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How Do Financial Advisors Get Paid? Glad You Asked! Thumbnail

How Do Financial Advisors Get Paid? Glad You Asked!

While a bit lengthy, we encourage you to consider some of these issues if you’re looking for a Financial Advisor.

How do financial advisors get paid?

One of the bigger hurdles people face when hiring an advisor is answering the question “How do financial advisors get paid?” If you can’t figure out how—and how much—your advisor gets paid for the work he or she is doing for you, it’s virtually impossible to determine whether or not you are getting good value from their services and from your money.

You would think understanding an advisor’s compensation would be fairly straight-forward, but a multitude of compensation options, combined with a lack of transparency and lots of industry jargon make this a more difficult proposition than it should be—and even modest fees can significantly impact your investment portfolio’s potential over time. Here is a resource written by the Securities Exchange Commission, "How Fees and Expenses Affect Your Investment Portfolio."

To help cut through the clutter, we’ll walk you through the most common compensation models financial advisors use and give you a set of questions you can ask prospective advisors to ensure you understand how you would be paying them.

There are three general types of advisor compensation models: commission only, fee-only, and fee-based (or hybrid).

Commission Only Advisors

Commission only advisors get paid on the financial products they sell you. These commissions can come in many different flavors, some of which are less obvious than others. The most common types of commissions include:

Trade Commissions

Some firms charge you a fee for each securities transaction you make. For example, if you buy or sell $10,000 shares of a stock, you may pay between $50 and $150 in commission to process the trade. Trade commissions can work well for people who trade infrequently, but can be more expensive for investors who add money to their accounts regularly or who execute a lot of trades. The one concern you should have with this model is its potential to create an incentive for your advisor to recommend more frequent trades, which could increase his or her compensation while decreasing how much of your money actually makes it into your investment portfolio.

Front-End Loads

Most often seen with mutual funds, a front-end load is a commission or sales charge that takes the form of a percentage transaction fee that the product provider takes out of your investment up-front. These charges can be as high as 8%, though most are in the range of 3-6%. Front-end loads reduce the amount of your initial investment. If the fund charges a 5% load, for example, and you invest $10,000, only $9,500 get invested and the rest goes to the firm and your advisor. The biggest advantage of front-end loads is that they often come with lower on-going annual fees than other mutual funds. Over the very long term they can be less expensive than a no-load fund. On the other hand, it may take several years for you to overcome the initial up-front cost and many alternative investment options have lower costs than mutual funds.

If your advisor recommends mutual funds, be sure to ask him or her whether sales charges and expenses factor into the funds that he or she selects for client portfolios. Some advisors can create a conflict of interest here, because advisor compensation is higher for products with larger front-end sales charges.

Back-End Loads (Or Deferred Sales Charges)

Another concept seen in mutual funds is a back-end load or deferred sales charge. These come in many different flavors, but the basic idea is that instead of charging you the commission up-front, the product provider will charge you if you sell the fund before a predetermined time period. This time period can be as long as six years, after which you can sell the fund without penalty. Whether this is better or worse for you than a front-end or no-load fund will depend on the specific terms / rules of the investment and how long you hold the investment.

12(b)-1 Fees or “Level Loads”

Again, this type of fee comes in many different flavors, but regardless of what it is called, it is an on-going fee paid out of your investment to your advisor in the form of a higher expense ratio. Unlike front and back-end loads, 12(b)-1 fees are more-difficult to understand because you do not see them removed explicitly from your investment value. In the case of a mutual fund, it simply affects the share price over time.

Embedded or Hidden Commissions

These types of commissions are most often seen in insurance or insurance derivative products. In these cases, the exact costs, both initial and on-going, are often hidden in the fine print of a legal document, which can be long and complex. Worse, the way they are marketed and sold often leaves the buyer (and in my experience many times the advisor too) with a very misleading impression of the underlying costs.

Are Commissions Inherently Bad?

If you do a lot of searching online you will discover almost religious debates on this topic. The primary argument you will hear against commissions is they create an inherent conflict of interest between the advisor and the client. Advocates of commissions, on the other hand, argue they are actually less expensive in many cases than fee-only advisors who often charge an on-going fee for advice regardless of what services are performed.

If you do decide to go with a commission-based advisor, it’s critical you understand how they get paid for their services and recommendations. This will help you determine whether or not you believe he or she has your best interests in mind, rather than making recommendations that might favor his or her financial interests over yours.

Fee-Only Advisors

Fee-only advisors are those whose entire compensation comes directly from you. They do not accept commissions or other incentives from product providers. Advocates of this approach point to its increased transparency and lack of inherent conflicts.

Within the fee-only world, there are many different business models. Here are the most common ones.

Assets Under Management (AUM)

This is currently the dominant compensation model amongst advisors. In this model, your advisor charges you a percentage of the assets you have him manage, typically 1-2% a year. Oftentimes, they roll any and all services they provide you (like planning and non-investment advice) into this fee. Advocates of this model point to the synergies with the client. As you make more money, so does your advisor. Conversely, if your investment value goes down, you pay less. Detractors would argue, however, that you may be paying more than you should depending on your level of activity and that the value of the services doesn’t necessarily grow in proportion to your account growth. In addition, an AUM-based advisor has an economic incentive to not make recommendations that might reduce the size of your portfolio, such as paying off a debt or making a major purchase.

Hourly Consulting

If you have ever hired a lawyer, you are familiar with this model. You simply pay an hourly rate for whatever you ask your advisor to do. One of the biggest proponents of this model is Sheryl Garrett of the Garrett Planning Network. The advantage of the hourly is the costs are crystal clear and you only pay for what you need. However, those costs can really add up if you want to delegate most of the work to an advisor.

Fixed Fee

Some advisors will create a comprehensive plan for a one-time fixed or project-based fee. This is very similar in concept to an hourly model, but is a flat rate and is mostly used in the case where someone wants one-time advice they will then execute on their own.

Retainer

A retainer model is one where the consumer pays the advisors a yearly or quarterly fixed fee for a set of services. As with AUM, this often includes planning as well as investment management with the difference being that the fees are fixed rather than being a percentage of the customer’s investment assets.

Is a Fee-Only Advisor the Best Choice?

As with most important decisions, the right answer will largely be predicated on your situation and your needs. With a fee-only advisor, you won’t have to worry about whether their recommendations are affected by how much a product provider is paying them. However, you also won’t be able to use them as a one-stop shop because certain financial products, like insurance, are only sold on a commission basis.

Fee-Based Advisors

People often get fee-based and fee-only advisors confused. This is not surprising since the two terms sound nearly the same. However, there are significant differences between the two types of advisors. Fee-based advisors are essentially a hybrid of fee-only and commission-only advisors. They can charge both fees and commissions, depending on the services they provide.

Advocates of this model would claim they offer the best of both worlds and can offer pricing that best fits the customer’s needs. In addition, they can be a one-stop shop, including handling the client’s insurance needs.

Detractors would say this model suffers from all of the same conflicts that arise in a commission-only model and has the potential for even less transparency (or at least clarity).

So, Which Type of Advisor is Right for You?

There are pros and cons to each compensation model. Picking the right advisor for you will depend on your specific needs and circumstances. The most important thing is finding an individual advisor you trust and fully understanding exactly how he or she will be compensated so you can make an informed decision.

Here are a few questions to ask prospective advisors to help you understand all the ways they will be compensated by working with you.

  • “Are you a fee-only, fee-based or commission-only advisor?”
  • For commission-only advisors

    • “Can you provide me with details on how I will be charged for the different products you recommend, including costs that may be embedded in the products and any other sales incentives you receive?”
    • “Do you provide financial planning, and if so, how are you compensated for this work? What do you provide as part of your financial planning?”
    • “If you receive payment from product providers, how do you approach and resolve the inherent conflict?” If the advisor replies that they are a fiduciary (meaning they have to act in your best interests), confirm that this is a legal obligation for them and not simply a standard they say they hold themselves to.

  • For fee-only advisors

    • “Please explain your pricing model in detail. What is covered? What is not covered?”
    • “Are there any other fees you would charge beyond what we just discussed? If so, how much are those fees and what are they for?”
    • If you are hiring an advisor for more than just investment management, clarify with them how they will help you with determining appropriate insurance policies, coverage levels, etc.

  • For fee-based advisors

    • Once you’ve agreed on the types of services they will provide you with, drill down on whether they will be charging fees, commissions or both. If it’s both, you’ll definitely want to understand what the fees are for and what the commissions are for. “Which services and products will be paid for through fees and which serviced and products will be paid for through commissions?”
    • Where commissions will be involved, ask the same questions you would ask a commission-only advisor.
    • If fees are involved, ask the questions we recommended for a fee-only advisor.

Now that you know what to ask, get started on finding the right financial advisor for you today, or contact us at Financial Freedom Planners.