How Financial Advisors Are Paid
Method: Fee-Only Advice/Service
- How it works: Your annual fee is a flat percentage of the money that the advisor is responsible for, typically somewhere between 0.75 and 1.25 percent. Many advisors use a sliding scale, so that the percentage drops as your assets grow, or the amount charged declines after certain breakpoints. The advisor is paid only by you; there are no commissions, either from you or from a third-party, for providing you with counsel.
- Plusses: The advisor's interests are aligned with yours; if you get great results, so does she, because your success means a great pool of assets to charge that fee on.
- Minuses: If you don't have much money to work with, you'll have a hard time finding fee-only advisors who want to take you on as a client. Most advisors want to get all of your available resources under management -- which may entail selling investments you have now -- rather than only handling some of your money. And critics say that a fee-only advisor can become disinterested over time, because he gets paid regardless of whether you act upon his advice.
- Possible conflicts: The advisor's focus will be on getting assets in the door, and their advice may skew in that direction. Say you receive an inheritance and want to know if you should pay down the mortgage or invest the proceeds; the advisor's pay goes up if you invest the money and stays flat if you pay off the debt. There may also be times when the advisor makes moves not because he believes the portfolio needs to be changed, but because he knows it's frustrating to pay a fee to an advisor who is not "doing something."
A Conflict over "Nothing"While paying a fee for assets under management does diminish conflicts of interest, it creates an interesting problem, where an advisor may sometimes make moves in order to justify his or her ongoing worth.
Say the advisor puts together a portfolio. It gives you roughly the return you expect, you go in for your annual review and the advisor says "change nothing." She collects her fee, and the next year the market is not so kind to your portfolio. Nothing horrible, mind you, but you're getting nervous come annual review time, when the advisor again tells you, "Don't change a thing." The third year, the advisor knows you are not particularly happy with the results; the market has been tough, and the portfolio has been in line with expectations, but you're frustrated.
Fearing that you may want to pull the plug on the whole thing if you hear another "Don't change a thing," the advisor advocates changes, not because they are the best long-term moves -- in fact, studies show that changing a portfolio for the sake of making a change tends to do worse than going the buy-and-hold route -- but because she needs to justify the fee.
It won't result in more fees for the advisor, but it's hard to say the advisor has your best interests at heart. Situations like this are why there is no such thing as conflict-free financial planning.
Method: Commission or Fee-Based Commission
- How it works: You pay a fee -- or your advisor gets a fee from a third party -- on every move you make. In some cases, as with some mutual funds, you might only pay something that's labeled a "sales charge" when you buy or if you sell after a short holding period, but a payment to the advisor from the fund company is built into the investment structure, and you could be buying an investment that is more expensive for life in order to pay that fee. Likewise, with insurance agents, commissions frequently are buried in initial premium payments, so that it's not quite as clear as "make this investment, pay the advisor X percent off the top." Make no mistake about it, however, whether it is a front-end load, a back-end sales charge, surrender fees, or 12b-1 fees for mutual funds, it's a "commission" if you are paying extra, and the advisor gets that money, either directly from you or from the company managing the investment.
- Plusses: Commission sales typically are available to all consumers, no matter how little money you have to work with. If what you want or need is someone to process your transactions, you can focus on paying the fee -- possibly even negotiating it down -- and getting the investment.
- Minuses: Because the advisor only gets paid when you act on his advice, you may be getting a salesman more than a long-term advisor. The brokerage firms, for example, are filled with young bucks anxious to make their bones, but the rate at which these newbies wash out of the business is high. Even if the advisor sticks around, he only has an incentive to work with you when he senses a sale coming on. You may talk to an advisor today, come up with a decision on an investment or a portfolio to buy, and then may not be able to get much ongoing counsel if the seller doesn't sense that he can make another sale and capture another commission.
- Possible conflicts: The basic problem here is that the advisor's best interest is served only when selling you something or getting you to make a move. The bulk of your financial life, you are holding and building, not buying. Moreover, many commissions are buried inside of financial products like insurance policies; the advisor will talk about the benefits to you of buying a certain financial product, without necessarily disclosing properly the way or the amount she gets paid. Finally, a commission salesperson may get an incentive or a heightened commission to sell products from specific companies, like the house mutual funds or issues that simply carry a bigger front-end sales charge; those higher payouts may unduly influence the advisor's thinking.
12b-1 FeeNamed for the regulation that allows it, a 12b-1 fee is a "sales and marketing fee" paid on top of the management fee of a mutual fund. In most cases, at least some of this fee acts like a "trailing commission," paying the advisor who sells the fund for his or her continuing efforts to keep your account open and in place. These fees add 0.25 to 1.0 percent to the cost of a fund and tend to be highest in cases where the fund is set up to avoid front- or back-end sales charges and make it feel like the customer is not paying for advice.
The Costs of Alphabet Soup for Mutual FundsIn mutual funds, share classes represent different ways of paying a financial advisor.
For Class A shares, think "all at once," because this is the traditional, up-front sales load. These days, that sales charge will take anywhere from 3 to 5.75 percent off the top of your investment.
For Class B shares, think "back-end costs," because the front-end load is gone, but you will pay a back-end fee if you sell the fund during the first few years. During the period when the surrender charge is in place -- typically four to six years -- you'll pay higher expenses than in an A share, with the difference basically being the compensation for your advisor. Once the back-end load phases out -- it typically starts at 4 to 6 percent and drops by roughly one point per year -- B shares typically convert into lower-cost A shares.
With Class C shares, think "costs, costs, and more costs." There is no load on the front or back end of your purchases, but the ongoing costs of holding the fund are higher forever. This is a good way to hold a fund for a short time, but it tends to be the most expensive over time. Sadly, many consumers miss that and are attracted to C shares -- and pushed toward them by advisors -- because it "feels" like there are no sales charges attached whatsoever.
While no one likes paying up-front sales charges, Class A shares are typically cheapest for a long-term shareholder and are the only ones with "breakpoints," discounts in the sales charge for investing more money. As you pass breakpoints -- which can start at anywhere from $25,000 to $100,000 depending on the firm and the fund -- an advisor who keeps selling you B shares is artificially inflating their payout.
Some fund firms have other share classes, often for retirement-plan investors or for their own payment plan with broker-dealers. Be sure you understand how it works and what it costs you.
Finally, many advisors put their clients in no-load funds, meaning shares with no sales charge whatsoever. Don't be fooled into thinking those advisors do not get their cut; they may not get paid directly from the fund company, but they're paid a percentage of the assets they manage for you.
Thus, if a financial planner charges 1 percent of assets under management and puts $10,000 of your money into Fund X, you may not be paying any direct sales charges for owning the fund, but the "true cost" of your fund ownership -- the expenses of the fund plus any and all advisory fees, sales charges, and commissions -- will be the fund's expense ratio plus the advisor's 1 percent. If the fund has an expense ratio equal to the average stock fund (1.4 percent), and its performance stays roughly flat, your true cost of ownership in the fund will be $240, the 1.4 percent of $10,000 that the fund takes to cover costs plus the $100 you paid the advisor to have that $10,000 under management.
Method: Flat Fee/Hourly Rate
- How it works: You pay either a flat fee for service or an hourly wage based on the amount of time the advisor works with you or works on the services she provides you.
- Plusses: You pay only for what you need, and you know upfront how your costs will be calculated and what they are likely to be.
- Minuses: There are not many financial advisors who work on an hourly basis. Those that do typically give you the basics but let you implement the program itself; that's not good if you need help to turn an "action plan" into real action. The hourly fees are often jacked up -- expressly because an advisor would prefer to have an ongoing relationship -- so that the perceived cost benefit of paying this way disappears and paying a fee for assets under management becomes the most efficient means of getting advice.
- Possible conflicts: There are plenty of ways to pile on the hours, and there are unnecessary costs that can be built into a flat fee. Overall, however, paying a flat fee or an hourly wage has the fewest potential conflicts of interest.
- How it works: The advisor accepts commissions and fees from third parties in addition to fees charged against your assets. When you make a move that generates a third-party commission, you get a rebate for some or all of the monies the advisor receives. Industry-wide, this arrangement is not all that common.
- Plusses: Ideally, you get the best of both worlds here. You pay for unbiased advice -- as in a fee-only arrangement -- but if the move generates monies, your asset-management fee is reduced. It keeps the advisor interested in you both when she is selling you something and when she is simply giving you advice.
- Minuses: The fees are sometimes a bit higher than in a fee-only arrangement, because the advisor may have costs -- order processing, sales quotas, and more -- as a result of working with those commission-generating third parties. Some advisors do not give the customer a 100 percent rebate on the commissions they receive.
- Possible conflicts: If the advisor keeps some of the commissions, how can you be sure that the original advice was unbiased? You can't, and that removes much of the advantage you signed up for when you decided to go this route.
- For most people, the way you pay sales charges and commissions is less important than how much you pay. If you pay 1 percent of assets under management, and it winds up costing more than a transaction-based fee, then perhaps you need to accept that a commission set-up is better suited for you.
- No matter how an advisor is compensated, there are always going to be potential conflicts of interest. Be aware of them, look for them, avoid them.
- Paying more than you have to for advice is bad, but so is paying anything for bad advice. A good advisor who helps you reach your goals will be worth what you pay him or her; a bad advisor is a bad advisor at any price and in any fee structure.
By Chuck Jaffe