How Is My Financial Advisor Compensated?

Sometime before the new year Dan Hite of Tedco software had asked me to explain the differences in financial advisor compensation. I asked if he was trying to tell me my fees were too high, but it turns out that wasn’t what he meant at all. Turns out that my friend Dan, like 98% of people, was trying to understand how advisors get paid. The basic thing you need to know is that the client pays the advisor; the question is: how convoluted a path does the money take getting from the client to the advisor.

Why is this even important? It is important because an advisor’s compensation plan tells you how your advisor is incented, and if they may have a monetary incentive to make certain recommendations above others. If the person advising you has incentives to make recommendations that are not in your best interest you should know that going in.

So how does your advisor (or the company that pays your advisor) get paid? For almost all companies the answer is either commissions, fees, or some hybrid of the two.

If a company receives its compensation by charging you a transaction fee for buying or selling an investment, or it is paid by a third party provider of investment products when you buy those products (typically mutual funds and insurance products like annuities) through them they work on commission. Even though the practice has become less popular in recent years it is still the most common method for paying your advisor. That a conflict of interest exists is clear: the advisor only gets paid if you buy (or sell) an investment. These investments can have large costs attached that can be hard to find, though a good advisor will make a point of disclosing the costs involved. Insurance-based financial products have been particularly guilty. These products are often complex with many moving parts. It becomes difficult to clearly see the costs involved. If you combine that with high payouts to advisors you can see why these products are popular among advisors (I have seen commissions in the eight percent range). The value of recommendations in this environment is highly dependent on the integrity and skill of your advisor and the culture of the firm they work for. Unfortunately, this compensation model tends to reward sales skill much more than technical ability. There are some great advisors out there who work on commission, but that is in spite of their business model, not because of it.

If you pay a fee for services (like money management and financial planning) and commission investments, your advisor is Fee Based. The term Fee Based has become more popular. The most common approach is to charge the client a fee for preparing a plan or model portfolio, then collect commissions for executing the recommendation. A variation of this model is called Fee Offset, but it is still the same basic model. There are some good advisors who only use commission products when they cannot find a non-commission alternative. Sadly there are others that will charge for a plan, and then recommend and sell heavy commission products; essentially they “double charge” for the work. This can be the most difficult model for the consumer to understand how the advisor is incented, though advisors like to refer to it as “more flexible”.

The smallest group are the Fee Only advisors. Fee only advisors (and firms) have only one source of revenue, a fee paid by the client for advice or ongoing management. This fee is not connected to the purchase of investment products, nor is the firm compensated by any third party. This model removes the incentive to recommend one product or investment over another. However, it cannot remove all conflicts as the incentive to persuade the client to use the advisor still remains. Still, this model can be argued to be the “cleanest” approach to providing financial advice. There are relatively few fee only advisors in the United States (or elsewhere) but the numbers are growing. The growth in this model has been largely consumer-driven as the total compensation tends to be lower than in other models, and in some cases the liability higher.

Whichever advisor you choose the most important part is that you have a high level of confidence in the integrity and ability of the advisor. If you want a third party opinion look for advisors with a CFP designation for planners  for investment managers you can also look for the CFA . If a fee only advisor sounds like the way to go you can find them at NAPFA , the largest organization of Fee Only planners.

About the author

Jim Heitman, CFP®

9 Comments

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  • Jim,

    I have a Roth with Morgan Stanley, and talk directly with my advisor who sets up contributions into mutual funds. We dont seem to talk about specific mutual funds, but it seems he spreads things out evenly amongst several mutual fund families. How does he/Morgan Stanley make money off me? I dont see fees or a cost breakdown on annual statements….

    Thanks,

    Allan

  • Jim, what paramaters do you use to ascertain what charges a client will receive? What are the ranges in terms of cost? I have met with several financial advisors and each one has their own finacial products they offer and no one has the same ones. Talk about a convoluted field. If you can respond to my email it would be better as I forgot about this email and stumbled on it again. Thanks

  • Ralph,
    The list of fee-only advisors in Rancho is, I’m afraid, rather short. I’m the only one I am aware of. However, if you expand your search parameters a bit you will find others as you move into LA and Orange county. Try the NAPFA website (www.napfa.org) and search by zip code, or the CFP board website (http://www.letsmakeaplan.org/choose-a-cfp-professional/choosing-a-financial-planner.aspx) and use the advanced search option, selecting FEE-ONLY advisors.

    You will see my name on both lists, and I would be pleased to help you. It seemed very self serving to just say “I’m the only one”, but if you are in Rancho I am the closest fee-only advisor I am aware of.

    Best of luck

    Jim

  • Do you have a list of fee only advisors for rancho cucamonga, CA. We need a “master plan” to start with for future planning and having choice of a financial manager not involved with the master plan is essential to us. My wife retires in the beginning of July 2012. I am retired with a gov’t pension. Thanks

  • Hi Rick,
    I wish there was an easy answer. It really varies from region to region and depends largely on what the market will bear. For managed assets it wanders around 1% (higher for more modest accounts). Financial planning fees are dependent on the complexity of the case, but $1,000 is low end, and can be much higher. Affluent urban areas will be higher. Check out NAPFA.org to find advisors in your area and give them a call.

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