Information Asymmetry or Why You Need a Fee-Only Advisor

with No Comments

I recently read a New Yorker article titled “Overkill: An avalanche of unnecessary medical care is harming patients physically and financially” by author Atul Gawande. It is about how the healthcare industry is harming and sometimes literally killing people because of the poor services they offer. And often it seems that these are services offered to make a profit.

We talk a lot about fees on our blog. The investment world is composed of mostly fee-and-commission-based advisors. I often call them “The Dark Side” of financial planning. You can be a good professional on the dark side, but the temptation to be bad is strong. When you get varying commissions from different products, the temptation is to sell the client the product that gets you the biggest kickback. Even if you avoid this very strong temptation, confirmation bias might lead you to justify a product with a larger commission over one with a smaller one. This means that a commission-based professional’s incentives are in opposition to yours. To increase his payment, he needs to get you to purchase products which cost you more.

Advisors who are fee-only avoid this particular conflict of interest entirely. They get no commissions, no kickback, no payment other than the client’s fee. The fee is up front and straight forward. If the fee is a percentage of assets under management, it increases when your asset value increases and decreases when your asset value decreases. This means that your fee-only investment advisor’s incentives are better aligned with yours. To increase her payment, she needs to increase your net worth. This means, we fee-only advisors have every incentive to keep your fund and brokerage costs as low as possible in order to keep the returns you receive as high as possible.

Incentives matter. If you are going to get a financial advisor, you need to select a fee-only advisor because you need to find an advisor you can trust.

As Gawande writes:

The virtuous patient is up against long odds, however. One major problem is what economists call information asymmetry. In 1963, Kenneth Arrow, who went on to win the Nobel Prize in Economics, demonstrated the severe disadvantages that buyers have when they know less about a good than the seller does. His prime example was health care. Doctors generally know more about the value of a given medical treatment than patients, who have little ability to determine the quality of the advice they are getting. Doctors, therefore, are in a powerful position. We can recommend care of little or no value because it enhances our incomes, because it’s our habit, or because we genuinely but incorrectly believe in it, and patients will tend to follow our recommendations.

You are hiring a professional because you don’t know as much as that professional about the service. This makes you vulnerable to abuse.

Healthcare providers want to be seen “doing something,” and they are paid more the more invasive the care is that they recommend. Thus, the temptation and confirmation bias errs on the side of doing too much. This could mean unnecessary cost, harm, and even death.

Commission-based brokers want to be seen “doing something,” and they are paid more the more costly the products are that they recommend. Thus, the temptation and confirmation bias errs on the side of wasting your money. This could mean unnecessary cost, loss of your financial freedom, or even bankruptcy.

You can be a good professional on the dark side, but the temptation to be bad is so strong that they might be spending so much time trying to mitigate their conflict of interest that they don’t offer you the necessary services.

As Gawande writes:

It isn’t enough to eliminate unnecessary care. It has to be replaced with necessary care. And that is the hidden harm: unnecessary care often crowds out necessary care, particularly when the necessary care is less remunerative.

Many people seeking a financial advisor don’t know what services they need. But every family deserves comprehensive wealth management.

Comprehensive wealth management is a nearly infinite service. It ranges from something as important as calculating a safe withdrawal rate for retirement or designing a customized Roth conversion plan to something as small as computing the taxable interest paid by mutual funds, exchange-traded funds, and money market funds which hold U.S. debt obligations for deduction on the state income tax return.

For many financial planning services, a commission-based advisor has little or no incentive to offer quality service since there is no product paying a commission. However, for a fee-only comprehensive wealth manager, the primary offer is comprehensive wealth management itself which provides the incentive to offer quality analysis.

While the computation of taxable income from U.S. debt obligations might be only a small value, some tax planning or estate planning services might be worth millions of dollars to a client. And potential clients often don’t know and therefore don’t prioritize these services as being even more important than investment management. Only a comprehensive wealth management team can give you the opportunity to experience this level of service.

Consumers often presume that an advisor associated with a large commission-based brokerage firm will provide them with access to specialists. But the incentive to provide those services are not usually built into a commission-based organization. Clients of such organizations are grouped in a silo approach where each advisor gains his or her revenue from the commissions that he or she generates in a “you eat what you kill” mentality. If they have other advisors with specialized knowledge, they may have no incentive to help.

Furthermore, many commission-based firms don’t offer financial planning services and, in their reporting to regulatory agencies, they often say they are merely financial product salesmen or, only slightly better, that they only offer investment management.

Personalized portfolio design and cash flow analysis are two nonnegotiable, necessary services for every family. You need the priceless asset allocation and personalized safe spending or savings rate that will help you meet all of your financial goals without running out of money. Sadly, very few financial professionals offer these services and even less are actually trained in how to get the right answer for a client.

Incentives matter. If you are going to get a financial advisor, you need to select a fee-only advisor because you need to find an advisor you can trust. Give us a call and get started today.

Photo by Maxime Le Conte des Floris on Unsplash

Follow Megan Russell:

Chief Operating Officer

Megan Russell has worked with Marotta Wealth Management since 2005. She loves to find ways to make the complexities of financial planning accessible to everyone. Her most popular post: The Complete Guide to Your Washing Machine