How Are Financial Advisors Paid? A Fee And Cost Guide

Posted by Jake Sadler on September 26, 2022

How Are Financial Advisors Paid? A Fee And Cost Guide

How are financial advisors paid? This is an important question to ask because it can directly impact your financial future. The source and structure of an advisor’s compensation can indicate where that advisor’s interests may lie, shedding light on any potential conflicts of interest that could possibly cloud their advice. Such conflicts could negatively impact the advisor’s ability to act in your best interest rather than their own.

For reasons we’ll explain in this article, there is no entirely conflict-free method of compensating financial advisors. There is, however, a spectrum of potential conflict along which financial advisory firms fall. Both advisors and clients can look to this spectrum to avoid and manage conflicts of interest to the fullest extent possible.

If this sounds a bit murky, try visualizing: At one end of the spectrum, conflicts of interest are ever present in each recommendation made by an advisor, because the recommendations are directly tied to their compensation. At the opposite end, the potential for conflicts of interest is reduced as much as possible, by virtue of a compensation model expressly designed to minimize them. In between there exists a middle ground, where advisors can at certain times make recommendations based on their compensation, and at other times make recommendations which avoid conflicts of interest. In this article, we’ll walk through these three most-common compensation structures for financial advisors, as well as how you can ensure the advice you receive has your best interests in mind.

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How are financial advisors paid? 3 Common Compensation Structures

The answer to the question “how do financial planners get paid?” can be confusing. Industry surveys regularly reveal that clients almost always assume their advisors are providing advice that’s in their best interest, even when this isn’t the case. This problem is largely driven by confusing, and often changing, terminology used to describe the role of compensation in shaping financial advice.

Even when consumers are aware of compensation’s role, it is easy to be confused by similar terms. For example the terms “fee-only” and “fee-based,” are often mistakenly used interchangeably. In reality, the two terms have markedly different meanings. Let’s dive into the definitions.

Fee-Only

Fee-Based

Commission-Only

The spectrum of financial advisors’ compensation structures.

1. Fee-Only

Fee-only financial advisory firms are compensated solely by their clients, and solely for services and advice—for example, advice in the areas of investment management or estate planning. They are not compensated for selling financial products, such as stocks, bonds, or insurance.

Nowadays, the financial industry in the United States largely adheres to the definition of “fee-only” set forth by the Certified Financial Planners’ (CFP) Board. The definition states that an advisor’s compensation must come exclusively from the client in order for that advisor to be classified as “fee-only.” The advisor cannot receive any third-party compensation.

In the past, a fee-only advisor could work for a firm in which someone else was selling insurance and brokering transactions for commissions. The advisor could provide fee-only advice to the client, and then “send the client down the hall” to another advisor in the firm to be sold products on commission. Today, however, in order for the CFP definition of “fee-only” to apply, the entire firm must adhere to the standards.

Fee-only firms can bill for their services in a number of ways, including:

  • Fixed Fee: Fixed fees can be calculated in myriad ways. For example, some firms charge set fee for a financial plan, often based on complexity. Other firms use detailed calculation methods, using figures like net worth, investable assets, and/or income to calculate the fee.
  • Hourly: A firm may charge $150 per hour for their work and provide you with a quote that states the work will take 10 hours to complete.
  • Assets Under Management (AUM): This is the most common fee-only compensation structure. The client pays a percentage to their advisor based on the total value of the assets the advisor directly manages for them—for instance, 1% of $500,000.

Debate exists in the financial industry around whether AUM is truly a fee-only service model. This is because there are inherent potential conflicts in an advisor-client relationship. For example, if you were to ask your advisor whether you should pay off your mortgage or leave a large sum of money in a brokerage account that they’re managing for you, your best interests would in that case oppose the advisor’s. It is therefore necessary for the advisor to clearly identify the potential conflict, do a corresponding analysis, and discuss options and objectives with the client before making a recommendation.

Such debate notwithstanding, the AUM model does fit the definition of “fee-only.” The reason is that fee-only advisors are required to provide fiduciary advice, and fiduciaries are legally obligated to act in their clients’ best interests. As such, when a potential conflict arises, the advisor is required to address and manage it. This is a way for the industry to have checks and balances in place.

2. Fee-Based

The fee-based compensation structure is a combination of the two other payment models: fee-only and commission-based. “Fee-based” refers to advice that you as a client are paying for in any number of ways, including via commissions on the sale of financial products.

For example, say an advisor is putting together a financial plan for you, you are paying for the plan, and the plan recommends a life insurance policy. Your relationship with the advisor relative to the life insurance policy differs from the financial advisory relationship, because an inherent conflict of interest—i.e., the potential for a commission if the advisor sells you the policy—surrounds the insurance.

Since there is little consumer awareness around issues like this, it is very common for consumers to seek out fee-based advisors when they’re really looking for fee-only advice.

3. Commission-Only

Commission-only advisors receive compensation for selling you certain financial products, such as insurance. This approach can be problematic because it calls into question whose interests the advisor’s advice really serves.

The commission-only model also may require you to pay your advisor a commission for making an adjustment to your investment portfolio, which could reduce flexibility in managing your investments or lead the advisor to continuously trade in the account to generate larger commissions

Plenty of commission-only professionals can and do provide prudent advice. Unfortunately, a few bad actors have neglected their clients and placed them in unsuitable situations resulting from conflicts of interest having motivated the sale of inappropriate products for a client’s specific needs.

How has compensation changed over the years?

The financial industry is experiencing a growing trend toward fee-only compensation, but this model is still only used by about 20% of financial firms. To complicate matters, the gray area of fee-based advice is getting larger. At the same time, the industry is seeing a big shift away from commission-only advice.

The financial industry is also trending away from the way it provided advice 30 years ago. Back then, it was a product- and sales-oriented sector. Over time, consumer awareness around conflicts of interest has led to change, and there is now an increasing demand for compensation structures that create the best environment for providing fiduciary advice. As a result, the industry is shifting away from broker-dealers and toward registered investment advisory firms, and there is a growing demand for fee-only services.

Which type of payment structure is right for you?

When asking, “how are financial advisors paid?” and “who should I work with?”, the answer comes down to whether you feel you can trust a particular advisor. That feeling of trust (or a lack thereof) is paramount.

That’s why it’s essential to understand the compensation structure in which an advisor operates. And it’s why advisors at fee-only firms, operating within a structure that endeavors to reduce conflicts of interest to the greatest extent possible, tend to inspire the most trust.

Find Out How An Advisor Is Compensated

Learning how an advisor receives compensation doesn’t have to be complicated. You can simply ask, “how are you paid?” This is a legitimate question, one that shouldn’t offend an advisor. You can also ask them to show you how their compensation model works, including all the fees you will encounter.

Pro Tip: All advisors must provide disclosures on compensation. Bound by law and professional ethics to discuss any and all fees that you as a client can expect, including any transaction costs, they will unfailingly comply. But the way they provide the information matters. It could, for example, be buried on page 97 of a 100-page contract. So it’s important to notice how an advisor brings these details to your attention. To what degree do they attempt to be transparent?

In addition, don’t forget to ask your financial advisor to let you know about any conflicts of interest they may have when it comes to working with you, and how they manage conflicts when they arise.

How does compensation work at Bay Point Wealth?

At Bay Point Wealth, we are a fee-only firm. We strive to be completely transparent about how we work with clients. Here, for example, is what you’ll pay for a variety of our services:

Investment Fees

After a complimentary consultation, you’ll pay us solely for our asset management advice and services, not for selling you specific investment products. Our AUM fee starts at 1% for managed assets up to $2 million and is reduced on a sliding scale as the level of managed assets increases. The fee includes our ongoing financial planning services as well as investment management.

Financial Planning Fees

We charge a flat rate to create a financial plan. Before we get started, we have an introductory conversation at no charge and will provide you with a cost estimate based on the scope and complexity of your personal situation, which we’ll dig into during your consultation. You can then reflect and decide if we are the best fit to help you reach your goals.

Tax Fees

Tax planning is included in our AUM fee. If you would like us solely to prepare your taxes, we’ll review your unique circumstances and determine our tax preparation fee. We’ll stick to whatever amount we provide you with in our estimate so there are no surprises.

Interested in learning more about how our team of trusted experts can help you? Schedule a call with us today.

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Topics: Financial Planning