Fee transparency has been a hot-button issue in the financial advising community over the past few years. High profile stories of unsavory compensation practices have appeared in national publications heralding extra scrutiny into just how financial advisors can be paid.
To lay it out simply, there are five main ways a financial advisor can be compensated for the services provided to clients. Broadly, these five methods of compensation can be segmented in two ways; fees paid to the advisor by clients and fees paid to the advisor by a third-party.
|Client Fees||Commission Fees|
|Percentage of Assets Under Management||Up-Front Commissions|
|Flat-fee or Retainer||Revenue Sharing|
|Hourly or Project Fees|
In reality, nearly all financial advisors receive compensation in more than one of the forms listed above. When determining if a financial advisor is a fiduciary, this means they only receive compensation in the form of client fees. A fee-only, fiduciary financial advisor cannot accept commissioned fees or a cut of the revenue generated from products and services recommended to you. When evaluating whether to work with an advisor, make sure you are clear on exactly how that advisor can be paid. In particular, be wary of advisors that can be compensated by both fees charged to a client and from other sources.
Before you begin working with an advisor, be sure to ask the right questions to ensure the financial advisor you hire is working in your best interest. If you want some help composing questions to ask an advisor, make sure you read our guide for interviewing an advisor:
Let’s get into specifically what each type of compensation means for the advisor and the client:
This is the most traditional and ubiquitous form of compensation for fee-only, fiduciary financial advisors. The advisor receives an annual percentage of the assets that they manage for the client. The percentage assessed by different firms can vary based on the scope of services and expertise provided. Typically, this ranges from 0.50% to 1.50%. At Ferguson-Johnson Wealth Management, our fee is a maximum of 1.00% and reduces for larger sums placed under our management. You can view our full fee-schedule here.
Generally, this fee methodology helps align the interests of the client with the incentives of the advisor. As a client’s account grows, the advisor receives commensurately more compensation. If the account falls in value, the advisor’s fee falls with it. Because the fee is not tied to any product, the advisor is encouraged to only select investments that are the best for a given client’s circumstances.
Some advisors will only provide asset management and may charge extra (in the form of hourly or planning fees) to perform services like comprehensive financial planning. However, many firms (including FJWM), include all of their services as a part of their AUM fee.
The main drawback of AUM fees is that most advisors typically have a minimum investment balance in order to begin a relationship with a client. For investors that do not meet the minimum, they will often have to seek service from potentially less desirable advisor models in order to obtain financial advice.
Retainer fees are generally employed for clients that either do not want to pay a fee that is linked to the value of an investment portfolio or that don’t meet an advisor’s asset minimum. Under this arrangement, the advisor will typically provide on-going, comprehensive service that mirrors that of the AUM model, including asset management, financial planning, and ready access to an advisor.
Usually, retainer fees are negotiated between the advisor and client to be fair to both parties and will be based on the amount of time and expertise expected to be required for the advisor to adequately serve the client. An example of a retainer fee would be fixed amounts of $2,500 per quarter paid to the advisor for retaining access to their services.
Paying an advisor specifically for a project you’ve negotiated or the time they’ve spent performing services on your behalf is the most transparent and straightforward way to work with a financial advisor. These pay-for-service arrangements can be attractive for do-it-yourselfers and individuals that don’t meet an advisor’s asset minimum.
However, one issue that we’ve found with working under an hourly or project-based arrangement with clients is that it promotes having a reactive relationship with your advisor. When clients experience uncertainty or face challenges rather than simply feeling the freedom to call their advisor, they first ask themselves “Is this question worth $300/hour?” Often, the answer to that question ends up being ‘no’. Minor unresolved issues can compound over time and eventually grow into a major financial crisis. Unfortunately, so much of leading a successful financial life requires being proactive about addressing threats to retirement planning or investment portfolio. Trying to address problems when you’re already in panic mode usually leaves few options available to deal with the financial obstacles that have been created.
Commissions in the advisory business are similar to how you would think about commissions in any other industry. The advisor is paid upfront for placing a client in a particular product or service by the company that produces the product/service. The most straight-forward example is when an advisor buys or sells an investment in a client’s account. If they are compensated by traditional commissions, they may receive a small fee on every trade that is made. The more trades that the advisor makes, the more they stand to earn in commission revenue.
I think you can quickly see how commissions may call into question recommendations that may be made by an advisor. Clients may (rightly) begin to question the impetus behind account activity. “Is my advisor selling this investment for another because it’s a prudent change for my portfolio, or is it simply to generate more fees?”
Think of it this way – car salesmen work on commission. If you enter a car dealership with an interest in buying a vehicle, you should understand that the salesman is incentivized to sell you the cars that are on their lot. I don’t think I’ve ever heard of a car salesman saying “You know what, after listening to your concerns, I think this Ford may not be a good fit. However, the Chevy dealer down the street sells a car that sounds like it would be perfect!”
The most problematic example of commission-style compensation comes into play with front-end mutual fund loads. Sometimes referred to as “A-shares”, these funds assess a fee of several percentage points on new money being placed into the investment. For instance, an advisor may recommend $50,000 toward an A-share fund that has a 5.75% load. In this case, $2,875 would be deducted from your investment to be paid to the advisor, therefore reducing the amount that makes it into your portfolio.
Since not all products confer a load that a commissioned advisor can take advantage of, this could significantly narrow the universe of investment options available to be recommended by the advisor. Often, this excludes nearly all low-cost, index funds that we believe make the most sense for the majority of investors.
Revenue sharing or trailing commissions are similar to regular commissions as described above. The advisor is getting paid based on the products and services they recommend. As with front-end commissions, the advisor has a strong incentive to utilize the products and services that will pay them the most without regard for what is truly best for the client. The difference is, the advisor is generally paid by having you remain in or using the recommended product/service as opposed to getting paid on enrollment.
Here are three examples of how advisors get paid this way:
Anecdotally, we notice that clients often have no idea how much (or even if their advisor is paid at all!) when revenue sharing is employed. When you hear about ‘hidden fees’ and a lack of transparency in the financial advisory business, it’s usually a result of advisors employing products that pay them trail fees.
So, is there any upside (to the client) for working with an advisor that receives kickbacks? The short answer is no. However, for individuals that don’t have the disposable income to afford an advisor that is compensated hourly/flat fee and also don’t have investment assets to meet an advisor’s AUM minimum, this may be the only option to receive financial “advice”. Unfortunately, that advice will likely take the form of “here are some expensive mutual funds and insurance policies that you need.” Ultimately, the choice is between receiving compromised advice or no advice.
This is impossible to answer broadly and will depend on your individual circumstances. Generally, advisors that are only compensated by their clients allow them to work in better alignment with their clients than advisors who are compensated through other sources. When looking for a fee-only advisor, NAPFA offers consumers a directory resource that only includes true, fiduciary financial advisors.
Ferguson-Johnson Wealth Management’s advisors are exclusively fee-only, fiduciaries. If you are ready to begin working with an advisor that will work in your best interest, give us a call or reach out to us to connect.