The Informed Investor

Decoding Financial Advisor Compensation Models

Many people ask us the difference between fee-only and fee-based compensation models for financial advisors. They also want to know how project fees, asset-based fees, and hourly fees work. For the average investor, the compensation models of financial advisors can feel downright confusing.

Few other industries have so much variation when it comes to paying a professional. When you hire an auto mechanic, you pay for parts and hours of labor. When you hire a piano teacher, you pay per lesson or for a set amount of time. All these methods are straightforward and easy to understand.

Unfortunately, the financial advisory world is a different ballgame. Payment models vary from firm to firm and, sometimes, from client to client (depending on client needs, services rendered, net worth, etc.).

Since payment models for financial advisors are sometimes complicated, misinformation abounds. Consumers might fall for “special offers” or “guaranteed returns.” Or they might believe they are entitled to free financial planning because large brokerage terms do this for “free.” However, there’s no such thing as a free lunch—those big firms are making their dollars somehow. Many of these large brokerage firms use 10-20 questions to be analyzed by a robo-advisor, which is NOT financial planning. Genuine financial planning is comprehensive, multi-layered, and involved. For most people, quality financial planning is worth the price tag.

But how can clients determine if a pricing model is fair? And how will they know if a particular pricing model is right for them? To clarify the confusion, let’s talk about different ways a financial advisor could be compensated AND which methods make sense for certain types of investors.

Two Compensation Models to Avoid

There are several legitimate, ethical compensation models for financial advisors. However, before discussing those, I want to touch briefly upon two models to avoid: commission-based and fee-based.

When a financial advisor is paid a commission or is incentivized by bonuses or prizes, it will shape their financial advice. Commission-based advisors are pressured to recommend products or services that make them the most money instead of making recommendations that only benefit the consumer. Similarly, some financial advisors may be compensated by both fees AND commissions. Fee-based advisors may charge a flat fee—perhaps an hourly rate or a percentage of assets under management—but they can also charge additional commissions. Some of these commissions may be hidden, so consumers may not always realize a commission is being earned. In short, if a financial advisor claims to be fee-based, know that sales may likely make up part of their compensation.

It’s best to avoid commission-based and fee-based models and opt for one of the following fee-only models, which I will discuss:

Fee-Only Models

Hourly Rate

One straightforward and easy-to-understand compensation model is the pay-by-the-hour model. In this model, a financial advisor charges for time spent on client services. The hourly rate will vary depending on the advisor’s experience, geographic region, and expertise. You can expect to pay anywhere from $150-$300/hour for the service of a qualified financial planner, and sometimes higher.

For some people, an hourly rate makes sense. Consumers with straightforward financial planning needs or only a few questions would likely benefit from an hourly compensation model. In these cases, the consumer may briefly meet with a financial advisor, gain some insights, and then part ways.

However, many circumstances are too complicated to be thoroughly addressed during one or two meetings. And those hours can add up quickly! For many investors, choosing a more comprehensive and all-encompassing model makes sense.

Project Fee

People often approach us after working with a commission-based financial advisor. They soon discover that some commission-based advisors are trying to sell them products rather than provide advice where biases are kept in check. After learning about this situation, we propose developing a comprehensive, evidence-based plan for them. They may think they already have a financial plan, but was that plan unbiased and comprehensive?

The simple truth is that when commission-based financial advisors are incentivized to push or promote certain products, they’ll probably do it. It can be difficult to fully trust any financial guidance that commissioned-based advisors offer, including “customized” financial plans that are prepared for the sole purpose of selling financial products. To get a personalized financial plan, it might make sense to pay a project fee. If you don’t have a large enough portfolio to justify money management, you could still benefit from holistic, comprehensive financial guidance.

For comprehensive financial planning firms, developing a financial plan involves an approximately two-hour-long diagnostic meeting in which a team of financial planners interviews the investor. Multiple advisors with various backgrounds and specialties work together to create a personalized plan using the information gathered at the meeting. The plan is presented to the investor, and the financial advisor addresses any follow-up questions or concerns. For such in-depth and involved work, it absolutely makes sense for the client to pay a project fee, rather than an hourly fee.

This example shows how project-based compensation might work. Other project examples may include a focus on estate planning, tax advice, financial coaching, and more.

Asset-Based Fee

A third common compensation model involves a financial advisor charging a percentage of assets under management (AUM). With this method, the investor pays a certain percentage of the value of their investment portfolio each year. The rate or percentage may vary depending on the type of asset (stocks, bonds, real estate, etc.), the complexity of the portfolio, and the total AUM.

In my experience, an asset-based fee makes sense for those with a high net worth seeking ongoing money management services (hopefully in tandem with comprehensive financial planning guidance). It can be challenging to track, manage, and rebalance one’s assets if they are wide-ranging and diverse.

For ongoing investment management, charging an asset-based fee has become industry standard. This model came on the scene when mutual funds were first introduced in the early 20th century, and it hasn’t changed much since then. Because, frankly, it works. When the market is doing well, and a client’s wealth increases, the fee will rise accordingly. If the market is in a prolonged slump, the client’s fee will also decrease.

Retainers

A less common advisory fee model is the retainer. If the client wants to pay a flat fee that isn’t tied to market performance, they might have the option to do so. A retainer-based structure usually involves ongoing fixed fees that may be charged monthly, quarterly, or annually. The fee is often based on the complexity of the client’s portfolio and/or complexity of the required services.

In my experience, this option could make sense for high-net-worth individuals who do not want their fees tied to market performance. Not every financial advisory firm offers this option, but many will consider it for individuals whose assets meet a certain minimum threshold.

It is essential for clients to think about which compensation model best suits their personal needs and circumstances and will be most cost-effective for them. Ultimately, the best fee model for a client will depend on the complexity of their specific situation and the services they require. In some cases, a combination of different fee structures may be most appropriate. With the help of a qualified financial advisor, a consumer can evaluate the various fee models and come to the best decision for their individual circumstances.

 

 

Learn more about David Bromelkamp

 

Hello! I’m Dave, the founder and chief executive officer of Allodium Investment Consultants, located in Minneapolis, MN. I am also the author of AdvisorSmart for the Individual Investor: Your Guide to Selecting a Financial Advisor to Get Better Financial Advice. I enjoy educating individual and institutional investors about financial planning and investing. When I’m not helping people make investment decisions, I enjoy traveling, hiking and spending time with my wife and family.

 

 

The information provided is for educational purposes only and is not intended to be, and should not be construed as, investment, legal or tax advice. Allodium makes no warranties with regard to the information or results obtained by its use and disclaim any liability arising out of your use of or reliance on the information. It should not be construed as an offer, solicitation or recommendation to make an investment. The information is subject to change and, although based upon information that Allodium considers reliable, is not guaranteed as to accuracy or completeness. Past performance is not a guarantee or a predictor of future results of either the indices or any particular investment.