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Q&A: How Are Financial Advisors Compensated?

Asset-based compensation is the only type that aligns with your interests.

By: Ric Edelman

Question: I’m thinking of 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?

Ric: Advisors are compensated in a variety of ways, and you should always ask up front, early in your initial conversation — while you’re interviewing them — how he or she is compensated. It’s a fair question that you shouldn’t be embarrassed to ask.

Some advisors charge a commission. That’s the old-school, traditional way that stockbrokers and insurance agents typically are 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 recommending the product to you because it’s good for you or because it’s good for him or her? You can’t be sure of the answer — and that’s a problem. There should never be any doubt.

Consider this: When your doctor prescribes medicine for you, do you wonder if he or she is suffering from a conflict of interest? No, because you know the doc is not earning a commission. You should have such confidence when taking advice from your advisor.

The alternative compensation approach is a fee that’s separate and independent from the transaction.

Be aware that advisors can charge fees in different ways. Some advisors charge hourly — like plumbers do. Some charge a flat fee — say $5,000 or $10,000 — similar to an attorney’s retainer. Likewise, an accountant might charge a flat fee to prepare your tax return, while other CPAs charge a certain amount for each form, and still others charge hourly. These are just some of the variations.

Perhaps the most common method for advisors is the asset-based fee. That is how we do it in the Edelman Managed Asset Program®. It simply means the fee is based on the value of your account. We chose this method many years ago for several reasons.

Most important, it aligns our interests with yours: We both benefit when your account rises in value. If your account goes down in value, I earn less, so I have an economic incentive for your account to grow. We have aligned interests. Isn’t that exactly what you want?

That’s not the case when working with advisors who charge a flat fee or an hourly fee. As far as they’re concerned, they’ve been paid for giving you advice, and that’s the end of it. They don’t really care whether you follow through on their recommendations. But as advisors whose fee is tied to the size of your account, we want to see you implement our advice. That gives us incentive to help your portfolio grow.

So it’s your choice. But here’s an important caveat: When you ask an advisor how he or she is compensated, 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 another 1.3% (the industry average) — meaning your total cost is really 2.3%.

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?”

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 complete financial planning services — help with employee benefits, insurance, taxes, mortgages, credit and debt, estate planning, college planning, elder issues, and much more.

With the appropriate financial planning, 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 advice — should dwarf the fee.

So shop around — and be sure to get complete information from anyone you interview.

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