How is your financial advisor paid?
There are essentially two ways your advisor can receive compensation for the services they provide to you: fees or commissions. Fees may be based on a flat rate or on the size of your portfolio. Commissions are based on the type and/or value of products or services your advisor sells to you or the number of trades he or she makes for you. The type of compensation your advisor receives may have financial and ethical implications so it is important to understand how you are paying for the service you receive.
Flat or percentage-based fees
Advisors who charge a fee are paid the same amount regardless of how many stock, bond or other securities trades are made in your portfolio (although some investment firms may impose an annual limit on the number of trades). Fees are most often based on the dollar value of your portfolio (assets under management) – often in the range of 1–2% – but there may also be hourly or flat fees for particular services. Fee-based advisors’ fees are for overall financial advice and management. If you don’t need broad financial advice and like to trade quite frequently, fee-based plans might not be the most efficient for you.
Advisors paid by commission are compensated based on how many transactions they carry out; that is, how often they buy and sell individual stocks, bonds and other products. If your commission-based advisor works for an investment firm, the firm likely has a fee of 1% of the transaction with a minimum fee per transaction, often as much as $125. If you tend to make frequent trades, commissions will eat away at your returns. If you invest in mutual funds, the commissions are called trailers and are a percentage of the value of the fund, usually 0.5–1% annually. This is similar to fee-based compensation but is not as visible.
What does the difference mean?
There may be nothing inherently wrong with charging commission, but it can present a conflict of interest. If an advisor is paid per transaction, the more trades they make the more money they make. And although the vast majority of advisors operate completely ethically, you may always wonder whether the trade is being suggested solely for the benefit of your portfolio, or whether the advisor may be considering his or her earnings from the transaction. Even subconsciously, commissioned advisors may recommend trades that may be of questionable value for the investor.
Another potential problem with commission-based fees is that advisors may neglect areas of financial planning that do not involve buying and selling financial products and focus only on your investment portfolio. These very important areas include overall wealth management; estate, tax and retirement planning; business planning and succession; the use of trusts for your heirs, and more. An advisor who is paid a fee based on something other than securities trading may be more inclined to pursue discussions with you about these other elements of your overall financial picture.
Importantly, because fee-based advisors charge based on the size of your portfolio, they have an incentive to help you grow that portfolio – so results matter much more than the number of trades.
The percentages for both commissions and fee-based costs may seem too small to matter much, but they can add up over the decades and as your portfolio grows. For example, if you pay 1% more per year in fees or commissions on a portfolio of $1 million, in 25 years that will amount to over $280,000. So even a fraction of a percentage point can make a big difference to how much you can save for your future.
Note that fees paid to your investment advisor related to managing your non-registered investments are tax deductible.
If you have believed that you are not actually paying your advisor, you are mistaken; they are getting paid somehow, you just aren’t aware of how. So ask some questions and find out. Check your investment statements. If you’re paying commissions, consider whether that creates a conflict of interest. If you have a fee-based advisor but feel you are not getting your money’s worth because you don’t trade frequently, look at whether your advisor is providing the other financial services they should be offering you.