There’s a lot of confusion and misinformation out there about how financial planners are paid for the services that they provide. Compensation models are more important in the financial planning industry than in many other fields, because the structure used can have a significant impact on the objectivity and quality of the financial advice given to clients.
How do financial advisors get paid?
There are three basic models for how financial advisors are compensated:
Commissioned financial advisors are paid when they make a sale of specific investment or insurance products. The amount of the commission is typically based on the type of product sold and the amount of money that the client puts into the financial product. Some examples of financial products often sold for commissions are annuities, life insurance, and mutual funds. This group would include people like stockbrokers and insurance agents. Any financial advice that they give to clients is deemed to be “solely incidental” to the sale of the product, and the salesperson is held to a fairly low legal standard called “suitability” to ensure that the products are not egregiously inappropriate for the client’s specific financial situation.
Commissioned advisors are not usually required to disclose to clients the amounts of the commissions that they receive or to describe any conflicts of interest that may exist. This means that they may be selling financial products which are best for them, and not for you. This model is the most predominant of the three options by a large margin. That is starting to change, however, because of greater consumer awareness and regulatory scrutiny.
Fee-only financial planners are paid directly by the client for the advice that they give, and do not receive compensation from any other third-party agreements. This ensures their objectivity, and that they are incentivized to act in the best interest of their clients rather than their employer. Nearly all fee-only financial planners are subject to a strict fiduciary standard, which imposes both ethical and legal obligations to put their clients before themselves.
Fee-based financial advisors are a hybrid of the other two options. They often charge clients fees for investment management or financial planning, but also still receive commissions for selling products such as insurance policies or variable annuities. Similar to commissioned financial advisors, they are not usually required to disclose the amounts of commissions or other conflicts of interest.
Why should I hire a fee-only financial planner?
Contrary to popular belief, most financial advisors are not legally required to act in the best interests of their clients. Though many commissioned financial advisors DO act in their clients’ best interests, the potential always exists for abuse and some of them regularly take advantage of clients who don’t know any better. Working with a fee-only financial planner ensures that they are providing objective advice, so you can have confidence that the recommendations they make are for well-founded reasons.
Would you rather visit a doctor who is paid to assess your medical situation and give professional advice based on what he’s learned in medical school and from treating patients over the years, or visit a doctor who is paid by the pharmaceutical companies whose drugs he sells? Consider applying this same framework when selecting a financial planner to work with. There’s nothing necessarily wrong with receiving commissions for a sale, but problems do arise when receiving advice from salespeople trying to make a sale.
How do fee-only financial planners charge clients?
There are a few different ways that fee-only financial planners charge their clients:
- Hourly – Similar to how you might pay your accountant or attorney, many fee-only financial advisors simply charge by the hour for services provided to clients. This model is more common for limited projects of a defined scope than it is for ongoing financial planning services.
- Assets Under Management (“AUM”) – More commonly for investment managers, they may charge clients a percentage of the investment portfolio that they manage. A fee of 1% per year is a common benchmark, though there are a wide range of options depending on the advisor and the types of services that they include. Fees will often decrease to lower percentages for larger accounts.
- Flat – A simple, pre-defined amount that the client pays for either a project or for ongoing advice. Some advisors charge every client the same amount, some may vary the fee based on the complexity of the client or the client’s net worth or income.
“It is difficult to get a man to understand something, when his salary depends upon his not understanding it!”
– Upton Sinclair