Enlisting the help of a financial advisor can improve the beginning of your financial journey. Having a trusted advisor in your corner can also be helpful at other times, particularly when making pivotal financial decisions that may involve various requirements with which you are unfamiliar. However, there are many different types of financial advisors with different compensation structures. The compensation structure determines not only how much you will pay for services but can also give rise to conflicts of interest and biased advice. Unfortunately, compensation structures are not always clear or in your best financial interest.
A financial advisor may also be called a wealth manager, investment advisor, financial planner, or similar descriptor. I use “financial advisor” in a generic sense to include all of these terms.
Commission-based compensation
A commission-based structure means the financial advisor is paid through commissions on product sales—for example, specific mutual funds, insurance policies, or annuities—and trading fees. A commission-based advisor is essentially a salesperson. They are motivated to promote products on which they will earn greater fees, often encourage frequent trading (which generates even more fees!), and have no duty to put your interests first. Because they earn money from selling you on a certain investment rather than on your accumulation of wealth, their interests are not necessarily aligned with your own.
Fee-only compensation
Fee-only advisors receive their compensation directly from their clients, rather than as commissions for products sold. This promotes transparency and reduces conflicts of interest. Unlike commission-based advisors, fee-only advisors are typically fiduciaries, meaning they are obligated to put your interests first. As a result, their interests generally align more closely with yours. Fee-only advisors fall into two sub-categories: assets under management (AUM) and flat-fee.
Assets Under Management (AUM)
Most financial firms use the AUM approach for at least some of their fees. Under an AUM structure, the client pays their advisor a specific percentage of the total size of their portfolio. One percent (1%) is fairly standard.
Sometimes tiered rates are available with discounted rates at higher levels. An example would be 1% for the first $1 million, 0.75% for the next $1 million, and so forth.
An AUM approach is straightforward, but your costs increase as your portfolio grows. Financial advisors take a percentage of their clients’ wealth, meaning wealth accumulation is good for the advisor, but this hinders the benefits of compound interest from taking full effect for the investor. The fees are typically deducted directly from the client account, rather than requiring a separate payment, so folks often have no idea how much they are actually paying unless they meticulously review their periodic statements. A small percentage may feel trivial, but paying $10k on a $1 million portfolio and subsequently losing the growth on that $10k for years to come adds up quickly over time.
Advisors often tout their ability to “beat the market” by more than the amount of their AUM rate to justify the fee, but there is scant evidence of this being a long-term reality. Beating the market is often more luck than talent. While someone with advanced skills in reading financial statements and distilling current events has a competitive advantage, it may not justify an AUM fee in the long run. Most folks will do just as well on their own investing in index mutual funds or ETFs rather than paying an AUM financial advisor to manage their investments.
However, if an AUM advisor offers other included services as part of their fee that you would otherwise actually pay for independently, paying the fee may be beneficial.
Flat-fee
A flat-fee model is a set cost for a particular service (or set of services) regardless of portfolio size. This is the most transparent compensation structure. As a result, it has become increasingly popular in recent years, evidenced by groups such as the Flat Fee Advisors network.
Flat-fee advisors typically start with comprehensive financial planning and offer ongoing advice, monitoring, and/or investment management; the ongoing service might be included in an annual service fee or offered as a separate add-on option. Fees are expressed as one-time project costs ($3,000 for a comprehensive financial plan), ongoing ($7,500 per year for financial planning and investment management including quarterly meetings), and/or hourly ($225 per hour as needed/desired). This allows investors to pay for only services they require and maintain a better awareness of how much they are paying their financial advisor.
Folks with the time and inclination to manage their own investments, but who still want to have a professional in their corner to help them allocate their investments and assist in other areas (such as estate planning, tax planning, or education funding), will find success with advice-only advisors. These advisors generally charge an hourly or project rate and can work with investors only when they have a specific need, thus preventing unnecessary ongoing fees.
Fee-based compensation
You might also come across a fee-based financial advisor. Because this sounds strikingly similar to fee-only, folks often conflate the two. Do not fall into that trap. A fee-based advisor is one who receives commissions based on products they sell and fees for services provided. This might even be both at the same time, such as charging a fee for financial advice where they recommend a commission-based product!
Other costs
Be aware that the costs discussed above only relate to your cost of procuring financial advice. They do not include costs associated with any investments themselves. You might have load fees, 12b-1 fees, account maintenance fees, and other costs. All these should be considered when choosing specific investments, but they are separate from choosing an advisor. There are myriad no-cost or low-cost investment options available, though, so be wary of anyone who consistently recommends investments with high transaction costs.
Vibes
Once you know what sort of financial advisor is appropriate for your situation and verify that they are indeed qualified to offer you the assistance you seek, you should absolutely hire based on vibes. Having someone on your team who understands you and is accessible, easy to work with, helps you feel comfortable, and empowers you is the best way to meet your goals.
At Phippen Tax & Financial Services, we offer advice-only financial planning in a fiduciary capacity. We believe that most often the best bet is to invest broadly in the market and self-manage your investments. This means we do not offer ongoing financial management (or the fees associated with it). Our approach is to help you set up your investments so you can manage them on your own as part of a comprehensive strategy, and we do not believe you should pay more based on the balance in your account. If you need or prefer investment management services or another approach, we are happy to offer an appropriate referral!
Comments