How does my financial advisor make money?

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A simple guide:

I started my career as a stockbroker (my card said “financial advisor”) at one of the largest Wall Street brokerage firms. I can’t count how many times clients and prospective clients asked me, “How do financial advisors get paid?” It’s a perpetual source of confusion.

At the risk of putting them to sleep, I would at least attempt to explain our 21-page Financial Advisor Compensation Plan. The result? My clients told me they greatly appreciated my attempt to provide transparency in an extremely nontransparent business. My clients trusted me and that was the most important thing to me. However, I also suspected my long-story explanation wasn’t making sense to them and they were always a little skeptical of the firm.

The financial universe has gotten only more complicated since then, so misunderstandings over how brokers get paid persist. Let’s cut through the confusion: There are only three ways that brokers or financial advisors get paid for their advice.

Commissions: When a broker whose working on commission basis recommends a certain fund, annuity or any other investment product, there’s a sales charge that comes right out of your pocket (a sales load, which can run 3-6% of your investment right off the top). Or sometimes the company whose product he or she is recommending pays the broker’s commission as a ‘marketing expense’ for that company. Think of it as a kick-back.

Either way, commissions create a conflict of interest for the advisor. Why? This broker or advisor has a big incentive to recommend the option that pays him/her the most whether or not those investments are really best for you, the client. Incentives are fine but we’re talking about investments, not hamburgers or used cars. Now you can now see why stockbrokers at most of the traditional brokerage firms are criticized for being nothing more than high-paid salespeople.

This is why if you do use a commission-based financial advisor, you’ll want hire one that is legally bound to put your interests first, above their own. This is known as an investment fiduciary.  

Ok so how do I get away from this Wall Street driven sales culture and get a fair deal?

Fee-Only: By far the most touted by the media and talking heads (like me) is the fee-only model. Fee-only registered investment advisors (RIAs) don’t sell products, don’t accept commissions and they operate as fiduciaries.

To hold yourself out as a fee-only advisor, you cannot also sell life insurance, annuities or any other investment for commission. Fee-only advisors work for their clients and ONLY get paid an hourly rate, a fixed annual retainer or a percentage of the investment assets they manage for their clients. The advice they give is independent of the products recommended.

Fee ranges are all over the map, but generally average somewhere between 1-2% of the total value of the investments being managed. Say you have a $500,000 portfolio that you manage with the help of a fee-based (that is, asset-based) adviser charging 1% of your portfolio’s value each year. In that case, you’re paying $5,000 a year for that guidance.

To determine if the service is worth the fee, you need to explore what value you’re receiving in return. If the portfolio is closely mimicking the overall market it may not be worth paying a manager even 1%.

But if this advisor generates stable, reasonable returns regardless of the market gyrations and keeps you from going off the rails whenever there’s market drama, or taking too much risk unknowingly, then a fee of up to 1.5% may be well deserved. If there’s a downside to fee-based management it’s that even when the overall market has a terrible year, your investment advisor still gets paid, so it’s important to hire someone who has expertise in both up and down cycles.

Fee-Based: Fee-based advisors blend the commission-only and fee-only models.  They can sell you an investment and get a commission from that transaction, or they may charge you a fee calculated as a percentage of assets to manage your portfolio, or they may do both.

While the term “fee-based” may sound very similar to “fee-only,” there are key distinctions. The fee-based model can be vulnerable to the same conflicts of interest that the commission structure entails. I know lots of really qualified advisors who are mainly fee-based (the majority of their revenues come from fees), but they can offer you a mutual fund or an investment that normally comes with a commission. For example, an advisor might really believe strongly in a fund family that has a sales commission or ‘load’ built in, but I’ve even seen cases where the advisor will make sure that cost does not come out of your pocket.

Whichever way you compensate your advisor, just make sure you get it down in the form of a simple, clear written statement. I always say, from my days as a broker, the thicker the documentation that explains an advisor’s compensation, the more you’ll pay for that advice.


 

Pam Krueger is the founder of WealthRamp, co-host of MoneyTrack on PBS and national spokesperson for The Institute for the Fiduciary Standard.

7 Comments

  1. FJ says:

    Thank you for the great information that I was looking for many years. Many people, even my close friends and family members, are paying high fee for poor financial advice. They would have better off if they have invested their hard earned money into a low fee index fund.

    I think fee-only advisors are worth consider instead of other two, or learn about finance 101 and invest in dividend growth stocks as I do.

    Best Regards,

  2. Interesting that you do not mention that investors can do their own stock choosing, buying and selling without involving a third party. With all the research and stock management tools available I am having a hard time understanding what financial advisers can do that I can not do myself. I know they would not spend as much time carefully choosing investments and monitoring them. I think it is that most people think investment advisers are some how have access to some kind of magic that consumers don’t – they don’t. Perhaps they want to have someone to blame for their poor decisions.

    • Profile photo of Pam Krueger Pam Krueger says:

      Hi Ian,

      Thanks for making this great point. I couldn’t agree more. The reality is, most people now know they can make and manage their own investments, and there are plenty of free tools that are incredibly useful. A really good, and qualified fiduciary financial advisor will not focus only on investing. He or she will start with the financial planning. This is where the collaboration comes in when you sit down with someone who will take the time to understand your whole financial picture, and then model out cash flow and spending scenarios. This planning should come before any investments. It’s like going to a doctor who instead of taking the time to learn about you, and why you’re there, he goes straight to selling you on prescription drugs. A really good advisor is not going to ‘sell’ you on his magical investing strategies, or his firm’s chosen funds– he will start with the planning process first.

    • jack herrmann says:

      Not everybody has time to invest themselves. That is why FAs were created, they also manage much more then just stocks, they have control over all of your finances and can save you thousands of hours of work.

  3. Richard Cobb says:

    Thank you for sharing. Great content.

  4. Heide says:

    I’ve been thinking about this conundrum for some time. Why is it that investors only have the option of doing it themselves or using an advisor who charges year round fees for periodic advice? Rarely if ever do you see an investment advisor charge you only for the work they do for you. I’m seeking to change this.

    • Profile photo of Pam Krueger Pam Krueger says:

      Hi Heide,

      Many advisors care take their clients’ portfolios by making sure they are properly diversified and in balance. Most are monitoring and making sure details are constantly in check. For example to ensure that withdrawals you’re taking from various retirement accounts are in sync with your goals and not overspending. The relationship includes the get-together meetings that only happen a few times a year or less, but there’s a lot to making sure on the back end that you’re in good shape with taxes, estate plans, etc. Reach out if you want any help in figuring out whether you should work with a planner by the hour, retainer or pay an inclusive assets under management fee. As long as the fee is reasonable, transaction costs are kept to a minimum, I have no problem paying someone to manage my portfolio. I also take full advantage of the education a really good advisor will provide. Thanks for your good comments! Cheers, Pam

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