advice and are designed for the “do it yourself” stock traders – not for the faint of heart.
Now that we know the history of brokerage commissions and the decline thereof, we can quickly review the difference between the ways financial advisors are paid for their services. For those savers who want investment advice, there have emerged two prominent ways to pay for it. One is through commissions, and another is by paying your advisor a percentage of the money that they are managing for you (typically around 1%). Smaller accounts are often charged more, larger accounts are often charged less. Typically considered a “wrap fee” or a “commission replacement,” this fee covers all trading expenses, account maintenance expenses and at least one annual in-person financial review. Moving to a “wrap fee” type structure removes the inherent conflict of interest with a commission-based account. This allows advisors to make as many or as few trades as a client wants.
Now, here is where it gets a little tricky. “Commission replacement” accounts are typically still advised by “brokers” who need prior client authorization to make a recommended trade. These financial consultants, in this capacity, are still earning commissions and acting as brokers. Although they have eliminated the conflict of interest with commissions per transaction, they are not acting as fiduciaries. A fiduciary has a legal responsibility to put the interests of the investor above their own or their affiliated brokerage firm. A fiduciary cannot, for example, recommend a strategy that doesn’t benefit you, but instead provides a kickback. It is very similar to the doctor-patient relationship. The doctor has a duty to provide patients with the best possible care. Many financial advising firms will not allow advisors to act as fiduciaries due to the heightened level of scrutiny and legal liability that comes with having discretion. By continuing to act as a broker, there could also be hidden firm-based kickbacks that don’t have to be disclosed in a brokerage relationship.
So, in the end, when you look for a financial advisor, hearing that they act as your fiduciary is a really good thing. It doesn’t mean their advice is always going to be right; but it does tell you that they are legally responsible to fully disclose all conflicts of interest, always put your interests above their own, and do their best to manage your investments prudently.
