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Q&A: Why Pay on a Fee Schedule?

It aligns our interest with our client's interest.

Q: If you called a plumber to come fix a leak at your house and he couldn’t fix it, would you pay him? I think you know the answer. So why can’t a financial advisor work the same way? In other words, if you make money for me, I pay you a percentage or a fee, but if you lose my money, why would I want to pay you? You didn’t fix the leak.

Ric: Actually, you do pay the plumber even when he fails. His visit to your home isn’t free. There’s a minimum service charge at least. You might even pay him twice. Maybe you paid him $100 to fix the leak, but later the leak returns and you call the plumber back. You could be charged again.

Obviously, no one wants to pay for incompetence, yet that happens in many instances. Consider the attorney who charges $100 per hour vs. another who charges $500 per hour. Who is cheaper? I’m willing to bet it’s the one with the higher rate.

Having greater knowledge and experience, he or she might solve your issue faster than the one who is fresh out of law school. The latter might take much longer and not do as thorough a job, and you end up paying more in the end. You’ve just paid for incompetence.

Also, think about this: Are doctors paid only if their patients survive? Are professional ballplayers paid only when they win?

In the financial field, I’m sure you’ve noticed that when you buy a stock, bond, mutual fund, annuity or other product, the person who sells it to you makes money — usually a fat commission — even if you don’t. It doesn’t seem fair, does it?

Thus your question: Why don’t financial advisors have fee schedules where you pay only if your account earns money?

There’s one simple reason: It’s illegal. The SEC prohibits it. Why? For the answer, imagine this scenario:

You’re the advisor. You have expenses to meet — staff salaries, office rent, computers, telephones, etc. You must earn some revenue to stay afloat. If a client’s account goes up 12%, perhaps you earn 20% of that, which is 2.4%. But your fee schedule also says you earn nothing if the account falls in value.

And let’s say it’s 2008. Your accounts are all losing money — meaning you’re not earning any income due to your fee schedule. So you say to yourself, “The year’s about over, and I’m facing the prospect of earning no revenue to pay my bills. I need my accounts to produce some gains in a hurry. How can I do that in the final weeks of the year? I know — I’ll buy lottery tickets!

I’ll take the money from all my clients’ accounts and put them into things like options and futures contracts. I’ll engage in hedge fund transactions. I’ll short. I’ll leverage. I’ll do whatever it takes to turn these losses into a profit so I can get paid by the end of the year. So what if my clients lose everything? I’m already earning nothing, so I have nothing to lose!”

This is precisely why the SEC prohibits fee schedules that are dependent on a client’s investment results. It is concerned that if advisors’ compensation were tied solely to account performance, they would have a major conflict of interest and might invest clients’ money in absurdly risky ways. There is one exception, however, which I’ll mention later.

At Edelman Financial — and I’d say also at the majority of fee-based firms — the fee is based on the size of clients’ accounts. Therefore we want to see your account grow, just as you do. Our interests are aligned with yours, reducing conflicts of interest. If the account falls, our revenue falls too. We have the same goal as our clients — and that’s the way it should be.

But there’s more. Investing money for our clients is not all that we do.

Our firm, like many others, provides advice in more areas than just investments. We may recommend that you buy certain kinds and amounts of insurance. If you receive a tax-free check from a claim on a policy we recommended that you buy, we don’t get a piece of that. Neither do we benefit financially from the advice we give on estate planning, college planning, mortgages, handling of 401(k)s and other areas — even if our advice results in a financial gain for our client.

All reputable financial planners should be advising clients in multiple areas. But we’re not compensated for that, so you should take that into consideration when evaluating the value of the fee.

I mentioned earlier that the SEC makes one exception regarding fee schedules based on performance. It allows such arrangements for accredited investors, who are deemed to be sophisticated enough be to able to understand the risks — and have the financial wherewithal to handle them.

I still don’t recommend you do this — not only because of the conflicts that can occur but also because of the incredible cost: typically a 2% annual fee plus 20% of the profits (and sometimes a 3/30 fee). These fee schedules provide strong incentive for the advisor to take very big risks — and that’s why we don’t offer such fee schedules ourselves or recommend that you sign up with an advisor who does.

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