How to pick a financial advisor

Picking a good financial advisor can be confusing and difficult. Yet, selecting a good financial advisor is a very important decision. There is an old joke that goes something like this; “If you pick the wrong spouse, you lose 50% of your money. But if you pick the wrong financial advisor, you lose 100% your money.”

Choosing a good financial advisor is a bit like choosing a good mechanic. There are good ones that will appropriately diagnose and repair your car quickly for a reasonable cost. However, there are also plenty of bad ones who fail to diagnose the problem due to incompetence or, worse, recommend unnecessary repairs to earn unethical profits. Compared to selecting an auto mechanic, picking a financial advisor is harder, and the stakes are higher. There are strict regulations against using testimonials, and it is rare to find reviews of financial advisors on Yelp or Google. Further, the licensing requirements to become a financial advisor are quite lax, meaning just about anyone can become one, no college education required. To make matters more confusing, the alphabet soup of designations makes it difficult to know which designations earn their weight in gold and which designations are just fluff.

Not being able to find an adequate guide on how to choose a financial advisor, I set out to write one myself. This is a guide on how to pick a financial advisor, written by a financial advisor. I have tried to keep it unbiased. This is the same advice I would give my family or my closest friends if they asked me for guidance on picking an advisor.

Compensation Structure

The single most important thing in choosing a financial advisor is making sure the compensation structure is appropriately aligned with the client’s best interests. There are three main types of compensation structures in the financial advisory space.

Commission-Based

This was the dominant compensation structure for financial advisors for a long time. Under a commission-based structure, the financial advisor is not paid directly by the client, but rather gets paid a commission from a third-party insurance or mutual fund company for recommending products. A front-load mutual fund might pay the advisor a 5% upfront fee just for placing you in the fund. Of course, the 5% commission ultimately comes out of your pocket (It is a surefire way to turn a $100 investment into a $95 investment on day one). Life insurance and annuities are also popular commission-generating products with commissions often equal to the first year of premiums. The advisor has an incentive to place the client in the highest commission / most expensive product even if it is not in the client’s best interest. Not all commissioned advisors are bad, but it is a bit like putting a bunch of cookies in front of toddlers and asking them not to eat any. Some may refrain, but you are not setting them up for success. It is best to avoid a commission-based compensation structure as it too often forces an advisor to choose between what is in his own best interest versus what is in the client’s best interest, with the client too often coming out on the losing end.

Fee-Only

The fee-only compensation structure completely does away with all commissions. The only compensation the advisor receives is directly from his clients. This significantly reduces conflicts of interest and should be the preferred choice. Fee-only compensation can come in various flavors such as a fixed fee that is loosely tied to income or net worth or the more common AUM (Assets Under Management) fee that is a certain percentage of the investments under management. The common denominator is the complete elimination of all commissions and product sales. I recommend that consumers begin their search by verifying the advisor they are considering is fee-only.

Fee-Based

Some advisors call themselves fee-based because although they collect commissions on product sales, they also earn fees directly from clients. It should really be called “Fee and Commission”, but “Fee-Based” is better for marketing. (I bet more than a few consumers have confused “Fee-Based” with “Fee-Only”). It is a hybrid of the commission-based and fee-only model. The idea is that the direct fee from clients reduces the reliance on commissions and thus reduces conflicts of interest. Half of a bad idea is still mostly a bad idea. Why stop halfway when you can eliminate most conflicts of interest by going 100% fee-only.

Fiduciary

Equally important in choosing financial advisors is finding one that is willing to be a fiduciary. A fiduciary is required by law to act in the best interests of their clients and put their clients’ interests above their own. You might be surprised to learn that many “advisors” are not fiduciaries, especially those that earn commissions from selling financial products. Most fee-only financial advisors are likely to be fiduciaries, but you should always confirm.

Professional Designations

Professional designations and certifications are a great way to identify advisors who have undertaken rigorous education and presumably know their stuff. However, not all designations are created equal. Some are fairly easy to get while others require years of study culminating in difficult exams. The dozens of designations that advisors can get make it very confusing for consumers. Below I breakdown the most popular designations by difficulty so your can know what to look for. (CliffsNotes version: the main takeaway is that you should look for a financial advisor with a CFP or CFA, the gold standard in financial planning and investment management, respectively.)

Difficulty: None

Financial Coach: This is the easiest title to get because it technically is not a designation and has no requirements. Anyone can call himself or herself a financial coach. Due to the lack of credentials, financial coaches are prohibited by law from giving investment advice. What they can do is help you with basic financial planning needs such as budgeting and debt management.

Difficulty: Easy

IAR (Investment Advisor Representative) and RIA (Registered Investment Advisor): An IAR is the official legal designation given to a financial advisor. The RIA is the legal terminology for the company that employs the IAR. Using my case as an example, Think Different Wealth Advisors LLC is the RIA and I work as an IAR for the firm. The requirements to become an IAR varies by state, but most commonly passing the Series 65 Exam is required. Passing the Series 65 is relatively easy, and it is the bare minimum required to be considered a financial advisor.

Difficulty: Medium

CLU (Chartered Life Underwriter): the CLU designation indicates extensive knowledge of life insurance. It is the gold standard for life insurance agents but is not particularly relevant for financial advisors. If a financial advisor has the CLU designation, it usually means they earn commissions from selling life insurance.

Education Requirement: Must complete coursework consisting of five core and three elective courses
Exam Requirement: No comprehensive exam. However, there is a test after completing each course.
Work Requirement: Three years of business experience is required. Having an undergraduate degree qualifies as one year of business experience.

ChFC (Chartered Financial Consultant): the ChFC and the CFP (Certified Financial Planner, discussed in next section) are the two most common designations for financial advisors who wish to distinguish themselves with more education. The ChFC is developed by The American College of Financial Services while the CFP is developed by the CFP Board. The CFP is generally considered the more difficult of the two due to the need to pass a comprehensive exam and more specific work requirements. The CFP also has better brand recognition among consumers.

Education Requirement: Must complete coursework on financial planning consisting of seven core and two elective courses
Exam Requirement: No comprehensive exam. However, there is a test after completing each course.
Work Requirement: Three years of business experience is required. Having an undergraduate degree qualifies as one year of business experience.

Difficulty: Hard

CFP (Certified Financial Planner): The CFP is the gold standard in financial planning.

Education Requirement: Must complete coursework on financial planning through a CFP Board Registered Program (takes an average 12-18 months) and hold a bachelor’s degree or higher
Exam Requirement: Pass the CFP exam. Pass rates for the CFP exam are in the 60% range.
Work Requirement: Complete 6,000 hours (3 years) of professional experience related to financial planning or 4,000 hours (2 years) while working under the direct supervision of a CFP professional.

Difficulty: Very Hard

CFA (Chartered Financial Analyst): The CFA is the gold standard in investment management. Its exams are notoriously difficult and has the lowest pass rates.

Education Requirement: There are three levels of curriculum each requiring 300+ hours of self-study for a total of 900+ hours of self-study.
Exam Requirement: Each level of curriculum comes with its own comprehensive exam. The exams are difficult with average pass rates at just 44% over the past 10 years. Passing all three levels of exams is required to obtain the CFA charter and takes a minimum of three years.
Work Requirement: At least 4,000 hours (over a period of not less than 36 months) of qualified experience in investment management.

CPA (Certified Public Accountant): The CPA is probably the designation consumers are most familiar with. CPAs are experts in accounting and tax preparation. However, the CPA alone is not sufficient for financial planning and investment management, which require different knowledge and skillsets.

Education Requirement: Bachelor’s degree and 150 semester units of education in accounting
Exam Requirement: Pass the CPA Exam. The various sections of the CPA Exam have pass rates ranging from 50-60%.
Work Requirement: One year of general accounting experience supervised by a CPA with an active license.

For the sake of brevity, I have only covered the most common designations you might run into. There literally dozens of designations, some in very niche areas. If your advisor has a designation not mentioned here, check out this resource or simply Google the designation to learn more. Having other designations can be an added bonus (such as the Certified Divorce Financial Analyst specializing in the divorce process), but I recommend you look for a financial advisor with either a CFP or CFA as their main designation.

Work Experience

Another factor to evaluate is the advisor’s work experience. There are no set formulas here, but it goes without saying that generally more experience is better than less experience. You do not have to find an advisor with multiple decades of experience (working with older advisors has its own drawbacks as they may be less tech savvy and more likely to retire soon), but you also want to be cautious with advisors who have no experience.

Even more important than the length of experience is the type of experience the advisor has. You want to make sure the advisor’s past experience is relevant to financial planning or investment management.

Website

The advisor’s website is a great resource to learn about them. It will usually contain information about their background, services, and sometimes pricing information. Beyond the information on the website, paying attention to the little things can often tell you a lot about an advisor. Is the website modern and professional looking? Or does it look like the 1990s called and asked for their website back? Are there pages that do not load properly or links that do not work? Is the information on the website being kept up to date? While a poorly designed website with broken links or outdated information is not a reason by itself to disqualify an advisor, it does raise some red flags about attention to detail. After all, if you cannot trust an advisor to keep their own website looking professional, can you really trust them to watch over your accounts?

Fees

The fees an advisor charges for his or her services is of course a key consideration. I believe advisors should post their pricing clearly on their websites. However, many advisors don’t. I suspect the reason is not because their fees are too low.

Here is an industry secret: all advisors must file their pricing policy with regulators. This information is freely available if you know where to look. Go to the SEC’s Investment Adviser Public Disclosure site. You can search by the advisor’s name or the firm’s name (more straightforward if you search by firm name). Either way, you must navigate to the firm page until you find the “Part 2 Brochures” download button. Clicking that button downloads the Form ADV Part 2A that is required to be filed with regulators. This is often an intimidating document that can be 20-30 pages of legal text. Go to the table of contents and look for “Item 5: Fees and Compensation.” This is the section where you will find the pricing information. Sometimes this is of limited help as the ADV may contain a wide range of fees. If that is the case, your only option is to contact the advisor directly to inquire about their fees.

And if the advisor tells you that you don’t have to pay any fees, that is the scariest of them all. It just means you have no idea how much “hidden” fees you are paying via commissions. Trust me, no one works for free.

Location

Location is an important concern if you like to meet in person. Where does the advisor usually meet their clients? Is this location convenient for you? If you like the flexibility of being able to work virtually, check to see if the advisor supports the ability to meet virtually. Even if you prefer to meet in person, you could end up moving away later. Having an advisor who can conduct business virtually may allow you to keep working with that advisor even after you move to a different city.

Personal Fit

Finally, a crucial, but intangible aspect is the personal fit. Does this advisor connect with you on a personal level? Do you like each other? Does this advisor’s work style match with your personality and preferences? There is no way to determine this until you meet with the advisor yourself. Most advisors offer a complementary first meeting so it is usually free to sit down and see if you click.

If you think you have found the perfect advisor, the last thing to check is to make sure the advisor will actually work with you. Some senior advisors at big firms only participate in prospect meetings and then handoff the client relationship to junior advisors. You don’t want to do all this work finding an ideal advisor only to be assigned to someone completely different (and likely less experienced / knowledgeable). Also check to see if the advisor will be in the area for the foreseeable future or does he or she have plans to relocate? If it is an older advisor close to retirement, ask when he or she plans to retire and whether there is a succession plan.

Conclusion

I hope this article has been helpful to you. At the end of the day, a good advisor is someone who is both competent and has the client’s best interest at heart. If you choose a CFP or CFA who is fee-only and does not take any commissions, you should have both of these aspects covered. Finding a good financial advisor is not easy, but it is an important task well worth spending time on. A good financial advisor will speed your journey on the road from financial security to independence to freedom. Good luck!