How is My Financial Advisor Compensated?

Many clients do not understand how their financial advisor is paid. The three basic compensation models are:

Commissions: The advisor is compensated for the sale of investments, insurance, or other financial products. Compensation is paid by the firm that provides the financial product, usually a mutual fund or an insurance company. This may be in the form of an up-front charge, trailing (ongoing) fees or a combination of both.

Fee-based: Typically the advisor will charge a fee for putting together a financial plan for you. If you chose to implement the recommendations in the plan, such as the purchase of insurance, an annuity, or investments, the implementation will typically be done via the sale of commissioned products.

Fee-only: The advisor charges a fee for the services rendered. This can be one-time or ongoing based upon the nature of your relationship and the services rendered. Fees may be hourly, flat or retainer based, or based upon a percentage of the assets under advisement.

Why should you care how your advisor is paid? Because his/her compensation can impact the choice of the products recommended to you and your return from those products.

An advisor who is paid via commissions will likely recommend those products that offer him a commission or sales load. Sales people generally sell what they are incented to sell. Commissions can, therefore result in a huge conflict of interest for your advisor. Does she suggest the very best and lowest cost products or does she suggest those products that pay her the highest commission?

Fee-only advisors do not have this inherent conflict of interest because they are paid by the client, not the financial product provider. They are free to suggest the best investment vehicles and financial products for each client’s individual situation.

Should compensation be the only metric used to select a financial advisor? Of course not, but the advisor’s compensation should be made crystal clear to you. When interviewing an advisor ask very direct questions. Ask them to detail ALL sources of compensation. These might include up-front commissions or sales loads; deferred or trailing commissions; surrender charges if you opt out of the mutual fund or annuity too early; a wrap fee on your overall investment account; or a myriad of other fees and charges in various combinations. While you will likely not be writing a check for any of these fees, make no mistake you are paying the freight. Excessive commissions or expenses serve to directly reduce your return on investment.

In the interest of full disclosure, I am a fee-only advisor and a member of NAPFA, the largest professional organization of fee-only advisors in the United States. I was recently elected to the Midwest Regional Board of NAPFA.