Related You Get What You Pay for, and Pay for What You Get articles

How Financial Advisors Are Paid

Lets examine the most common ways you will pay an advisor, and the plusses and minuses to each method of payment.

Method: Fee-Only Advice/Service

• How it works: Your annual fee is a flat percentage of the money that the advisor is responsible for, typically somewhere between 0.75 and 1.25 percent. Many advisors use a sliding scale, so that the percentage drops as your assets grow, or the amount charged declines after certain breakpoints. The advisor is paid only by you; there are no commissions, either from you or from a third-party, for providing you with counsel.
• Plusses: The advisors interests are aligned with yours; if you get great results, so does she, because your success means a great pool of assets to charge that fee on. No sales charges; all of your money goes to work and the fee is earned over time.
• Minuses: If you dont have much money to work with, youll have a hard time finding fee-only advisors who want to take you on as a client. Most advisors want to get all of your available resources under management which may entail selling investments you have now rather than only handling some of your money. And critics say that a fee-only advisor can become disinterested over time, because he gets paid regardless of whether you act upon his advice.
• Possible conflicts: The advisors focus will be on getting assets in the door, and their advice may skew in that direction. Say you receive an inheritance and want to know if you should pay down the mortgage or invest the proceeds; the advisors pay goes up if you invest the money and stays flat if you pay off the debt. There may also be times when the advisor makes moves not because he believes the portfolio needs to be changed, but because he knows its frustrating to pay a fee to an advisor who is not doing something.

A Conflict over Nothing

While paying a fee for assets under management does diminish conflicts of interest, it creates an interesting problem, where an advisor may sometimes make moves in order to justify his or her ongoing worth.

Say the advisor puts together a portfolio. It gives you roughly the return you expect, you go in for your annual review and the advisor says change nothing. She collects her fee, and the next year the market is not so kind to your portfolio. Nothing horrible, mind you, but youre getting nervous come annual review time, when the advisor again tells you, Dont change a thing. The third year, the advisor knows you are not particularly happy with the results; the market has been tough, and the portfolio has been in line with expectations, but youre frustrated.

Fearing that you may want to pull the plug on the whole thing if you hear another Dont change a thing, the advisor advocates changes, not because they are the best long-term moves in fact, studies show that changing a portfolio for the sake of making a change tends to do worse than going the buy-and-hold route but because she needs to justify the fee.

It wont result in more fees for the advisor, but its hard to say the advisor has your best interests at heart. Situations like this are why there is no such thing as conflict-free financial planning.

Method: Commission or Fee-Based Commission

• How it works: You pay a fee or your advisor gets a fee from a third party on every move you make. In some cases, as with some mutual funds, you might only pay something thats labeled a sales charge when you buy or if you sell after a short holding period, but a payment to the advisor from the fund company is built into the investment structure, and you could be buying an investment that is more expensive for life in order to pay that fee. Likewise, with insurance agents, commissions frequently are buried in initial premium payments, so that its not quite as clear as make this investment, pay the advisor X percent off the top. Make no mistake about it, however, whether it is a front-end load, a back-end sales charge, surrender fees, or 12b-1 fees for mutual funds, its a commission if you are paying extra, and the advisor gets that money, either directly from you or from the company managing the investment.
• Plusses: Commission sales typically are available to all consumers, no matter how little money you have to work with. If what you want or need is someone to process your transactions, you can focus on paying the fee possibly even negotiating it down and getting the investment.
• Minuses: Because the advisor only gets paid when you act on his advice, you may be getting a salesman more than a long-term advisor. The brokerage firms, for example, are filled with young bucks anxious to make their bones, but the rate at which these newbies wash out of the business is high. Even if the advisor sticks around, he only has an incentive to work with you when he senses a sale coming on. You may talk to an advisor today, come up with a decision on an investment or a portfolio to buy, and then may not be able to get much ongoing counsel if the seller doesnt sense that he can make another sale and capture another commission.
• Possible conflicts: The basic problem here is that the advisors best interest is served only when selling you something or getting you to make a move. The bulk of your financial life, you are holding and building, not buying. Moreover, many commissions are buried inside of financial products like insurance policies; the advisor will talk about the benefits to you of buying a certain financial product, without necessarily disclosing properly the way or the amount she gets paid. Finally, a commission salesperson may get an incentive or a heightened commission to sell products from specific companies, like the house mutual funds or issues that simply carry a bigger front-end sales charge; those higher payouts may unduly influence the advisors thinking.

12b-1 Fee

Named for the regulation that allows it, a 12b-1 fee is a sales and marketing fee paid on top of the management fee of a mutual fund. In most cases, at least some of this fee acts like a trailing commission, paying the advisor who sells the fund for his or her continuing efforts to keep your account open and in place. These fees add 0.25 to 1.0 percent to the cost of a fund and tend to be highest in cases where the fund is set up to avoid front- or back-end sales charges and make it feel like the customer is not paying for advice.