Most people know that financial advisors have to get paid somehow, but few can tell you exactly how—and even fewer know how they’re paying their own financial advisor. Financial advisors commonly use 1 of 4 compensation models to get paid: commission, fee-based, fee-only, and salary plus bonuses. If you’re already working with a financial advisor or even if you’re just considering working with one for the first time, be sure you understand how the advisor is paid. It’s important to note that, with the new Department of Labor rules on fiduciaries, advisor business models and how advisors get paid are in flux and are almost certain to change.
Salary and Bonuses
This cost model is the easiest to understand for most people, because it’s self-explanatory. The advisor is paid a salary and receives bonuses, often for reaching certain goals, like client retention or a sales target.
A financial advisor who is paid on commission is being paid by the products he or she sells. These payments can be generated by stock and bond transactions, mutual funds, and other products and transactions. Many mutual funds, for example, pay “trails” to the advisor for providing advice and service to an investor on an ongoing basis. For equity mutual funds, a typical trail is around .25% of the amount invested. That trail is considered part of the account’s management expense ratio (MER). Mutual funds returns are posted net of expenses, so your stated return is always less than the fund’s actual performance. High expense ratios for your mutual funds mean that you’re not earning as much of a return as you could be. MER costs aren’t detailed on regular client statements so if you want to know who is making what from your account, you have to ask or do some research on the internet.
Fees, unlike commissions, are paid directly to the advisor by the client to an advisor who serves as a fiduciary and, as such, must serve the best interests of the client above all. This is considered the highest standard of conduct in the industry. All registered investment advisors (RIAs), for example, are fee-only and serve as fiduciaries for their clients. Fee-only financial advisors may also choose to bill clients by the hour for advice or a flat fee per project, but billing as a percentage of assets under management is the most common method. For example, you might agree to pay your advisor monthly or quarterly, and the fee would be equivalent to 1% of your account. Of course, that means your fees will go up as your account increases in value.
Some advisors advertise that they are “fee-only,” which many people mistakenly believe means “fee for service.” However, in the financial world, “fee-only” actually means that the advisor makes all of his or her income from fees. This type of advisor does not collect commissions, but can opt to charge “fee for service” which is an hourly rate model much like a lawyer or to use the percentage-of-assets model to determine fees.
What’s the difference between a fee-based advisor and a fee-only advisor? It’s not in the method they use to calculate their bills. Both of them can use a fee-for-service model or use a percentage of assets to determine what they charge. One difference is that while a fee-only advisor makes all of his or her income from fees, a fee-based advisor can collect commissions in addition to fees. The term “fee-based” simply means that most, but not all, of the advisor’s income is generated from fees. Keep in mind that a commission-based advisor can also charge fees, but most of their income will come from up front commissions and product trails.
Which Method Is Best?
From a client’s perspective, a fee-only advisor is usually the best bet. This advisor has no economic incentive to sell you products that don’t meet your needs, unlike advisors that are collecting commissions or trails. By generating all of their income from fees, fee-only advisors maintain their independence, which means they can focus on serving your best interests.