Have you ever wondered how your financial advisor gets paid? For many people, it's impossible to identify how their advisor is compensated and what fees they paid in a given year. In reality, it should be crystal clear. Unfortunately, this is not the industry norm.
Often fees are buried in statements or paid through sales loads or commissions that are not clearly disclosed to clients. This lack of transparency is confusing and it's not necessary. Understanding how your advisor is being compensated is essential. There are many different fee structure models in the wealth management world. Here's an overview of some of the most common models:
Fee-only advisors are paid directly and only by their clients, generally as a percentage of assets under management (AUM). Often the percentage decreases as the size of the assets increase. The assets under management model aligns the incentives of the client and the advisor. The better the client’s investments perform, the more money the advisor makes. Fee-only advisors do not earn any commissions or receive any financial incentives for placing their clients in a certain investment or financial product. (For more, see: How Your Financial Advisor Gets Paid.)
This model creates a transparent relationship thus avoiding conflicts of interest. Most fee-only advisors are fiduciaries. Fiduciaries are required to place the best interest of their clients above their own. Fiduciary advisors are generally part of a Registered Investment Advisor (RIA) firm and regulated by the Securities and Exchange Commission (SEC) or state securities regulator. By definition RIAs are considered to be acting in a fiduciary capacity on behalf of clients. RIAs operate with a higher standard of disclosure and due care than would be found in a traditional securities brokerage firm.
Commissions are one of the most common ways financial salespeople get paid. Notice the word “salespeople” and not advisor. There are some good advisors who earn commissions, but the potential for conflicts of interest with commission-based compensation models is high. Brokers, insurance agents, and some financial advisors earn commissions for recommending a certain fund, annuity or other investment product to their clients. The commission is either paid by the client - as is the case with a sales load or surrender charge - or can come from the company whose product the advisor is recommending.
In this model, the broker or advisor is incentivized to invest their client in what pays the advisor the most, not necessarily what is in the best interest of the client. How can this be? Aren’t investment advisors held to the fiduciary standard? It is true that Registered Investment Advisors are held to the fiduciary standard, but the term “financial advisor” isn’t a regulated term and many brokers and insurance agents call themselves financial advisors, but are not fiduciaries. (For related reading, see: Fee-Only Advisors: What You Need to Know.)
Instead, brokers and other financial salespeople are held to the suitability standard. Under the suitability standard, the broker or advisor is only required to make sure the recommended investment is suitable for their client. But if one product pays a higher commission, they can elect the more personally lucrative investment option even if it is not in the client’s best interest. It just has to be suitable.
Fee based sounds a lot like fee only, however, it is a distinctly different model. Fee-based advisors make money both from their clients via an AUM structure and from commissionable sales. This can create confusion for clients as they think the only compensation their advisor receives is based on the assets managed. In reality the advisor is also earning compensation through recommended investment products, thus creating the potential for conflicts of interest.
It can be a challenge to understand when your advisor is acting as a fiduciary and when they are held only to the suitability standard. To whom is your advisor really loyal?
Hourly, Project-Based and Retainer Fees
Fee-only, commission and fee-based models may involve only placement in an investment or insurance product, ongoing investment management, or both financial planning and investment management services. Other fee structures are an hourly rate, project based or retainer fee. These are generally used by financial advisors or planners who are giving advice, but not managing assets. This can be a good option for clients who are looking for financial advice and are willing to implement and monitor the advice on their own.
The retainer fee is a bit different in that it typically involves an annual retainer and an ongoing cycle of financial planning advice. Much like attorneys and accountants, hourly and project rates and quality of services vary. This can be an appealing model for the “do it yourself” investor.
Whether you’re working with an advisor now or looking to start a new relationship, always ask for a clear explanation of how they are compensated. I recommend looking for a fee-only advisor that acts as a fiduciary all of the time. This provides peace of mind knowing that your advisor is looking out for you. (For more, see: Choosing a Financial Advisor: Suitability Vs. Fiduciary Standards.)