The Informed Investor

Does Independent Advice Matter?

Let’s say you own a business, like a restaurant. That restaurant is beholden to a variety of health and safety standards, federal regulations, state, and even city regulations. Your restaurant will be periodically checked by a licensed food service inspector, who will make sure your perishable goods are properly refrigerated, your chefs are practicing good hygiene, your cooking equipment complies with safety standards, and a host of other considerations. In addition to these official inspections, your restaurant may have other internal standards such as how your food is harvested, packaged, or processed.

 All these inspections and regulations have been put in place to give your diners a safe and enjoyable experience. No one should have to worry about catching a Salmonella infection, eating expired food, or being exposed to an allergen due to mislabeled food. Their only concern should be whether or not to splurge on a cheesecake for dessert.

The restaurant is an independent entity, and many of the standards and regulations related to it are upheld by outside regulatory bodies. In addition to outside regulations, restaurants also have internal quality control measures for inspecting all food items that are delivered through the doors or prepared on site for quality, safety, and proper packaging.

This example illustrates why independent entities that work in tandem with outside agencies, interests, or regulators are a good thing. It’s about checks and balances. A house can’t be built without numerous experts inspecting it. A law can’t be passed by an individual legislator. 

The same standard should be expected in the field of financial advice.

While it’s true the U.S. government and independent agencies regulate certain aspects of the financial sector (the FDIC makes sure deposits are insured at banks; the SEC regulates the investment profession), there is a lot of gray area that is loosely regulated or up for interpretation. One of those gray areas has to do with independence.

What is the Definition of Independence as Related to Financial Advice?

It’s difficult to pin down a specific definition of independent financial advice or independent advisors, but I tend to think of it in simple terms: Advice that strives to be free of conflicts of interest. 

Conflicts of interest can arise in a variety of ways. If a financial advisor also works as a broker, she may receive bonuses or incentives for selling certain financial products. If a bank or insurance company partners with a financial advisory firm, that firm will likely be incentivized to promote products sold by their bank and insurance company partners. These are clear conflicts of interest, but they can be much more nuanced and difficult to pin down. For example, a broker may receive a kickback for selling certain securities, but that kickback might be built into a transaction fee.

Truly independent financial advisors are not tied to any specific products or product-selling companies. Their focus is on delivering prudent advice, as unbiased as possible, to their clients. 

If a financial advisor is incentivized by sales commissions or bonuses, they—and the advice they give—are not truly independent. Their advice may be colored by the pressures of the financial advisory firm or third-party product providers to sell specific products. 

Why Independent Financial Guidance Matters

Let’s look at the case of Bernie Madoff to highlight why independent financial guidance is vitally important. Madoff not only acted as a financial advisor for his clients, but also as a broker and the investment manager of a proprietary selection of securities. He handled all aspects of his clients’ investments as a custodian, broker, banker, and investment manager. There were no checks and balances. No outside money manager, financial planner, or investment advisor to raise a red flag.

With no third party to sound the alarm, Madoff was able to maintain his shady practices for 17 years.

In an article by CNBC, fraud attorney Andrew Stoltmann notes the importance of investing money with reputable third parties. He says, “Ensuring a financial advisor uses a reputable, third-party custodial firm like Fidelity or Charles Schwab to hold investor money is essential…That makes it much harder for an advisor to steal money or take advantage of a client, since the assets aren’t held in-house.”

If an investment advisor is also registered as a broker, they are not required to uphold the same fiduciary standards as someone who is solely licensed as a registered investment advisor (RIA). While an RIA is legally required to meet a fiduciary standard, a broker is only required to meet a “suitability standard,” which means they may not always be acting in the client’s best interests.

I understand all too well the temptations of financial incentives and bonuses. When I worked as a broker back in the 1980s, I was certainly not immune to them, and neither were my colleagues, despite our best intentions. My eventual rejection of a commission-based system led me to start Allodium Investment Consultants in 2005. When I selected the name for my firm, I chose a word that directly relates to independence. 

Allodium is defined by the Collins English Dictionary as “lands held in absolute ownership, free from such obligations as rent or services due to an overlord.” Contrast the allodial system of independent land ownership with the feudal system which required allegiance to an overlord through servitude. The concept of allodium represents the philosophical foundation of Allodium’s fiercely independent approach to investment advice, without the same conflicts of interest that plague Wall Street banks and brokerage firms. As a fee-only firm, we strive to provide objective investment advice that is not biased by the sale of commission-based investment products.

How Do You Know if a Financial Advisory Firm is Operating Under an Independent Framework?

I suggest following a few basic steps to determine if a financial advisory firm is independent. Keep in mind, it can be exceedingly difficult to pinpoint all potential conflicts of interest, but doing some cursory research can set you up for success.

1. Avoid Investment Securities Brokers

For reasons we’ve already discussed, investment securities brokers have inherent conflicts of interest and cannot be considered independent. Avoid working with brokers by visiting Financial Industry Regulatory Authority’s (FINRA) Broker Check website, which allows you to type in the name of an individual financial advisor or institution to determine who is licensed as an investment securities broker, and who is registered as an investment advisor. Keep in mind, some investment advisors are also registered as a broker, which means they carry the same conflicts of interest as a typical broker.

2. Choose Fee-Only Financial Advisors

According to The National Association of Personal Financial Advisors (NAPFA), “…a Fee-Only financial advisor [is] one who is compensated solely by the client with neither the advisor nor any related party receiving compensation that is contingent on the purchase or sale of a financial product.” Though not every fee-only advisor is completely independent, you (as a consumer) will have a much better chance of finding an independent financial advisor if you focus your search on fee-only advisors. To do this, check out NAPFA’s Find an Advisor database which contains fee-only financial advisors who are part of NAPFA’s association (the largest professional association of fee-only financial advisors in the nation). 

3. Look for Language About Independence

If a financial advisory firm is committed to providing independent advice, they will likely describe that commitment on their website or other literature.

For example, on Allodium’s website, we write:

“Our financial advice is independent, comprehensive and disciplined. We believe the best advice is completely aligned with your objectives. As a fee-only firm, we provide objective investment advice that is not biased by the sale of commission-based investment products.”

Clear language about independence is a great sign the financial advisory firm is committed to this value.

4. Look for Checks and Balances

An optimal investment structure includes a series of checks and balances. Unlike Madoff’s system, an independent financial advisor will ideally be acting separately from investment managers, brokerage firms, and custodians. This way, any advice given to the investor will be less influenced by these other investment service providers.

Independent financial guidance matters. If a financial advisor is saddled with conflicts of interest, they will constantly deal with that friction and may find it difficult to remove bias from their advice. As a consumer, do not underestimate the importance of independence when it comes to seeking a financial advisor.

Learn more about David Bromelkamp

Hello! I’m Dave, the founder and chief executive officer of Allodium Investment Consultants, located in Minneapolis, MN. I am also the author of AdvisorSmart for the Individual Investor: Your Guide to Selecting a Financial Advisor to Get Better Financial Advice. I am dedicated to educating individual and institutional investors about financial planning and investing. When I’m not helping people make investment decisions, I enjoy traveling, hiking and spending time with my wife and family.

The information provided is for educational purposes only and is not intended to be, and should not be construed as, investment, legal or tax advice. Allodium makes no warranties with regard to the information or results obtained by its use and disclaim any liability arising out of your use of or reliance on the information. It should not be construed as an offer, solicitation or recommendation to make an investment. The information is subject to change and, although based upon information that Allodium considers reliable, is not guaranteed as to accuracy or completeness. Past performance is not a guarantee or a predictor of future results of either the indices or any particular investment.