Our next guest blogger is Karen Chan, owner of Karen Chan Financial Education & Consulting, LLC and a featured presenter at our recent series of financial literacy programs as part of MoneySmart week. We asked Karen what consumers should look for when evaluating financial advisors. She gave us the following guidelines:

If I hire a plumber to install a garbage disposal, I can pretty quickly judge whether the plumber did a good job: Did it leak? Does the garbage disposal work? Did he damage anything else during the installation? Did he clean up and leave my kitchen in good order? Within a few days, I will probably know whether he did an acceptable job.

With financial services, it is usually much harder to evaluate the quality of the services you receive. Inappropriate investment recommendations may not be become apparent until years down the road. Even fraudulent investments may not be discovered until much time has passed, as was the case with Bernie Madoff.

Because it is hard to evaluate the quality of financial services, it is especially important to select your investment professional carefully. Unfortunately, this provides challenges, too.

The first issue is that, in the United States, we have lots of different labels for financial advisors. Some titles have clearly defined meanings, but many do not. For example, the term financial planner implies what the person does. But the term is not legally defined. As a result, insurance and annuity salespeople, brokers, investment advisors, and probably others all call themselves financial planners. But their qualifications, the services they provide, and products they sell or recommend can vary widely.

Two terms regarding investment professionals are defined by law: registered representative (which is the technically accurate term for a broker) and registered investment advisor. A registered representative has passed certain examinations and is licensed to sell certain investment products, determined by the examinations he has passed. The stereotypical idea of a stock broker is the person that you call when you want to sell your shares of IBM, or who calls you with a recommendation of a stock for you to buy.

A registered investment advisor is registered either with the state or with the Securities and Exchange Commission, and is authorized to provide investment advice. Historically, the investment advisor was the person who determined things like how much of your portfolio should be invested in stocks or bonds and other investment management decisions, while the broker executed the buy and sell orders to implement your plan. That distinction has become muddied over the years, and today many investors don’t know whether they’re working with a broker or an investment advisor. The two professions are held to a different standard of care in the services they provide. A broker must recommend investments that are suitable, but it is perfectly legal for him to take his own compensation and incentives into consideration when deciding which mutual fund or other investment to recommend. A registered investment advisor, on the other hand, is held to a fiduciary standard and must recommend only what is in the best interests of the client. That is a significantly higher standard than the suitability standard for brokers.

Today, some investment professionals are licensed both as brokers and as registered investment advisors. This makes it harder for the consumer to understand the nature of the relationship, and what standard the investment professional is following at any given time.

The issue of compensation adds another layer of confusion. The two general ways that an investment professional is compensated are commission and fees. Most people understand the concept of commissions: if you buy a product, the salesperson receives a percentage of the price you pay as his commission. Fees are also pretty easy to understand: if I hire this person to provide a certain service, I will pay a fee for that service. It might be hourly, or it could be a flat fee for the task. Think of how you hire a housepainter: you might pay by the hour or by the job. In either case, you’re paying a fee for the service.

Two similar-sounding terms describe dissimilar models of compensation. Fee-only advisors are compensated only by fees paid by you, the customer; they receive no commission and no consideration from any company whose products you purchase. Fee-based advisors, on the other hand, may charge a fee for their services, but they may also charge commissions or receive incentives or consideration from the company whose products they sell. The challenge for the consumer is not only to understand how the investment professional is paid, but also to understand any conflicts of interest that are introduced by the form of compensation. It is because of the potential for conflicts of interest due to how the person is compensated that much of the financial press suggests looking for a fee-only advisor. The SEC provides an excellent set of questions to ask your financial professional about how he is compensated (see the last page of the Investor Bulletin).

Another factor in evaluating a financial professional is education and training that is relevant to the services they provide. There are a multitude of designations used by financial professionals. Some require significant training and passing of stringent examinations; others merely indicate that the person paid a fee or participated in a short training. For financial planners, which includes many investment advisors, the Certified Financial Planner™ (CFP®) designation is one to look for. It requires five college-level courses and passing a two-day exam (which about 35% percent of people fail), and a few years of experience. The Chartered Financial Consultant (ChFC) designation from The American College and the Personal Financial Specialist (PFS) for CPAs indicate comparable levels of expertise, but with different focus: insurance for the ChFC and taxes for the PFS. All three of these designations required continuing education to retain the designation, and the designation can be revoked if the financial professional violates the ethics or other requirements for the designation.

In my previous work with University of Illinois Extension, a colleague and I developed Choosing a Financial Professional, a website designed to help investors understand these issues. It includes an interview guide to help investors evaluate and select a financial advisor. Trusting someone to make decisions about your money is an important decision. It’s worth taking the time to make an informed and thoughtful choice.


Karen Chan has been educating the public about financial topics for twenty years, first as a Consumer Economics educator with University of Illinois Extension and now through her own business, Karen Chan Financial Education & Consulting, LLC. She holds the Certified Financial Planner™ designation. She uses that training to teach rather than practicing as a financial planner. She presents on a wide range of financial topics, from basic money management to technical subjects such as strategies for maximizing Social Security benefits. Her goal is to make even complicated subjects easy to understand so that her workshop participants can make wiser decisions with their money.