31 Aug How Financial Advisors Are Paid
How Much You are Paying Your Financial Advisor or Financial Planner?
When it comes to financial advice people want to know the cost. How much should you expect to pay? How do financial advisors make money? What is the best way to compare financial advisors? It can be difficult to find the answer to these questions because not all financial advisors or planners charge their clients the same way. This can make it difficult to compare one to another and unfortunately fee structures are not always as transparent or simple as consumers would like.
Some financial advisors only offer investment advice or manage portfolios, while others are also financial planners. The inverse is true as well; some financial planners only plan and some manage portfolios too. It is important to note that there are many different titles you may come across when seeking financial advice and it is difficult, if not impossible, to determine how the financial professional is paid on title alone. Furthermore, due to the inherent differences in the services provided between a portfolio manager and a financial planner, the way clients are charged is often, but not necessarily, different.
People have their own preference on how they would like to pay for investment advice; the important thing is to understand how your advisor is being paid, the amount you are paying them and if your advisor is adhering to either a fiduciary or suitability standard of care. It is also important to understand what you are receiving in return. An advisor deserves to be paid for their services and you deserve to get something in return for the amount you are paying them.
The first fee structure, and possibly the easiest to understand, is fee-only. If a financial advisor or planner is holding themselves out as a fee-only investment advisor this means that they will never take a commission, they don’t sell “products” and they operate as fiduciaries. Those offering financial services on a fee-only basis can use a couple of different methods of charging for their expertise and time.
First, for someone who is managing assets they can charge on percent of Assets Under Management (AUM). For instance, if you have $100,000 in an IRA account managed by a fee-only advisor who charges 1% of AUM you will pay $1,000 for these services per year, often billed quarterly. These fees are typically around 1%-2% and often decrease in percentage as your assets increase. Some advisors include other services like financial planning, tax advice, etc. along with the asset management as a full service offering for one price.
Another popular way for fee-only advisor may charge for services, especially financial planners, is on an hourly basis. A CERTIFIED FINANCIAL PLANNER™ will often charge between $150-225 an hour for a plan. A CFP® is able to provide clients with an estimate of how many hours their specific plan will take depending on the complexity of their goals and financial situation, but most plans take on average 6-12 hours. Be sure to get an estimate of how long your financial plan will take before you sign the contract to avoid any surprises.
Lastly, the advisor may charge a flat fee either in the form of an ongoing retainer or on a per project basis. This is popular with financial planners, who might offer a full financial plan for $2,500 for example. There are also advisors managing portfolios for a flat fee as well. A flat fee is a good option for people that want to know exactly how much the services will cost before they sign up, where with hourly rates there can be a range depending on exactly how much time the financial planner takes on the plan.
Financial advisors and planners who are fee-only are working as fiduciaries for their clients. This means that by law the advisor must put the clients needs before their own. It is the highest standard of care that a financial professional can adhere to. The best way to know if your advisor is a fiduciary is to ask them. It is not always clearly stated, but it is definitely something that you should be informed about.
A second way that someone can be compensated for financial advice is a fee-based model. This is common for dually registered investment advisors, some financial planners and insurance agents.
Those paid using a fee-based structure will bill you in some form; this can be done hourly or a flat fee for the project. On top of that the advisor or planner will also collect commissions if they sell you a product. For example, you might pay a financial planner $1,000 for a financial plan to make sure you are on track with your retirement savings and investments. The planner will deliver the plan and recommend that you buy a few mutual funds to better diversify your portfolio and maximize returns. If you act on the advisor’s recommendations and purchase funds through them, they will receive a commission on that sale as well as the planning fee that will be billed to you.
Just like with a full commission model, these conflicts of interest need to be disclosed, but it is not always clear that there are commissions being paid. The best way to know for sure is to ask- especially since fee-based can often times look and sound very similar to fee-only. Fee-based advisors operate under the suitability standard, not the fiduciary standard that fee-only advisors typically adhere to. The suitability rule means that the advisor must recommend products or securities that the advisor believes are reasonably suitable for their client without regard to cost considerations. This differs from the fiduciary standard where the advisor is always acting in the best interest of their clients.
Salary Plus Bonuses
It is common for discount brokerages and banks to compensate their employees with a base salary plus bonuses or incentives for bringing on new clients. Have you ever been asked if you are interested in purchasing CD’s from your local bank? Employees may be receiving incentive pay for selling certain products. There is nothing inherently wrong with incentives, but you should be aware that they exist.
The commission-based fee-structure is very common among brokers and insurance agents. These advisors do not bill you separately for their service and this leads to a common misperception that they provide their services for free. Commission based advisors are compensated through commissions they receive for selling products. Thus, they may do a financial plan for “free” and then recommend and sell you mutual funds for which they receive commissions. Commissions can come in the form of a flat fee or a percent of the amount invested in a product. If your advisor is purchasing individual stocks and bonds or Exchange Traded Funds (ETFs) for you the commission per trade can be $25 – $40. The commission is charged when they buy and when they sell. Commissions that come in the form of percentages are usually Mutual Fund products and typically range from 1-6%. Keep in mind that your advisor doesn’t get to keep all these commissions for themselves as some part does go to the company they work for.
Commissions on Mutual Funds are paid typically in one of two ways. The first is from the issuing company, often referred to as a “marketing” expense or 12b-1 fee. The second way that an advisor earns their commissions is by selling front-load (also known as Class A) or back-end load (class B or C) mutual funds. The client pays 3-6% typically of the value of the investment. For example, if you purchase $100,000 in a front-load mutual fund from your advisor with a 4% fee, you are actually only investing $96,000 after the $4,000 in fees is deducted from your investment.
A few other ways that these advisors are compensated is through new account bonuses and free trips awarded by the companies that are marketing the financial products. Vacations are given to those who achieve goals in one particular category of products. For example, American Funds might give 5 vacations away to the 5 advisors that sell the most of the American Funds Growth Fund during the year.
Some products pay more than others, so there is always a conflict of interest when a commission fee structure is used. Conflicts of interest should be disclosed, but if you’re not sure the easiest way to know for sure is to ask – “Do you get a commission for selling me this product?”.
Financial advisors that receive commissions are held to a “suitability” standard. This means that they could recommend a more expensive product if it were suitable for you.
Wrap Account Fees
Most full-service broker-dealers have developed managed account programs (or “wrap accounts”) that charge fees based on the assets they are managing bundling the management and trading costs. They very similar in theory to the way in which a fee-only advisor investment advisor bills for service. However, where fee-only advisors charge about 1% per year, wrap accounts are typically charging on average between 1.25% and 3% and some invest in mutual funds which also add an additional layer of fees. In fact, it can be difficult to tell how much the total fee is in wrap accounts because the it is broken down into multiple parts and buried deep within their account statement. Your broker gets a portion of this fee for making the sale, the manager receives part of it and some of the fee is retained by the brokerage firm itself. In short, wrap account fees are generally expensive and far from transparent.
So, which is Best?
There are pros and cons to each fee structure mentioned above and depending on your goals, investment strategy, investment knowledge, the amount of money you are investing as well as personal preference will dictate which fee structure makes the most sense to you. In our opinion, the fee-only model serves the public best. However, there are reputable professionals in all categories. The two questions you must ask an advisor (hopefully before you hire them, but better late than never) are:
- How are you paid? You can dig deeper into who is paying them, how much and when, too. This is your hard-earned money you are investing and you deserve to understand everything that goes into your investment decisions.
- Are you a fiduciary? If the answer is no, understand that products recommended to you may not the very best option for your unique situation.
More important than the fee structure that your advisor uses is that you understand it and are comfortable with how you are paying them and the level of service you receive in return. After all it is hard to really trust your advisor if you don’t even understand how they are being paid.