12/20/2011 01:12 pm ET | Updated Feb 19, 2012

Finding an Honest Financial Adviser

It's that time of the year when people start thinking about their financial outlook. If you are like many people, you might want to get the help of a financial adviser. But whom can you trust? Here are the three key "insider" questions that you should ask.

1. Do you accept commissions of any form?

The best answer is usually "no."

Many financial advisers are paid "commissions" by third parties to promote their goods. The most commonly affected products include investments, insurance, annuities, and loans. Even many "independent" advisers take commissions -- they are only "independent" in the sense that they are not selling products manufactured by their own company.

Not all commission-based advisers are bad people. I have several friends whom I trust that work on commissions. Still, you should understand that commissions could bias your own adviser's recommendations in ways that you might not appreciate. These commissions are ultimately paid by you in the form of larger fees that are often difficult to detect. They can take the form of sales loads, management charges, surrender penalties and back-end charges.
Fees can have a tremendous impact on your bottom line over time. Consider, for example, Sally who is age 30 and has a $50,000 IRA. She makes annual contributions equal to 4 percent of her salary. At age 65, her projected balances are $252,258 with a typical commission-based financial adviser. But, if her adviser suggested similar investments without embedded commissions, she is projected to have $344,317 or more, even if we subtract the fees that Sally might be paying the adviser directly for no-commission advice.

2. Are you "fee based" or "fee only?"

The best answer is usually "fee only."

Fee-based advisers are actually dual registered advisers who can hat switch between "planning-fee mode" and "commission mode." They collect planning fees and commissions. The Financial Planning Association has argued that few clients are aware of this type of switcheroo. The FPA and two other trade organizations are promoting a uniform set of standards. The federal government's GAO has also recently argued for providing clients with clarity. The UK has recently outlawed hat switching altogether. If you are unsure about your adviser, ask for his or her's "ADV Part 2." A commission-based adviser must check the box "Commissions."

There are some limited cases in which a commission-based insurance policy is actually cheaper for the same coverage and insurer rating. So a fee-based adviser might sometimes have a bit more flexibility. To cut through all the details, ask your adviser for an itemized list, on a single page of paper, of all the ways and exact dollar amounts in which he or she is monetizing your financial plan. If you think the total costs are unreasonable then ask for a price cut. Any honest financial adviser will welcome this conversation and the opportunity to build trust.

3. At all points in time, will you serve me as a fiduciary?

The best answer is "yes."

By law, a fiduciary must act in your best interests. Fee-only advisers are required to be fiduciaries at all times. In contrast, fee-based advisers can shift seamlessly between their fiduciary duties and lower legal standard called "suitability." Suitability does not require your adviser to work in your best interest; it only prohibits recommendations that are clearly not suitable for a person of your age, your income, and so forth.

The distinction is very hard to detect. Some national firms advertise that they act in your best interests. But they omit the word "always" and require you to sign a lengthy Client Service Agreement, often in front of the adviser, where you acknowledge potential conflicts. Of course, very few people probably read or understand this fine print -- after all, they've come for help.
So, you should ask your adviser to document in writing whether each investment and insurance recommendation is being made under a fiduciary standard or a suitability standard. If a suitable product is being sold, ask whether there is a better one for you. If the answer is no, remember to ask your adviser for all the ways that he or she is monetizing your plan to see if it is reasonable. Moreover, it never hurts to seek a second opinion.

A good financial adviser can help you to live a rewarding life. But you've got to ask the right questions ahead of time. Any honest adviser, regardless of their business model, is more than happy to answer the three key questions that I outlined above.

About the Author: Kent Smetters is the Boettner Chair Professor of Business and Public Policy, the Wharton School of the University of Pennsylvania.