A few years back, as a global strategist at JPMorgan, my job was to provide market and economic insights to financial advisors around the world. At one point, I was doing 240 presentations a year and speaking to thousands of financial advisors. The experience gave me a good grasp of their business.
The journey of using a financial advisor can be daunting for many, and the ins and outs of the business can be overwhelming. With this in mind, we created this blog series, Financial Advisors, The Tell All. In this initial post I will outline the different ways in which financial advisors make money. In the upcoming posts I’ll dive into the different players, Brokers vs. Advisors, followed by What Makes For A Great Advisor? and finally, Do I Need a Financial Advisor? My aim is to tell all, so that you, our readers, can make informed decisions.
Five Ways Advisors Get Paid
There are 5 payment methods, each of which has its pros and cons for the client. The pros and cons metioned here relate to the way in which each method helps to align the interests of the advisor with those of the client. The more closely aligned, of course, the better.
1. Yearly fee as a percentage of the investment account balance
The advisor receives a yearly % on the balance of your investment account. These fees range from 0.25% to 1.5%, depending on the level of services.
Pro: The more your investment account grows, the more money the advisor makes i.e. the advisor’s incentives are better aligned with the client’s.
Con: Minimum balances of investable assets generally have to be upwards of $200K to make it appealing enough for a good advisor to provide this service, which means it’s not available to everyone.
2. Commissions paid per trade
A financial advisor charges a commission every time they buy or sell any stock or bond on the client’s behalf. This commission is deducted directly from the client’s investment account and cash doesn’t change hands.
Pro: No cash needed. People that have limited cash on hand and can't, or don’t want to, pay out-of-pocket, tend to gravitate towards this method.
Con: The more trades are made, the more money the advisor makes. The advisor is incentivized to trade a lot in order to generate fees. This often creates a trading mentality in which the advisor reaches out to clients to tell them about "exciting opportunities" or to provide color on the week-to-week market moves. This will probably ring a bell if your parents have an advisor, as the traditional players still often use this model with baby boomers.
3. Commission kickbacks from products sold to you
When advisors buy certain mutual funds or life insurance products on a client's behalf, they collect an up-front sales commission or "trail commission" each year. Therefore, as long as the client remains invested in the mutual fund or owns the insurance, the advisor continues to receive their annual commission.
Pro: Clients aren’t charged directly for the advisor’s service. For clients with savings under $200K and insufficient monthly income to pay an up-front fee for the service, this form of payment can be appealing (although not ideal).
Con: The advisor is incentivized to push a product onto a client that nets them the greatest commission, regardless of whether it's the best product for the client. Brokers don't win awards at their firms for best customer service, they win awards for most sales.
4. Flat Fee (Retainer Fee)
The client pays the advisor a flat annual fee to provide them with financial advice and to invest on their behalf. “Fee-only” means that the only payment the advisor receives comes from the client. “Fee-based” means that most of the payment comes directly from the client. In many instances, fee-based payments may also include commissions on products sold. The yearly fee varies significantly depending on the the complexity of the client's case.
Pro: Since flat fee advisors do not have any other source of fees, besides the client's, and the fee is not directly tied to the size of the managed investments, the advisor’s incentives are most aligned with the client's. For instance, if a client is deciding between buying a home or investing their savings, an advisor that is compensated out of a % of investable assets, might be more inclined to recommend that the client invest the money, whereas an advisor on a retainer fee is truly impartial in his recommendation, since he earns the same regardless. (That's why it is important to clarify ALL revenue streams with the advisor.)
Con: Client pays an out-of-pocket fee every year, which is not only psychologically tough, but it becomes an expense from their annual income rather than from their savings.
5. Hourly Fee
The advisor charges an hourly fee to the client.
Pro: The advisor’s incentives are well aligned with the client's. This type of payment option is also great for a client with limited cash flow or savings.
Con: The client pays an out-of-pocket fee. There is also the possibility that an advisor overcomplicates advice in order to increase their hours.
What payment method is best for me?
When it comes to deciding what is best for you, you will need to consider both the payment method, the type of advisor, their competency levels and your circumstances. For now we will focus solely on payment methods, with the other factors coming up in the rest of the series.
Below chart illustrates the worst and best aligned forms of payments for clients:
*general guidelines, alignment of interest depends greatly on the client's situation.
Generally speaking, working with a "fee-only" financial advisor is often most suitable as it removes most conflicts of interest.
The above are related to aligning the interests of the advisor and client, they are NOT recommendations on the advisors’ skills or abilities.However, by knowing how advisors make money, you can identify the payment options that are most suitable to you. With that knowledge you can get a better sense of whether or not an advisor is a good fit from the get-go.
Coming up next - Brokers vs. Advisors: What is the difference between a broker and an Registetred Investment Advisor (RIA)? We take a look at how these advisors differ in the ways in which they earn their money and in the services they provide.