How your financial advisor is paid is one of the most important things to know about them. It’s important to know not just to know the cost, but to understand how they are incentivized to give to advice. In this article you will first learn the three ways nearly all advisors can be paid. Then we will review the pros, cons, and incentives each method offers. Let’s take a closer look.
How a financial advisor is paid largely depends on what they sell, their target demographic, and their business model. The three ways that advisors are paid are: commission, percentage of assets under management (“AUM”), and flat fees. Percentage of assets under management and flat fees are commonly referred to as “fee-only.”
Financial advisors paid by commission earn their income by selling a product. Typically these products are direct investments, like mutual funds, or insurance products like annuities and whole life policies.
The upside to commissions is that you typically pay the bulk of the costs up front, although there can be future costs associated with holding the product. Commissions are paid out of your investment into the product and not separately, so it can feel like you aren’t paying anything out of pocket. Even though you feel you aren’t paying anything, trust me, you are. Make sure you understand the total fees, not just the commission before you make your purchase. Other fees can include annual management and expense fees and sometimes there can be riders attached to insurance policies that increase ongoing fees.
If you know exactly what you require and plan on holding the product for a long time then commissions can be a good way to pay for your product.
The downside is that these commissions can be quite expensive as a percentage of your overall investment. It can range from 3% to 10%, depending on the complexity of the product you purchase. This is much more than the assets under management fee. If you are constantly changing investment strategies or products then commission-based compensation will get very expensive over time.
Your advisor is incentivized to sell a product. Once that process is done they will need to sell something else to you in order make more money. They are either incentivized to 1) sell more products in the future, or 2) focus on attracting new clients. These are the only ways they can continue earning income. You need to consider their incentives when deciding whether to make another purchase/investment. They are also incentivized to find new clients, which means they may be more focused on new business rather than servicing you. If you are looking for continuous advice then this is probably not a good fit for you.
Certain products also pay higher commissions than others. Generally, the more complex the product the higher the commission. So, there is an incentive for your advisor to sell a more complex product than may be necessary.
Commission-based products can be a good fit for some people, but these advisors typically search for less-sophisticated clients. One reason why they search for these clients is because they are often ignored by fee-only advisors. In the next two sections you will see why.
Advisors paid based on AUM continuously manage your account directly. They charge a percentage of the value of your account, usually 1% to 1.5%. Some advisors charge less if they manage a large volume of business from you.
Advisors earn money derived from your account value, so their interests are aligned with yours. The more your account grows the more money they make. The opposite is true too: a dwindling account will reduce their income. The fees are typically paid directly out of your investment account. This is very transparent because the fees are reported on your statement. They can also be verified by calculating the fee against your advisory agreement.
There is very little downside. AUM fees can be relatively expensive if you don’t require much ongoing service. Another downside is that they want as much of your money in the managed account as possible, so they may discourage you from investing your money elsewhere.
Advisors are incentivized to keep you happy and do well for you. They continuously earn income, which means they must continuously provide service or risk losing you as a client. They are also incentivized to grow the account as much as possible, which is exactly what you want. Account size is very important to these advisors, so they will want the highest percentage of your net worth as possible. Also, account size can disqualify less wealthy investors, meaning you may get ignored altogether if your account is not substantial.
Flat fees are relatively new in the investment advisor world, but they are growing more popular. You basically pay for the advice you are given. These fees can either be on an as-needed basis for their advice, or it can be a subscription-style fee, typically monthly.
You pay for advice. That’s it. It is totally inarguably fair. The advisor will advise you on whatever their expertise is.
You pay out of pocket. If you don’t have a lot of money the percentage cost can exceed even commission products.
Advisors are incentivized to give you the best advice possible so that you will trust them to continue. Advisors who are paid hourly need repeat visits. Those who are paid subscription fees need to justify that fee with continued, valued advice. People with less money can benefit from this style of advice because they pay for time and unbiased opinion. It is also particularly good for people who are willing to execute a plan on their own, with professional guidance coming from the sidelines.