How Are Financial Advisors Paid?
Updated: Mar 17
Many of us have seen the movie, The Wolf of Wall Street, where Leonardo DiCaprio plays Jordan Belfort, a young stockbroker who makes a FORTUNE by defrauding investors out of millions. Thousands of similar cases have led to stricter laws, regulations and higher ethical standards for financial professionals to protect smaller investors.
My initial thoughts.
Financial advisors/planners are compensated in many different ways. It's essential for you to know how advisor are paid. To be clear, this isn't to smear dirt on any type group of advisors but educating investors on how advisors are compensated in different ways and ensure they are getting the best financial advice. And how advisors are compensated will largely depend on who they work for and their firms' structure. The compensation structure can have an impact on your investments and it's performance.
How are financial advisors paid?
Compensation for a fee-only advisor is quite simple; you pay a fee for their services and never pay commissions. Fee-only advisors are not incentivized to sell or push you any particular products or services. Their primary objective should be to give financial advice and investment advice (financial planning) that's in your best interest to help you achieve your personal and financial goals. They win, when you win.
Fee-only advisor may charge an hourly rate, flat rate, monthly subscription rate, or an agreed-upon percentage of assets under management (short for AUM). With the AUM model, as the client account values, investment management may grow due to how fee's are calculated. The incentive is to grow your money while protecting it from market drops. Overall, fee-only advisor want to provide an unmatched client experience where clients want to continue to work with the advisor.
Example of how AUM fees work: If the advisor manages $1,000,000 of client funds and charges a 1% fee, the annual management fee is $10,000. Typically, fees are charged quarterly; therefore, the fees can vary based on account value each quarter.
A commission-based advisor may sell certain financial products, like insurance (e.g., life, annuities, auto) and or investments (e.g., mutual funds) and get paid a commission (% of sale) on the purchase made. It's possible, advisors who get paid on a commission-based model; their focus may be on selling you a product or service that may benefit the advisor more (higher commission) than the client. We can both agree, in this case, they are not putting your best interest first. Not saying this is always the case, but something to be mindful of.
Example of how commissions work: Let's say you are looking for term life insurance. A commission-based advisors may have access to different term policies. Suppose one option is the better term life option for the client (you), but the second option pays a higher commission. It's possible, the advisor may try to convince you to purchase the second option…
A fee-based advisor is a hybrid between commission-based and a fee-only (Fee + Commission). We often see advisors offer financial planning as a fee while also recommending investments or other financial products that pay a commission. A fee-based advisor cannot call themselves a fee-only advisor!
Example of how Fee-based work: Using the same client with $1,000,000 of investable assets. The advisor may charge a client a flat fee for financial planning, let say $6,000/year. When reviewing the financial plan, they suggest purchasing a $100,000 annuity to protect market risk from their overall portfolio. That annuity may pay a 10% commission. If purchased, the advisor would be compensated $6,000 (financial planning fee) + $10,000 (commission) = $16,000. Although commissions are not paid directly by you, the client, there are certain limitation/drawbacks built into the contract like surrender penalties could result in a penalty. Be sure understand how these products work before signing the dotted line.
Base Salary + Bonus
An advisor compensated with a base salary plus bonuses may not benefit from selling you a particular product. Regardless of which investment you select, they may receive no incentive (commission). Their responsibility may be servicing existing clients and bringing in new clients into the firm. Based on the advisors' performance and other factors, a bonus may be paid to the advisor.
Example of how Base + Bonus work: An advisor may be paid a base salary of $50,000, and at year-end, if his target was $1,000,000 of new assets, he may be receive a bonus for reaching his target. This is a hypothetical example as all companies may have a different compensation structure.
What's the Best Way Your Financial Advisor Should Get Paid?
That's completely up to you! People do business with individuals they know, like, and trust. Working with a fee-only advisor makes sense for some, but not all, and really is based on your needs. If you're looking for a one-time financial plan, paying an hourly rate may makes the most sense (fee only). If you're in the market for life insurance, a commission-based agent or broker may be the best option. Stated above, this isn't to paint an ugly image on any group of advisors but to inform investors the potential conflicts that may arise from how advisors are paid. Advisors who are focused on providing the best financial advice for their clients should have no worries about how they are compensated (fee, fee-based, or commissions) because their clients should already be fully aware of how their advisor is getting paid.
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