It can be somewhat confusing how a financial advisor gets compensated for her time and financial specialty. Aside from perhaps an initial planning fee, the details of what you pay can be murky.
Quality financial advice is worth what you wind up paying for it - even more so when you are navigating through a tough financial decision. A financial advisor can help you decide the best investments to help you reach your goals, how much savings you need in retirement, or contingency plans if something unexpected happens or tragedy strikes.
While the theoretical value of a financial advisor is clear, why is his compensation such gray area?
Most financial advisors do not post their fees on their website. So where do you look to find the answer to this an important question that will not only help you better understand the value a financial advisor will bring to the table, but also help filter out the wrong type of financial advisor for you?
How are financial advisors compensated?
Here are two common ways financial advisors are compensated:
1. Fee-Only Compensation
Fee-only is exactly how it sounds. This type of compensation means that a financial advisor will have fees associated with the services they offer. If you hire a fee-only financial advisor, you may pay a flat fee or an hourly rate for a financial plan.
Also, if you have assets that you want a financial advisor to manage, fee-only advisors typically charge a percentage based on the total amount of money managed. For example, a fee-only advisor may charge a flat fee of 1% of your managed assets annually. Or, fee-only advisors may charge percentage of assets on a tiered schedule, meaning that the percentage they charge is based on a schedule at different asset amounts.
All fee-only advisors charge fees for their services, but how they do so varies from advisor to advisor so it is a good question to ask before you select your financial advisor.
2. Commission-Based Advisors
Just like fee-only compensation is exactly as it sounds – so, too, is commission-based compensation. A commission-based financial advisor is paid when he makes the sale – the sale of financial products, such as certain investment funds or insurances.
I would want to know if my advisor was receiving a commission for the financial advice he or she was recommending to me. It could be a strong indication of bias and you would likely want to consider a financial decision even more carefully to make sure that you are comfortable with any action you are about to take. This is a compensation model so different from the fee-based model that you really won’t find these two compensation methods operating under the same business. Commission-based financial advisors are only paid when they sell "commissionable" products to you, and so you will find them at the larger brokerage houses. They are less likely to be independent or working with a Registered Investment Advisory firm.
This is not to say that they do not provide good financial counsel or that they are not recommending the right products for you that are suitable for you. It just means that their advice is not 100% conflict-free and that is something you should be wholly aware from the very beginning.
3. Fee-Based (not to be confused with fee-only)
Lastly, a hybrid model exists that blends commission-based compensation and fees called “fee-based.” These financial advisors are paid by collecting fees for the services they provide and are collecting commissions off some or all of the financial products they use.
Where to Look for Confirmation
You don’t need to take your financial advisor’s word for it if you have any lingering doubts about how they are compensated after talking with him. All financial advisors are required to file what is called a Form ADV. They are also required to send these to their clients annually and make them available to the public on their website.
The Form ADV has 2 parts
According to the Securities and Exchange Commission: Part 1 requires information about the investment adviser’s business, ownership, clients, employees, business practices, affiliations, and any disciplinary events of the adviser or its employees. Although designed for a regulatory purpose, investment adviser filings of Part 1 are available to the public on the SEC’s Investment Adviser Public Disclosure (IAPD) website at www.adviserinfo.sec.gov. Part 2 requires investment advisers to prepare narrative brochures written in plain English that contain information such as the types of advisory services offered, the adviser’s fee schedule, disciplinary information, conflicts of interest, and the educational and business background of management and key advisory personnel of the adviser. The brochure is the primary disclosure document that investment advisers provide to their clients. When filed, the brochures are available to the public on the IAPD website.
What may be merely suitable in the case of commission-based financial advisors may not be the best choice for you. As a word of advice, select the financial advisor who has your best interests in mind! You can know this plainly when you discover exactly how a financial advisor is paid.
Chris Hardy - CFP®, EA, ChFC®, CLU®,