Surprisingly many people are not aware of what a financial advisor charges for their service. According to a survey by the Investor Education Foundation, 17% of investors do not know what they pay for investment fees. 60% of investors that work with a financial professional do not even believe they pay for investment advice at all.
While many investors that hire a financial advisor are not aware of what they truly cost, it is important to know because it can heavily impact long-term investment goals. The more money being paid out to a financial advisor by an investor equals less money to invest. The result can end up being thousands of dollars less than an investor might have been able to walk away with.
When it comes to paying a financial advisor, it is important to not only understand what it will cost but if the expense will be worth it.
What are the most common methods of how a financial advisor is paid?
AUM or Assets Under Management
One of the more popular methods financial advisors use today for charging clients is by the amount of Assets Under Management. How this works is the advisor for example will charge an annual fee based on the investment portfolio size of the client. If a client were to have $200,000 invested, the financial advisor might charge a 1% fee. The cost for this financial advisor would be $2,000 per year.
Financial professionals that charge based on a client’s investment size will many times charge a higher or lower fee depending on the amount of money. Because larger investment portfolios offer a bigger payout, the advisor will many times charge less for these investors. For example, an advisor might only charge .75% in fees for a customer that has a million dollars to invest while they could charge 1.25% for a client that has only $150,000 of investible assets.
The average fee based on an asset under management structure in 2021, according to Advisory HQ News Corp, was 1.02% for $1 million dollars invested. This comes out to an average annual fee of $10,200.
Flat Fee or Hourly Rate
Another way a financial advisor might get paid is through an hourly fee or flat rate by the plan they put together. It could also be a flat annual fee. It is estimated that advisors who charge a flat fee charge between $2,000 to $7,500 a year. An hourly rate can be expected at $100 and even more for a very experienced financial advisor. It is not uncommon to see financial advisors that charge as high as $400 per hour for their advice.
When it comes to investment professionals, they are frequently put into a similar earning category as an attorney and therefore their hourly rate is expensive.
Decades ago, earning a commission was the most common method by which a financial advisor was paid. The products they sold came with a sales charge. The problem with this is it incentivizes financial professionals to sell certain investment products that have the highest payout. For example, one mutual fund company might pay a higher sales commission than another or a certain type of investment might offer a larger payday.
The average upfront sales charge for a mutual fund today is typically between 3%-6%. If a person paid $10,000 for a mutual fund and the commission was 5%, the financial advisor commission would be $500.
Paying for financial advice through commission-based sales still exists today but it is not quite as common for several reasons. However, the main problem is how it likely is not in the best interest of the client.
What a financial advisor truly gets paid is almost always different than most investors realize.
Reviewing the different ways in which a financial advisor gets paid shows what a client will spend. However, it is almost always not what the advisor gets in the end.
The compensation structure for financial advisors is dependent on several factors and the brokerage firm they work for or clear the investments they sell through has a key role. Financial advisors often either work independently or are directly employed by a brokerage company.
Independent financial advisors typically work on their own. They might have their own office someplace and it is their responsibility to cover the operating expenses. In addition, an independent advisor could be covering their own retirement and health insurance benefits. For this reason, their payout agreement with the broker they clear their investments through might pay 90%-100%. If for example, this financial advisor earned a fee from a client of $5,000 in a year, the actual payout the financial advisor receives would be $4,500 to $5,000.
A financial advisor working directly for a brokerage firm would likely be earning less in fees and commissions. The reason for this is they would be considered an employee. As an employee the company the advisor works for would be paying for office space and employment benefits, such as health insurance. The agreement for this type of financial advisor when it comes to their earnings could be something like 50%-70%. A financial advisor considered an employee that earned a $5,000 fee from a client might only see $2,500 to $3,500.
The basic difference between an independent financial advisor and an employee is just this. The advisor that works on their own is considered an independent contractor covering all their own operating costs. An employee receives benefits and has lower costs to operate.
In addition to a financial advisor’s status as either working on their own or being directly employed, the money they earn from fees or commissions is many times paid out on a quarterly basis and not in just one big lump sum. A financial advisor that is due a fee from a client of $5,000 in a year would likely get $1,250 each quarter as opposed to being paid the entire amount annually.
When it comes to financial advisor compensation it is important to realize the advisor is seldom receiving the entire fee or commission. More frequently what occurs is there are several people getting a small cut from the brokerage firm to a possible branch manager.
What is the best method for compensating a financial advisor as a client?
There is no simple answer to which method of paying a financial advisor is the best one. It really depends on the service a person gets, the job of the financial advisor, and the amount of money a person pays. However, generally, the best approach is to hire a financial advisor that is independent. The reason for this is they will have a high interest in preserving their reputation because it consists of their entire business. Moreover, independent advisors are almost always less likely to be told to push certain investment products.
Although paying an advisor based on the amount of money a client invests is likely one of the most popular today, it is not always the best choice. Many arguments for this type of payout are not always true in the claims that are made.
Most people will say a financial advisor fee structure based on assets under management only incentivizes an advisor to do better for the client. This is not always the case. If a client is not interested in the growth of their portfolio but possibly focuses more on income, then a fee-based structure is not always the best.
Another problem with the financial advisor industry and fee-based investment portfolios is when advisors or advertisements overuse the fiduciary term. This term is an industry-standard some financial people have that is supposed to keep them to a higher standard and only look out for their client’s interests. The issue with this phrase is it’s used too many times falsely implicating it will always ensure a financial professional is honest.
All financial advisors are not fiduciaries. The ones that are designated as this are supposed to be held to a higher standard but it doesn’t mean they will not break that requirement. The idea a large number of fiduciary advisors try to put in the head of their customers is that they should be trusted more compared to just a typical financial advisor. This is a falsehood. They can break that trust just like any other investment professional.
Financial advisors that are held to a Fiduciary standard can be held accountable for actions that are not in the interest of a client. Yet, it is frequently difficult to prove. An advisor that is a Fiduciary will not be able to guarantee protection from losing money and it doesn’t assure a profit.
Assets under management can be a good way to compensate a financial advisor. But paying a flat fee by the hour or annually can also be a better choice depending on the situation. Commission-only financial advisors are almost always a bad idea because they will nearly always sell the investment products with the highest payout.
What should you expect from hiring a financial advisor?
At a minimum, a financial advisor will meet with their clients one or two times a year to review their portfolio. The amount of service almost always is dependent on the amount of money a client has invested. Customers with large investment portfolios will tend to receive better service and more of it. The reason for this is due to the fact they are paying more money for the advisor’s time.
If you are an investor with an average investment portfolio size, do not expect to be in constant contact with your financial advisor. It is also important to be aware most financial advisors today will have a minimum account size requirement. At least this is the case for more seasoned financial professionals. A requirement might be something like a client needing a minimum of $300,000 to invest.
An investor that decides to work with a financial advisor that works on a commission-only basis can expect to only be contacted when the financial professional needs to sell another product for a paycheck. With someone that doesn’t have much money, don’t expect to really hear from the financial advisor again once they have sold what they can.
Don’t expect above-average returns.
One of the biggest mistakes most investors make when they decide to hire a financial advisor is the idea that an advisor will achieve above-average investment returns for them. The truth is that over 80% of the time financial advisors will not outperform the market. Not even actual mutual fund managers beat market returns each year.
A good financial advisor might outperform the market but they will not do it over a long-term investment horizon. They will almost always average as good or even less in some instances.
Hire a financial advisor for the right reasons.
Hiring a financial advisor strictly for high returns is not a good idea. The result is going to be disappointing. A good financial advisor is valuable in the right situation. They can help with diversification and minimizing taxes. For an investor with a lot of wealth, a financial professional can be very useful. Because there are so many people that seem to be a financial advisor, it is important to hire one that is both qualified and trustworthy. Here is a good guide on important questions to ask a financial advisor you might be considering hiring 25 Questions to Interview Your Potential Financial Advisor.
Make sure the financial advisor you hire is earning what you pay them.
If you hire a financial advisor, it is important to set the expectation early. An advisor that does not give you the attention you desire is not going to work out well. If for example, a financial advisor claims they will review your investment portfolio twice a year and fails to do so, do not stay with them. The disappointment will likely only get worse.
Paying a financial advisor a fee based on the amount of money invested can get expensive. For this reason, it is important to ensure the financial professional is at least matching market returns after all fees. For example, if the market were to average 8% in a year and the financial advisor is charging a 1% fee, that advisor should have at least achieved a 9% return for your investment portfolio.
A financial advisor should be at the least averaging the return of the market. If not, it might not make sense to have a financial advisor. A good index fund that tracks something like the S&P 500 with a lower fee than 1% will do just as good of a job at a lower cost. This is unless that financial advisor is offering more services that are beneficial, such as in-depth diversification strategies.
Far too often investors will use a financial advisor that shows good investment returns but they do not consider the fees they are paying. You do not want a financial advisor that is making thousands of dollars off you in a year for a few portfolio reviews only to be losing money compared to market average returns.
Is hiring a financial advisor worth it?
Deciding to hire a financial advisor is a personal decision and can vary based on the investor. Yet, the truth is for most average investors today it might not make sense. The reason for this is the high cost of hiring a financial professional can take away from the compounding dividends and interest over the long-term of an investment. A good index fund can many times achieve the same results compared to hiring a financial advisor. This is due to the lower cost.
Another reason it might not be worth the cost to hire a financial advisor is due to the education and technology available today when it comes to investing. For someone that wants help investing, a Robo-Advisor can be a good alternative. These software programs can build investment portfolios similar to the service of a financial advisor but at a much lower cost.
The wealth of information on investing and the ease at which it can be accessed also makes it possible for investors to educate themselves on investing. There are so many places to get good information for someone to act as their own financial advisor.
A financial professional is only worth the cost for someone that has the true need for their assistance. This type of investor is someone that has the wealth for someone to watch over. They have the need for a financial professional and the money to pay them. An investor that truly needs to diversify their investments and minimize taxes. Most people do not have the accumulated wealth that requires this.
Financial advisors do not work for free and this is understandable. There is a cost to hiring a financial professional and most people are not aware of what the cost truly might be. Financial advisors are compensated in different ways but frequently their earnings are based on the size of a client’s investment portfolio.
There is no right or wrong answer to the best method of paying a financial advisor. It really depends on the investor and the advisor. However, paying by the hour or based on assets under management is regularly a preferred method with a financial advisor that is independent. Commission-only based financial advisors should generally be avoided.
The cost of a financial advisor is only worth the cost when they can at the very least match average market returns after their fees. A financial advisor that is competent with investment diversification and minimizing taxes that can perform well might be worth the cost to the right investor. Yet, most average investors are many times better off on their own due to the cost of hiring a financial professional.