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In the business world, conflicts of interest can be a disruptive component to working relationships. They break trust, undermine clients, outcomes, and are ultimately an unethical way to conduct business.
The financial world is unfortunately no exception to these types of misaligned incentives. The primary role of a financial advisor is to provide sound advice for financial investments, strategies, and assets in the best interest of their client. This is because clients rely on their financial advisors advice and are inclined to believe what they suggest.
Unfortunately, in many cases, financial representatives may not have their clients’ best interests in mind and are incentivized to enhance their own earnings opportunities as a financial professional.
Where Conflicts Arise
Financial conflicts of interest can take many different forms, both explicit and implicit. There are a few different types of conflicts of interest in particular that are critical to evaluate in any type of advisory relationship.
Commission-based Compensation
Depending on the fee structure used, an advisor may be entitled to lump-sum payments based on the products they recommend. For instance, advisors who use commission – based structures are often affiliated with brokerage firms or insurance companies. In such cases, these third-party entities may incentivize an advisor to recommend products that serve their self-interest.
An example, if an advisor recommends an actively managed mutual fund with a 1% annual management fee on a $1,000,000 investment, the fund company would collect $10,000 annually. As part of the arrangement, the advisor might receive a 0.5% commission on that investment, which would amount to $5,000. Thus, the financial advisor who makes these recommendations may be incentivized to promote funds that generate higher fees, even if they may not be the most cost-effective option for the client. This creates a conflict of interest, as the advisor’s financial gain is tied to the fees generated by the product, potentially leading them to prioritize their own compensation over the client’s best interest.
Fiduciary Duty
Reliable and trustworthy financial advisors are fiduciaries, meaning they are legally obligated to only act in the best interests of their clients, not their own. Referring to the example above, as you might expect, commission-based entities in almost all cases do not abide by the fiduciary standard. Instead, they are more focused on earning potential and profitable opportunities under a less rigorous suitability standard.This suitability standard requires that the financial product recommended be appropriate for the client’s financial situation but does not necessarily require it to be in the client’s best interest. This said, conflicts of interest are more likely to impact relationships absent of a fiduciary standard.
Proprietary Products
In addition to commission-based products, some firms may promote internal products that directly impact their bottom line. As a result, these companies are often highly incentivized to push their own products, looking for any opportunity to profit from their sale.
This becomes a major conflict when financial advisors encourage their clients to invest in these internal products, even if doing so isn’t in the clients’ best interest. The conflict of interest arises because, instead of having their financial well-being tied only to their client’s success, advisors have a vested interest in the company’s profits as well, profiting off both at the same time.
For example, consider a situation where an advisor recommends an internally-managed mutual fund to a client. The Investment Team, who is also employed by the company, might be reluctant to acknowledge underperformance or replace the fund manager(themselves), as doing so could result in a loss of business and commissions for the firm.
In such cases, the advisor may continue to promote the fund, even though there are better-performing 3rd party alternatives available, because both the advisor and the firm are benefiting from keeping the client invested in the internal fund. This misalignment of interests, even absent commission-laden incentives can lead to suboptimal outcomes for the client, as the advisor and firm are prioritizing their own profits over the client’s financial well-being.
Impact on Clients and Steps to Protect Yourself
All in all, the situations above exemplify major conflicts of interest because they involve instances where financial advisors are forced to choose between their personal or professional interests and the interests of their clients. These conflicts can lead to suboptimal investment decisions, higher costs for clients, and, ultimately, push clients into unsuitable financial scenarios.
To protect yourself and ensure you are working with an advisor who has your best interests at heart, here are some important steps to take:
- Hire fee-only, fiduciary advisors: Fee-only advisors do not receive commissions, meaning they are compensated solely for the services they provide to you. This ensures that their incentives are aligned with your needs, as their income is based on the fees you pay, rather than the products they sell. Furthermore, fiduciary advisors are legally obligated to act in your best interest, offering an additional layer of protection. This way, everything works in your favor, not anyone else’s.
- Conduct independent research: Finding the right information for your financial needs is crucial. Take time to read books, articles, or other resources that explain what to look for in a financial advisor. Once you’ve compiled a list of prospective advisors, perform background checks to analyze their experience, credentials, who they’ve worked with, and how long they’ve been advising clients. Look for reviews or any regulatory history that could signal potential issues.
- Ask the all-important questions: Don’t be afraid to ask key questions such as, Are you a legally binding fiduciary?” or “What additional costs do you charge beyond the upfront fees?” A fiduciary is legally required to put your best interests first, so if the advisor answers that they are not a fiduciary, that’s a red flag. Also, inquire about any hidden fees or charges. Their answers to these questions can reveal potential red flags or show you their professionalism and expertise. You won’t know the truth unless you’ve done your research and asked these critical questions. To help, below is a link to helpful questions when evaluating any financial firm. 10 Questions to ask – Passive Capital Management.
- Do you use proprietary funds?: A very important question to ask is whether the advisor recommends or uses proprietary funds managed by the firm they work for. If they do, it’s crucial to understand how the advisor is compensated for recommending those funds and if any conflicts of interest arise from the relationship. Advisors who push proprietary products may have an incentive to recommend them, even if other, better-performing options exist for you. Be sure to ask for a clear explanation of how these products work and whether they truly align with your financial goals.
By following these steps, you can help protect yourself from potential conflicts of interest and ensure that your financial advisor is truly working in your best interest.
