Well-planned investing is vital for building wealth and ensuring a comfortable retirement. However, figuring out how to invest your hard-earned money can be tricky. A miscalculation or error in judgment can set your financial goals back by several years. To avoid such a scenario, you may consider reaching out to a professional financial advisor who can guide you on which investments to pick and build a substantial retirement corpus. The success of such a relationship will rely heavily on the level of trust, transparency, and accountability between you and your advisor. As such, it would be a good idea to have a formal framework that spells out the terms, responsibilities, and expectations associated with such a relationship. This is where letters of engagement (or engagement letters) come into play.
This article discusses what financial planning engagement letters are, their purpose, and how they work.
What is an engagement letter?
A letter of engagement (concerning financial planning) can be defined as a legally binding simplified contract that expands and presents the relationship between an advisor and the client. This financial planning agreement outlines each party's duties and responsibilities along with the compensation terms. Although they are typically used by accountants, lawyers, and other kinds of consultants, they are used by professionals who offer financial planning and advisory services.
Once the terms of the services and other details are discussed and finalized, the advisor can draft the letter of engagement. It is signed before the commencement of the services and is required to be produced under the CFP Board's Code of Ethics and Standards of Conduct when engaging in any kind of financial advisory services.
What is the purpose of an engagement letter?
An engagement letter is vital for framing the expectations of both parties who enter into a professional arrangement. In essence, engagement letters aim to prevent confusion and act as a less costly and complicated substitute for a standard contract. If the duties and obligations of the firm or a professional providing financial services are not spelled out in written form, there can be no guarantee of any set standards, goals, or even liabilities. This can be counterproductive to the relationship between the client and the advisor. A letter of engagement highlights the services and duties that both parties need to abide by, paving the way for a fruitful and transparent relationship.
Also see: 6 Important Things to Consider Before You Make Investing Decisions
How does an engagement letter work?
In most cases, an engagement letter outlines the services you, as a client, will receive. Financial advisors will draft official paperwork and the letter of engagement after the initial consultation to set forth your aims and objectives and the services they can provide.
At this point, it is important that you go through all these legal documents carefully.
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What does an engagement letter include?
A financial planning engagement letter should include the following:
- Names, dates, addresses, payment details, frequency of payments, date of commencement and end of the service period, signatures, etc.
- Objectives of the engagement
- Financial advisor’s responsibilities
- Any limitations of the engagement
- Compensation for the services provided
Although each engagement letter is unique, it may follow a similar format. A sample engagement letter, with common sections, is provided below:
1. Parties
Every engagement letter starts with a list of the people or firms who will be involved in the engagement. Here, one party would be the advisor, and the client is the other party.
2. Service classification
Each engagement letter clearly states the type of services that the financial advisor will provide to its client. It is important that you know the list of the services and products that the advisor will offer to you, along with an explanation of how the advisor will approach financial planning for you.
3. Particulars of the service
The engagement letter should cover the nature of the work to be performed. This would help avoid miscommunication and set clear expectations for the quality of service. Typically, the deadlines and pricing for a given service are included in this section.
When it comes to pricing-related details, in addition to the professional’s fee, the following information may be included in your engagement letter:
- The portion of the fees that are payable in advance.
- Discounts (for example, if payment is made in full in advance).
- Penalties (such as late payments) that may be imposed.
4. Each party's obligations
This section sets out the roles of both parties. It should include a list of the duties the financial advisor will carry out to plan your finances successfully. This section may also acknowledge that the advisor might need to fulfill their obligations before getting paid in full.
5. Disclaimer
The disclaimer is mentioned near the end of the engagement letter. This is where the advisor clearly communicates what they cannot guarantee or the services they do not provide as part of the agreement.
6. Validity and duration
The engagement letter may be in effect only until a specific time or until the service is fully completed, which is spelled out in this section. Additionally, this section may outline what to do if you and your advisor mutually or unilaterally decide to part ways. This section will also specify if the advisor offers refunds for unperformed services and the procedure for claiming the same.
Also see: 8 Questions to Ask your Financial Advisor During Your Annual Review
4 things to remember when signing a letter of engagement
1. Letter of engagement does not replace other legalities
This is a critical factor to remember when dealing with letters of engagement. Typically, dealing with professionals or investment advisory firms involves a lot of paperwork. And a letter of engagement is not a substitute or replacement for the same. You will still need to clear Form ADV, Form CRS, and all other legalities required by FINRA and other concerned agencies.
2. Changes will be a part of the process
Financial planning is a long process, often extending to retirement. In addition, your financial planning will undergo numerous changes as per changing circumstances, government policies, and more. As such, it is important to be flexible when dealing with your advisor and keep revisiting your letter of engagement regularly to incorporate your changing needs.
3. Clear any doubts about the procedure or the drafting of the engagement letter
If you are unsure about a service or section stated in your letter of engagement, do not hesitate to clear it with your firm or advisor. Have an open conversation with the professional to avoid unpleasant situations later on.
4. Maintain proper communication to set expectations beforehand
The importance of clear and regular communication cannot be stressed enough. Be clear about the answers to certain questions such as, are the fee terms viable to you? Are the services rightfully mentioned? Setting a certain bar prior can help avoid false expectations and can give an accurate representation of your relationship with your advisor.
To conclude
An engagement letter is an important document for individuals looking to hire a financial advisor. It can streamline communication and take the guesswork out of your relationship. Professionally drafted engagement letters can help highlight several pointers such as compensation, duties, services, number of meetings, and more. Moreover, it also sheds light on which tasks are outside the advisor’s ambit of service. For the best outcome possible when hiring a financial advisor, ensure that the engagement letter you receive provides the details discussed above and you clear up any doubts that you may have about engaging the services of the financial advisor.
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