A financial advisor should help you make informed decisions on your way to financial success. When choosing a financial advisor, it's crucial to understand how they are compensated. Their fee structure can significantly impact your long-term returns and your ability to achieve your financial goals. Each of these structures has its own advantages and disadvantages which must be understood to ensure that you, the client, is making informed decisions that are in your best interest.
Fee-Only Advisors
Fee-only financial advisors are compensated by charging their client a fee rather than by receiving a commission for selling a product. These fees can be charged in a few different ways including hourly fees, flat fees and a percentage of the assets under their management (AUM).
Hourly Fee
With this model the client is charged an hourly rate for their financial advisor’s time. The client is, generally, billed directly for hours their advisor spends on their account. These hours can include time spent in face-to-face meetings along with hours used for research and preparing for meetings.
Flat Fee
Financial advisors using the flat fee structure charge a specified fee for each part of the financial planning process. This structure allows for “a la carte” financial planning, you can choose the services you are interested in receiving and pay for only those specific services.
Assets Under Management
This compensation structure has been rising in popularity and is one of the most commonly used models. In this model financial advisors charge each of their clients a percentage of the assets they manage. The percentage that is charged can vary from client to client depending on the client’s assets along with other factors.
While this is a commonly used compensation structure the primary disadvantage is that this fee is charged regardless of your portfolio’s performance. In years with positive market performance you are charged this fee and in years with negative market performance you are charged this fee. Over time this fee has the potential to negatively impact your overall portfolio return.
Advantages:
· No conflict of interest
· Transparent pricing structure
· Potential to pick and choose the services you want
Disadvantages:
· Can be more expensive
· Generally limited to clients with significant assets
Commission-Based Advisors
Commission-based financial advisors are paid a commission from the products they sell. These commissions are paid by the company who offer the product being sold rather than by the client directly. The amount paid to the financial advisor is, usually, a percentage of the amount being invested. The main types of commissions are upfront sales commissions, trailer fees on mutual funds and trading commissions.
Upfront Sales Commissions
Upfront sales commissions are a percentage of the amount being invested that is paid to the financial advisor. The percentage paid is pre-negotiated by the company offering the product and the financial advisor. There are industry regulations that dictate the maximum percentage that is allowed to be paid to a financial advisor for selling each product.
An advantage to the upfront sales commission model is that mutual fund companies offer discounts to the percentage charged to the client depending on the amount that is invested. In this model, the more you invest with a specific company the less you will pay in fees.
Trailer Fees on Mutual Funds
Almost every mutual fund offered today have an expense ratio which is a percentage of the fund’s assets that are used to pay for various expenses. These expenses can include paying the fund managers, marketing the fund and the administration costs of the mutual fund. Financial advisors are also paid an ongoing commission for the mutual fund’s expense ratio to compensate them for managing the client’s account.
Trading Commissions
Financial advisors can also be compensated for buying and selling securities. With this structure the client is charged a commission, normally a percentage of the amount being invested, every time they buy or sell securities in the client’s account.
Advantages:
· May be more affordable than fee-based financial advisors
· Access to a large range of products
Disadvantages:
· Higher potential for conflicts of interest
· May prioritize products that pay higher commissions
“CRPC® Designation conferred by College for Financial Planning.