Advisor Terms: What’s a fee-only advisor?
How does your financial advisor get paid? If you’ve ever dealt with a financial professional before, you’ve probably had the sneaky suspicion that they were earning money in ways that weren’t entirely clear to you.
In this first installment of my blog post series called “Advisor Terms,” we are going to look at the different ways a financial advisor is paid. In particular, I want to want to draw your attention to what it means to be a “fee-only” advisor, which is the fee structure I use here at Honey Lake Advisors.
To preface the conversation: I firmly believe the future financial planning resides with fee-only financial advisors. As we will see, it’s the most transparent and straightforward compensation structure out there. And more times than not, if you are working with a fee-only advisor, you are working with someone that is looking at your ENTIRE financial picture, not just a slice of it.
3 Ways a Financial Professionals Make Money
There are three basic ways a financial professional makes money on their relationship with you. The structures are not necessarily unique to the financial services industry, but a lot of times it’s not entirely clear HOW your advisor is earning his or her money from you. The most common compensation structures are:
- Commissions & Fees (sometimes referred to as Fee-based)
Financial professionals who are commission-based make their money by selling products to you. Much like an auto dealer, he or she will earn money when you make the decision to buy something from them.
This type of compensation is most often seen in the insurance and mutual fund industries. Many life insurance and annuity products are sold by agents who earn a commission on the sale of these insurance products. Similarly, some investment professionals will earn a commission based on the type of mutual fund you buy. These commissions are oftentimes called “Loads.”
A common trait for many professionals that earn their money through commissions is that they are normally only looking at one specific aspect of your financial life, not the whole picture. If you go into a life insurance agent’s office asking about comprehensive financial planning, the solutions you get will almost certainly revolve around insurance products they can sell you. These products may or not be the best options for you.
Now, there are a lot of commission-based financial professionals out there that are great at what they do and add a lot of value to their clients. You just have to be aware that their incentive is to sell you whatever it is they are selling. You wouldn’t go to a Honda car dealer and expect the salesperson to recommend you buy a Chevy instead because it’s a better car for your needs.
Commissions & Fees (Fee-based Advisors)
Advisors who earn compensation via a combination of Commissions & Fees are most often seen at large, national financial institutions. Typically, you would pay a fee that is based on a percentage of the investments the advisor is managing for you. In addition, the advisor would have the opportunity to earn compensation above and beyond your fee based on the products or investments they recommend to you.
An example would look like this: you need someone to manage your investments. You find an advisor that is willing to help you and charge you 1.25% of the value of your investments as a fee. Seems simple enough.
What isn’t entirely clear unless you read all of the fine print is that the advisor can also earn compensation for themselves based on recommendations they make. They may recommend you invest in XYZ Mutual Fund, which pays the advisor an incentive to make that recommendation. It may not be a bad mutual fund, but the cost of those advisor incentives has to be paid by someone and that someone is typically you. XYZ Mutual Fund company will recoup those incentive costs by charging a higher underlying fee in the fund you are investing, which is a real cost to you when compounded over a number of years.
When a financial professional is compensated under a “fee-only” structure, the only compensation they receive is the fee that you pay them. By definition, these professionals are not able to receive any commissions or incentives based on the recommendations they make to you.
Fee-only financial advisors typically charge you one of three ways:
- Hourly charges – similar to how lawyers charge their clients – where the advisor will charge the client based on the number of hours of work they perform planning for the client.
- Fixed-fees, whereby you and the advisor agree to a specific flat fee for receiving advice, plan implementation and/or ongoing investment management.
- Percentage of assets under management, whereby the fee the advisor receives a fee that is a percentage of the investments they are managing for you.
In each of these cases, you and the advisor agree to these fees up-front at the beginning of the relationship. The benefit here is that you know exactly how much you will pay them and how much they will earn from your relationship before you start working with them.
Many professional organizations have strict rules regulating members that describe themselves as “fee-only advisors.” For instance, as a Certified Financial Planner (CFP®), I must certify to the CFP® Board that I receive no commissions or incentives whatsoever as a result of the advice I give to clients in order to call myself a Fee-only Advisor. Similarly, organizations such as NAPFA and XY Planning Network – both of which I’m a member of – require that I sign an oath stating that my only form of compensation is from the fees I receive directly from clients. No commissions or kickbacks allowed.
Why Fee-only compensation is cleaner than Commissions or Commissions & Fees?
There are two big reasons why I believe the fee-only form of compensation is the cleanest for a client to understand and work with.
First, we have to look at human nature. If my compensation is directly tied to you buying something from me, then what is my incentive in my relationship with you? Trying to sell you whatever I’m selling.
Sometimes these incentives may not be totally clear. For example, you may need to buy some life insurance to protect your family. A life insurance agent will help you buy the life insurance you need, but it might not be the BEST type of life insurance you could buy in your situation. There may have been another, less costly, insurance solution for your situation that you were not offered because it would have paid a lower commission to the agent.
The second reason why I believe fee-only compensation structures are cleaner is due to the nature of the work a fee-only advisor is doing for you. Most fee-only advisors offer what’s called “comprehensive financial planning.” This means that the advisor is looking every part of your financial picture – from retirement to sending your kids to college, to whatever unique life situation you face. Conversely, advisors and agents that are commission-based will typically only focus on one part of your financial picture – the part that their products can help you resolve.
The Comprehensive Financial Planner (CFP®) is well-versed in many aspects of your finances. They understand the array of solutions that are out there for you and can help you find the most cost-effective products that can get the job done. The CFP® may recommend you buy life insurance, but they’re not incentivized to point you to expensive products you don’t need.
Fee-only sounds great – what’s the catch?
Fee-only financial advisors aren’t conflict-free. In fact, the conflicts that exist with fee-only advisors are much more subtle and harder to spot than a commission-based salesperson telling you to buy their product. What are some examples?
One example relates to clients that are paying a percentage-based fee on investments being managed by the fee-only advisor. The math here is simple: the more investments the advisor manages for you, the more fees they will earn.
But what if you’re charitably-inclined and would like to start giving away your money? Your advisor may know you have a generous heart but fail to recommend charitable giving strategies because their fee would go down if you start giving your money away!
Another risk to you is that if you are paying a fee-only advisor a fixed-fee to handle your financial planning over the course of the year, they may not do all the work they promised they would do. The problem is that you wouldn’t really find out unless you asked them to show you the work they did for you.
The point here is that there is no perfect compensation structure that eliminates ALL conflicts of interest. They exist. But by engaging with a fee-only financial advisor, you’ve at least eliminated some of the strongest conflicts that exist with other forms of advisor compensation.
In conclusion: Why this conversation matters
I’m extremely passionate about American families engaging in comprehensive financial planning. I truly believe our society benefits when the public is financially prepared to send their kids to college and pay for their own retirement.
The issue we have is that the financial services industry has not treated clients fairly. By selling expensive, hard-to-get-out-of annuities or overly expensive mutual funds, the industry has created a level of distrust that keeps people away from getting the advice they vitally need. Who wants to get taken advantage of?
Being a fee-only financial advisor is the best way I know to help clients gain comfort that conflicts of interest are being meaningfully limited and that their interests are always held above my own self-interest. I firmly believe that both clients and advisors can thrive alike when we have compensation structures that are transparent and fair.
In next week’s installment of Advisor Terms, I will look at what it means for an advisor to be a fiduciary, and more importantly, what it means when they are not.
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