Whether you're looking for a tax preparer or a mechanic, the cost of most services you receive is usually pretty easy to discern. With financial planners, that’s often not the case. And if you’re not careful, you could be paying a whole lot more than you should.
What makes things particularly confusing is that there’s no single way that advisors get paid – in fact, many are compensated through a combination of different fees. So knowing what they cost usually requires a little research.
The Commission Collectors
In the financial services world, the term “advisor” is used somewhat loosely. In most cases, the professional providing investment advice is actually a representative of a broker-dealer, who gets paid commissions for selling mutual funds and other financial products.
There are a couple of sources of commission-based income for these reps. One is a front-end sales load, which represents a percentage of your fund purchase. Typically, it’s assessed when you complete the transaction – i.e., actually make the buy – although some fund companies also have a “contingent deferred sales charge” or back-end load, which you’ll incur if you sell shares within a certain timeframe.
Some investment companies also charge something called a 12b-1 fee, which is part of the fund’s annual operating expenses – and therefore harder to notice. Part of the fee may go to the investment company itself, and part of it is passed along to the salesperson. Even so-called no-load funds can carry 12b-1 fees, of up to 0.25%. Of course, many funds charge even higher fees.
Which is worse: the load or the fee? That depends. As a percentage, sales loads are typically much higher: The Financial Industry Regulatory Authority, or FINRA, permits loads up to 8.5% of fund purchases. But they’re one-time fees. In contrast, you pay the 12b-1 fee each and every year that you own the fund, so over time it can have an even bigger impact on your returns.
It’s imperative, then, to read the fine print when you’re working with a commission-based representative – and to be aware that the method of his compensation might be figuring into his or her recommendations. If you’re a relatively knowledgeable investor, you may find that sales loads or high 12b-1 fees simply aren’t worth it and opt to avoid the middleman. But for financial novices who feel like they’re also getting solid advice, the planner might be worth every penny in commissions. See What Type of Person Needs a Financial Advisor?
The Fee-Based Folk
Unlike broker-dealers, registered investment advisors (RIAs) aren't paid for selling financial products. Instead, they charge clients directly for the guidance they offer. There are a few different ways they can do this:
- Flat rate. In this case, the advisor charges a fixed amount for his or her services. Usually the amount will vary based on the nature of the service and how much effort it involves.
- Hourly. For more complex financial needs, the planner might assess an hourly fee – typically between $250 and $500 an hour. An advantage of this arrangement is that the total fee is commensurate with the amount of time he or she puts in.
- Percentage of assets. Yet another method, typical of active investment managers, is to assess a fee based on the size of your portfolio. Typically, the annual advisory fee is around 1% of assets, but smaller accounts often pay a bigger amount. Larger clients have more leverage and frequently pay a smaller percentage.
Figure 1. The following chart shows the average annual cost for major brokerage firms, including both advisory fees and fund expenses, according to a survey by financial planning website Personal Capital. Merrill Lynch was the most expensive of the bunch, with total fees of 1.98% each year. The figures assume a starting balance of $500,000 that grows at an annual rate of 7%.
Source: Wealth Management, Personal Capital
Because they’re not compensated for choosing specific funds, RIAs are sometimes viewed as having fewer conflicts of interest than the broker-dealer types. They’re also held to a higher regulatory standard. As a fiduciary, an RIA is legally bound to operate with clients’ best interests in mind. From the government’s perspective, brokers merely have choose products that are “suitable” for the investor. (See Financial Advisor vs. Financial Planner.)
That doesn’t mean registered advisors are less expensive, however. In fact, the opposite is often the case. As an example, let’s take a client with $500,000 in assets who pays an annual 1% fee to an advisor. That’s $5,000 every year that’s being drained from the account balance. And as the balance grows, they're getting an even bigger dollar amount.
For some investors who are getting excellent service, that advice might feel worth the price. But if you’re not getting a lot of attention from your planner, that same fee can look pretty bloated.
Don't forget, if your advisor is putting you into mutual funds, you'll be paying those funds' annual fees and charges, aka their expense ratio, too. So it's important to watch out for high-priced investment choices. It's really the total cost – the fund expenses and advisory fee together – that matters.
As a percentage, the difference in fees among providers may look small. But because of the compounding effect, they have a major impact on your portfolio's rate of return over the long haul. As Figure 1 demonstrates, a difference of less than 1% annually can mean you're paying nearly twice the fees over a 30-year period.
The Bottom Line
Unfortunately, the compensation that financial professionals receive isn't always transparent. As uncomfortable as it may be, it’s imperative to ask questions up front about how they make money (fee-only or commission-based) and how much they’re charging. Each compensation method has its pros and cons (see Paying Your Investment Advisor – Fees or Commissions?), so only you can determine if what you’re getting in return is worth what you'll ultimately be paying.