So, you have decided you want to leave the DIY behind and get some help with your money. That is until you start searching and find that you need a degree in finance just to understand the different types of services and fees.
Save yourself some time with this guide to the most common types of advisors, how they are paid and the duty they owe to you as their client.
Option 1: Sales-Driven Advice
Someone who sells products like mutual funds, bonds, insurance policies or annuities often receives a commission from the various products they recommend. They might receive a commission at the time you purchase their product, throughout the time you own it, or at the time you get rid of it.
Let’s say the advisor recommends that you buy $10,000 of ABC mutual fund. He or she may not mention the fund has an up-front commission of 5.75%. If you buy the fund, $9,425 of your money will be invested in ABC and $575 will be paid as a commission to the advisor. That means you must earn 6.1% on your money just to get back to the $10,000 you originally invested.
Pros: This can be a good way to access financial advice when you don’t have enough to hire a more expensive advisor or don’t need financial planning and other comprehensive services. This is often how people start working with advisors at large brokerage companies when they want nothing more than advice on specific buy or sell transactions.
Cons: Commissions often go unnoticed because they are deducted from the value of your investment. Advisors who are solely compensated this way are not typically held to a fiduciary duty. Instead, they must provide solutions that are suitable. A fund is considered suitable even it has a higher commission than a very similar alternative.
Option 2: Hybrid of Sales-Driven and Fee-for-Service
Often referred to as fee-based, companies may offer a hybrid of the traditional sales-driven approach in addition to providing investment or financial planning advice for a separate advisory fee.
Pros: Working under a hybrid arrangement can give you access to certain investment and financial planning advice that may otherwise be cost-prohibitive.
Cons: When acting in a sales capacity, advisors are governed by less stringent standards but when acting in an advisor capacity, they must put their client first. As a client, it is nearly impossible to tell when the advisor is acting in a sales or advisory capacity. Fee-based means that commission income is still part of the advisor’s compensation which could impact the advice they give.
Option 3: Fee for Service Based on Hourly Rates
Professionals who do not receive any commission income or referral fees are called fee-only advisors. There are numerous ways fee-only advisors get paid, one of which is being paid by the hour for their services. They may also charge a single fee for an entire project based on the estimated number of hours the project will take.
Pros: These services can be an affordable way to access fee-only financial planning and is especially good for people who can execute the advisor’s recommendations on their own and don’t want ongoing investment advice. The absence of sales commissions may increase fee-only advisors’ objectivity.
Cons: Clients who see value in ongoing monitoring of their plan and investments may not get that from hourly or project-based advisors. The sense of being on the clock can cause clients to avoid asking for help even when they may benefit from it. There are far fewer advisors that operate this way so they can sometimes be difficult to find in your area.
Option 4: Fee for Service based on Assets Under Management
Aside from sales-driven fees, the most common method of calculating fees in the financial industry is as a percentage of a client’s Assets Under Management (AUM). The fee is typically a percentage of your investment accounts that the advisor can invest for you, usually between .75% and 1.5% per year. AUM includes IRAs, Roth IRAs and brokerage accounts but does not include a 401(k) or other plans that cannot be moved until you leave your job.
Pros: Advisors who charge based on AUM are incentivized to grow your portfolio since their income will increase as the size of your portfolio grows. If the advisor is fee-only, none of their income will be tied to the recommendations they make.
Cons: Advisors that charge on AUM usually have minimum asset requirements that keep their services out of reach for many people. There are certain cases in which an AUM advisor may be incentivized to provide recommendations such as rolling over a 401(k) to an IRA because once the money is in an IRA it is considered an asset under management on which the advisor can charge. If the advisor is a fiduciary, they should not make a recommendation solely for this purpose.
Option 5: Fee for Service based on Assets Under Advisement, Net Worth, Income or Complexity
As advisors are offering comprehensive financial planning services that impact more than the investment portfolio, they are implementing fee structures that align with the holistic nature of their services. The advisor may consider the client’s 401(k) value, their home equity, their income, or other factors to determine an appropriate fee based on the complexity of the services they provide.
Pros: Rather than being incentivized to grow only the investment portfolio, fee structures based on net worth incentivize the advisor to grow a client’s total wealth, whether by investing or reducing debt. Charging fees on employer retirement plans or home equity enables advisors to work with clients earlier on in their life as these are the most common methods of beginning to build wealth.
Cons: Clients with significant wealth in home equity or employer retirement plans may initially find net worth or asset under advisement fees to be costlier than their AUM counterparts. Once a client retires and employer retirement plans are considered AUM, the fees tend to be more comparable.
There is no one-size-fits-all advisor but if you can identify the services you need, what you can afford and how important it is to have an advisor who works in your best interest, you can start to narrow the field of advisors to the one that is right for you.
Maybe more important than any of the information above is to remember that anyone who provides you financial advice should be able to explain their fees clearly and simply. If they can’t, it might be time to shop for another advisor who has your best interest in mind and has a fee structure that you can understand.
As originally published on Forbes: https://www.forbes.com/sites/danielleseurkamp/2020/08/27/the-truth-about-financial-advisors-services-and-fees/#27ec60dd570e