Understanding how financial advisors are paid can be very confusing. Yet a potential client needs to be able to understand how they will pay for the services they receive. The goal of this post is to look at the major ways financial advisors are paid, the advantages and disadvantages of each method and how to evaluate your options.
Before we begin, there is a quick disclaimer for this post. The financial professionals who use each of these compensation methods refer to themselves under varying titles (financial advisors, financial planners, broker, wealth advisor etc), but there is a vast difference in how they work with clients, and their legal responsibilities. Understanding the terminology (and the resulting confusion it creates) is beyond the scope of our discussion. For simplicity’s sake, the term financial advisor is used to refer to all of them.
Compensation Models Explained
With that out of the way, let’s get started. The three main compensations methods are commission only, fee only and fee based. Here is how each of these compensation methods work:
1. Commission Only
This used to be the most prevalent model, but is less commonly used today. The financial advisor is paid for the advice they offer around a transaction that they helped a client handle. For example, if they recommended (or the client wanted) 100 shares of Apple stock, the advisor would be paid for helping to advise and facilitate on that specific transaction.
Generally, the financial advisor is paid when a client would buy or sell an investment or insurance. Meaning that an advisor makes money when money is in motion, not when it was just sitting in an investment.
How are the commissions charged? Here are the main methods:
A. Stock/Exchange Traded Funds (ETF) – when you buy/sell a stock/ETF you are charged a commission that is included in the overall cost of the trade. This is normally disclosed on your trade confirmation that lists all the trade costs.
B. Bonds – the commission is built into the price of the bond, and listed on your trade confirmation.
C. Mutual Funds – clients are normally sold load based shares which have a fee attached to them. There are many different share classes that assess fees in different ways, but the two most common share classes are the A share where clients are charged an upfront fee but have lower ongoing fund management expenses, or the C share where clients are charged no upfront fee, but have higher ongoing fund management expenses. Both options include 12b-1 fees (which is an ongoing commission paid to the financial advisor ranging from .10% to 1% annually) that are paid to the advisor every quarter that the investment is listed under their name.
D. Insurance – the advisor may also be a licensed insurance agent, and receive commissions via their insurance sales. If a client buys a life insurance policy or annuity contract, the insurance agent is paid a commission at the time of sale (and possibly an ongoing commission). The commission amount is not disclosed to the client, and is paid to the agent directly by the insurance company.
The main advantages of a client working with a commission based advisor, are that the client pays for advice or assistance when they need it (such as buying/selling investments or insurance). It also enables clients with smaller account balances receive help as advisors using other compensation methods may not be able to work with them efficiently.
The disadvantages are:
- It is not always clear how much the advisor is being paid.
- Can pit the client’s interest against the advisors. The client may be better off holding an investment for the long-term, but then the advisor will not be paid as much (or at all) unless a transaction happens.
- The client may pay ongoing fees (12b-1) and not receive anything in return
Who May Benefit From This
- Those who do not need ongoing investment management or financial planning support
- Clients who want to pay only when they need specific advice that is involved with buying/selling investments or insurance
- Investors just starting out who don’t meet the asset minimums of other financial advisors
2. Fee Only
Over the years, a growing number of financial advisors felt there had to be a better way to help their clients, and this resulted in moving to charging their clients fees instead of commissions.
These fees are assessed in various ways, but we will look at the three most common methods:
A. Hourly – if a client wants financial planning advice, they would be charged an hourly rate by the financial professional for their time and expertise. This fee could range anywhere from less than $100 an hour to over $500 an hour based on the expertise, training and choice (as some advisors choose to charge a lesser amount to reduce the cost barrier for potential clients) of the advisor.
B. Project/Flat Fee – some advisors charge fees based on the project (complete financial plan) that can run from $1,000 – $5,000+ depending on the complexity of the client’s situation.
C. Asset Based – if a client needs help managing their investments, the financial advisor may charge a percentage of the assets that they are helping their client with. The average fee is about 1%.
For example, if the client needed help with their $100k Roth IRA account, then the fee for the year would be $1,000 (assuming no growth or decline). Some advisors will include financial planning in this fee, while others will charge a separate fee for that service.
They do not receive any commissions from clients, and will refer clients to an outside insurance agent for their insurance needs. Fee only compensation is a growing compensation method for financial advisors.
The advantages of this method are the client is paying for advice (not being sold products), knows what they are paying, and can choose what they want help with or what they want to handle on their own.
The disadvantages are that:
- Many people hesitate to call for issues if on an hourly arrangement. As they are “on the clock” they only will call when things are absolutely necessary, which may be too late for an easy course correction.
- For hourly and project based billing, the client may not ever implement any of the recommendations as there is little or no accountability. Thus, the client paid for help and does not get the full value.
- Asset based billing can create a conflict of interest for the advisor. Will the advisor recommend you pay off your mortgage from your investment account, if it means they will make less money?
- If the client is buying insurance, they are referred to an outside commission based insurance agent, who may/may not have the client’s best interests at heart.
Who May Benefit From This
- Clients who want a clear understanding of how much they are paying their advisor
- Those who handle their finances and need a periodic check in to ensure they aren’t missing anything
- Clients who want to receive unbiased advice (as much as possible) on their overall finances, instead of being sold investments
3. Fee Based
Is where the financial advisor accepts both fees and commissions. There are two main types of fee based advisors:
A. Hybrid advisors – these are advisors who can charge a client either an asset management fee or commissions to implement their investment plan (and sometimes both). They can offer the method that is the best for the client or what the client would prefer.
For example, if the client won’t be trading much and not require much assistance, putting them in a fee based arrangement may not be in the best interest of the client. Having the option for either method of fees, provides the client options without the need of finding a different advisor.
This advisor may also receive insurance commissions.
The advantages (in addition to those listed under commission only and fee only) of this arrangement is a choice of compensation methods. The disadvantage (in addition to those listed under commission only and fee only) is that it requires the advisor to wear different hats, potentially causing them to recommend the option that pays the advisor the most, which may be detrimental to the client.
B. Registered Investment Advisor (RIA) Firm – these are firms similar to fee only (who charge either an hourly, project and/or asset management fee), but also accept insurance commissions. This enables the firm to analyze their client’s financial picture and help them put any necessary insurance in place.
An advisor at an RIA firm is a fiduciary (legally required to act in the client’s best interest). If they are a CERTIFIED FINANCIAL PLANNERTM (CFP®) their fiduciary responsibility extends to insurance transactions.
The advantages are (in addition to those listed under fee only) that the RIA option allows someone acting as a fiduciary to help a client review their entire financial picture and implement all the recommendations under the fiduciary standard (if they are a CFP®).
The disadvantages are (in addition to those listed under fee only) that the advisor will wear different hats, that could cause the advisor to recommend insurance that is not in the client’s best interest (but helps the advisor’s bottom line).
Who May Benefit From This
- Those who trust their advisor and want flexibility in how they pay them (hybrid advisors)
- Clients who want an advisor to help them implement their entire financial plan, rather than being referred to an outside commission based salesperson for their insurance needs (RIA based advisors)
Does the Compensation Model Really Matter?
The two most common compensation models you will find today are fee only and fee based. The main difference between the two revolves around whether the advisor accepts commissions or not.
Here are a few points to consider:
1. All Models Have Potential Conflicts of Interest – if you read much on this subject, many advisors will claim that being fee only is the moral high ground of the industry and free of any conflicts of interest. However, that does not reflect reality. As my compliance consultant says, if a client is paying a financial advisor, there is a conflict of interest.
For example if the advisor is paid by the hour, do they stretch their time out to get paid more? If they are paid via a percentage of assets, are they willing to advise a client to give more, pay off their student loans etc out of the account the advisor manages and he/she takes a paycut?
If they are not willing to admit that there are conflicts of interest with how they are paid, you need to find a more honest (and humble) financial advisor.
2. Being a Fiduciary Matters – this type of advisor is legally required to act in the client’s best interest, not their own. The industry and regulators are trying to muddy the water on this and confuse investors, which is a shame. Not everyone in the financial field is held to the same standard.
An advisor at an RIA firm is a fiduciary, and if they are a CFP® their fiduciary requirement extends to all financial matters (to include insurance sales). Just because someone receives commissions does not mean they are out to take advantage of clients. If anything, purchasing insurance from a CFP® professional at an RIA firm helps protect the client’s interests by ensuring the same standard of care across their entire financial picture.
3. It’s Their Heart Not the Compensation Model That Matters – if an advisor wants to take advantage of their clients, it really doesn’t matter how they get paid, they will find a way to make it work in their favor.
The key for a client is to find an advisor who has a servant’s heart and is not focused on making money at your expense. Unfortunately, there is no easy way to discern this. Working in the finance field, it takes me a while to discern people’s true motives, and I know what to look for. As a client it would be very difficult to determine.
A few things to look at or questions to ask would be:
A. The Advisor’s Lifestyle – does it seem to be focused on consumption and accumulating more?
B. Volunteer History – does the advisor volunteer his or her time with their church or community?
C. Do they do pro bono work? – do they use their financial expertise to help others in need of assistance for free?
D. How do they keep potential conflicts of interest from harming clients? – if they don’t have an answer to this question, I would encourage you to find another advisor. All advisors have potential conflicts of interest and need to deal with this.
Frequently this information cannot be found on the advisor’s website or brochure. Having a conversation with a prospective advisor can be beneficial, as there are many other things to look for.
How to Select the Best Method For You
Having options is a good thing, because it allows you to find the best one to fit your particular situation. Determine whether you need infrequent or ongoing support, understand the conflicts of interest that will arise and ask lots of questions of what services will be provided.
The process is much more transparent than it used to be, so hopefully this post helps you to select the best method for you.
1. Receiving or not receiving commissions is not the issue, the heart of the advisor is.
2. As with anything in life, you get what you pay for. A good advisor will cost money to work with, but can benefit you tremendously.
3. Ronald Reagan once said when asked if he trusted the Russians, “Trust but verify.” You need to trust your advisor, but don’t do so blindly. Verify they are doing what they promised.