How Your Financial Advisor Makes Money

Have you ever specifically asked your financial advisor how much you pay them each year? They might say that they get a small amount from the funds in your account. Or maybe they told you that they get a percentage of the amount of money they manage for you. Either way, this leaves their total compensation pretty vague. If there’s anyone who should know the cost of your portfolio, it’s you. 

2 Ways Advisors Are Compensated

There are two main ways that financial advisors are compensated - commissions on products or fees you pay the advisor. If your advisor receives payment from the investment or product that he or she sells you, they are receiving a commission. Rather than your advisor receiving compensation from you, they get paid by the fund company that they’re recommending for you. (For more, see: How to Find the Financial Advisor of your Dreams.)

In this situation, as an advisor, you discover that there’s a couple different investments that might be suitable for a new client. However, you might receive a 5% commission if you put the prospect in one type of investment or a 7% commission if you put the prospect in s similar, but different, investment. The problems that this scenario creates are obvious and this happens every day in advisor offices around the country.

Commissions create conflicts of interest and can be harmful to the investor. In the last five years, the word fiduciary has come up often in the financial planning world. The fiduciary standard mandates that an advisor is legally bound to providing the highest standard of care and must always put his or her client’s interests above their own. It aims to prevent advisors from making product recommendations and investment decisions based on the payments, or commissions, they will receive.

How Fiduciary Advisors Get Paid

Fiduciary advisors are paid by their clients, but the fees they are paid can come in different forms. Clients might pay a financial planning fee. A financial planning fee is an upfront charge that you pay your advisor to create a financial plan for you. This financial plan can cover topics such as retirement planning, college planning, insurance planning and more.

You are hiring the advisor to take a few hours of their time to understand your goals and create a plan to show you how to accomplish those goals. You might also pay a monthly fee to work with this advisor on an ongoing basis to help you stay on track with your plan. Then, when your circumstances or goals change, your advisor is there to help you update your plan.

The most common fee-based compensation method advisors are using today is charging a fee based on the investments that they are managing for you. The advisor will typically charge a percentage of what he or she is managing for you. Say, for example, this fee is 1%. If you have a $250,000 portfolio and you pay your advisor 1% then you are paying them $2,500 per year, or $250,000 x 1%. I typically see fees range from 0.6% to 1.5%, although they vary. (For related reading, see: The DOL Fiduciary Rule Explained.)

The Difference Between Commissions and Fees

The difference between paying commissions versus fees is in the incentives they create. An advisor that receives commissions is inherently incentivized to recommend products that pay the highest commissions. An advisor that charges a financial planning fee or an investment management fee is incentivized to do a good job for you. This is because they only continue to receive their fee if you stick around and keep working with them.

How can you find out what that fee is? A 1.25% advisory fee might not sound like a lot. But what does that represent on a $1,000,000 account? It comes out to $12,500 per year. It could be that your advisor is providing that much value to you and your plan and I certainly hope that they are. However, these costs must be clearly articulated to you when you start working together. If you don’t know what you’re paying your advisor and you are curious, you can ask them directly. They should send you a fee schedule. 

Most advisors today actually operate as what is called a “fee-based” advisor. Not to be confused with a “fee-only” fiduciary advisor, a fee-based advisor can charge clients under either the commission structure or fee structure. Depending on the client and situation, a fee-based advisor can choose whichever payment structure he or she would like. Don’t assume that because your advisor says they’re fee based, it means they legally must put your best interests ahead of their own.

How can you tell if your advisor can charge commissions on your investments? Ask them if they are registered with a broker-dealer. If the answer is yes, then your advisor is not operating as a fiduciary to all of his or her clients. True fiduciaries and fee-only advisors do not receive any commissions for the advice they give and do not have an affiliation with a broker-dealer.

Trading Fees and Fund Expenses

Just because you know how your advisor gets paid it doesn’t mean that you know the whole story. On top of the fee that you pay your advisor, there are other costs and expenses involved in investing your money. These costs exist whether you work with an advisor or not, but your advisor should help you keep these costs as low as possible.

Anytime you buy or sell a stock, mutual fund or exchange-traded fund (ETF) you might be paying a trading cost. These costs can range from $10 per trade up to $50 per trade. The trading costs on your funds will depend on where you hold your investments (TD Ameritrade, Fidelity Investments, Charles Schwab Corp., etc.). These companies, known as custodians, make their money through trading costs so it’s important that you work with a custodian that keeps costs low.

Another cost is the internal expense of funds. Pay attention to this one. Unless you enjoy reading through pages and pages of prospectus materials (the legal language that outlines the fees, objectives and performance history of mutual funds and ETFs), then you probably don’t know the actual internal cost of the funds that you’re invested in.

What is an internal cost? It’s the cost associated with the management and operation of the mutual funds or ETFs that you invest in. All mutual funds and ETFs have an internal expense. If the internal cost of your funds is anywhere near 1% or higher, you should have a conversation with your advisor about the reason for this. There are good mutual fund and ETF managers that offer funds with internal expenses between 0.05% and 0.40%, so it should be hard to justify paying more than that.

I believe wholeheartedly in the value of a good financial planner but think it's important that clients are aware of how much they are paying them. (For more, see: Fee-Only Financial Advisors: What You Need to Know.)