Money topics are high on American’s minds, but rarely discussed in a meaningful way.
While investing is a popular party topic, people are more willing to discuss controversial topics such as politics and religion than the inroads they have made in their long-term financial future. According to 2023 Harris Poll research commissioned by Empower, 71% of Americans said they bought a lottery ticket, and 24% of millennials said they’ve spoken to a fortune teller, but only 33% of Americans have spoken with a financial planner.
While Congress, the Securities & Exchange Commission and other regulatory bodies have worked diligently to make investing more consumer-friendly, the resulting required disclosures have not alleviated the challenges consumers face in understanding how much professional investment advice costs. Even when a financial advisor is refreshingly transparent about fees, it can also be a challenge to determine the real value of that advice. What makes the task even more daunting is that there are myriad ways clients can be charged.
Currently, advisors can be compensated in five distinct ways. There is no superior method, although advisors may use their preferred compensation structure as a means to differentiate themselves from their competitors.
Each client’s situation is unique, and they should consider an advisor they are comfortable working with from a compatibility perspective, as well as the right compensation structure. Keep in mind that some clients may not have the funds to pay an advisor as they may ideally desire. These clients may choose to start with one compensation structure and grow into a completely different one over time.
Here are the key factors you must keep in mind before hiring a financial advisor:
- Compensation structures.
- Financial advisor fees vs. investment product fees.
- Robo advisors.
- Ongoing invoices.
If you are not writing a check directly to the financial advisor, then it is important for you to know how they are being compensated for their advice and recommendations. Financial advice is not free.
A financial advisor is compensated with one of these five compensation structures:
A registered investment advisor, or RIA, is compensated based upon their advice. They can only charge fees, and the most prevalent structure is the assets under management, or AUM, model. AUM fees are calculated as a percentage of the assets they manage and can be charged on a yearly, quarterly or monthly basis for as long as the advisor has a relationship with the client.
A 2021 AdvisoryHQ survey showed that an AUM of just over 1% is common.
A 1% AUM fee means that a client will initially pay an annual fee of $10,000 to work with an advisor on an investment portfolio of $1 million. However, the client’s portfolio value at the beginning of the year will change, based upon market returns, new investments, distributions and other factors. So, while the AUM percentage will remain the same, the actual fee will vary based on the increase or decrease in the managed assets.
While 1% is the most common percentage charged, there are many factors that go into an advisor’s choice of percentage. The percentage can be as high as 3% on smaller accounts, as they can be labor-intensive for advisors and challenging to manage profitably. The percentage may decrease to as low as 0.25% for high-net-worth clients. When a client has substantial assets, typically over $5 million, advisors will often negotiate the fee with the client.
The AUM fee is in addition to the investment fees associated with any recommendations, which can vary widely.
An advisor must disclose both their AUM fee structure and the benefits it covers. They do so in a Form ADV Part 2A, a disclosure document that they must deliver to the client at the beginning of the relationship. This document is updated regularly and must be easily accessible to the client. While regulators require disclosure, these forms are not always easy to understand by the public, so do not hesitate to ask your advisor the dollar amount your account will incur, versus a percentage.
A registered representative, or RR, will receive compensation from the sale of products that they recommend. The company that offers the products compensates the advisor for recommending its financial solutions.
The client will not receive a regular bill, but they will pay for the advisor’s expertise within the product itself or in stiff fees to exit the product early. These costs are detailed in a prospectus, which is required to be delivered to the client at the beginning of any product sale. Some products will outline the features and benefits in an illustration, which is a multi-page document. Some products may require the illustration to be signed before the transaction is considered complete.
The costs may be referred to in the documents as expenses or loads. The percentages will likely be higher than an annual AUM fee, but they may be payable for a shorter duration. The percentage may be a higher amount in earlier years, also known as heaped, or spread out over a longer time frame, known as levelized. Thus, it is important to ensure that the factors are properly aligned before comparing costs over the first year, the total time duration of the desired investment and other milestone dates.
A prospectus is updated annually with a required notice to the client. An inforce illustration can be generated after a product is sold and will reflect the actual performance of the product since the date of sale and then a fresh projection of potential future values. The advisor will typically request inforce illustrations as part of an ongoing review assessment with their client.
Fee-based or Hybrid
Some advisors may choose to implement their firm’s recommendations through a hybrid arrangement, using both the AUM advice and commission-based product models. An advisor who chooses to do so must take extra care to explain both compensation structures clearly and completely to the client. Additionally, they must continually ensure that the client is aware when the recommendations are under the standard of client care required by an AUM fee versus a commissionable product, which differs.
Flat, Hourly or Project Fee
Flat, hourly and project fees are newer forms of compensation designed to make professional advice more accessible to younger clients with fewer assets and older clients who may be drawing down their investments to pay for their living needs in active retirement. Flat fees are also gaining acceptance for clients who simply prefer a level fee structure instead of one that changes as their assets rise and fall.
Flat and hourly fees are comparable to the rates that a CPA or attorney may charge for their services. As with the other types of fee structures, the advisor must detail what services are covered with these alternate fee structures in their Form ADV.
Project fees or per-plan fees align well with unique situations, such as saving for a child’s wedding, where the timeframe is a much shorter duration than longer-term life events such as retirement. Project fees may also cover strategic documents, such as a financial plans created for retirement, estate transfer or a business exit strategy.
Much like AUM, these fees are fully disclosed in the firm’s ADV Part 2A documents required to be given to clients in the beginning of their relationship.
These fees are most frequently present in qualified retirement plans, such as a 401(k) offered by a client’s employer. Much like commissions, the product provider is compensating the financial advisor, so the client does not readily see a fee being paid.
Financial Advisor Fees vs. Investment Product Fees
When a professional advisor makes a financial recommendation, there are two parties that must be paid.
A client is not paying twice for the same benefit; rather, they are paying all parties to the transaction.
- The advisor is receiving compensation for the human side of the advice.
- The financial solution also has fees associated with the investments secured to implement the recommendation. Investment fees may also be referred to as expense ratios and are also fully disclosed in the account paperwork.
Investment fees are added to the advisor’s fee to determine the total fee. So, a client may pay a 1% advisor fee and a 1% investment fee, for a 2% total fee.
Robo advisors have arisen as financial institutions and fintech entrepreneurial businesses attempt to profitably capture the attention of younger generations who may be working with smaller amounts of money as well as to reduce costs for more experienced investors. They are best utilized by clients who have straightforward needs and are less emotional about their assets.
These services typically follow the fee-only compensation structure and their costs are outlined in the new account paperwork required at the beginning of the relationship. Digital-only advice may cost as little as 0.2% to 0.35% plus investment product fees. However, depending on the additional services the financial institution may offer to customize the experience, the advisory fee may rise.
AI continues to rapidly improve and can rival human-based advice for some planning needs, but add-on services may actually create fees that exceed more personalized interaction. Therefore, a robo advisor may not always be the least expensive option. Additionally, many clients find that there can be complex feelings around their assets. While more expensive, the additional value from personalized human advice can guide them more comprehensively than a robo advisor.
In order to be paid, a financial advisor has to expense the client correctly. This can be a significant challenge for practitioners who are still calculating invoices manually.
As Lacey Shrum, founder of RIA billing software company Smart Kx says, “Advisors have an increased responsibility to their clients in that they calculate their own fees and pay themselves from the client’s account. It is important not only from a fiduciary standard and legal perspective that they charge an accurate fee, but also from a purely ethical standpoint.”
Errors are common, especially if the advisor has been open to negotiating fees, has revised their fee structure or offers multiple fee structures. Many advisors prefer to invoice annually in order to reduce the burden of paperwork, but this may inadvertently create more pressure on the firm if they are trying to complete large numbers of invoices during the holiday season.
Clients do not always feel pressured to check on the fees they are paying because they are primarily deducted directly from the investment account. The SEC and other regulatory bodies have stepped up their oversight to keep advisors from overcharging clients, even unintentionally.
Unfortunately, not only are clients potentially overpaying for services, but those funds are not staying invested, depriving them of the potential market returns on the difference.
Therefore, understanding the fees you are paying for services rendered may help you save lost dollars from billing errors. If you believe that you have been charged the wrong fee, you have every right to question your advisor and ask for an account reconciliation. Good advisors want to both run an efficient office and maintain excellent client service. Any pushback that you receive for asking about questionable fees should be a red flag.
In 2017, Congress passed the Tax Cuts and Jobs Act, which eliminated the individual tax deductibility of financial advisor fees. However, some provisions remain for trust and business accounts. The loss of tax deductibility under this act will sunset in 2025. At that time, Congress will determine whether the provision will be extended, revised or the deduction may be restored. Your advisor can refer you to a CPA or tax attorney to explore how the law applies in your situation, as well as work with you on other tax efficiencies in your portfolio to help offset the expenses of working together.
There’s no shame in asking an advisor about what they make managing your assets. Much like government employees whose salaries are public knowledge, a financial advisor’s costs are required to be fully transparent.
An astute advisor will give straightforward answers and favorably view this conversation as an opportunity to demonstrate their expertise and differentiation from their peers. For example, they may discuss why their niche market allows them to go deeper with their clients because of the specialized knowledge they can bring. They may also discuss other professionals they can bring in from around the country to address taxes, risk mitigation, insurance and subject matter expertise that may be included in those fees or available to the client in a different compensation option.
Advisors who charge under the AUM, or asset-based, compensation model may point to the concept that the parties are aligned in growing assets and that they avoid ethical conflicts as a result. With an AUM fee structure, an advisor makes more only when a client’s assets are increasing. However, clients may need to withdraw funds from their accounts as their goals and objectives change. For example, they may wish to purchase new assets, such as a vacation home, a boat or even life insurance, that may cause the account value to drop. As clients retire, they may need to shift from a growth model to principal management and monthly distributions to meet monthly expenses. An astute financial advisor will work with their clients to ensure that they are prospering under the best compensation structure to fit their revised needs.
- What is the total cost for me to work with you over this next year and what will I receive in return?
- If you only do better when my account grows, what actions are you going to take when the market suddenly drops?
- I understand that you will make a commission on this sale. How are you paid so that you will continue to take an interest in managing those funds for me?
At the end of the day, a client must find the advisor that charges in a way that best aligns with their investment needs, their reliance on the advisor and their own financial acumen or lack thereof. Once the client understands and accepts how they are paying for professional services, it is then up to the advisor to ensure that the value they bring to the table exceeds the compensation being rendered.