How Financial Advisors Get Paid
One of the extremely gray areas of the financial services industry is how financial advisors are paid. Even defining who actually is a financial advisor isn’t super clear with so many different job titles and folks calling themselves financial advisors.
Other financial professionals – such as CPAs and estate attorneys – have straight-forward compensation: you write them a check. However, for better or for worse , financial advisors have different business models (and regulations) that make it somewhat perplexing how much and to whom a client is paying. In general, there are three broad categories of a business model an advisor can operate in: Commissions, Fee-based, and Fee-only. Here is a brief description and then three pros and three cons of each from the client standpoint.
This type of advisor is paid a commission for recommending/selling certain investments or other products. Most of the time, this commission is embedded within a product and not easily seen by a client, so unless an advisor is disclosing what the amount is, a client may never know. This is by far the longest tenured business model, stretching back decades to stock-brokers who were compensated by recommending clients buy or sell certain individual stocks. Examples of commissions that advisors receive include recommending A or C share mutual funds, placing a life, disability, or other insurance product, and ticket charge markups within brokerage accounts. Typically an advisor who receives commission is a registered representative or broker for a certain company that disperses the compensation.
Three Pros of Commissions:
- On the surface, it seems to be the cheapest option.
- When it comes to insurance, fewer insurance companies offer non-commission products, meaning more options, especially when it comes to annuities or variable/whole life insurance policies.
- Direct correlation between an action being completed and compensation.
Three Cons of Commissions:
- Does not have to be in the “best interest” of a client – only a “suitable” recommendation.
- Not clear how the advisor is being paid.
- May introduce conflict of interest of selling products instead of giving advice.
A fee-based advisor is one who can receive either commissions or fees from a client. There is no criteria for how much of the business is commission or fee-derived, simply that the advisor can do either. When using fee-deduction, typically an agreed upon percentage of managed assets is taken out of the accounts that the advisor is managing.
Three Pros of Fee-based:
- Better transparency of advisor compensation when using fee-derived investments.
- Availability of lower-cost investment vehicles such as index funds within portfolios.
- Advisor has ability to place certain commission-only products such as annuities, variable/whole life policies.
Three Cons of Fee-based:
- Advisor still has potential conflict of interest with higher commission products.
- Potential increase in confusion on who and what is paying for advisor’s services.
- The “suitability” vs “best interest” determination is still applicable.
A fee-only advisor is only compensated by the client – not through third-party commissions or kickbacks. The exact means of compensation varies with each advisor, from retainer or subscriptions, to hourly, to percentage of assets, or to other metrics such as a percentage of client income or net worth. No matter how the fee is calculated, the delivery and compensation is what makes a fee-only advisor fee-only in that the client is the only one paying the advisor. The CFP Board broadens the definition of fee-only to even excluding the ability to earn a commission, even through a related party (such as a separate insurance agency).
Three Pros of Fee-only:
- Compensation to advisor is for giving advice, regardless of individual solution or recommendation.
- Client understands what the compensation is to the advisor.
- Helps reduce potential conflicts of interest with variable commission products.
Three Cons of Fee-only:
- Can cost more out of pocket-expenses for client.
- Seems to be more expensive than commissions because of increased transparency
- May prove more costly for younger investors starting out if advisor has a minimum fee schedule.
Which is best?
Fident is set up as a fee-only registered investment advisor, so is obviously slightly biased towards the fee-only approach. However, when Fident was being established, it was done so with three convictions when it comes to fees in the advisory world:
- Transparency: every client should know exactly what fees they are paying and to whom.
- Value: charge clients in a way that the perceived and tangible value far surpasses the price.
- Fairness: no client will be under-served and no client will overpay for Fident’s services.
In addition, there are certain types of clients who may have a strong need for a financial planner, but who do not have significant assets that can be managed by the advisor. Examples might include money within 401ks, business ownership, or the client is simply in the beginning states of investing. A fee-only business model gives the advisor flexibility to create a service model that’s not tied only to asset management, which the commissions or fee-based advisor may be limited to.
At the end of the day, Fident believes that an advisor can operate ethically and morally within any of the business models. Equally as true, an advisor can bend the rules within any of the models, including fee-only. None of them are perfect. What a client should be looking for is an advisor who they can trust, and who they feel comfortable with how much they are paying for the service.
If you don’t know what your advisor is charging, then you should ask – and keep asking clarifying questions until you know exactly what the answer is. Fident doesn’t believe there is a magical number that each client should pay, it’s all about relative value to what is being delivered. However, it’s difficult to know if your advisor is worth what you’re paying him or her if you don’t know what the compensation figure is.