Why You Need to Know How Your Advisor Gets Paid

I began my journey in financial services in the same way as many others—I joined an insurance company. 

As a young “financial representative,” I was paid only on commission. That meant that in order to feed my family, I had to convince others that they needed to purchase the product that my company sold. This conflict meant that virtually all advice needed to lead to a sale if I was going to get ahead financially. It’s not hard to see how a commission-based compensation model isn’t desirable for the consumer-advisor relationship.

But what are your other options? I’m encouraged by the fact that there seems to be a growing awareness among consumers that it makes a whole lot of sense to understand how your financial advisor gets paid. Not only that, but there’s been an increased emphasis on working with fiduciary and “fee-only” financial advisors. 

These are great steps in the right direction, but I believe more understanding is necessary.

Traditional Methods of Advisor Compensation

Traditionally, advisors have either been compensated based on their ability to sell you a product (commission) or based on an advisory fee arrangement. If your advisor is paid on commission, it becomes very difficult to determine if the advice they are offering really is in your best interest, or merely suitable or justifiable based on our circumstances. 

Precisely for this reason, there’s been a growing emphasis on working with fee-only financial advisors. (As an aside, please note that there’s a big difference between working with a “fee-only” advisor and a “fee-based” advisor. A fee-based advisor charges you fees for service, but also gets paid on commission from products that he sells you.)

So how exactly do fee-only advisors get paid? You might think that fee-only advisors get paid like most other service professionals—hourly, some sort of retainer, or maybe project-based. In reality, most fee-only financial advisors are paid based on a percentage of your investment “assets under management.”

The problem with the Asset Under Management (AUM) Compensation Model

Paying your advisor through a fee based on a percentage of assets under management (or AUM) means that you will be assessed a fee based on how much you have invested with any given advisor. 

For example, if you have $500,000 invested with an advisor charging 1% AUM, your annual fee is $5,000. This likely isn’t a fee that you physically cut a check to. In most cases, it’s extracted directly from your investment account. 

So while you might not feel the pain of the fee, you most certainly are paying it. 

Now, I’m not necessarily saying that $5,000 per year isn’t a fair amount to pay for financial advice and investment management. My view is that you should pay an advisor what you believe is a reasonable price for independent advice and the service they provide. 

But let’s consider a larger investment under the AUM compensation model to make my point. Imagine that you do a great job saving and by the time you’re 55 you’ve amassed $2,000,000. At the same 1% AUM rate, you’re now paying $20,000/year for the same service. 

You might think that because you’re paying so much more than individuals with smaller accounts that you’d get access to some super secret financial planning or investment strategy. Nope. But won’t the returns be higher since you’re paying so much more? False. 

The truth is that while you’ll likely get more attention from the advisory firm (they really don’t want to lose your business), you may not be getting substantially different planning and investment management than those clients who are paying less because they have smaller accounts. At least not if the advisor is fulfilling their fiduciary duty to act in their clients’ best interests—no matter how wealthy those clients are.

Conclusion

I’m not trying to say that advisors in the AUM model or the commission model are bad people. Let’s clear that out right away. There are good people everywhere. But I do think it makes sense to be educated and understand that these aren’t your only options. There are financial advisors who are paid on hourly rates, as well as annual retainers that can be much more affordable than advisors who charge based on a percentage of AUM. And every dollar that you don’t spend for investment management and financial planning is a dollar that you get to keep for yourself. 

So if you’re paying $10,000 per year for an investment professional to manage your $1,000,000 portfolio and there is an advisor offering the same service for a flat $5,000 annual retainer, you should ask yourself what your current advisor is doing that makes him your best option. 

Like all other professionals, it’s important that you get a fair price for advice.


Disclaimer:

The content you just read is for informational purposes only. Yes, I’m a financial advisor, but this article really isn’t intended as advice for you specifically. Your unique situation needs to be taken into account, and the ideas presented here may not apply. 

So, please make sure you do your due diligence BEFORE implementing anything. Due diligence includes hiring a qualified professional who understands your situation completely and can offer you personalized advice.


Donovan Sanchez