Summary/TL;DR
Understanding how your advisor is paid is one of the most important parts of determining whether or not someone is the “right fit” for you and your family, as conflicts of interest abound. The most common models in the industry are commission based (compensated by selling products), fee-based (compensated by charging fees to clients and selling products), and fee-only (only compensated by clients). Within the fee-only model, there are still multiple ways for advisors to charge their clients, most commonly an assets under management (AUM) fee, a flat-fee, or both.
Introduction
Finding a financial advisor is easy. Just about anywhere in the country, you can drive through your neighborhood and come across multiple different advisory firms. Finding a great advisor, however, is very tricky. The financial services industry is full of shiny objects and fancy jargon that can trick just about anyone (including those who sell them!) into paying hefty sums (much of which remains undisclosed) in exchange for useless products and services.
Furthermore, even amongst the true advisors, skill-sets and competency levels vary widely, making it easy to get overwhelmed. My goal in this short series (comprised of two parts) is to present the most important things to look for in an advisor to determine if they’re the “real deal”. This first part (posted last week) dealt with areas of focus and common advisor certifications, while part two will explore various advisor compensation models.
Common Advisor Compensation Models
As we review compensation models, it’s important to be mindful of what models align an advisor’s pay with your interests. When you engage an advisor, you don’t want them to have an incentive to do anything except give you impartial and unbiased advice. As we’ll see, there’s some compensation models that are terrible at this, others that are better, and one that reigns supreme.
Commission
Advisors who are paid commissions are compensated for selling products such as annuities, insurance, or mutual funds. This compensation model clearly presents a severe conflict of interest and should be avoided at all costs.
Fee-Based
This is likely the most common compensation model for advisors today, and it’s certainly a step in the right direction. Fee-based advisors will typically receive most of their income from a fee charged to give their clients advice, commonly in the form of an Assets Under Management (AUM) fee. They can also receive commissions from products they sell, although this tends to be less of their business.
Fee-Only
Fee-only advisors receive no commissions of any kind and are compensated solely for advice given to clients. These advisors could also earn referral fees for referring clients to other professionals such as attorneys or CPAs, and while this is still a conflict of interest, it’s not nearly as serious as others that could be present. While no compensation model is perfect, fee-only advisors tend to have their interests far more aligned with yours than advisors who are compensated by selling products.
Types of Fees
Now that we’ve discussed compensation models, we can turn to the common types of fees that fee-based and fee-only advisors might charge along with their respective strengths and weaknesses.
Assets Under Management
An AUM fee is by far the most common type of fee charged by advisors. It is assessed as a percentage of the funds being directly managed by the advisor. For example, if an advisor charges a 1.00% AUM fee and you have $500,000 under their management, you are paying a fee of about $5,000 per year. If you later rolled over an old 401(k) that had $1,000,000 in it, the total under the advisor’s management would rise to $1,500,000 and your fee would be about $15,000.
While AUM fees can be simple to understand, I believe they suffer from a few relatively serious shortcomings. First, they clearly present a conflict of interest. The advisor is less likely to recommend anything besides their management, such as a real estate investment or employer sponsored retirement plan. Second, AUM fees are not transparent. I prefer fee models that are quoted in dollars and cents instead of percentages. And due to the fluctuation of the market and irregular cash flows throughout the year, the precise dollar amount that you will pay an advisor who charges an AUM fee is unknowable in advance. Finally, AUM fees really stop making sense beyond a certain portfolio balance. A 1.00% fee charged on a $2,000,000 portfolio is $20,000 per year! And even if the fee schedule was tiered in some fashion so that the average fee was 0.8%, this is still $16,000!
Flat Fee
With the flat fee model, clients pay a single fee for all services including financial planning, asset management, and regular review and one-off meetings. Flat fees have the advantage of being simple, transparent, and present no conflicts of interest between the advisor and client. It’s for these reasons that more advisors, including myself, have changed to a flat fee model.
The downside of flat fees is that they might exclude “smaller” clients from being able to afford financial planning services (although they will almost certainly be less expensive in the long run). I believe these shortcomings are overcome by the advantages listed above, however.
Conclusion
Understanding the various compensation structures of advisors is easily the most dizzying part of finding someone you can trust. It’s when you explore this question that you begin to realize that the title “financial advisor” has a wide variety of definitions and that conflicts of interest lurk around every corner.
Fortunately, cutting through the grime is relatively straightforward once you can understand how someone is paid. When used in conjunction with the topics discussed in the first post of this series, one’s compensation model should contain enough information to help you determine who is and isn’t the “right fit”.
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