You are in great company if you have no clue how much you are paying for your financial advisor’s advice.
In 2017, a Harris Poll survey found that over 60% of respondents had no idea how much in fees they were paying on all their money accounts, nor how the fees were charged.
Given that you need professional help with your banking, investments and retirement, it’s no surprise that you may not understand how much that advice is costing you.
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. What makes their task even more daunting is that there are myriad ways clients can be charged.
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Advisors can be compensated in multiple ways, which can make any discussion about fees challenging. There is no superior method, although advisors may use compensation 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. Additionally, some clients simply 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
— Non-Human Advice
— Ongoing Invoices
— Deductibility
— Transparency
Compensation Structures
Fee-Only
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.
An AUM fee of 1% is quite common. This means a client will initially pay $10,000 annually 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. So, while the AUM percentage will remain the same, the actual fee will vary from year to year based on the increase or decrease in the managed assets.
The percentage can be as high as 3% on smaller accounts, decreasing to as low as 0.25% for very large accounts. Smaller accounts often have a higher charge because they can be labor-intensive for advisors and can be challenging to manage profitably.
An advisor must disclose both their AUM fee and the benefits it covers. They do so in a Form ADV Part 2A 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.
Commission
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 or an illustration, which is also required to be delivered to the client at the beginning of any product sale.
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 as many 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, or realistic snapshot of lifetime performance, can be generated after a product is sold. The advisor will typically request this 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 product models. An advisor who chooses to do so must take care to explain both compensation structures clearly and completely to the client. Additionally, they must continually ensure the client understands whether the recommendations at hand are fee-only or a commissioned solution.
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.
Project 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 documents given to clients in the beginning of their relationship.
Wrapped Fees
These fees are most frequently present in qualified retirement plans, such as a 401(k), from a client’s employer. Much like commissions, a company is compensating the financial advisor, so the client does not readily see a fee being paid.
If you are not writing a check directly to the financial advisor, then it is important for you to know where they are being compensated for their advice and recommendations. Financial advice is not free.
Financial Advisor Fees vs. Investment Product Fees
When a professional advisor makes a financial recommendation, there are two parties that must be paid.
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. A client is not paying twice for the same benefit. Rather, it is like ordering à la carte from a restaurant menu.
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.
Non-Human Advice
Financial advice continues to be available from a variety of advisors, including artificial intelligence.
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.
These services typically follow AUM guidelines, and their costs are outlined in the paperwork 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 institution may offer to customize the experience, a robo advisor may not always be the least expensive option.
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.
Ongoing Invoices
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.
Deductibility
In 2017, Congress passed the Tax Cuts and Jobs Act, which eliminated the individual tax deductibility of financial advisor fees until 2025. However, some provisions remain for trust and business accounts. Your advisor can refer you to a CPA 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.
Transparency
There’s no shame in asking an advisor about what they make. Much like government employees whose salaries are public knowledge, a financial advisor’s compensation structure is required to be fully transparent.
An astute advisor will give straightforward answers and 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 in their mutual interests. 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 compensation model may point to the concept that the parties are aligned in growing assets. In AUM, an advisor makes more only when a client’s assets are increasing. However, a quality advisor may recognize that a client’s needs have shifted from growth to principal management due to retirement. This may require a different compensation structure in order to best fit the client’s evolving needs.
Here are three questions that advisors can expect to hear from prospective clients:
— “What is the total cost for me to work with you over this next year? 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? You can’t control that and I am going to really want your help even though you will be getting paid.”
— “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 compensation choice 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.
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What to Know About Financial Advisor Fees and Costs originally appeared on usnews.com
Update 01/19/23: This story was published at an earlier date and has been updated with new information.
