When you hire a financial advisor, you should clearly establish just how this individual is to be paid. Whether you are investing large sums of money or just dabbling in the TSX, it matters how one pays for financial advice. Perhaps the financial advice you are getting is free. It may be from reading the business sections of the Globe and Mail, Toronto Star or a mutual fund company's promotional material. It may be from watching television shows or attending a workshop hosted by your bank or talking to a professional colleague. However, if you are led astray by the advice you get without paying for it, “free” could well turn out to be very expensive.
It may be uncomfortable for some people, but compensation is one of the most basic items you must understand when entering into any professional relationship that involves your money. Whether starting a new relationship or re-evaluating an existing one, there may be more options, each with consequences, than you realize. The three basic forms of compensation in Canada:
- A financial advisor may be paid by commissions generated from each transaction. One example is a stockbroker, who earns a commission every time you buy or sell a stock or a bond or some other product purchased through the broker.
- A financial advisor may be paid based on a fixed percentage (eg one percent annually) of the total value of your investment portfolio. If the portfolio appreciates, so does your advisor's fee (and vice versa).
- A financial advisor may be paid strictly on an hourly basis at a specified fee. Here, you are buying only the advisor's experience and expertise, and of course his or her time.
Each one of these forms of compensation gives the advisor some sort of incentive.
A financial advisor whose compensation depends on transactions has a financial incentive to generate transactions in your account. A commission-based financial advisor might determine that the most appropriate investment for you is T-Bills, but may be reluctant to suggest this because no commission is involved.
A mutual fund salesperson whose compensation includes commissions has more incentive to persuade you to invest in a back-end load fund starting with a six percent deferred sales charge if the assets are redeemed during the first year of purchase. Then the deferred sales charge declines by one percentage point each year until it reaches zero, instead of a fund with a three percent back-end load.
A financial advisor whose pay is based on the size of your assets has an incentive to see those assets grow – and of course to persuade you to place a higher percentage of your assets under his or her management. If you pay the financial advisor a straight percentage, then you both want to achieve exactly the same goal: profits. Be careful not to incur too much risk while aiming for this objective.
A fee-only advisor has a financial incentive to take as much time as necessary to complete the work you need – but no incentive to steer you to any particular product. Some investors balk at paying an hourly fee for something they think they can get for free. But in the case of investment advice, doing that can be considered “penny wise and pound foolish.”
Whatever arrangement you prefer, any top-notch financial advisor will be glad to discuss this topic with you quite candidly. Seek an advisor who is willing to be open with you. Remember, advisors are in business to make money, not to do charity work. If your financial advisor dodges this topic or gives vague answers, it is time for you to look elsewhere.