How Do Financial Advisors Get Paid?
The world of financial advice can be convoluted. With varying titles (financial planner, financial advisor, wealth manager, etc.) and certifications (CFP, CPA, CFA, ChFC, etc.), it can be even more difficult to understand what you're paying to whom and what services you're receiving for the cost. Whether you're paying for financial advice or for a monthly shaver subscription, it's important to know how much you're paying and for what. So let's break down a few of the most common financial advisor compensation models.
Commission-Based
Typically, advisors on a commission-based model receive compensation based on the products that they recommend, such as an investment fund or an insurance product. Their commission is often built into the underlying cost of the product. For instance, the advisor commission on an investment product could be built into the annual Fund Expense. Similarly, the commission on an insurance product would be factored into the cost of the premiums. While the advisor is required to disclose the cost of the commission, it may take a little more digging to find since it's based on the underlying product. These costs may or may not include Financial Planning services as well; this is where you'll need to do some more due diligence to find out what services are included in the cost of commission.
Fee-Only
Advisors under a fee-only model do not receive any commission for products that they recommend. In fact, they are legally not allowed to refer to themselves as "fee-only" if recieving commission of any kind. This model may present itself in several different ways, but the most common is in the form of an Assets-Under-Management ("AUM") charge, meaning, the advisor receives an annual fee based on the assets he or she manages for you. For example, if you have $1,000,000 being managed by a fee-only advisor, he or she may charge 1% annually to manage those funds. Alternatively, some fee-only advisors may charge an hourly or flat fee for services they provide. Again, what services are included in these charges depend on the advisor. So it's important for you to understand if these costs include financial planning, or purely investment management.
Fee-Based
Finally, the third most common advisor-compensation model is "fee-based", which means the advisor is compensated through a combination of fees and commission. For instance, they may charge an AUM fee, or a monthly retainer, and also receive commission based on products they recommend for you.
Consider the All-In Cost of Financial Advice
Before making any kind of financial decision, make sure you understand your "all-in" cost. Don't just look at the "advisor" or "planning" fee because that's just one piece of the puzzle. For example, while "advisor" fees may be small or non-existent with a commission-based advisor, the cost of your investment funds may be higher than that of an AUM-based advisor. Alternatively, a fee-only advisor may offer investment funds with cheaper annual fees, but their "advisor" or "planning" fee could be higher. All that is to say, you need consider the cost of everything and everyone you pay (advisor, fund manager, insurance company, custodian, etc.).
Furthermore, you should factor in the cost of bad advice. If you hire an advisor that doesn’t consider taxes when making recommendations, the consequences of an additional or avoidable tax liability could easily outweigh the amount you “saved” in advisor fees. Of course, hindsight is 20/20 so it’s not always easy to identify “bad advice” upfront, but that’s where credentials and experience can come into play (a topic for another day).
Consider the Services
Finally, know exactly what services you are receiving for the cost you're paying. "Financial Planning" means different things to different people. For some, it could simply mean providing you access to budgeting tools. For others, it could mean comprehensive planning that includes tax management, estate planning, education planning, etc. The regulations over the term "financial planning" are loose, so it's up to you to find out what that means when an advisor tells you they offer financial planning services. Know the cost and know the deliverable.
When deciding to work with an advisor, take the time to carefully evaluate the costs and services. Don't succumb to the pressure you feel when sitting in an office with a prospective advisor. Taking that step to allow someone to manage your hard-earned money is a big decision, so take the adequate time to evaluate all aspects of the relationship before committing to anything.