Financial Advisor Compensation: A Primer
Charles Schwab is known as a giant in the industry not just for its commercials but lately its subscription service payment option for the financial services it provides--namely, for providing financial planning advice. The linked commercial highlights a common problem in financial services: the shroud over advisor compensation. In this post, I break down the different ways advisors are compensated as well as the pros and cons of each.
The modes are many
Historically, financial planners were stock brokers who worked in wire houses and bucket shops, places where stock quotes were often written or posted on boards and the ticker tape rattled on during trading hours. Commission was the name of the game and still is for many advisors. Then, fee-based agreements became popular. Various hybrid models still exist, comprising some combination of commission and fees. Most recently, subscription-based services have cropped-up; Only time will tell if this is a passing fad or an evolution of compensation for financial advisors.
Today, advisors who charge commissions usually have insurance licenses through the state department of insurance or securities licenses through the Financial Industry Regulatory Authority (FINRA). The advisor is limited as to which products (s)he may sell a client based on the licenses attained. Like all licenses, there is an education component, background check, an exam, and continuing education and fees to maintain them. These individuals are typically held by what's called the suitability standard, which means that the client in question must fit a specific profile in order to be eligible for a specific product. If the client doesn't fit, the advisor shouldn't sell him or her that product. An example is a mutual fund that focuses on growth. These funds are typically riskier because they invest in newer stocks that have room to grow. This fund might be suitable for a young, risk-hungry investor but not a senior citizen who is on a fixed income. The downside to commission-based compensation is that, once the suitability test is met, the advisor is pretty much free to select whichever product (s)he believes benefits both the investor and him/herself. So, if two products are similar, and both pass suitability, the advisor can sell you the one that pays a 4% commission instead of the one that only pays 2%. Sometimes, this is material for the client because some companies pay the advisor out of the client's funds, but not always. The benefits of transactional compensation is for savvy, sophisticated, and well-disciplined investors who know precisely what they want and do not need investment advice. Another benefit: commissions enable advisors to help the less wealthy. If you're just starting out and can only put away $50/month, the only advisors who will engage you are those who are paid on commission because there's not enough money (yet) for others on which to base their fees. If commission-based business were outlawed, those who would suffer the most would be lower income individuals. Unfortunately, pro bono financial advisors number far less than, say, attorneys and legal centers.
In terms of investments, advisors paid on commission are known as "registered representatives." By contrast, advisors who are able to charge fees on accounts, including assets under management (AUM) are usually known as registered investment advisors (RIA) if they are the employer and investment advisor representatives (IAR) if they are an employee of an RIA. As the name implies, these advisors charge fees usually based on the account's value. One benefit of this is an alignment between the interests of the client and the advisor. If the advisor does well and makes the client money, then the advisor's compensation will likewise increase. If the advisor performs poorly, his/her compensation will dwindle because it is based, as a percentage, on the advised funds. Normally, the rate decreases with the account value. For instance, a fee schedule may look something like this:
< $50,000 1.75% $50,000 - $250,000 1.5%
$250,000 - $2 million 1%
$2 million - $10 million 0.5% > $10 million 0.25%
This incentivizes investors to place more money under a single advisor and penalizes spreading the wealth out over multiple ones. The downside of fee-based compensation is that it can become quite expensive relative to the work being done. Suppose (using the table above) your advisor manages $1 million of your money. After the initial consultations and meetings, your advisor sends you quarterly statements, calls you twice a year for a few minutes, and meets with you in-person for an annual review of your accounts. Is that worth $10,000?
NEW! Subscription-based services
Not unlike Netflix or other monthly programs, the subscription form of compensation charges clients on a monthly basis, often in exchange for a set number of hours the advisor will (or may) spend advising the client. This phenomenon is too novel to illustrate diagram taxonomies and formal structures. The general percentage is based not on AUM but on the client's income, usually between 1% and 2.5%. For instance, in exchange for a few hours of availability or dedicated work each month, the advisor may charge a client 1% of income. Assuming a household income of $100,000 and total invested assets of $1 million, the subscription client would pay $1,000 per year instead of the fee-based client who is paying $10,000. Even if that particular advisor held a "use it or lose it" policy on the monthly hours, the client would pay only 10% of the AUM fees, and those dollars would come not from the account (which makes a BIG difference if that account is tax-advantaged in some way). Assuming the advisor performed the same amount of work for both clients, then clearly the subscription-based arrangement would be better for the client. But, all else is rarely ever equal.
So, which compensation structure is best?
That depends on many things, including:
* Investment horizon;
* The nature of the accounts in question;
* Risk tolerance; and
* Family/household dynamics.
To name a few. Keep in mind that this only pertains to the investments (and maybe retirement) portions of your financial plan. There are other challenges that pertain to other areas. Nevertheless, you want to ask your advisor the following questions:
1) How are you compensated?
2) Do you receive referral fees from other service providers?
3) Does your company?
4) What is your relationship with your company?
5) In the event my account crosses certain thresholds, how will that affect our engagement?
The particular answers to these questions themselves may not be good or bad, but they will help you make an informed decision before you choose to place your money and your trust with the advisor. Some advisors are required to disclose these facts to you, others aren't. It can be difficult to tell which is which and when an advisor owes you a certain level of care, but that is a subject for another post.