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How does my financial advisor make money?

How does my financial advisor make money?

August 24, 2015

A simple guide:    

I started my career as a stockbroker (my card said “financial advisor”) at one of the largest Wall Street brokerage firms. I can’t count how many times clients and prospective clients asked me, “How do financial advisors get paid?” It’s a perpetual source of confusion.

At the risk of putting them to sleep, I would at least attempt to explain our 21-page Financial Advisor Compensation Plan. The result? My clients told me they greatly appreciated my attempt to provide transparency in an extremely nontransparent business. My clients trusted me and that was the most important thing to me. However, I also suspected my long-story explanation wasn’t making sense to them and they were always a little skeptical of the firm.

The financial universe has gotten only more complicated since then, so misunderstandings over how brokers get paid persist. Let’s cut through the confusion: There are only three ways that brokers or financial advisors get paid for their advice.

Commissions: When a broker whose working on commission basis recommends a certain fund, annuity or any other investment product, there’s a sales charge that comes right out of your pocket (a sales load, which can run 3-6% of your investment right off the top). Or sometimes the company whose product he or she is recommending pays the broker’s commission as a ‘marketing expense’ for that company. Think of it as a kick-back.

Either way, commissions create a conflict of interest for the advisor. Why? This broker or advisor has a big incentive to recommend the option that pays him/her the most whether or not those investments are really best for you, the client. Incentives are fine but we’re talking about investments, not hamburgers or used cars. Now you can now see why stockbrokers at most of the traditional brokerage firms are criticized for being nothing more than high-paid salespeople.  

This is why if you do use a commission-based financial advisor, you’ll want hire one that is legally bound to put your interests first, above their own. This is known as an investment fiduciary.  

Ok so how do I get away from this Wall Street driven sales culture and get a fair deal?

Fee-Only: By far the most touted by the media and talking heads (like me) is the fee-only model. Fee-only registered investment advisors (RIAs) don’t sell products, don’t accept commissions and they operate as fiduciaries.

To hold yourself out as a fee-only advisor, you cannot also sell life insurance, annuities or any other investment for commission. Fee-only advisors work for their clients and ONLY get paid an hourly rate, a fixed annual retainer or a percentage of the investment assets they manage for their clients. The advice they give is independent of the products recommended.

Fee ranges are all over the map, but generally average somewhere between 1-2% of the total value of the investments being managed. Say you have a $500,000 portfolio that you manage with the help of a fee-based (that is, asset-based) adviser charging 1% of your portfolio’s value each year. In that case, you’re paying $5,000 a year for that guidance.

To determine if the service is worth the fee, you need to explore what value you’re receiving in return. If the portfolio is closely mimicking the overall market it’s may not be worth paying a manager even 1%.

But if this advisor generates stable, reasonable returns regardless of the market gyrations and keeps you from going off the rails whenever there’s market drama, or taking too much risk unknowingly, then a fee of up to 1.5% may be well deserved. If there’s a downside to fee-based management it’s that even when the overall market has a terrible year, your investment advisor still gets paid, so it’s important to hire someone who has expertise in both up and down cycles.

Fee-Based: Fee-based advisors blend the commission-only and fee-only models.  They can sell you an investment and get a commission from that transaction, or they may charge you a fee calculated as a percentage of assets to manage your portfolio, or they may do both.

While the term “fee-based” may sound very similar to “fee-only,” there are key distinctions. The fee-based model can be vulnerable to the same conflicts of interest that the commission structure entails. I know lots of really qualified advisors who are mainly fee-based (the majority of their revenues come from fees), but they can offer you a mutual fund or an investment that normally comes with a commission. For example, an advisor might really believe strongly in a fund family that has a sales commission or ‘load’ built in, but I’ve even seen cases where the advisor will make sure that cost does not come out of your pocket.

Whichever way you compensate your advisor, just make sure you get it down in the form of a simple, clear written statement. I always say, from my days as a broker, the thicker the documentation that explains an advisor’s compensation, the more you’ll pay for that advice.

 

 

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That whole fee based and fee only thing seems like semantics to me although I did once run across a fee only advisor who couldn't sell me a fund I wanted because it had commission. Didn't fully understand the deal but it sounded strange so I left.

Profile picture for user Pam Krueger

K.G., Your's is a perfect example of why advisors must be able to tell you in simple, straightforward language how you are paying them, and how much. If you are not their main source of income-- who is? Their firm is paying them to sell their investments and strategies. Your financail advisor should work only and directly for you. That means, he or she becomes your advocate to keep the fees and expenses as low as possible. Advisors must be full fiduciaries which means full transparency. Let's say you do want to invest in a mutual fund that does have a 'load' or commission built in. Many or even most of the independent advisors here on my platform will not accept that commission or kick-back from a fund that you may want to buy because their 'advice' fees come from you only. A true fiduciary advisor will talk to you about his fee right upfront and make sure you're comfortable. There's a reasonable guideline for these fees and I don't like to see fees that amount to more than 1-1.5% of the total amount you ask the advisor to manage. If you have a $500k portfolio that's $5,000/yr in advice fees. It's likely your advisor is going to do some heavy lifting at the start of the relationship including cash flow analysis and budgeting along with managing your investments, then it may make sense to pay more than 1% knowing that fee will be less next year because you probably won't need as much planning.

Advisors at brokerage firms are sales people, not financial planners. Real advisors bother to take the time to become fiduciaries and take the necessary courses to become planners and money managers. (Sigh) Why can't brokers just be.... brokers. Let them sell all day long. But let real financial advisors be the one's who offer real advice.

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