HOW DO FINANCIAL ADVISORS GET PAID?
Maybe you’ve heard the terms Fee-only, commissions, or Fee-based when it comes to investment advice. But, most people don’t really understand how their financial advisors get paid or even how much they are paying for financial advice. This is due in large part to the number of different ways “financial advisors” are compensated, and the fact there is set rule on who can and can’t use the term “advisor”.
In this post I’ll describe three of the main ways that advisors are paid and the benefits and drawbacks of each. Then I’ll define a few terms I think you should know that can help you find the right type of advisor for you. Advisors can use pieces from all three of these fee structures, so be sure to ask any advisor to explain exactly how they are paid.
I will state up front that I am biased against the commission-based structure. It is unfortunately designed to introduce conflict between the broker and their clients, and push people into products and portfolios that are not right for them.
The three main fee structures are
1) Commission based
2) Assets Under Management (AUM)
3) Flat fee – usually charged hourly, monthly, or quarterly
1) Commissions.
Pros: ?
Cons: No fiduciary duty, incentives not aligned, higher likelihood of conflicts of interest
In this model a client works with a stock broker or insurance broker, but they can also call themselves an advisor. When you buy your stocks, bonds, mutual funds, annuities, or insurance policies from this person they earn a commission from the company that provided it. Their client, you, doesn’t pay them anything directly, but you could be losing because of the misaligned incentives in the system.
One of the main problems with this model are that the broker probably earns a higher commission from some products than others, which means they are incentivized to sell you those products more than others that pay them a lower commission. As a broker they are not legally bound to look out for your best interest. They just have to provide you with advice or products that are “suitable”. Consider this example:
You want to purchase $100k of a balanced stock mutual fund for your retirement and they have 2 funds with similar performance to choose from. Fund A costs you, the client, 2% expenses annually, but Fund B only costs you 0.05% expenses annually. You would probably choose Fund B for yourself, right? But Fund A gives the broker a 5% commission and Fund B only gives them 1%. The broker will only make $1,000 by selling you Fund B instead of $5,000 if they sell you Fund A. If you were the broker which choice would you make?
By having the fund companies and insurance companies pay your advisor instead of paying them yourself, you may feel like you are paying less for advice, but you might be paying more in ways you don’t realize or be pushed into buying products that aren’t right for you.
2) Assets Under Management (AUM)
Pros: Incentives aligned, easy to understand fee, fee isn’t a concern for monthly cashflow
Cons: Fees can drag on investment performance, does value increase along with the fee increase, clients can forget what they are actually paying for advice, clients need to have adequate AUM to work with advisor
In this model the advisor charges a fee based on the value of your portfolio that they advise you on, your assets that they manage. Typically, the fee is somewhere between 1%-2% and gets smaller as your portfolio gets larger, so 1.5% for $1M, 1% for $1M – $1.5M etc. But this is can vary greatly between different advisors, so make sure you ask before signing on the line that is dotted.
This can be a good way for an advisor to structure their fees, and if they are only charging AUM then they would qualify as a fee-only advisor. In this structure the advisor and client’s incentives are aligned, as the advisor’s fee increases along with the growth in the value of the portfolio.
These fees are typically paid out of the portfolio as well, rather than out of a client’s monthly cashflow. This can be nice for a client because they do not have to budget for monthly or quarterly payments to the advisor, but it also puts a 1% or greater, drag on the growth of the portfolio. Paying monthly or quarterly, the same as with your other recurring expenses could help improve your returns and judge the value you receive from your advisor for the fee you are paying. Another question a client should ask as their investments grow is if the value they receive from an advisor managing a $2M portfolio is twice as much as when they were managing a $1M portfolio.
Another downside for the AUM model is that it is designed to work for a client that has an account for the advisor to manage. Such as a brokerage account, IRA, Roth, etc. For younger clients who are still in their prime working years, their largest accounts are probably their 401k’s. These reside with the 401k plan where they work, and cannot be managed by an Advisor unless rolled over into an IRA, which is likely not be the best option for most people.
3) Flat fee – usually charged hourly, monthly, or quarterly
Pros: Easiest fee structure to understand, doesn’t drag on investment performance, easy to judge value for fee, can work with clients without large AUM
Cons: Usually have to pay out of monthly cashflow
An advisor charging a flat fee looks like most of the transactions that we are used to, the advisor provides a service and the client pays them for it. This makes the flat fee model one of the easiest to understand one of the reasons why it is growing in popularity for advisors and clients alike.
With this model an advisor can charge for specific work on an hourly or project basis, much like an attorney. Or an advisor can work with clients on an ongoing basis where clients pay a standard monthly or quarterly fee. This level of flexibility allows clients to pay for as much or as little service as they need.
The fee charged for advisory or planning services can vary based on the needs of the client and the specialization of the advisor. An advisor may charge a higher fee to individuals with small businesses and rental property than to a younger single professional. Or an advisor might charge a higher fee to a client to prepare a retirement plan versus a client just needing investment management advice. Clients can find advisors charging from $150-$1000 per hour for different projects, and from $150-$500 or more per month for ongoing financial planning or financial advising relationships.
The flat fee model allows an advisor to work with individuals who might not be a fit for an advisor that charges on AUM, while also helping prevent the conflicts of interest that can occur with the commission model.
Helpful Terms To Understand
Fee-only:
When you see the term fee-only it is used to describe a registered investment advisor that has a fiduciary duty to serve their client’s best interest.
Fee-based:
The term fee-based was created by commission-based agents and brokers to muddy the waters and confuse consumers. As a term it means advisors charge a fee in addition to collecting commissions.
Registered Investment Advisor
A registered investment advisor is an advisor that has registered with the SEC to provide advice to their clients, they have a specific fiduciary duty to their clients to act in their client’s best interest.
Certified Financial Planner (CFP®)
The CFP® is a professional designation awarded by the CFP board. Someone holding the CFP® must have a bachelor degree, 6,000 hours of financial planning experience, complete the CFP® educational program and pass the final examination.
Where you see someone using the terms fee-only, registered investment advisor, and CFP® you can be reasonably certain they are using an AUM fee structure, flat fee structure, or a combination of the two, but always do your due diligence and ask how they are compensated to be certain before entering into any agreement.
At Steady Climb Financial Planning we are a fee-only, registered investment advisor located in Upper Arlington, Ohio, and I have earned the CFP®. You can learn more about the services we offer here: Planning, Investing, and more or about our firm here: About Us, or answer some general questions here: FAQ.
If you are looking for a financial planner or are curious about how we can help, or just have some general questions, please contact us today.