Financial advisors don’t work for free and their compensation structure can have a significant impact on your financial health.
Clients typically pay their advisors one of three ways:
- Commissions from selling financial products such as stocks, bonds, mutual funds, insurance, annuities, etc. These commissions may be implicit (e.g., how a car salesperson is compensated) or explicit (e.g., how a residential real estate broker is compensated).
- Assets under management (“AUM”) fee. The advisor charges a percentage of the assets being managed, typically in the range of 1%. Generally, when you pay an AUM fee, transactions are made on a commission-free basis, but that is not always the case.
- Hourly rate. As with other professional services, the advisor simply charges by the hour, for the time devoted to managing your needs.
The first two structures are the most common, but both can be conflicted, costly, and likely to have hidden fees. The commission model conflicts are straightforward — the advisor’s income is based on transactional volume, rather than doing what is in the client’s best interest. The conflicts with AUM fees are less obvious.
The AUM model may seem to unify the client and advisor’s interests but it doesn’t. For example, imagine the client has $500,000 of assets under management with an advisor. The client asks for advice about paying off a $200,000 mortgage by drawing down assets. If she does so, the advisor’s fees will decline by 40%. This can be an awkward situation for an advisor to consider.
Further, why should a larger portfolio warrant a proportionally larger fee? Does a $1 million account require double the time or expertise of a $500,000 account on the part of the advisor? I would think the effort is nearly identical for the two.
There is another subtle shortcoming with the AUM model, especially in this era of low interest rates. A portion of your investment portfolio will almost certainly be invested in bonds and their after-tax returns are currently ~2.5%. If your advisor is charging a typical 1% AUM fee, that means you only receive 1.5% of the 2.5% investment returns — 40% accrues to your advisor! You contribute 100% of the capital, absorb 100% of any losses, but keep only 60% of the gains. Does that sound unbalanced to you? It does to me. This imbalance is particularly important for older clients who typically have a larger proportion of their portfolio invested in bonds.
Advisors using an AUM model will often say your interests are aligned because the advisor’s fee only grows when your assets grow. This is true but meaningless. Remember that the advisor takes no risk, and is paid whether your assets grow, shrink, or under-perform what could have been achieved by passively investing in a low-cost index fund.
From the advisor’s standpoint, the first two models have a big advantage — the fees are hidden. Clients often neither know how they compensate their advisor nor how much, and some even think the service is free. These fees do not appear on a monthly invoice but instead are automatically deducted from the account and may require forensic accounting expertise to uncover from an account statement. Hidden fees can be substantial and it’s easy for advisors to avoid a conversation about them.
The hourly rate model is your best option as the total amount of fees will be significantly lower and the cost will be transparent. Unsurprisingly, many advisors are unwilling to provide their services on that basis. Even some clients are reluctant because it may seem that the fees are higher because they now become visible and explicit.
Don’t be fooled by this optical illusion — ask for an hourly fee arrangement with your advisor. You will incur substantial savings.
This perfectly captures the title of a dated but still relevant book about Wall Street. From the introduction:
The title of his book, Where are the customers yachts? refers to an old joke: a tourist is being shown all the fancy boats in the harbour, and is told, “These are the bankers’ yachts, and these are the stockbrokers’ yachts.” When he asks, innocently, “Where are the customers yachts?” he is told that there aren’t any.
Need help decoding your advisor’s fees? Please get in touch.
You may also want to read Crystal Balls and Coin Flips where I wrote about how financial advisors add value.
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