Financial advisors have many different ways they can be paid for their work. Many clients give little thought to how their advisor is compensated and, the truth is, the differences in these compensation structures can dramatically affect your experience as a client. These differences can also affect the quality and type of advice you receive from an advisor. In this post, I’ll break down the ways in which advisors are paid and what this means for you as a client. 

Commissions

What is it?

Commissions are dollars paid by a company to a salesperson as compensation for a sale. In financial services, insurance agents and stock brokers receive commissions. For example, a life or disability insurance agent might receive a commission from the insurance company after a client purchases a policy from them. The amount of the commission is usually based on how much coverage you purchased with a higher commission being received for greater amounts of coverage purchased by you. 

Why does this matter?

Because commissions are based on the size of a sale, advisors compensated under a commission-based model have an incentive to sell you “more” regardless of your need for it. The companies that they represent might have minimum sales goals that their salespeople must meet in order to maintain certain benefits. For example, some firms tie their advisors’ eligibility for health insurance and retirement benefits to minimum sales goals each year. 

Going one step further, advisors under a commission-based model can often represent more than one company at a time. For example, a stock broker might offer two different brands of mutual funds which each pay very different commissions to the advisor for recommending their funds to a client. If mutual fund company “A” is offering brokers a 5% commission while mutual fund company “B” is offering only a 3% commission, the stock broker has a natural incentive to recommend mutual fund “A” over mutual fund “B”.

What should you do about it?

This is my least favorite fee model and I recommend avoiding advisors who are paid commissions when seeking financial advice. Should you need to purchase insurance, you will need to engage with an advisor who receives commissions. However, if you are unsure about how much coverage to purchase or if the type of coverage being recommended is in your best interest, I suggest seeking guidance from a fee-only advisor. At a minimum, you need to keep in mind that the advisor, agent, or broker under this compensation structure does not work for you and is not being paid by you, they work for and are being paid by the company they represent in the transaction. The product recommendations they make might be influenced by which company is paying the highest commission rather than which product is best for you. Finally, I’ll give you an easy way to tell if your advisor has the ability to receive commissions - ask your advisor if they have a life or health insurance license, or a series 6 or 7 FINRA license. If they say “yes” to any of these, then they are able to receive commissions. Better yet, go to this website and type in the advisor's name to see if they are currently registered as a broker. 

AUM fees

What is it?

AUM stands for Assets Under Management. AUM fees are fees paid for portfolio management by a client to an advisor. These are generally expressed as a percentage of your portfolio. For example, an advisor might charge a 1% fee to manage your retirement or brokerage account. So, the more money an advisor manages for you, the higher their fee will be in absolute dollars. Since the advisor is compensated by the AUM fees that their client pays, the agency conflict that exists with a commission-based advisor does not exist with an AUM-based advisor. 

Why does this matter?

In contrast with the commission-based model, AUM-based advisors are paid by the fees their clients pay to them. This better aligns the relationship you have with your advisor since the fees you pay are going directly towards your advisor's paycheck. However, this model isn’t devoid of conflicts. Since this advisor’s fee, in dollars, is based on the absolute size of your portfolio, they have an incentive to grow and retain portfolio assets. For example, they might suggest that you borrow money for a large purchase vs. paying cash. While this might be the best option for you, it also could be their recommendation because it maximizes their compensation by way of retaining a larger asset base under their management. 

What should you do about it?

There is a growing “anti - AUM fee” movement in the financial advice industry. Financial influencers and authors, such as best selling author Ramit Sethi, have brought to the forefront just how much these fees can add up over your lifetime. While I do not subscribe to the “no AUM fee, ever” mindset, I do think consumers need to understand how much they are paying, what they are getting for that fee, and how that compares to other options. If you are just looking for asset management without any other financial planning or advice, I would suggest looking beyond your local advisor or national, legacy brand. While many national brands and local advisors charge 1% or more in annual fees, online advisors such as Vanguard, Betterment, and Wealthfront provide similar strategies at a fraction of 1%. Most importantly, I suggest consumers exploring this fee model take their time, explore multiple options, and always make the advisor tell you, in dollars, what your fee will be each year. If you are curious to see how much your advisor’s AUM fees are costing you in the long run, you can find a calculator here.

Project-based or Fee-for-Service

What is it?

Project-based fees are most often seen in the way of financial planning fees. This is a one time fee that you pay a financial advisor to provide you with some type of analysis, guidance, or advice. For example, you might be thinking about retiring in 10 years, but wondering if you are on track for that timeline. You might consult with an advisor who charges you a one time fee to perform an analysis of your current financial situation and then map out a plan to help you achieve your retirement goal. Or, you may be wondering how much life insurance you need to protect your family’s financial wellbeing should you die prematurely. This type of advisor would be able to assist with an analysis and suggest an amount of coverage. These advisors may or may not offer assistance with investment management. 

Why does this matter?

In contrast to the previously mentioned fee models, the fee for service model is fixed and transparent. You will often pay this type of advisor on either an hourly or project basis and will know at the outset of your work with them what it will cost you. And, as it also is with AUM fees, since you are paying the advisor directly, you should expect that they will be working in your best interest. 

What should you do about it?

Because fee-for-service models, like project-based, are not as profitable for the financial services industry as the commission and AUM fee models, this pricing structure is not as widely adopted within the financial services industry. This fee model is best suited for consumers who are looking for a one time financial plan, a specific piece of advice on a specific financial topic, or an ongoing relationship with price transparency.  

Fee Only

What is it?

“Fee Only” is meant to describe any relationship in which the advisor is only paid by the client-paid fees, not commissions. An advisor holding themselves out as Fee Only might be AUM only, Fee-for-Service/Project-based, or a combination of both. 

Why does this matter?

The goal of the Fee Only model is to eliminate the agency issue that exists with the receipt of commissions. Since, under the Fee Only model, the advisor is only paid by the client, there is a purported reduction in conflicts of interest. 

What should you do about it?

Fee Only advisors are gaining traction as the preferred choice amongst educated consumers. Because of the reduction in conflicts of interest made possible by the elimination of commissions, consumers place more trust in the advice given by advisors operating under this fee model. It is worth noting that these advisors may still charge AUM-based fees and you should therefore refer back to my recommendations above on hiring an AUM fee based advisor. 

Flat Fee

What is it?

Flat fee can also be described as complexity-based pricing, and is an evolution of the Fee Only model. It is a newer fee model that is quickly gaining traction with clients due to its high level of price transparency and its ability to better tie the price you pay to the value that you receive from an advisor. In this fee model, the advisor sets a fixed price, in dollars, for providing a set of services to a client on an ongoing basis. For example, a client might want an advisor to provide them with ongoing, comprehensive financial planning for both their personal and business finances as well as investment management services on their entire portfolio. After meeting with the client and discussing their needs, the advisor would provide them with a fixed, annual fee, in dollars, to provide all of the desired services. Full disclosure, Blackwater Financial is a flat fee firm.

Why does this matter?

A flat fee model eliminates many of the conflicts of interest described above with other models. This model can fit many different types of financial advice engagements, but is best suited for consumers looking for a comprehensive relationship and ongoing advice. Clients who engage with this type of advisor often place a high value on price transparency and a long term, holistic relationship with their advisor. 

What should you do about it?

This type of advisor fee model still makes up a small percentage of financial advisors’ offerings. Consumers who value price transparency and want to ensure that an advisor will always be working in their best interest should explore a flat fee advisor. 

Which is right for you?

In my opinion, your primary advisor should be project/fee for service-based or flat fee. Although no model is entirely conflict free, these two options minimize conflicts of interest significantly more than other fee models. While it might make sense for you to have stock brokers, insurance agents, and asset managers on your advisory team, you likely won’t want them to be the financial professional who is driving your financial plan. The conflicts of interest inherent to their respective compensation models means that the advice you receive could be heavily influenced by their own financial incentives. If you are interested in learning more about our fee structure at Blackwater Financial, you can check out our pricing page here. And, if you are not sure how your current advisor is paid for their services and would like a straightforward, no obligation explanation, you can schedule a free assessment with me here.