How Financial Advisors Get Paid
Anyone about to begin their search for a financial advisor will quickly find that there are many, many choices out there! In fact, there are over 93,000 CFP Professionals alone and far more than that without the CFP credentials. The goal of this article is to explain, and help you understand, how financial advisors get paid.
Show me the incentive and I will show you the outcome. - Charlie MungerCharlie Munger
It is important to note that fees should not be your only criteria for choosing an advisor. There are no doubt good advisors providing excellent advice and service under any of these methods. However, you should understand how your financial advisor is compensated as it influences what services, products, and recommendations are made.
If your advisor is compensated primarily based on selling products like life insurance or annuities, their financial recommendations will inevitably be centered around pitching those products. If your advisor is primarily compensated on your assets, their advice will be centered around accumulating as much of your portfolio under their management as possible.
As Charlie Munger put it, incentives matter in advice so choosing an advisor whose compensation method aligns most closely to achieving your goals is a key decision.
Let's break down the most common fee methods
Across the financial services industry, Management Fee or Assets Under Management Fee are the most common approach. Under this model, the advisor is compensated based on a percentage of the investments they are managing.
These schedules typically come in two forms: Flat and Tiered
Flat management fee schedules charge one percentage for the entire portfolio managed. Typically, advisors will raise or lower the flat percentage based on the amount of assets a client has but this is not an automatic process.
Tiered percentage models charge higher percent at the first level of assets and lower percent as higher levels of assets as illustrated for a sample $1.1M portfolio. Additional monies managed do increase the overall fee but at a lower percentage.
A Commission a fee based on a single transaction.
Insurance and Annuity advisors mostly fall under this compensation method. Be aware, however, that many advisors who charge a management fee may also collect commissions from these products in addition to their management fees.
Total Fees paid by commission go up based on the size of the transaction made or the number of transactions.
A large insurance policy, for example, will carry a large commission. On the other hand, a commission on your trades may be small, but adds up when repeated many times. There is a time and place for commissions. If you plan to make a single purchase then never make a change to it (for example, buy a stock and hold it for a decade or purchase an appropriate life insurance policy), a commission arrangement may be the cheaper option over management fee. If fact, many compliance departments will eventually force a transfer of such a position to a non-managed account.
Commissions vary between different products (for example, annuities may have different commissions), which can influence advisors to recommend products based on the commissions they will bring in instead of what is best for the client.
Also, commissions are not always transparent for the client. In some products you may not even see one being charged as in the case of indexed annuities. In these cases, rather than paying the commission by writing a check out of the investment, the commission is paid by reducing your future returns.
With Fixed Fees you pay a set amount based on the complexity of your needs or an estimate of the time it will take to develop a plan for you.
A client pays the flat fee up-front or the planning fee can be an annual fee.
Well, that’s it for this section. Notice how simple that was?
Some advisors charge based on an hourly rate allowing clients to receive advice on specific areas of their finances. Typically, you’ll be quoted an amount of time they expect to take and an hourly rate.
Some advisors may have set advice packages with pre-defined rates on financial topics like education planning.
Terminology Tip: Fee-Only vs. Fee-Based
In your research, you may hear the terms Fee-Only and Fee-Based. The primary difference between the two is that Fee-Only advisors cannot accept commissions from products whereas Fee-Based advisors can often recommend products that have commissions.
At Gilbert Wealth, I am a “fixed, fee-only” advisor. By stating that, I am unable to accept commissions and my fees are based on the time I intend to spend on your situation and not how many assets you have (unless those assets add complexity).
Why is all this important?
You need to balance the skill and expertise of your advisor, the true value they add to your financial life, with what the advisor and the products they recommend truly cost you.
To put it another way– if you were hiring a jockey to ride your racehorse, you would want the most skilled, but you would also want the lightest. It doesn’t matter how fast your horse can run– if you’re going to add a heavy load to its back, it’ll make it harder for the horse to win.
Horses run faster when they are carrying less weight. Returns on your assets are higher when there are fewer fees sitting on top.
As a fee-only advisor, I am a pretty light jockey and I know how to win this race for you.
One more thing... the fees you're paying to other people.
These fees do not go to the advisor, but to the Mutual Fund, ETF or Insurance company… but you still have to pay them! Even I can’t avoid these all the time but I can minimize them.
Fund Expense Ratios
Mutual Funds and Exchange Traded Funds (ETF’s) both incur investment expenses which are passed onto the investor before returns are posted to statements. That means you won’t see the exact dollar amount anywhere on your statement. The expenses charged are visible in investment research tools.
Fund expense ratios are charged in basically any type of account you can think of. 401(k)’s, 403(b)’s, annuities, variable life insurance, IRA’s, investment accounts, and Thrift Savings Plan. You can find very low-cost and very high-cost options depending on the fund you are looking at.
If your money is invested through me, you’ll find me prioritizing high-quality, low cost funds and ETFs.
Transaction Fees
The custodian you invest with will determine which mutual funds and exchange traded funds have transaction fees. Some mutual funds may trade free at one custodian but not at another. This decision typically depends on if the custodian wants to promote their own fund or if there is a revenue sharing agreement between firms.
With ETF’s there is a small SEC mandated fee that is applied to each selling transaction.
If you own or are being proposed an insurance contract or annuity contract…
Mortality and Expense Fees: for the cost of insurance part of the contract
Annuity and Insurance Rider Fees: for any extra protection features you want to add on
Administrative Fees: for all the paperwork and staff the insurance company needs to hire
Again – these fees are not compensation to the advisor, but they do influence the performance of the investment. If I do recommend a product that with fees we can’t avoid, I will make sure you know exactly what you are paying,