You’d never think about hiring a contractor to build a room addition without knowing the cost, right? Yet more than 1 in 5 investors has no idea what they pay in investment fees, and another 10% don’t know if they’re paying any fees at all.
Like everyone else, financial professionals have to be paid for their time and services, which is primarily advising new and existing clients. Their cost is going to depend on how they get paid, of which there are three primary ways:
Let’s take a detailed look at these three methods, why you need to know how they get paid, and a few questions you should ask a financial professional about how they’re compensated.
Fee-only financial advisors
Fee-only advisors charge clients a percentage of assets under management (AUM). These fees are deducted from your account, usually quarterly or monthly, which is typically determined by your account balance.
The majority of fee-only advisors use a sliding scale to determine the percentage of AUM they’re going to charge you, for example:
- 1.2% for accounts under $1 million
- 1% for accounts over $1 million
- 0.59% for accounts over $30 million
So, if you have an account valued at $1 million, a fee-only advisor would probably charge you a fee of 1% annually, which is $10,000 and is deducted from your account.
This type of advisor compensation plan has its pluses and minuses for the client. Let’s imagine you start the year with a $1 million account balance and see how this would work out for you.
In a good year, let’s say your portfolio had an annual return of 10%, your advisor would get 1% of your new AUM of $1.1 million, which comes out to $11,000. You probably wouldn’t mind paying the fee.
Conversely, let’s say your account lost 10% of its value that first year. Not only would your account have dropped to a value of $900,000, but you’d also be paying your advisor a fee of $9,000. You probably wouldn’t feel pleased about paying the fee on a down year.
Many advisors sell this percent of AUM compensation plan as a benefit for clients because they claim this arrangement motivates them to grow your account every year, so you both make more money. The validity of this claim depends on the advisor’s motivation level and is more attractive to growth-oriented investors.
Some fee-only advisors charge by the hour they spend on your account, an annual or quarterly retainer that’s not based on your AUM, or a flat fee for any service they offer (i.e., $2,500 to create a comprehensive financial plan). These types of non-AUM-based advisor compensation plans are often preferred by more conservative value-based clients, like retirees.
Commission-based financial advisors
Commission-based advisors are paid through the products you buy, whether it be an investment product like a mutual fund or a life insurance policy.
Commission-based advisors have been disparaged over the years by being accused of having a conflict of interest and recommending products to clients based on the commission percentage they’ll earn, which can be costly to their clients.
For example, annuities are notorious for having hefty commissions that aren’t always disclosed by their advisor (they can be upwards of 10% of the amount deposited into the annuity, and carry heavy surrender fees if the client wants to cash out of their annuity in the early years).
The sales loads on mutual funds can also be high (as much as 8.5% of the amount invested), and brokers may receive a commission of 1% to 2% of a bond’s value.
It can be tempting to some advisors to recommend the highest-paying products, which may not be the best product for the client. This is an apparent conflict of interest.
It should be noted that the majority of commission-based advisors do have their client’s best interests at heart and do not take advantage of clients or withhold commission rates or fees from them.
Fee-based financial advisors
Many advisors are compensated by a hybrid model and are referred to as fee-based advisors (not to be confused with fee-only advisors).
Fee-based advisors will often charge an AUM fee and also earn a commission on any products sold. This requires an advisor to wear two different hats — sometimes wearing a fiduciary hat (all advice given is only in the client’s best interests) and sometimes wearing a salesperson’s hat and selling products.
A good question for you to ask a fee-based financial advisor is, “Are you required to act as a fiduciary 100% of the time?”
Questions to ask financial advisors about their compensation
Financial advisors would attach a price tag showing their fees to their business cards in a perfect world. Unfortunately, this will likely never be the case. This puts the responsibility on you, the client, to inquire about a financial advisor’s fees.
Here are some questions to ask an advisor about their compensation:
- How do you get paid?
- Do you earn commissions?
- How much money do you and/or your company make to put me in a product you recommend, whether it be investments or insurance?
- What are my total costs for working with you?
An advisor should give you straightforward answers to these questions, and those answers should be easy to understand. If they won’t answer these questions, you should probably look elsewhere for an advisor.
Why should you know how an advisor is paid?
As you can see, there is a substantial variance in how financial professionals are paid. Their method of compensation is going to directly impact you in two ways:
- Commissions and fees are going to reduce the value of your investment, whether it be losing 10% off the bat when you purchase an annuity or paying a 50% first-year commission to a life insurance agent that impacts your cash value growth in a whole life insurance policy.
- An advisor's method of compensation can bias their recommendations. If you do end up working with an unscrupulous investment broker or insurance agent, their advice to you will be determined by how much they benefit monetarily, not how you benefit long-term.
In any business relationship, trust between both parties is paramount. Take the time to talk with your advisor, or potential advisor, about their compensation. Make sure you’re comfortable with the arrangement so you can enjoy a profitable, long-term relationship together.
The information and content provided herein is for educational purposes only, and should not be considered legal, tax, investment, or financial advice, recommendation, or endorsement. Breeze does not guarantee the accuracy, completeness, reliability or usefulness of any testimonials, opinions, advice, product or service offers, or other information provided here by third parties. Individuals are encouraged to seek advice from their own tax or legal counsel.