Did you know that not all financial advisors get paid the same way? And while compensation does not make the financial advisor, how they’re paid can influence the advice you receive and potentially the outcomes of your financial goals. What’s more, if you don’t understand what your own financial goals are, you may end up paying for products or services that you don’t necessarily need.
Knowing where your hard-earned money goes should be your top priority when it comes to working with a financial advisor. This understanding is essential because your ability to make smarter decisions with your money rises when you know what you’re paying for and how your advisor gets paid. And when you make smart money decisions, you increase the chance of achieving important long-term financial goals.
Not All Financial Advisors Get Paid the Same Way
One of the first things to know before you go out and spend on a financial advisor’s services is that there are some critical differences in how their firms earn money. In general, when engaging with a financial advisor, you are likely to pay either 1) a commission, 2) an asset under management (AUM) fee, or 3) an hourly or flat-rate fee.
When you work with a commission-based financial advisor, the commitment typically is transactional. For example, a transaction occurs when you complete a securities trade with an advisor’s assistance, or they help you buy/sell assets in your investment portfolio. Specifically, you’re likely to meet a commissioned-based advisor when you buy a product like an annuity or a mutual fund.
Typical fees for annuity commissions and mutual fund loads can be as high as 8% of the product sold. At an 8% fee, for every $100,000 you allocate to an annuity or mutual fund, the advisor’s broker-dealer will keep $8,000 of your money and split it with your advisor.
Size matters for advisors who operate under an asset under management (AUM) basis. Assets under management represent the dollar value of investment accounts for which a financial advisor is responsible. The industry average AUM fee hovers around 2% of investible assets but varies from one advisory firm to the next. Such firms typically have AUM minimums (many around $250,000).
This minimum comes from the fact that firm compensation is commensurate with the amount of assets managed. Typically paid quarterly and in advance, a 2% fee on a $250,000 investment comes out to around $5,000 per year and could be paid directly out of your investment account.
The fee-for-service model is the third way you may pay for a financial advisor’s services. For instance, fee-for-service financial advisors typically charge for financial planning or investment management services using an hourly rate, a retainer, or a fixed fee approach. Hourly rates can average $250 and are useful for project-based work like creating a debt payoff plan. Similar to the way many legal firms charge their clients, a retainer fee is paid to an advisor’s firm in advance and billed against the time you use to speak to or work with your financial advisor.
A fixed-rate fee is typically associated with a robust suite of services that include comprehensive financial planning, or flat-rate investment management services all for one price. Fixed rates usually average $3,000 per engagement, and you’ll likely pay this fee directly to your financial advisor’s firm.
Another distinction is a fee-based advisor, who may charge a fee for their service and yet receive a commission for selling you insurance or securities products. Fee-only advisors, on the other hand, typically sign a fiduciary oath (more on fiduciary later) and pledge not to receive commissions.
Compensation Can Influence Your Experience and Outcome
The incentives used by your financial advisor’s employer may also influence your experience and overall financial results. Indeed, firms that hire financial advisors (banks, broker-dealers, insurance companies, registered investment advisors) have developed compensation structures meant to drive outcomes for their organizations.
Put simply, an organization’s leaders will incentivize (pay) financial advisors to hit sales, asset, or client acquisition goals. What this means to you is that there may be a fine line between whether your financial advisor is looking out for your, their own, or their firm’s best interests.
The organizational goal of a commission-based advisor is generally to drive product and insurance sales for their firm. Commission-based advisors are typically associated with a broker-dealer or insurance company. The eat-what-you-kill culture of a commission-based environment may be enough to drive the sales goals of an advisory firm.
Even so, some business leaders have implemented quotas stipulating that an advisor must meet rising dollar or product sales targets to remain employed with their firm. Therefore, if it’s the end of the quarter and your financial advisor hasn’t met their quota, guess which product or service they’re going to recommend to you?
Accumulating more assets is a crucial organization goal of AUM-centric advisory firms. Such companies may be associated with a bank, broker-dealer, or registered investment advisor (RIA). Because client assets tend to move from one firm to another over time, advisors have an incentive to bring in new clients to make up for lost revenue.
At the same time, the percent-relative nature of the AUM model naturally leads to higher firm revenue (and advisor pay) as assets under management rise. Indeed, a financial advisor could receive the same compensation by working with a single million-dollar client as they would with ten $100,000 clients. If an advisor’s compensation rises with AUM, and their time is limited, what type of client do you think they’ll want to work with most?
A primary goal of fee-for-service oriented companies is to increase the number of clients that come in through the firm’s door. Banks, broker-dealers, and RIAs may employ a fee-for-service model. Yet, registered investment advisors are increasingly leading the way on fee-based and fee-only offerings.
However, some low-cost, fee-for-service offerings may require a financial advisor to work with a large number of clients to achieve the organization’s revenue targets. What does this mean to you? Well, there are only so many hours in a day. Think about a financial advisor who has hundreds of clients that they’re servicing. How much time, care, and attention do you think your financial priorities will receive when it’s your turn to talk about your goals.
Suitability vs. Fiduciary Standard
Understanding the difference between suitability vs. fiduciary standards may influence your financial advisor experience. Simply put, one standard is more legally rigorous as it relates to the kind of advice a financial advisor provides.
For example, let’s say that you want to add an index fund to your investment portfolio. Under the suitability standards, your financial advisor must ensure that a fund they recommend suits your needs, goals, and objectives. So far, so good, right? Not so fast. There’s nothing to say that an advisor can’t recommend a higher load, a-share mutual fund when a lower-cost exchange-traded fund (ETF) would do the job for you just as well.
Under fiduciary rules, however, a financial advisor is legally bound to serve your best interests. This standard is similar to those required of accountants, doctors, and lawyers. In the case of our example, an advisor must find a suitable solution for you. Still, if a lower-cost product like an ETF is in your best interest, then by fiduciary rules, your advisor is required to recommend the product that is in your best interest.
So, to whom does a suitability standard apply? This standard typically applies to commission-based advisors associated with broker-dealers and insurance companies. The fiduciary standard, on the other hand, usually refers to bank- and RIA-based advisors. What’s important to note here is that an advisor can be simultaneously associated with both a broker-dealer and a bank or RIA. If a fiduciary standard is important to you, you should ask your advisor how much time they spend in a fiduciary role.
Buyer Beware: You Get What You Pay For
A final point about paying a financial advisor is ensuring you have a clear understanding of what you’re trying to accomplish. There are a host of reasons (we wrote about ten of them here) why you might set out to work with a financial advisor. However, a mismatch between the kinds of services that you’re looking for and the advisor you ultimately hire may lead you to subpar outcomes and a lower chance of achieving your financial goal.
For example, if your reason for seeking out an advisor is to develop a process that creates wealth, like increasing cash flows or paying down debt, then working with an AUM-based advisor may or may not be a good match. Even if you meet an advisor’s asset minimums, you may end up paying for investment services that you otherwise may not need.
Alternatively, an insurance-based financial advisor may or may not be the best person to speak with if you are planning for a retirement that’s still 10-20 years out. Why? You could end up purchasing an expensive insurance product that does not keep pace with your lifestyle or evolving risk tolerance or financial goals.
The point here is that each advisor brings their kind of value to the table, so be sure to clearly understand what services you need and shop around before committing to a single financial advisor.
Knowledge is Power
It’s important to understand that compensation does not always make the advisor. For example, some commission-based advisors provide excellent service, seek to put their clients in the lowest cost, most suitable products, and ultimately help their clients achieve critical financial goals. In contrast, a fee-for-service advisor may deliver an inadequate financial plan because they failed to hear their client’s needs, leading to poorly understood or improperly defined planning objectives.
Even so, knowing where your hard-earned money goes should be your top priority when it comes to working with a financial advisor. This understanding is vital because your ability to make smarter decisions with your money rises when you know what you’re paying for and how your advisor gets paid. And when you make smart money decisions, it improves your overall financial planning and investing experience and increases your chances of achieving important long-term financial goals.