The Big Question

How Is Your Advisor Compensated?

This question is probably THE most important question you need to know the answer to if you are working with (or are considering working with) a financial advisor.

People generally don’t work with or trust financial advisors-a CNBC article from 2019 cites that a staggering 83 percent of people do not work with a financial advisor, and that 75 percent do not seek any kind of professional financial assistance whatsoever. The main issues reported in the survey are that people either think advisors are a scam, or that they are only for rich people. The sad thing is that this justified hesitancy may be costing people. A survey done by the National Financial Educators’ Council found that Americans cost themselves about $1600 a year with their own financial illiteracy. Another study done by Strategic Business Insights found that people who work with a financial planner end up with approximately 2.5x more wealth than those who don’t. However, some people prefer not working with an advisor and are able to manage their finances well.

The tough part about this situation is that the lack of trust is not unwarranted. The finance world is extremely complicated and full of jargon that often goes right over people’s heads. This has allowed for many folks to have bad experiences with advisors, and it makes it hard for people to understand the way their advisor is being paid. Combine that with the 2008 crisis, movies portraying guys like Jordan Belfort, and people have a general distrust of the industry. So even if someone is prudent enough to ASK how their advisor is paid, the answer may be so convoluted that they still don’t end up with a clear answer.

In this article I’m going to break down in broad terms what to look for when an advisor is explaining how they are paid, what follow-up questions may be helpful to give you more clarity, and what we believe is the most client-friendly fee structure.

We believe the first rule is this: if the advisor can’t explain it to you clearly, it may be in your best interests to look elsewhere. The information below is intended to help give you some insight on how your advisor’s pay structure may include conflicts of interest that may influence their recommendations.

Let’s use a hypothetical advisor who says something along the lines of: “we go over your financial situation, do a financial plan, and then I will recommend investments based on your situation and your risk tolerance (and drones on)”. At this point you’re probably still not clear on how they are paid, so the next question to ask is: “Are you a fee-based advisor or are you paid commission for products you recommend to me?” This is an important distinction I’ll explain further below.

The answer to that question is important for this reason: if your advisor is paid a commission for certain products you should know what products they are soliciting, and how much they are paid for putting you into said products. They may also be subject to sales goals that encourage them to move on to new clients as quickly as possible to meet their metrics. Commission-based advisors are required to provide you a prospectus, which provides a ton of detail regarding the product you are investing in and advisor pay, and a form CRS which will detail exactly how they are paid.

Based on the type of advisory arrangement you are looking for, the answers to these questions should help you determine if this type of relationship is a fit for you. If you desire an ongoing, planning-based relationship you should ask the advisor how often you’ll be meeting them and what incentive they have to be proactively looking out for your overall financial picture. Their answer at this point can help you determine whether you’d like to proceed.

You may also want to consider that this kind of arrangement may cause a conflict between your goals and the investments that are recommended to you. To give an example, suppose the advisor recommends you invest in a mutual fund (a basket of stocks and/or bonds). X company and Y company both offer the same type of fund to accomplish your goal, but Y company’s fund has lower administrative fees than X company’s. However, the advisor only gets paid if they sell you X company’s fund so they do that instead. Based on your situation either fund could have accommodated what you needed, but Y fund would have reduced your costs for a similar investment. Please note that cost should not be the only criteria used in choosing an investment.

With all that being said, this structure may work for some people. There are folks who want an advisor strictly to make investments in an effort to outperform the market (or other goals that don’t involve ongoing financial planning), and don’t really care to have an ongoing planning-based relationship. This type of structure may work for these clients as they are paying specifically for investment returns.

Let’s backtrack to the initial question again. Now, instead, the advisor explains that they will cover all aspects of investment and financial planning with you, and they are on the fee-based side. What does that mean?

Fee-based advisors are usually paid in one (or a combination of) these three ways: they provide one-time financial plans, ongoing financial planning on a subscription/retainer basis, and/or direct management of their clients’ assets.

One-time plans: The advisor typically charges $XXX dollars for a one-time comprehensive financial plan. Come back as often as you need, but you’ll pay every time. Great, that’s easy to understand. They’re going to give you a roadmap and recommendations and it will be up to you to implement it.

They may also say that they have a retainer or subscription-based planning fee, like Netflix. It would be similar to the above arrangement in that they will give you a roadmap, with the key difference being that you will get an ongoing partnership with them to continuously work together on your finances. Make sure to ask them how many meetings that would include on a yearly basis, and what accessibility would be like. If they’re charging you monthly they’ll need to explain how often you would meet and when they will be available to answer your questions. If you’re satisfied with the answers to those questions then you can decide to work on that basis.

These arrangements may work best for people who are self-starters and can DIY some of their money management. This requires some time and expertise, so make sure you have those things so you can implement recommendations.

The other fee-only arrangement would sound something like this: the advisor tells you they are paid a percentage of the money that they manage for their clients. Fee-only advisors may give you a flat fee they charge to manage money and/or a percentage of your assets they are managing. For example, an advisor may have a 1% fee for the first 500k they manage, then .75% for the next 500k, and so on. They should be able to explain these fees clearly.

The next question you would want to ask if the advisor is charging a percentage of the assets they manage: what comes with that X% fee? Is it just managing your portfolio, or are they going to cover other aspects of planning like retirement preparation, taxes, estate planning, real estate, etc.? How often would you be meeting for planning conversations? Hopefully the answers to those questions match the advisor relationship you are looking for.

The main pitfalls to look out for with an AUM or subscription model would be insufficient ongoing care/advice to justify the fee. You are paying the advisor on an ongoing basis, and it should be worth your money. This ARTICLE (https://smartasset.com/financial-advisor/financial-advisor-cost) spells out the average costs for fee-based planning nationwide. The advantage is that you can terminate the relationship at any time you want, and you will only have paid the advisor for services rendered up to the point of termination.

So what do we believe is the best compensation structure for financial advisory clients’ who desire ongoing planning? We really love (and utilize) the fee-based approach. Why? Because we believe they provide incentive for ongoing care, and allow advisors the freedom to pick the investments they believe will help achieve their clients’ goals, free of conflicts of interest.

With an AUM model and with subscription-based planning we believe the advisor is incentivized to consistently provide care for their clients because if they aren’t, then the buck stops there. In both of these formats the clients can terminate the relationship at any time if they feel they aren’t getting the ongoing planning they need.

We see it this way: do clients want themselves to be the boss, or do they want to wonder where they fall on the totem pole of sales production goals, product-based goals, the advisor’s personal financial goals, and other outside pressures because the advisor is paid by everybody but them? Asking your advisor how they get paid is one way that may help you determine if they have any conflicts of interest, and give you some clarity on whether they are the best fit for what you are trying to achieve in an advisor relationship. We encourage clients to be empowered!

This material is provided as a courtesy and is for educational purposes only. Please consult your investment professional, legal or tax advisor for specific information pertaining to your situation.