Q: I’m thinking about consulting a fee-based financial planner but am not familiar with how that works. Are fees typically based on the amount of assets I have to invest? Or do some advisors have other forms of compensation that might be preferable? I’m curious how financial advisors get paid.
A: Financial advisors get paid in a variety of ways, and you should always ask upfront, early in your initial conversation, how he or she is compensated. It’s a fair question that you shouldn’t be embarrassed to ask.
Ways financial advisors get paid
There are three main ways that financial advisors get compensated.
1. Commission based
As the name implies, in this scenario, advisors get paid a commission when they recommend and sell certain financial products to their clients.
That’s the traditional way that stockbrokers and insurance agents are typically compensated. When you buy a mutual fund, stock, bond, insurance policy, annuity – whatever product they’re selling – they earn a commission from you.
The concern with commissions is that they can create conflicts of interest. Is the agent or advisor recommending the product to you because it’s in your interest or because it’s good for him or her? You can’t be sure of the answer – and that’s a problem.
2. Salaried advisors
Just like in many other professions, some firms pay their advisors a salary. And though they don’t get any compensation from fees or commissions, these advisors could have an incentive structure that allows them to earn bonuses if they hit certain milestones, like meeting their quotes for onboarding new clients.
3. Client fees
In this scenario, the financial advisor earns fees based upon how much money they are managing for their client. For example, if they are managing $500,000 worth of investments with a 1% management fee, they would earn $5,000 for the year, though the fees are often paid quarterly.
In some cases, the management fee will vary depending on how much money is under management – the more money, the lower the percentage – while in others, the advisor’s fee schedule may allow them to earn extra “performance fees” should they hit certain benchmarks for returns.
Financial advisors can also charge hourly or flat fees for their work.
Fee-based or fee-only?
Because there are a wide variety of ways that financial advisors can get paid via fees, it’s important to know the difference between a fee-based and fee-only compensation model.
A fee-based advisor can earn revenue both from client fees and from commissions. This means they can charge you fees directly related to managing your money – percentage, hourly or flat – as well as earn commissions on the side for financial products they sell you.
A fee-only advisor, by contrast, only receives compensation from the fees they charge you for managing your money. They don’t get paid from commissions.
This is the approach we take at Edelman Financial Engines.
Our financial planners are fee-only advisors, and the fee is based on the value of your account. We chose this method many years ago for several reasons, the most important of which is that it places us on the same team: If your account drops in value, your advisor earns less, and if it rises in value, they earn more.
That’s sometimes not the case when working with fee-based advisors. For example, the cost of an advisor who works on an hourly rate could increase throughout the year, even if your assets under management drop in value.
It’s also important to understand that the way an advisor is compensated has nothing to do with whether or not they are a fiduciary.
What is a fiduciary?
A fiduciary is an individual who acts in the best interest of a particular person or beneficiary. In the world of financial services, that means fiduciary advisors must only buy and sell investments that are the best fit for their clients.
And every advisor at Edelman Financial Engines is a fiduciary.
How to ask the compensation question
Ultimately, it’s up to you to choose the best financial advisor for you. But here’s an important caveat: When you ask how the financial advisor gets paid, be sure to ask the question correctly. Do not ask, “What’s your fee?” If you do, he or she might reply, “Well, my fee is 1% of the assets under management.”
The problem: That’s an incomplete answer. The advisor might leave out the fact that the mutual fund being recommended charges an additional fee – meaning your total cost may be more than 1%.
That’s why you should instead ask, “If I hire you, how much will I pay all in?” Or “What will be my total cost for all expenses – your fee plus the cost of the products you recommend?”
With the appropriate wealth management, the total value of the advice you receive – from the convenience of not having to do all the work yourself to the ongoing access to comprehensive financial planning – should certainly make the fee worthwhile.
It’s also vital to ask what the total services are that you will receive. It’s not enough for an advisor to help you with your investments. Ideally, your advisor should provide you with comprehensive wealth management services – help with employee benefits, insurance and tax planning, mortgages, estate planning, investment advice and portfolio diversification, college planning, elder issues and much more.
That’s what we provide for our clients here at Edelman Financial Engines.
So shop around – and be sure to get complete compensation information from anyone you interview and find out whether their goals are aligned with yours. We’re always happy to provide a no-cost, no-obligation consultation to help pair you with the right financial planner for all your wealth management goals.