We all love getting something for free. It doesn’t really matter what it is, or even if we need it…what matters most is that it is free. It seems like rational thinking to most people. However, when we really consider the perceived value of what we received and what it “actually” cost us, it could be a completely different story.
In the book Predictably Irrational, Author Dan Ariely talks about the real value of free. Ariely suggests that it is normal to dismiss the downside of something when it is free. Consider this phrase – FREE PUPPIES. While it seems like a win-win situation (who wouldn’t want a cute and cuddly little puppy – at no charge!), a free puppy has a very real cost. It’s true, the emotional attachment we have to the word free can often make us overlook the downside of the item we are about to own at no charge.
I would argue that the same can be said in the financial planning industry. At Financial Fiduciaries, we have many clients who come to us and suggest that they are receiving “free” financial advice from another source. However, I would argue that things might not always be as they appear. Consider this thought – most people don’t know how their advisor is paid. A Registered Investment Advisor (RIA) is required to disclose fees, so the customer knows what they are being charged. The same cannot be said of a broker who is not fee-only. They do not have to disclose their compensation arrangements.
This means that if one investment offers the broker a higher commission, they could suggest it over a tool that may be a better fit for the client’s financial plans. If the client really knew what they were paying for their investment options, they might make different choices.
Consider this scenario:
The American Funds Growth Fund symbols AGTHX and RGAGX have the same exact investments but one class is used by brokers and one class is used by RIA’s. AGTHX 5.75% commission plus .70 % expense taken off the return per year for fund expense. RGAGX has 0% commission and .34% expense for the fund.
In the first year the consumer will pay over six times more to a broker than to a RIA (if the RIA charges 1.2% of AUM). In addition, what prevents the broker from recommending another fund after a couple of years to capture more of the upfront commission? (In a word – Nothing)
Beside the high upfront cost, another consideration is the fact that the advice doesn’t have to be in the client’s best interest if it is given by a broker – It only has to be “suitable.” A broker can recommend buying an expensive low performing mutual fund and, as long as it was “suitable,” for the clients portfolio mix, the recommendation would be seen as acceptable. By comparison, a RIA is required to provide advice that is in the client’s best interest even if, financially speaking, it is not in the best interest of the RIA.
The bottom line is that consumers are generally unaware of how their brokers are getting paid, how much they are getting paid and how the choices of investments recommended affect both the broker and the client. So that “FREE” advice might not actually be free after all.