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.