Three Answers to a Most Important Question

August 13, 2020
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I can always tell when the question is coming. It is the same question I get all the time, and it is almost always asked with awkwardness and uncertainty. I suppose that those who ask it do so out of respect for my time and efforts, but perhaps they also ask out of fear. The financial industry has done a horrendous job of answering “the question,” and after numerous scandals it is only natural of the public to be wary of those in my profession. That said, I feel it is my duty to make sure that my clients and those around me have a good understanding of the answer to this important question. That’s right, I am talking about how I get paid. How do I, or how does anyone else for that matter, make a living as a financial advisor?

It is an important question indeed, and with an answer that is often quite misunderstood. The answer has become overcomplicated over the years as new products and services have been introduced. Governmental entities, such as the Department of Labor, have added to the complexity and misunderstanding by suggesting that certain types of advisor compensation are good, while others are cast under a blanket statement of “not in the client’s best interest”.

It is important that clients know how much they are being charged; however, as an advisor, I think it is equally important that they understand how they are paying me and for what services they are being charged. I want to cut through the complexity and provide you, the reader, with a general overview of what I see as the three main ways in which financial advisors are compensated. But first, a disclaimer: This is by no means a comprehensive list and is not meant to represent any and all options or situations. How you work with an advisor should be determined on an individual basis and this list is for educational purposes only.

 

  1. Commissions

 

The term “commissions” has been around forever, and is used in any industry where sales are found (so basically all of them). In broad terms, it refers to any time compensation is received as a result of a sale of a product. In financial services, this term has long been used to describe the sale of insurance or individual stocks and bonds. It can also be used in connection with the sale of mutual funds or ETFs. Some advisors are paid exclusively through commissions paid on mutual funds and insurance products. Others utilize commission income as only a part of their overall compensation. A good example of this is an advisor who does full financial planning for clients, which includes making sure that they have adequate life insurance. The advisor would be paid a commission by the insurance company to sell their life insurance product.

One criticism of a commissions-based compensation model is that the advisor could potentially be financially incentivized to sell one product over another. This could cause a conflict of interest, especially if the advisor works for a firm with proprietary products that pay higher commissions. There are, however, situations where it might make more sense for the client to pay a commission versus another type of compensation. We will look at that further as we move on.

  1. Fees as a percentage of assets

 

Over the last decade, there has been a shift away from commissions because of the aforementioned concerns over conflicts of interest. Many advisors have begun charging a fee as a percentage of the total amount of client assets. For example, a client may have $100,000 invested with an advisor who has agreed to assist them with managing their investments and developing a financial plan. For his or her efforts, the advisor might charge the client a fee of 1 percent, which would equate to $1,000 per year. Typically, this fee would not be billed to the client, but rather would be taken directly from the investment account. This gives the advisor the latitude to perform several different services for the client that are all covered under the asset-based fee. Some advisors have gone all in on this model of compensation and insist that it is the only way of doing business.

There are, however, some drawbacks to this model, especially for the younger investor. For many young people, the “fees as a percentage” model is simply not feasible because they do not have large enough accounts to justify it. Many firms have put account minimums in place for fee based advisory relationships to prevent this from happening. This is where it may make more sense to charge a one time or ongoing commission as opposed to a fee.  Another concern is that an advisor will become complacent in their duties as they are paid whether they follow through or not. Again, a commission (or fee for service as we will see next) might make more sense depending on the situation.

 

  1. Fee for service

This type of advisor compensation describes a broad range of compensation arrangements. Put simply, the advisor charges either a dollar amount for each service they provide or a recurring dollar amount for all advisory services. This gives the advisor the flexibility to offer the client only the services that they need. For example, a client may only wish to have a financial plan completed and nothing more. The advisor could charge $1,500 to complete the client’s financial plan. By contrast, the client may wish to begin financial planning but do not have investments from which to draw an asset-based fee. The advisor could charge a monthly or annual fee for their advice and consultation.

                As with the other models mentioned, paying a fee for service is by no means perfect. It fits a few specific situations and should not be utilized in every instance. It also requires the client to pay for financial advice directly out of pocket which elicits a different, more emotional response than say, seeing a 1% fee taken out of your account.

               

                At this point, I think it is important to say that there is no perfect way for every client to pay for financial advice. In fact, at Provisio we use all three methods for different reasons, different people, and different circumstances. There is no “cookie cutter” mold for which every client fits. We are constantly evaluating each client’s unique situation in order to make sure that the value we bring is in line with the compensation that we receive and the way in which we receive it. It makes for a lot more work for us, but a much better client experience overall. Click here to learn about just a few ways that we work with clients. If you are curious about what it might look like for you to work with us, click here to schedule a free meeting to get to know us electronically!