By Thomas Drew.
It's important to trust the people who give us financial advice and in order to trust them, we need to know how they are paid. Your advisor will shape your retirement, your lifestyle, and maybe even your children's education. It's important to understand how your advisor is compensated, so that you can look out for any conflicts of interest. Fortunately, the ways financial advisors are paid are relatively simple and can be grouped into 5 general methods: percentage of assets managed, commision, hourly, for a specific service, and by retainer. Let's look more closely at each of these payment methods and learn what they mean for you.
Assets Under Management (AUM): When Your Advisor Invests for You
If you want a financial advisor to actively manage your money, they will typically charge you a yearly fee that is between .75% and 1.5% of your portfolio size. As an example, an advisor managing a $1 Million portfolio will collect a fee of approximately 1% or $10,000 regardless of how well that portfolio performs. Although the price-tag may seem steep, these advisors relieve your burden of day to day management of your investments. The percentage that they charge is a management/advice fee that compensates for a variety of professional services, none of which is compensation for selling securities or advocating transactions.When an advisor manages your money actively, you will get:
Advisors who manage money provide a higher level of care so they can only service about 50-100 clients at one time. Since they dedicate so much time to each client, they almost exclusively handle clients with over $100,000 to invest.
Financial advisors can be compensated by earning a commission for financial products or services that you purchase. These advisors get paid when you purchase an annuity, a life insurance policy, or even when they reallocate the assets in your portfolio. These advisors typically represent a larger firm and are compensated like salespeople. While their advice will be biased towards their own firm, commission-based advisors are commonplace and they can be a good option in some cases.
It is completely reasonable to be leery of someone who gives you advice, but is paid by someone else. The incentive structure that many commission based advisors operate under can bias them towards giving you advice that might not be in your best interest. For example, if your advisor is paid when they purchase stock, they might be inclined to manage your portfolio very actively, which might not be what you want. Also, an advisor who gets paid to steer you toward particular investments will behave more like a salesperson than a teammate.
So why would you want an advisor who is employed by their company rather than by you? Imagine you are someone who knows what they want. Good salespeople give you the information you need to know and they help you actually complete the transaction. That's a valuable service, but it's not valuable for someone who does not fully understand their own needs.
Not every commission based advisor is looking to squeeze money out of you, but there are conflicts of interest that can complicate things. Be sure to ask your advisor directly how they are compensated. A good advisor will be upfront with you to alleviate your concerns.
Advice by the Hour:
Almost all advisors who are paid by the hour are fee only advisor (learn about fee-only advisors). Because these advisors are only paid to give you advice, they won't be swayed by conflicts of interest. In fact, many who give hourly advice are also fiduciaries, which means they have sworn to put your interests above their own.
Almost any advice can be offered on an hourly basis. You can get investment tips, learn how to limit your exposure to risk, or work towards a building a retirement plan. While the advisors will dispense guidance, you will ultimately be responsible for turning their recommendations into action.
Retainer: Complicated Financial Issues
If you have a complicated portfolio that requires frequent advice, it might make sense to hire an advisor on retainer. The way you interact with the advisor will be similar to an hourly fee model, but you'll be able to meet with an advisor more regularly, without the pressure of getting your moneys worth looming over your head. So who might find the retainer model userful? If you will be making major changes in your portfolio several times a year, it might make sense to be able to check in frequently. Having an advisor on retainer could also encourage you to stay on top of your finances. Seeing that monthly charge in your bank statement will remind you to use the services you are already paying for.
Payment for a Task: When You Have a Certain Project
Financial advisors can also be compensated for completing a project. For example, an advisor could put together an estate plan for you, fill out the documents, and hand the whole package over to you. Instead of charging an hourly fee for the services, an advisor might ask to be paid a pre-determined amount for delivering the goal.
Constructing a retirement plan is often charged as a pre-determined price. Having a price ahead of time prevents you from worrying about an advisor taking her time while charging you an hourly rate. You'll also know exactly what is expected so there shouldn't be any surprises.
Understanding how your financial advisor is paid is critical to being a well-informed investor. The best course of action is to be upfront with an advisor and ask exactly how she is paid. Once you understand the potential conflicts of interest, you'll be able to better interpret their advice and determine whether they are acting in your interest. Like the rest of life, clarity reduces future headaches.
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