How Financial Advisors Are Paid

Let's examine the most common ways you will pay an advisor, and the plusses and minuses to each method of payment.

Method: Fee-Only Advice/Service

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

12b-1 Fee

Named 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 Funds

In 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

Method: Fee-Offset

Key Points

  • 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
Chuck Jaffe is a senior columnist and host of two weekly podcasts at MarkWatch. He has also been a guest speaker on several television and radio shows.

Copyrighted 2016. Content published with author's permission.

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