Fees for financial advice and management have been getting a lot of attention lately. Advisors are exploring new structures, regulatory bodies are trying to increase transparency and the industry is debating about how to best serve clients while being compensated fairly. Despite all of the discussion, clients may feel a bit out of the loop when it comes to not just understanding their own advisor’s fees, but knowing what’s out there in the first place.
The Relationship Comes First
The foundation of a great relationship is open communication and trust. It’s crucial that an advisor understands your situation and that you feel comfortable trusting him or her with your money and financial plan. But it’s also crucial that advisor compensation is clearly communicated and fair to both parties. If someone asked you “what does your financial advisor charge?”—would you be able to answer the question?
Talk through fees with your advisor to get total clarity on what services are being provided and how the advisor is being compensated. This discussion should not be an uncomfortable one. Use the following information to better educate yourself in the different compensation methods to ask more informed questions.
You’ve probably heard some jargon when it comes to advisors and their fees, such as fee-only, fee-based and commission, but it may not be clear what the real distinctions are. Here’s a basic overview:
- Commission: A commission is a service charge based on the sale of an investment product. A commission can take many different forms. It may be a commission paid up front on the purchase of a mutual fund, a surrender charge upon the sale of an annuity or a commission upon the sale of an insurance product, among others. Regardless of how the commission is received, the common characteristic is that it is paid from the company offering the investment product to the advisor as a commission in exchange for making the sale.
- Account Fee: Sometimes called an advisory fee, an account fee is taken as a percentage of your account value, regardless of what investments you hold within the account. Rather than being based on the sale of an investment, this fee is based on the management of the portfolio. The investments within the account will often be low-cost funds to keep expenses down.
- Flat Fee: This is a fee paid directly to the advisor for providing a specific service. A flat fee traditionally is not tied to the sale of any product or for direct investment management.
- Hourly Rate: This is a rate charged for an advisor’s time, as opposed to investment management or specified service provided. Regardless of the duties performed, the fee is charged per hour of work.
- Retainer: A retainer fee is charged either quarterly or annually for a financial planning relationship, regardless of time, services or investments used by the advisor.
Advisors may stick to just one of these options but many choose to employ a combination of fee types and let the specific situation determine the compensation form.
What To Watch For
Broadly speaking, no form of compensation is inherently right or wrong. Advisors have given quality service and a fair price using each form. Some advisors also can, and have, unjustly exploited certain methods for personal gain. Hence the reason it’s critical that you trust your advisor and he or she is open and honest about compensation structures. Use the details below to either help reinforce that your advisor’s fees are fair, or to know when to raise a red flag:
- Commissions, for example, are good for when there is very low turnover (switching of investments) inside an account. One downside is that if advisors trade commission-based products often, they can generate a lot of commissions without much payoff for the client. This creates a cost issue every time a portfolio needs to be rebalanced. Of course, excessive trading in commission-based accounts is referred to as “churning” and is illegal. Also, because regulations on commissions only surround the sale of the product, there is no legal obligation to provide management of the account or client service once the sale is completed.
- Account fees, as a percentage of assets, are often used when it comes to investment options and trading frequency. Managers can trade more often without driving up costs due to commissions. They can also select from a broader range of investment options, since they are not restricted to investments that pay them commissions. While an account fee can be a drag on returns, the low internal costs of the funds used in comparison to commission-based accounts make the fee more competitive while adding more flexibility. But there are downsides to this model. Because the advisor’s compensation is dependent upon the size and growth of your portfolio, care must be taken to ensure the advisor isn’t taking too much risk in your portfolio to make money, or be too cautious in order to protect the assets under his or her management.
- An hourly rate can avoid the conflicts inherent in the above models, which is a big advantage. However, advisors may be prone to billing too many hours relative to the amount of work necessary, or simply set an hourly rate that is not commensurate to the level of service being provided. Clients may also resist calling an hourly advisor because they don’t want to be charged for the call.
- Flat fees and retainers are good in that you know exactly what you are paying and may be able to work with the advisor in determining the right amount. However, because these fee amounts are ultimately under advisor control, advisors may be charging a fee that is too high given either the services provided or how much they are truly worth. This can be a great advantage to the client, however, because it is technically the most transparent and understandable form of fee.
The Bottom Line: Know what you’re paying and why
It can be daunting to try and determine when you are getting a fair price for an advisor’s service. That said, the decision ultimately rests with you. While it’s important to understand the different compensation structures, it’s most important you understand the way your advisor is compensated and why he or she is using that structure. If anything is unclear or you aren’t comfortable with how much you are paying or will pay, ask your advisor questions about what he or she charges and why. It’s critical that everyone be on the same page so that you can focus on working toward your financial goals.