Do you know how your financial advisor gets paid?
Financial advisors can get paid by:
· commissions
· a percentage of assets under management
· a percentage of assets under advisement
· a percentage of your income
· a percentage of your net worth
· a flat monthly fee, or an hourly fee …
or any combination of these.
Why should you care?
The reason you should care is a concept called “conflict of interest”. A conflict of interest arises whenever there is an incentive for your advisor to put their own interests ahead of yours. These incentives can take the form of commissions, trips, extra office space, access to expensive technology or just recognition as the top earner in the office. All of these things could tempt your advisor to put their own interests ahead of yours.
Commissions are a pretty easy example of a conflict of interest. If your advisor sells insurance or annuities they might be tempted to sell the one that has the highest commission and not the one that is best for you.
What about more subtle conflicts? The dominant business model for financial advisors today is commonly referred to as assets under management or AUM. This usually means that the advisor gets paid a percentage of the assets that you give them to manage. These fees can range from less than one quarter of one percent (0.25%) to as much as three percent (3.0%). The most common charge for accounts of less than $1 million is 1%.
Since the fee is paid by the investor, you would think that interests are aligned. Some firms even advertise that the AUM model means that “we do better when you do better”. This may be true but in the AUM model it is difficult to charge clients for advice on assets other than stocks, bonds, ETFs and mutual funds. Real estate, private business investments and other alternatives do not easily fit into the model. In fact, if your advisor charges 1% to manage $1million for you do you think they will be unbiased when you ask them about a real estate investment that requires $200,000 of the assets they manage? If it reduces the amount they get paid, they may be reluctant to endorse the transaction, even though it might be the best thing for you. It is also difficult to understand why you should pay twice as much, for example, for an account with $1million in it compared to an account that has $500,000. Do you think your advisor is doing twice as much work for the $1million dollar account?
Recently, advisors have tried to come up with other ways to charge that would eliminate the inherent AUM conflict. Arrangements based on a percentage of the client's net worth or income would seem to eliminate the bias against alternative investments. My own opinion is that people are looking for simpler ways to pay for advice, not more complex.
What about advisors who charge a flat monthly fee or an hourly fee?
These compensation methods seem to provide a business model with the least conflict. Currently less than 10% of financial advisors offer this type of arrangement. Advisors who choose this business model report that they find it liberating. Clients can invest in anything that makes sense and the advisor can help. Without feeling like they are hurting their own bottom line. A curious side effect of this model is that flat fee advisors can run into client retention problems because of something called “fee salience”.
This simply means that clients are more aware of fees that are expressed in a dollar amount rather than as a percentage. If I charge you $400 per month, you immediately compare that to a car payment or a mortgage payment. If I charge you 1% of the assets I manage for you, your brain does not automatically turn that into a dollar amount. You are less likely to question the value of that transaction, even if it is actually twice as much in dollars.
It may be impossible to avoid all conflicts of interest but there are some rules of thumb that will help you minimize them:
Never let anyone else pay your advisor for your financial advice. If an insurance company pays your advisor to sell you an insurance policy, they may be unduly influenced to sell more policies.
Look for a fee-only fiduciary advisor. Fee only means they get paid only by you. Fiduciary means they have a legal obligation to put your interests ahead of their own.
Look for advisors that charge a flat monthly fee or an hourly rate. The flat fee advisor can give you their best advice and doesn’t care where your assets are invested as long as it makes sense for you.
The Bottom Line
Understanding how your advisor gets paid is the first step to ensuring that you get the value you want, and the advice that is best for you.
